Cost Management is an integral part of Project Management because all progress and actual costs will be measured against the budget. This process starts with planning and estimating costs to develop an approximation of the financial resources required to complete a Project. This process ultimately results in a budget and having a resource loaded schedule helps, but it doesn’t end there.
Before anything happens there must be a meta-plan about how cost management will be done through the establishment of policies and procedures. This documentation will guide the project team on planning, managing, executing, and controlling the project costs. Most organizations already have this documentation in place so it’s simply a matter of referencing those documents and sometimes tweaking things a little if needed.
One more topic before moving on, before Project Costs are planned there should already be a scope and baseline schedule so the project team knows what is supposed to happen and when it’s supposed to happen. The scope is decomposed into Work Packages and then assigned a summary level called a Control Account. Once we begin planning the schedule that information will be decomposed further into the individual tasks or activities that need to be performed to execute the project. In most cases it’s simply a matter of applying resources to that schedule to get a preliminary understanding of costs as a basis of estimation.
This introduction will focus on a few topics including:
- Project Costs & The Five Types of Costs
- Budget vs. Funding
- Reserve / Contingency Funds
- Cost Estimating
Project Costs & The Five Types of Costs
Simply put, anything that costs money on a project is a Project Cost. This can include employees, contractors, consultants, materials, travel expenses, etc. If it has a financial impact on the project, it is a project cost.
In identifying project costs, there are five major cost types: Fixed, Variable, Direct, Indirect, and Sunk. These cost types are not mutually exclusive so you can have direct costs that are also variable, or indirect costs that are fixed, and any cost that are realized are considered sunk.
- Fixed Costs: This cost type includes expenses that never change over the life of the project. Some examples include equipment rental, office space, etc.
- Variable Costs: These costs change depending on the amount of work that is performed on the Project and they include hourly labor, materials, supplies, etc.
- Direct Costs: Direct costs include charges that go directly against the project such as labor resources or materials specifically for the project.
- Indirect Costs: Indirect costs are incurred by the business and are not specific to any one project, and are often factored across multiple projects. Examples include administrative costs and overhead such as electricity.
- Sunk Costs: This includes any costs that have been applied to the project, or “sunk” into the project, and cannot be recovered.
Budget vs. Funding
The concept of Budget vs. Funding can be a bit vague. Budget is the entire costs anticipated for performing the tasks on the Project. Whereas Funding is when the sponsor or financially responsible party submits a payment to cover the budget, which usually happens in regular intervals.
For example on a 12 month project anticipated to have a total Budget of $100,000 the sponsor is probably not going to pay the entire $100,000 up front. Furthermore, the performing organization generally isn’t willing to incur the expenses involved to execute the project at risk of non-payment. So the sponsor may fund the Project in monthly or quarterly intervals and that money will be applied towards the actual costs of the project.
Why is this important to know? Because in certain environments there may end up being a disconnect between the Budget and Funding. For example, due to an administration change on a government project I was working on, our funding was cut in half while the budget remained the same. This put the project team in a position to prioritize tasks in order to maintain the critical path while knowingly falling behind on other tasks.
Management Reserve vs. Contingency Reserve
Reserves can be used to manage risks by providing additional funding if needed. There are two main types of reserves used on Projects: Management Reserve and Contingency Reserves.
- Management Reserves: Cost reserves built into the project but not a part of the Budget Baseline. It’s used to manage unidentified risks or “Unknown-Unknowns” and these funds are owned by Management and cannot be allocated without going through the formal Integrated Change Control process.
- Contingency Reserves: Cost reserves build into the schedule and is a part of the Budget Baseline and are generally located at the Control Account level. These reserves are owned by the Project Manager or Project Management Office and are used to manage identified risks or “Known-Unknowns”.
There are three primary ways to estimate costs depending on how much information is available, they are: Analogous Estimating, Parametric Estimating, and Three-Point Estimating. Please note that there are other methods available but are outside the scope of an introduction.
- Analogous Estimating: This technique for estimating costs of an activity is based on historical data from a similar activity or project. This method is used when there is limited amount of detailed information available about the project. Basically take a look at similar projects and make a best estimate.
- Parametric Estimating: This technique uses an algorithm to calculate cost based on historical data and project parameters. Parametric Estimating uses a statistical relationship between historical data and other variables like square footage to calculate an estimate for activity parameters.
- Three-Point Estimating: Finally, Three-Point Estimating identifies three scenarios: best case, worst case, and most likely scenario. Once the three scenarios are identified, then one of two methods is generally used to calculate the budget. The first method is a triangular distribution where E = (O + M + P) / 3 (where O=Optimistic, M=Most Likely, and P=Pessimistic). This creates an average of the three to establish the budget and create a cost baseline. The second method is the Beta Distribution where E = (O + 4M + P) / 6 (where O=Optimistic, M=Most Likely, and P=Pessimistic). Using the Beta Distribution allows for the most likely scenario to be weighted minimizing the influence of the optimistic and most likely scenarios.
Cost estimating can be an art as much as a science on some Projects and it’s considered best practice to leverage Subject Matter Experts who have some experience costing their products or services. It’s also a good idea to build contingencies into the budget. If you do add contingency budget into your estimates, be sure to show the customer and identify risks associated with the additional costs. Resist the urge to build contingencies it into the hours or materials, this will maintain transparency and trust from your customer.