CHAPTER 11

Project Cost Management in Practice

PAUL LOMBARD, PMP, CQM, PM COLLEGE

Project cost management is so easy and yet so hard. It affects many aspects of project work and is affected by factors within and outside the project. How do we overcome this problem? An important first step is to have an effective cost management system on your project. As you might expect, no single cost management system is correct in all cases, so it is more effective to speak in terms of the general attributes, or key elements, of an effective cost management system. The foundation of that system must be the guidance and procedures defined and promoted by your organization’s leaders. This guidance must also be coupled with the cost management needs of all the project’s key stakeholders. In defining the necessary elements of this system, you should remember that you may need to interact with elements outside of your project domain, so it is usually best to use generally accepted or recognized standards. The cost management knowledge area in the Project Management Institute’s Guide to the Project Management Body of Knowledge (PMBOK^® Guide) suggests a four-process cost management system: plan cost management, estimate costs, determine budget, and control costs.² These four processes, either formally or informally, should be considered for all projects, and they can be performed as discrete activities or combined as the needs of the project dictate.

PLAN COST MANAGEMENT

The first step in establishing your cost system is the plan cost management process. This planning process consists of actions taken by the project manager, usually with the project team, to define what the cost management system will look like on your project. To determine this, the team needs to think about the amount of rigor, or the degree of formality, it will want to implement. This means identifying the right mix of procedures, processes, reporting mechanisms, governance, documentation, and other methods deemed appropriate to ensure that all the elements of project cost (planning, managing, expensing, and controlling) are included and attended to. This requires the team to prepare by reviewing existing information in the organization such as current plans, existing standards and guidelines, the project charter, and the current operating environment. In essence, the team is discovering what exists already in terms of guidance and what is going on internally and externally that must be planned for. This discovery process cannot be limited to narrowly defined costs only. For example, a common dilemma today arises when companies buy expensive portfolio management software systems. The goal of a portfolio system is to provide automation that enables the leadership team to manage key investments. However, when that same organization does not have a consistent practice of program and project management, it becomes very hard to gather the data needed to support the portfolio system because there is no consistent process in place for producing the data. For this reason, some companies fail in their initial portfolio management efforts.

So, in defining the cost management system, project leaders should review appropriate inputs, use the right tools, make use of expert judgment, analyze all relevant data, and, during a good kickoff meeting, establish an effective cost management plan that is the right size for the project. Armed with this guidance the team is ready to perform the next step: cost estimation.

COST ESTIMATION

The objective of estimating cost is to “approximate the monetary resources needed to complete project activities.”³ For many years as a project manager, I thought the most common approach to estimating was PIDOOMA, an acronym for Pulled It Directly Out of Mid-Air. In other words, we guessed. Guesses are seldom based on reality, and clearly this approach is fraught with problems, because the game often becomes guess and guess again. Without clarity, the target result keeps shifting. How can projects be effectively managed if the target is constantly shifting? They can’t. A more disciplined approach is required. As a first step, review existing project and cost plans, especially the scope and schedule baselines, depending on the size of the project, and other plans and documents should be reviewed as well (e.g., the human resource staffing plan, the risk register, etc.). In addition, the team should review and consider any external factors that could impact the project, such as market segment information, economic trend information, and so on. After reviewing the relevant documentation, the team can begin to build the estimate. The goal is to achieve a project cost “baseline.” The baseline is the approved version of a work product (e.g., the project plan) that can be changed only through formal change control procedures and serves as a basis for comparison.⁴ It is an excellent tool for comparison, because when it is complete it functions as an “area of order” for the project against which the project manager can assess variation and deviation from the plan. Without it, there is no context, and variation does not appear to exist. To create this baseline, the team must first develop a cost estimate. Although many estimating tools and techniques are available, the collection of common activities performed fall into two general categories: estimate development methods and estimate verification methods.

Estimate Development Methods

Methods employed to build and sustain the cost estimate include the following:

Expert Judgment. In this method, one or more “experts” are solicited to analyze characteristics of part of a project or the whole project and to provide an estimate of the costs based on their knowledge or experience. This technique is often used when no prior data exists.

Analogous. This approach uses actual costs or data from prior projects to develop an estimate for the current project. The estimate is usually adjusted to compensate for complexity or other factors, such as time or the time value of money. Rightly or wrongly, this technique is often used to develop a quick estimate of costs. However, this can be dangerous if the previous project is not exactly the same and critical special complexities are overlooked.

Parametric: This method builds on the statistical relationship between historical data and other variables to calculate an estimate for a given activity. For example, a construction company knows it costs 100,000 euros for each mile of straight road. That cost is then multiplied by the number of miles to be built and then adjusted for other considerations. Usually, parametric estimating is best when used in conjunction with other methods, such as expert judgment or bottom up.

Bottom Up: Also known as the “definitive method,” this approach requires a more detailed view of the project. Normally, all or many of the component work packages or activities have been identified, and each is estimated (cost, time, resources, etc.). These individual estimates are then rolled up or summed up at the next higher level. The bottom-up estimate is considered to be the most accurate estimate. (Some sources quote the level of accuracy of the bottom-up estimate to be between −5% to +10%,⁵ because of the level of detail, but it does take time and knowledge to develop.) The bottom-up estimate is believed to provide the team with the ability to closely track and control a project because of the level of detail. The good thing about this estimate is that it tells you how much your project will really cost; the bad thing is . . . it tells you how much your project will really cost!⁶

Three-Point Estimates: In some cases, there is uncertainty about the task to be performed or disagreement about some aspect of it (e.g., cost, duration, risk, etc.). The three-point estimating approach arrives at an estimate that considers these uncertainties. This approach triangulates three estimates to compensate for risk or uncertainty:

• Most likely (ML): often provided by the resource owner or performer, this is the assessment of the real effort required to accomplish the work.

• Optimistic (O): assumes that those performing this task will have perfect or near-perfect results. Implicit in this estimate is that the ideal circumstances exist (e.g., perfect requirements, right tools available, best worker, excellent design, etc.).

• Pessimistic (P): assumes “worst case scenario” performance of the task. For example, requirements are poor, equipment is not available, workers are unskilled, and so on.

There are two common methods for calculating the three-point estimates; triangulation and beta distribution. The formula for each approach is as follows:

Note that E = estimate and c = cost. Each formula has its benefits and drawbacks. The common expected distribution of events is represented by the triangular distribution formula, while a distribution of events with high degrees of uncertainty is represented in the beta distribution formula (also known as the program evaluation and review technique [PERT] formula). The use of triangular or PERT estimating is sometimes a required activity when developing a project schedule, and PERT is especially useful when there is uncertainty about cost or work durations. PERT functionality is a common feature in most popular project scheduling tools.

Estimate Verification Methods

The following are additional methods to verify the completeness or assess the accuracy of the cost estimate:

Reserve Analysis: A contingency reserve or allowance is added to the developed estimate to account for risk or uncertainty; these items are often referred to as the “unknown unknowns.” It is usually a set amount (e.g., 10 or 20 percent) based on organizational guidance or the best estimate of the project team.

Cost of Quality: The four traditional “costs of quality” are prevention costs, appraisal costs, internal failure costs, and external failure costs. The measure for a given organization can be gathered over time, and historical data can be used to verify and, if necessary, adjust the estimate. Cost of quality performance from prior projects can be very helpful in strategizing your cost estimate and managing your current project.

Vendor Bid Analysis: An assessment of vendor bids can be compared with the estimate developed by the project team. The result can be used to verify and adjust the cost, if necessary. Once the cost has been an agreed upon by both parties, the resulting cost estimate becomes a baseline against which vendor work can be tracked and controlled.

After the cost estimating is complete, the project team will have tools to help them and management understand how the estimate was derived (basis of estimate [BOE]) and to track and control the project (activity cost estimates).

Determine Budget

Budgeting, ideally, is the act of “aggregating the estimated costs of individual activities or work packages to establish an authorized cost baseline.”⁷ In other words, the budget is the money allocated to accomplish the project. In preparing to establish the budget, the project team should review and validate all relevant information (e.g., cost management plan, BOE, key project plan elements (e.g., scope documentation, schedule, resource calendars, risk registers, activity cost estimates, etc.) as well as any agreements, contracts, and organizational process assets.

Once this has been accomplished, the team should begin to define the budget. If done properly, budget development initially involves assembling or bringing together in a structured format the estimating data already derived. The team should ensure the estimate includes not only work items but also other key factors, such as risk, profit, overheads, and so on, before it is presented to stakeholders for agreement or approval. In many cases, contingency costs have been added at the work package level in anticipation of known risk; this is known as planning for known unknowns. However, at this stage of budget development, the project team typically adds some contingency for the unknown unknowns, as we discussed earlier. Another important activity the team should consider is seeking expert opinion to ensure that the budget is “sufficient and complete” to accomplish the project objectives. The team may also consider comparing their initial budget against similar projects, or historical information, to determine if any area varies excessively. If there is a large variance, it should be analyzed to ensure it is appropriate. Each project is unique and some large variance is correct. Using prior project experience can be very helpful in ensuring that all key factors have been considered and that you have not overlooked key details or are too optimistic in your estimates. Once the above steps have been accomplished, the last step should be to ensure that your budget is consistent with the amount allocated for it. This reconciliation ensures your project will be properly funded.

The goal of the “determine budget” activities is to efficiently arrive at a budget that is realistic, executable, and amenable to your organization’s monitoring and control activities. Project budgets are of no value if they are not tracked and controlled. Two important considerations for budget developers warrant mention here: market viability and game playing. The budget serves as a baseline for tracking and controlling costs. Unfortunately, many budgets are based on faulty historical, or no historical, information. The historical information that does exist in many organizations is based on performance of processes that are not efficient. Such data are of limited use and will cause your budget to be either uncompetitive, as it is on the high side, or unrealistic, as it is on the low side. It is unfortunate to lose a work project because of an inflated budget, but it is worse to win a work project that cannot be delivered within the budget assigned. It not only hurts relationships with customers, it can also adversely affect the motivation of the performers of the work. Also, the project manager should be alert for “game playing”⁸ in the budget. Game playing is the addition of added cost elements based on faulty assumptions, fears, or power. These items can inflate your budget and reduce your marketability.

Control Costs

“The importance of project control and its impact on business performance has long been recognized. Effective control helps run the project according to plan, often in spite of changes, contingencies and work-related contingencies.”⁹ Any organization concerned with its business performance in these uncertain times must implement effective cost control as one of its key control mechanisms when managing projects. Cost control “is the process of monitoring the status of the project to update the project costs and managing changes to the cost baseline.”¹⁰

Not developing an estimate and establishing a budget is essentially the same as not knowing where you want to go. There is no mechanism for controlling cost, because data have no meaning without context. In project management terms, the baseline serves as the context, and one critical element of that project baseline should be cost. Without it, any expenditure is OK! Controlling project costs requires a baseline that includes cost.

An even more confusing practice is to create an initial cost baseline but not update it when changes are approved or project performance requires it. Remember, a baseline is the approved version of a work product that can be changed only through formal change control procedures and is used as a basis for comparison.⁴ Controlling cost should be thought of as an iterative process, repeated many times through the life of the project. It is comprised of gathering, organizing, analyzing, and deciding (GOAD) project information to enable achievement of the project result in a manner that enables effective project management. The first three steps of the GOAD model, G, O, and A, are most applicable to the monitoring activities; the last part, D, is the control function that we will discuss later in this chapter. In project terms, these steps are as follows:

Gather: This set of activities is associated with collecting actual project performance information. However, before undertaking the data collection process, a cost control system should be established to provide guidance on how data will be collected on your project. In establishing the cost control system, all relevant project documentation should be reviewed, including the existing project management plan, project funding information, work performance data, as well as organizational process assets. As part of this review process, special attention should be given to key tools (e.g., project software, financial and accounting procedures, etc.) and templates that may help streamline the data gathering process. Once the system is established, gathering is the process of collecting the defined data in accordance with the system.

Organize: In this step, the team assembles and prepares the data for analysis according to organizational guidelines and personal preferences in assembling project performance data in a way that enables effective analysis. The key considerations are who will be reviewing and analyzing the data, and what format lends itself to effective analysis. Organizations often use the “dashboard” features available on most popular software programs to help organize data. A dashboard is a display similar to those you might see in a cockpit or an automobile that has key information relating to cost (or time or resources) structured in an easy-to-read graphical format.

Analyze: Once the data have been organized, they need to be effectively analyzed to understand current status and implications for the future. As a suggested rule, look at data for one cycle back and three cycles forward. You should not become too fascinated with past data for the same reason you cannot drive a car forward looking through the rearview mirror. Data analysis may be carried out by the project team, the project management office, or the leadership oversight team. In all cases data should be analyzed against the project: the baseline to assess how much the project has varied, what that means in future terms, and, if necessary, what the causes are of problematic variance.

Decide: Analysis of data reveals information that may require action. The goal at this point, in accordance with organizational guidance and effective project practice, is to take appropriate action(s) to keep the project on track. The two big failures of project teams are to act when they shouldn’t and to not act when they should. This usually happens when the fundamentals are not in place. As a result, team members do not know the real status of the project and, thus, do not act appropriately.

COMMON TOOLS FOR MONITORING AND CONTROLLING PROJECT COSTS

Deliverable and Milestone Tracking

In this approach a cost is determined and assigned to each milestone or deliverable. As costs are incurred, they are attached to a deliverable for management and control. Many organizations like this approach because it is simple, less bureaucratic, easy to define, and fits well with most work breakdown structures. However, the long time between deliverables can obscure problems in the system, so getting each party to agree on the attributes of a complete and correct deliverable or milestone result can frequently be a challenge that causes disagreement, delay, and added cost.

Measurement by Work Percentages

Many organizations use this approach. They associate cost with work on the basis of reported percentages of work complete. For example, if the team has accomplished one day’s work on a five-day task, the organization might assign a figure of 20 percent complete to that task. This does enable easy financial reporting, because 20 percent of a 1,000-euro task is easy to calculate. It is also popular because most stakeholders understand (or believe they do) what 40 percent complete means, and that makes project reporting simpler. However, this approach has several problems. The first and probably the most important is the challenge of defining exactly what 40 percent complete means. Percentage data are easily misunderstood, confused, or mis-represented. In addition, some projects and tasks can reach 80 percent very quickly and might therefore be considered to be in great shape, but the most challenging piece might be the last 20 percent. In some cases, that last 20 percent never gets finished!¹¹

Customer Satisfaction Measures

Occasionally an organization selects customer satisfaction as the key measure to control projects because it often speaks directly to a specific area that organizational leaders track quite closely, and it forms a common basis between the customer and the providing organization. However, using customer satisfaction as the primary measure usually leads to more problems. For example, customers can be delighted when they receive every change they requested at minimal or no cost. However, the profitability of the providing organization is sinking. Also, customer measures are too subjective to function as a stand-alone cost management tool. These measures can be used effectively when coupled with other project data, but they are normally not effective when used alone.

Earned Value Management

Organizations use this technique because it combines the best of the measurement approaches discussed above and extends them to a greater precision. The strength of earned value management (EVM) lies in its approach to representing the data. It combines the concepts of budget, cost, work performance planned, and work performance completed to arrive at a representation of current performance. This means that EVM can be applied to all projects in all industries and can be accomplished at any level of the project domain. It also provides the capability to forecast results derived from current performance. Sometimes organizations resist its use because it requires learning a new approach. Further, it might not be used because it relies on up-to-date project information. Gathering these data leads to added work on the project, and the data are not easily understood by the leaders to whom the data will be presented. However, its use is growing and, in some cases, is mandated because of the insights provided by its use.¹² EVM is covered in more detail in Chapter 33.

CONCLUSION

There are several effective techniques for project cost management, most of which are used by numerous organizations around the world. The technique selected to control costs on the project should be based on careful consideration of project factors, such as size, complexity, corporate procedures and guidelines, and client or customer needs. The goal of any system should be to enable effective management without creating an unnecessary burden.

Once the tools for controlling costs are selected, project leadership is responsible for defining at what intervals performance reviews will be conducted. The content of the review depends on the goals of the reviewer. For example, a high-level leadership team may review project cost performance as compared with the contract, project charter, or project plan. Project managers may be concerned about other factors in addition to core cost and status. For example, they may also compare documents, such as the actual spending plan against the original planned spending rate, staffing costs, and so on. Other entities may review other financial aspects of the project. The key is that if your documentation is in order, the project will be easier to manage and costs easier to control, no matter who reviews the project.

REFERENCES

¹ “Lessons learned, again, and again,” ASK Magazine, NASA, issue 12 (June 2003).

² Project Management Institute, A Guide to the Project Management Body of Knowledge, 5th edition (Newtown Square, PA: PMI, 2013).

³ Ibid.

⁴ Ibid.

⁵ James C. Taylor, Project Scheduling and Cost Control (Plantation, FL: J. Ross Publishing, 1997).

⁶ Lionel Galway, “Quantitative Risk Analysis for Project Management: A Critical Review,” RAND Corporation Report WR-112-RC, February, 2004.

⁷ PMI, 2013, p. 208.

⁸ Integrated Master Schedule Directive, Office of the Under Secretary of Defense, DI-MGMT-81650, 2005.

⁹ Eliyahu Goldratt, Critical Chain (North River Press, 1997).

¹⁰ PMI, 2013, p. 193.

¹¹ J. K. Pinto and J. W. Trailer, Essentials of Project Control (Newton Square, PA: PMI Publications, 1999).

¹² Flight School, An Accelerated Project Management Learning Experience, PM College Training Course, www.PMCollege.com.