Estimating project costs is a process that helps you figure out an approximation of costs associated with each of the resources planned on all activities of the project.
Why is this required?
Dr. John McManus and Dr. Trevor Wood-Harper write about a study conducted from 1998 to 2005, covering 214 information system projects, across 10 sectors from Manufacturing to Agriculture, of value ranging from less than a million euros up to 80 million euros. The intention of the study was to find out at which stage does a project has greater chances of failing, and to find out the reasons for abandoning projects.
Out of 214 projects, 51 (23.8%) were canceled.
Their findings state that “Results from the analysis of cases indicate that almost one in four of the projects examined were abandoned after the feasibility stage of those projects completed approximately one in three were schedule and budget overruns.“
Hence it pays rich dividends to the project manager to spend a good amount of time and effort on cost management.
Cost management is practiced throughout project duration.
Why?
Because some of the costs are seasonal, while some are inflation-related. Sometimes what you calculated during planning phase may not hold good when it is time to make use of these resources on the project. Also as project progresses you get to know more information which may help you prepare better, concrete estimates.
At the beginning of the project, usually, the confidence of accuracy of estimates is less. Hence you will use a Rough Order of Magnitude (ROM) of about -25% to +75% on your estimate numbers.
As you get more information and feel confident of better accuracy of estimation, you narrow the range to -5% to +10% – which is called a Definitive Estimate.
And the other category of estimates are?
Preliminary estimate – these are typically the estimates you’d provide when the project is in the proposal stage. You’d put more effort in understanding a bit more details of the needs so you come up with better than a ROM estimate.
Preliminary estimates are usually in the range of -15% to +50%. As you can see there is still half the actual budget (estimated, rather, when you are doing preliminary budget) on the upper side of the estimates in here, which is the cushion needed.
Budget estimate – Budget estimates are better than the Preliminary estimates and pretty closer to the real estimates. As you can see by now, the more accuracy of estimates is needed (with good confidence level too) more work & time are required to be invested.
Typically, the budget estimate is in the range of -10% to +15% of the final estimate.
Actual/Final estimate – this is the most accurate one you can come up with. Usually associated with bottom-up estimates, and as you might have guessed rightly, required if you are going for Fixed-price contracts!
Cost Estimation Categories for PMP exam: ROM Vs Preliminary Vs Budget Vs Definitive Vs Final Estimates
From the PMP examination perspective, you can expect a question or two on the project cost estimation categories.
These could be given in the form of Scenario, Formula, Knowledge, or even Red herring types. Thus, spend a couple of minutes on this and the previous section to understand the meanings, and remember the range of estimates for each type.
Various project management estimation types and their accuracy ranges are –
- Rough Order of Magnitude (ROM) Estimate: -25% to +75%
- Preliminary estimate: -15% to +50%
- Budget estimate: –10% to +25%
- Definitive Estimate: -5% to +10%
- Final estimate: 100% accurate
These are the ones you need to know from the PMP exam perspective. You can learn about more types of estimations here.
What do you need?
You basically need 2 important plans – Cost, Quality management plans.
Quality is built into the project – and there are direct and indirect costs of quality that need to be estimated. This information will be present in the quality management plan.
Resource requirements people are central to most of the projects. A team needs the right mix of skill set for optimal costing.
For instance, a software development project may have a workforce pyramid consisting of 5 junior engineers, 2 senior engineers, and a technical lead. You would also need to consider additional costs such as training costs, rewards and recognition costs, back-filling costs to manage attrition.
If required resources are not available in-house, then they’ll have to be acquired at a higher cost.
Project scope baseline, which consists of
- Project scope statement – funding constraints, and financial assumptions
- Work Breakdown Structure (scope broken down to work package level)
- WBS dictionary (deliverable ids and description) – hierarchical structure of scope broken down to lowest level, and related information
…all of which are considered while estimating costs.
Project schedule – gives you schedule activity resources and durations to calculate costs. As noted in the Estimate Activity Resources process, cost estimating is to be closely coordinated with it – some of the resource costs may change and need to be constantly looked at to assess the impact on the budget.
Risk register – this is a big aspect of cost. Project management is as much of anticipation of ‘unknowns’, risks and mitigating them as managing the ‘knowns’.
There can be negative risks as well as positive risks on a project. Negative risks are threats, and positive risks are opportunities. As an example, a takeover bid of a performing organization by another company may be perceived as a threat but can be an opportunity as well. It may become easy to get skilled resources from the resource pool of the new entity.
And of course, all governed policies, templates, and lessons from earlier projects are considered.
How do you do it?
Expert judgment combined with historical information is very valuable in assessing costs taking into account cost fluctuations around resources. When different methods used to estimate costs return different numbers, you would use expert judgment to analyze and decide which one to consider.
Cost Estimation Types for PMP exam
From the PMP exam perspective, you would need to know 5 types of cost estimates.
Analogous estimating – helps you consider previous similar projects, look at their costs and prepare estimates. This is a quick tool, less accurate, and useful only when you are comparing projects of pretty similar size and type.
Parametric estimating – you use one of the formulae-driven spreadsheets, software, or tool to put in parameters specific to your project and let it derive cost numbers.
Bottom-up estimating – is like using the Divide and Rule method. Helps you in estimating tasks that are big and complex. You can break them down into simpler, smaller pieces and put cost estimates for these pieces. Then you roll up the cost numbers and get the final cost for the original task.
Three-point estimating – This simple PERT tool is a weighted average of worst case, most-likely and best case estimates to have realistic numbers. Recall that we used this in the Estimate Activity Durations process. Again, there are two formulae based on which distribution of estimates are assumed.
If Beta distribution is assumed –
Expected Cost = [Optimistic Cost + (4 x Most likely Cost) + Pessimistic Cost] / 6
cE = [cO + 4 cM + cP] / 6
If Triangular distribution is assumed –
Expected Cost = [Optimistic Cost + Most likely Cost + Pessimistic Cost] / 3
cE = [cO + cM + cP] / 3
Reserve analysis – we saw this in the Estimate Activity Durations process. There are two types – contingency reserve and management reserve. Contingency reserve is also called contingency allowance, where you add some amount of cost to address uncertainty on known risks. For unknown risks such as discovered tasks that are very much part of the project scope, you have management reserve. Reserve analysis is a very useful tool that helps you manage uncertainty. This could be applied at the activity level, WBS component level, or even milestone level.
In short, contingency reserve is for “known unknowns” and management reserve is for “unknown unknowns”.
Cost of Quality (CoQ) – is the cost incurred in the effort to ensure that the output produced matches the requirements.
This includes the cost of activities performed to ensure that a good quality product is produced (training, testing, equipment) AND the cost of activities performed as a result of producing a bad quality product (rework, scrap).
You can see more details in the Plan Quality process.
Alternates analysis, Reserve analysis, Vendor bid analysis.
When you decide to contract out a certain amount of work, you would talk to vendors, float request-for-proposal (RFP), look at vendor responses, award contract, measure their output, pay them – all these would cost that need to be estimated. The details of these activities are part of the Project Procurement Management Knowledge Area.
What do you get?
Cost estimates of tasks (or activities) – list of probable cost estimates for all activities on the project. We say ‘probable cost estimates’ because estimating costs is not a one-time activity.
We do cost estimation throughout the project. And each time we refine the cost of the activities. And we include all the supporting assumptions, reasoning, and documentation as well.
Having just estimates does not work. The reasons and logic behind this estimation are important, and hence Basis of Estimates is another important document to produce. So are all the assumptions, constraints, identified risks, and costs associated with managing the risks in case they are realized.
And finally, the confidence level on the estimates made.
While doing all this we’ll uncover few changes needed to project documents such as risk register, issue log, lessons learned register, changelog, contracts, and so on – we swiftly go ahead and make those changes.
These will be used to create a project budget. Let us discover this in the next lesson.
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