Lecture 5

Project Cost Management

Prepared by: Atef Hamza

The Importance of Project Cost Management

 IT projects have a poor track record for meeting

budget goals
 The CHAOS studies found the average cost overrun
(the additional percentage or dollar amount by which
actual costs exceed estimates) ranged from 180% in
1994 to 56% in 2004; other studies found overruns to be
33-34 %.
 A 2011 Harvard Business Review study reported an
average cost overrun of 27%.
 What Went Wrong?

According to the San Francisco Chronicle front-page story,

"Computer Bumbling Costs the State $1 Billion,"
 United States Internal Revenue Service (IRS) is a prime example
of how not to manage costs.
 A series of failures in the 90’s cost taxpayers more than $50
billion, roughly as much money as the annual net profit of the
entire computer industry.
 United Kingdom National Health Service electronic payments
system called “the greatest IT disaster in history” $26 billion
overrun over 10 years.
 What is Cost and Project Cost Management?

 Cost is a resource sacrificed to achieve a

specific objective.
 Costs are usually measured in monetary units
like dollars.
 Project cost management includes the
processes required to ensure that the project
is completed within an approved budget.
 Processes of Cost Management

 Planning cost: involves determining the policies, procedures,

and documentation that will be used for planning, executing,
and controlling project cost. (cost management plan)
 Estimating costs: developing an approximation or estimate
of the costs of the resources needed to complete a project.
 Determining the budget: allocating the overall cost estimate
to individual work items to establish a baseline for measuring
performance. (cost baseline)
 Controlling costs: controlling changes to the project budget.
Basic Principles of Cost Management
Most CEOs know a lot more about finance than IT, so IT
project managers must speak their language.
 Profits: are revenues minus expenditures
 Profit margin: margin is the ratio of revenues to profits
➢ Example: $100 revenue generates $2 profit
2% profit margin
 Life cycle costing: allows you to see a big-picture view
of the cost of a project throughout its life cycle
 Cash flow analysis: is a method for determining the
estimated annual costs and benefits for a project and
the resulting annual cash flow.
Basic Principles of Cost Management

 Tangible costs or benefits are those costs or benefits

that an organization can easily measure in dollars.
 Intangible costs or benefits are costs or benefits that
are difficult to measure in monetary terms.
 Direct costs are costs that can be directly related to
producing the products and services of the project.
 Indirect costs are costs that are not directly related to
the products or services of the project, but are indirectly
related to performing the project.
 Sunk cost is money that has been spent in the past and
can’t recovered in the future.
Tangible and Intangible assets
Direct and Indirect costs
Sunk Cost
Basic Principles of Cost Management

 Reserves are money included in a cost estimate to

mitigate cost risk by allowing for future situations that
are difficult to predict.
➢Contingency reserves allow for future situations that
may be partially planned for, and are included in
the project cost baseline
▪ Examples: employee vacations, employee turnover
➢Management reserves allow for future situations that
are unpredictable.
▪ Examples: illness, natural disasters, weather
Planning Cost Management

Developing a cost management plan requires the

following inputs:
 Expert judgment
 Analytical techniques
 Meetings
Estimating Costs

Project managers must take cost estimates

seriously if they want to complete projects
within budget constraints
It’s important to know the types of cost
estimates, how to prepare cost estimates,
and typical problems associated with IT
cost estimates
Types of Cost Estimates

 Rough order of magnitude (ROM): is an estimate of what a

project will cost
➢ Accuracy is typically -50% to +50%, though may be
much wider
 budgetary estimate is used to allocate money into an
organizations budget
➢ More accurate than ROM -10% to +25%
 definitive estimate provides an “accurate” estimate of
project costs
➢ Accuracy -5% to +10%
Types of Cost Estimates
Cost Management Plan

 A cost management plan is a document that describes

how the organization will manage cost variances on
the project.
 A large percentage of total project costs are often
labor costs, so project managers must develop and
track estimates for labor
➢ Note that labor cost per resource (run rate) is often
much higher for contractors than full time employees
➢ Example: $45/hr FTE, $75/hr contract
 Cost Management Plan
 Because a large percentage of total project costs are often labor costs. Many
organizations estimate the number of people or hours they need by
department over the life cycle of a project.

➢ Northwest Airlines
Cost Estimation Tools and Techniques
Basic tools and techniques for cost estimates:
 Top-down estimates: use the actual cost of a previous, similar project as
the basis for estimating the cost of the current project
➢ Less costly than other techniques, but may be less accurate
 Bottom-up estimates: involve estimating individual work items or
activities and summing them to get a project total
➢ Preferred if there is a detailed WBS available
 Parametric modeling uses project characteristics (parameters) in a
mathematical model to estimate project costs
➢ Most reliable but also can be more inaccurate than other models if
executed incorrectly (lack of experience)
Typical Problems with IT Cost Estimates

 Developing an estimate for a large software project is a complex

task requiring a significant amount of effort.
➢ Remember that estimates are done at various stages of the project
 Many people doing estimates have little experience doing them.
➢ Try to provide training and mentoring
 People have a bias toward underestimation.
➢ Review estimates and ask important questions to make sure
estimates are not biased
 Project managers must negotiate with project sponsors to create
realistic cost estimates
Cost Budgeting

Cost budgeting involves allocating the project

cost estimate to individual work items over time
The WBS is a required input to the cost budgeting
process since it defines the work items
Its important to produce a cost baseline
➢ A time-phased budget that project managers use to
measure and monitor cost performance
Sample of cost baseline
Controlling Costs

Project cost control includes

➢monitoring cost performance
➢ensuring that only appropriate project changes
are included in a revised cost baseline
➢informing project stakeholders of authorized
changes to the project that will affect costs
Earned Value Management (EVM)

 EVM is a project performance measurement technique that

integrates scope, time, and cost data.
 Given a baseline (original plan plus approved changes),
you can determine how well the project is meeting its goals.
 You must enter actual information periodically to use EVM.
 More and more organizations around the world are using
EVM to help control project costs.
Earned Value Management Terms

 Planned value (PV) is that portion of the approved total

cost estimate planned to be spent on an activity during
a given period.
 Actual cost (AC) is the total of direct and indirect costs
incurred in accomplishing work on an activity during a
given period.
 Earned value (EV) is an estimate of the value of the work
actually completed to date.
➢Earned Value (EV) = total project budget multiplied by
the % of project completion.
 Example

 Assume we’re halfway through a year-long project that

has a total budget of $100,000. The amount budgeted
through this six-month mark is $55,000. The actual cost
through this six-month mark is $45,000.
So, in summary:
 Planned Value (PV) = $55,000
 Actual Cost (AC) = $45,000
 Earned Value (EV) = ($100,000 * 0.5) = $50,000