CHAPTER 10
Project Cost Management in Practice

PAUL LOMBARD, PMP, CQM; PM COLLEGE

A Project Team for a major national retail products company was given the scope for a large new production facility and asked to prepare an estimate of the cost to build it. The completed estimate was presented to management, whose members informed the team that they already had a budget figure in mind and the team’s estimate was much too high. The project team reexamined the scope, used a second estimating process, and validated their original estimate. Once again, the team presented the estimate to Management but, once again, Management disagreed, even blaming the estimator and alleging that the team was “gold plating” the work. So, the two sides made an agreement to cut the scope of the facility to bring it into alignment with the team’s cost estimate. Unfortunately, the reduced scope was later determined to be unworkable; the smaller building was not large enough to accommodate the size of machine that would be inside of it. Ultimately, a Management decided to add the original scope back into the plan, but not to increase funding. In the end, results were that the project team did a great job on time and scope delivery but had major cost overruns. The project cost result was 40 percent higher than management’s budget for the project but almost exactly the initial cost estimate provided by the project team.¹

This kind of story is, regrettably, repeated many times over in organizations around the world. Project cost management is so easy, and yet so hard. Project cost management affects many aspects of project work and is affected by factors within and outside the subject project. An important first step in dealing with these factors is to have an effective cost management system on your project. Unfortunately, no one correct process exists for managing costs, so it is more effective to speak in terms of the attributes, or key elements, of an effective system. The foundation of that system is the guidance and procedures given by your organization’s leaders and the cost management needs of the project’s key stakeholders. In defining the elements of the system, you should remember that factors outside of your project will affect it, so it is usually best to use generally accepted or recognized standards. Perhaps the most popular standard is A Guide to the Project Management Body of Knowledge (PMBOK^® Guide).² This cost management system includes three processes: Estimate Cost, Determine Budget, and Control Costs. These three areas, either formally or informally, should be part of all projects, and they can be performed as discrete activities or be combined as the needs of the project dictate.

ESTIMATE COST

The objective of estimating cost is to try to define or “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 known as PIDOOMA, which roughly translates to Pulled It Directly Out of Mid-Air. In other words, we guessed. Guesses are often not based on reality, an understanding of the scope, the effort to achieve it, or the other dynamics of the project. Clearly, this approach is fraught with problems because the game becomes guess and guess again. How can projects be effectively managed if the target is constantly shifting? A more disciplined approach must be followed. As a first step, before you and your team start estimating, review all applicable documentation, such as the Project Charter, the Contract, Product Description, Scope statement, Business cases, and any elements of the project plan that have already been defined (WBS, Schedule, Risk Register, and so on). In addition, review and consider any external factors that could impact the project, such as market segment info, economic trend info, and so on. To estimate cost in a bubble is to set yourself up for failure. All factors should be considered.

After reviewing relevant documentation, the project team can begin building the estimate. The goal is to achieve a project “baseline.” The baseline is the original estimate, plus or minus all approved changes.⁴ It serves a key purpose in that it is the “area of order” for the project. Armed with it, the project manager can effectively judge the impact of variation and deviation from the plan. Without it, there is no context in which to assess problems. To arrive at the baseline, the first step is developing 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 update the cost estimate

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 best thing about this estimate is that it will tell you how much your project will really cost. The bad thing is that it will tell you how much your project will really cost.

Pert 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 Program Evaluation and Review Technique (PERT) estimating approach attempts to arrive at an estimate that incorporates these uncertainties. This approach, originally developed by the U.S. Navy,⁶ uses 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 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 not available, workers unskilled, etc.

The above factors are placed in the PERT formula as follows:

The use of PERT estimating is sometimes a required activity when developing a project schedule and should be, in most cases, a useful practice when there is uncertainty about the cost or duration of the work at hand. PERT functionality is also a common feature in most popular project scheduling tools.

Estimate Verification Methods.

Additional methods used to verify the completeness or assess the accuracy of the cost estimate are as follows.

Reserve Analysis

A contingency reserve or allowance are is added to the developed estimate to account for risk or uncertainty. It is usually a set amount (e.g., 10% or 20%, etc.) based on organizational guidance or the best estimate of the Project Team.

Cost of Quality

The five traditional “Costs of Quality” are Prevention Costs, Appraisal Costs, Internal Failure Costs, External Failure Costs, and Test and Measure 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.

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 an agreed-upon cost has been reached between both parties, the resulting cost estimate can be used to track and control vendor work.

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, or BOE), and track and control the project (activity cost estimates). In addition, they will discover in the course of developing the estimate that the project plan and associated documents will need to be updated to reflect new information and learning.

Determine Budget

As illustrated in the story at the beginning of the chapter, estimating the cost for the project can be helpful IF it is used in a practical way. Unfortunately, as was illustrated, in some cases, the budget precedes the estimate. This can present the project team with a challenge because they will have to perform an estimate and hope it is close to the budget. Budgeting ideally is the act of “aggregating the estimated costs of individual activities or work packages to establish an authorized cost baseline for the project.”⁷ In other words, the budget is the money allocated to accomplish the project. In preparing to develop the budget, the project team should review and validate all relevant information (e.g., BOE, Scope information, Schedule, Resources, contracts, charter, etc.).

Once this has been accomplished, the team should begin to develop the budget. If done properly, budget development initially involves assembling or bringing together in a structured format the estimating data already derived. Once the initial budget data has been developed and before it is presented to stakeholders for agreement or approval, it should be further examined to ensure that a sufficient reserve has been applied. In many cases, contingency costs have been added at the work package level in anticipation of known risk; however, at this stage of budget development, the project team is trying to determine if a “project contingency reserve” is necessary to cover additional uncertainty. Another important activity would be to seek expert opinion to ensure that the budget is “sufficient and complete” to accomplish the project objectives. Another key activity the project team should consider is to compare the initial budget estimate 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. Prior project experience can be very helpful in ensuring that you have not overlooked key details or were too optimistic in your estimates. Once the above steps have been accomplished, the last step (sometimes the first step) should be to ensure that your budget is consistent with the amount allocated for it. This funding reconciliation ensures your project will be properly funded and, when necessary, may require negotiation for additional funding or time.

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 will not be tracked and controlled. Two important considerations for budget developers deserve 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 and are full of waste. Such data are of limited use and will cause your budget to be either uncompetitive on the high side or unrealistic on the low side. It does no good to not win work because of an inflated budget, but it may be worse to win work that cannot be delivered within the budget assigned. It not only hurts relationships with customers, it can also adversely affect the performers of the work. Secondly, 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 budget and managing changes to the cost baseline.”

The following is a passage from Lewis Carroll’s classic, Alice in Wonderland:

Alice: I was just wondering if you could help me find my way.

Cheshire Cat: Well, that depends on where you want to get to.

Alice: Oh, it really doesn’t matter, as long as…

Cheshire Cat: Then it really doesn’t matter which way you go.

This passage unfortunately captures the approach that too many organizations take in monitoring and controlling project cost. 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 has no meaning without context. In project management terms, the baseline serves as the context, and one critical element of the project baseline should be cost. Without it, the Cheshire Cat would say: 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 plan for the project, plus or minus all approved changes. 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 (GOA) 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 described as follows.

Gather

This set of activities is associated with collecting project actual 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, the cost performance baseline, project funding information, work performance guidelines. and organizational standards and procedures. 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 will 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 their current status and implications for the future. As a general rule, look at data for one cycle back and three cycles forward. It is important to not become too fascinated with past data for the same reason one cannot drive a car forward looking through the rearview mirror. In addition, a key problem in analysis is to review data for what it is telling us rather than to confirm what we already believe. Data analysis may be carried out by the project team, the Project Management Office, or the Leadership Oversight team. It is also important that data are analyzed against the area of order used to establish the project: the baseline. The analysis team should be trying to assess how much the project has varied from the baseline, what that means in future terms, and what are the causes? In the analysis phase the team may also formulate potential courses of action to remedy variance.

Decide

Analysis of data will reveal 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. Any action taken should be appropriate for the variation detected.

CONTROLLING COST

To begin the process of controlling costs, the project team should review and understand all the key project artifacts created to this point. Items to review include the Project Management Plan, the Project Charter, the Project Budget, Work Standards, and Guidelines and Performance Information, as well as Organizational Policies, Guidelines, and Procedures. Some of the common tools used to monitor and control project costs include the following.¹⁰

Deliverable and Milestone Tracking

In this approach a cost is determined and assigned to each milestone or deliverable. As costs are incurred, they 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 to 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 is easily misunderstood, confused, or misrepresented. 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!

Customer Satisfaction Measures

Occasionally an organization will select customer satisfaction as the key measure to control projects. This measure is selected 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. Nonetheless, customer satisfaction usually lead to more problems if used as the primary measure. 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. Secondly, 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 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 quality of “consilience” (the “jumping together of knowledge by linking of facts and fact-based theory across disciplines to create a common groundwork of explanation”¹¹) 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 this 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 Earned Value is covered in more detail in Chapter 10A.

CONCLUSION

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. The goal of any system should be to enable effective management without creating unnecessary burden. In addition, ensuring selection of the approach conforms to the reporting and control needs of all stakeholders.

Once the tools for controlling costs are defined, 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. The Project Manager may be concerned about other factors in addition to core cost and status. For example, he or she may also compare documents, such as the actual spend plan against the original plan, staffing costs, etc. 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.

There is ample reason in today’s difficult economic environment to try to manage key aspects of organizational work more effectively and efficiently. If we are selling fewer products, then internal efficiency becomes an increasingly important area for maintaining profitability. Internal efficiency results from improvement based on objective data. The case for effective cost management using the techniques and concepts described in this lesson is clear; but getting started is many times harder.

REFERENCES

¹ Lessons Learned, Again, and Again, ASK Magazine, NASA, Issue 12. June 2003.

² The Guide to the Project Management Body of Knowledge, 4th Edition, PMI, 2008.

³ Ibid.

⁴ Ibid.

⁵ James C. Taylor, Project Scheduling and Cost Control, 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, Guide to the project Management Body of Knowledge.

⁸ Integrated Master Schedule Directive, OUSD, DI-MGMT-81650, 2005.

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

¹⁰ Essentials of Project Control, Pinto and Trailer, PMI Publications, 1999.

¹¹ Flight School, An Accelerated Project Management Learning Experience, PM College Training Course, www.PMCollege.com.

¹² Edward O. Wilson, Consilience, The Unity of Knowledge, Little Brown and Co., 1998.