3 Steps to Accurate Project Cost Estimation and Budgeting
Completing the projects within budget is a subject of very high interest for project managers. Unfortunately. cost overruns continue to be very common.
As per a recent Economic Times report;
423 infra projects show cost overruns of Rs 4.95 lakh crores. The average time overrun in 721 delayed projects is 43.34 months. “Total original cost of implementation of the 1568 projects was Rs 21,59,802.67 crore and their anticipated completion cost is likely to be Rs 26,54,818.05 crore, which reflects overall cost overruns of Rs 4,95,015.38 crore (22.92% of original cost)
This sounds ridiculous, isn't it ?. Here is my list of root causes contributing to schedule and budget overruns.
Root cause#1. Inaccurate cost estimation and budgeting
Inaccurate cost estimation and budgeting are the main root causes of project cost overruns. Once the budgeted costs are lower than what is really required, the recovery is very difficult. The only way out is re-estimation, and re-budgeting, which is a long drawn-out process, especially for infrastructure projects based on fixed price bids. Why is this so?.
Projects are progressively elaborated, and so are budgets. The expected accuracy of estimates increases as the project progresses. When the project is in the evaluation stage a Rough Order of Magnitude estimate (ROM) will serve the purpose. The expected accuracy levels of rough order of magnitude estimates are between -15 to +75 percentage. During project portfolio planning a budgetary estimate is required. The expected accuracy level of budgetary estimates is between -15 to +15 percentage. During the planning phase of the project, one needs the most accurate estimates known as definitive estimates whose expected accuracy level is between -5 to +5 percentage. Definitive estimates are based on detailed Work Breakdown Structures (WBS) meeting the 8-80 rule. Budgetary estimates are possible with high levels of work breakdown structures. Unfortunately, fixed price contracts are signed much before the preparation of the detailed work breakdown structures with the required granularity. Hence, budgetary estimates get labelled as definitive estimates.
Very often, the estimation team fails to factor appropriate overheads into the engineering and construction costs before finalizing the project budget. One has to bear in mind the following, while estimating cost and budgeting. Error in the judgment of any of these components will impact the budgeting process negatively.
Cost + Contingency costs + Management reserves = budget
Budget + Profit = Price (quoted)
If the quoted price itself is lower than the budget, then it is only a matter of time before the actual cost exceeds the planned cost.
Root cause#2. Inadequate cost monitoring and control systems
Recently, I was shocked to see the pathetic state of the spreadsheet-based planning and tracking system of a very large infrastructure project where well-known global giants are stakeholders. Automated real-time progress monitoring based on earned value management principles is what is needed.
Root cause#3. Improper vendor selection
Very often price is the primary determinant when choosing vendors / sub-contractors. In the process, the quality aspects take a back seat. Previous track records and the processes followed must carry equal weightage on par with price. Another aspect is the transparency of the selection process.
Root cause#4. Improper contract types
If the scope is absolutely clear, then fixed-price contracts will work perfectly. For this, we need definitive estimates based on work breakdown structures of a high level of detail. If the scope is not very clear, then cost reimbursable contracts are a better choice.
Root cause#5. Lack of professional ethics
Lack of professional ethics is a milder way of addressing ‘CORRUPTION’ which shadows every aspect of many projects which are lagging behind both schedule-wise and cost-wise.
Having said that, let us focus on how to improve the accuracy of project cost estimation and budgeting.
Here are the three steps to accurate Project Cost Estimation and Budgeting
- Plan Cost management
- Estimate costs
- Determine budget
Step#1 – Plan Cost Management
How do we manage project costs?. The Project’s Cost Management Plan addresses the ‘How’ part of cost management. The best way to understand the planning of cost management is to analyze the contents of the cost management plan.
1.1 Contents of Cost management plan
1.1.1 Units of Measure
For most I.T projects, the cost is synonymous with effort. So is the case with most knowledge work-intensive projects. The biggest cost driver in such projects is the time of the knowledge worker. Generally, Engineering and design-intensive projects fall into this category. In EPC projects where the highest cost drivers are material and equipment, accounting happens in currency.
1.1.2 Level of Precision
How will we round off the digits in cost-related calculations?. Though sounds simple, the cumulative impact is very high. The rules for rounding off the digits must be decided at the beginning of the project. This is applicable for other measurements as well.
1.1.3 Level of Accuracy
There are budgets of varying levels of accuracy like ball park, approximate, budgetary and definitive. During the conception phase of projects, stakeholders work with ball parks and approximate estimates as the scope is not well developed during this phase. In the organization’s budgeting phase we depend on the budgetary estimates of the upcoming projects. During the planning and execution phases of the project, we rely on definitive estimates. The expected accuracy levels of definitive estimates are within plus or minus five percentage. In order to develop definitive estimates, one needs a detailed scope. It is impossible to arrive at definitive estimates without the help of detailed work breakdown structures.
1.1.4 Organizational Procedures
As discussed already, the budgeting is directly linked to the work packages. Work packages are the lowest level in the WBS. Each work package is associated with a control account. In order to monitor budget vs actual data, these control accounts act as the key. Organizational procedures and guidelines govern the definition and allocation of control accounts and the accounting of budgets and actuals.
1.1.5 Control Thresholds
When will you say yes and no when it comes to project budget and cost-related decision-making?. When will you escalate decision-making?. Some project managers are risk averse and will not take even small risks. They keep escalating even the smallest risk. Where as some others are high-risk takers and will not escalate even the major ones. Both are not desirable behaviors. If the cost overrun crosses ten percentage above the budgeted, then escalate it to sponsor else you decide is a good example of control threshold definition.
1.1.6 Rules of Performance Measurement
For progress reporting, organizations follow their own rules of credit. Some of the most common definitions are 0-100 which considers the work as earned only when it is a hundred percentage complete. A 50-50 rule suggests that work can be considered as fifty percentage completed when it has started and the remaining fifty percentage will be considered as completed only when the remaining fifty percentage is fully completed. If nothing is specified, it is assumed that percentage completion is the rule where someone literally measures the actual work completed as a percentage of the planned work.
1.1.7 Reporting formats
How are we going to present the budget Vs the actual?. One of the most popular formats is the ‘S-curve’ where the actual cost is plotted against the planned budget. The same can be shown in a tabular form.
Step#2 – Estimate Costs
The cost management plan is ready. The next logical step in budgeting is cost estimation. Here is the list of tools and techniques used for project cost estimation;
2.1 Analogous Estimation
How many of you have taken the effort to see how much was the actual cost of a past similar project or activity, before embarking on a similar new project or task?. I am sure almost everyone would have checked a previous similar work’s cost before estimating the cost of a new similar activity. Estimation based on a comparison with a past similar activity is known as an analogous estimation. While performing analogous estimation one must validate the similarity of the past similar activity with the task under estimation.
2.2 Parametric Estimation
Have you ever heard about the term ‘cost per square feet’?. Cost per square feet is widely used in the construction industry. Cost per square feet is calculated by taking an average of the actual cost incurred per square feet from past similar projects. In software testing very often we hear the term ‘Defects per hundred hours of testing’ which is arrived at from historical testing data. Parametric estimation is more accurate than analogous estimation.
2.3 Bottom Up Estimation
As the project progresses, we gain more insight into the project. When we have sufficient details, we can do the bottom-up estimate. That is to say, when we know the activities within a work package, we add up the individual activities estimates and compare them with the top-down estimate of the parent work package. Then we can add up the work package level costs to arrive at the module level and then to the project level.
2.4 Three Point Estimation
From the Optimistic, Pessimistic, and Most likely values are estimated, a single point estimate is worked out by applying any one of the formulas;
In multiple projects, I have successfully applied a combination of Delphi and three-point very successfully. Here are the steps;
- Expert team formation
- Shared details of the work
- Team members estimated Optimistic, Pessimistic, and Most likely values
- Discussions to arrive at a single Optimistic, Pessimistic, and most likely value
- Calculation of single point estimate using either;
2.5 Reserve Analysis
Unforeseen things happen in projects. Therefore one must always account for the unforeseen by adding time and money for contingencies. They are known as management reserves.
2.6 Cost Of Quality
Cost of quality (COQ) has two components. The Price of Conformance (POC) includes all those activities we are performing to prevent problems from happening. Can you think of some examples?. The costs associated with the right recruitment, training, reviews, process definition, implementation, etc are examples of POC. The second component, Price of Non-Conformance (PONC) contains all those unwanted costs which we could have avoided. Customer complaint handling, deviation from ideal, penalties paid, replacements, etc fall into this category. How will the project team treat the COQ elements?. Good project budgets have elements of these factored in.
2.7 Type of Project Costs
Cost is classified as direct and indirect costs. Costs directly related to the work packages or activities are direct costs. Direct costs can be further classified into;
- Direct fixed – Direct costs which are fixed. Team’s salary which is not linked to output
- Direct variable – Direct costs which are proportional to the output. Material costs, Team incentives
Indirect costs are further classified into;
- Indirect fixed – Indirect costs which do not change with the output. Project manager’s salary.
- Indirect variable – Indirect costs which change with the output. Power.
Step#3 – Determining Budget
3.1 Cost Aggregation
Now it is time to aggregate the costs and determine the budget. Every task in the project has a cost element and start and end dates. Bottom-up aggregation of cost from the task level to the work package level and to the project level yield the time-phased cost budget of the project.
In general, a project budget has three components;
- Management reserve – reserved for managing unknown risks. Management has the authority to sanction it.
- Activity / Work package costs – Cost of work. Supervisors have the authority to use it.
- Contingency costs – Reserved for managing known and known-unknown risks. The project manager has the authority to use it.
By factoring in Management reserves and contingency reserves to the cost baseline we arrive at the time-phased budget of the project.
3.2 Historical Information Review
Historical information provides very valuable insights into the estimation. These are very helpful while validating the project budgets. In the construction domain, the budget till foundation work completion is considered accurate if the budgeted amount till the foundation is within 20% of the overall project cost.
If the requirements and design effort are within 30% of the overall project budget for a software development project it is considered normal. In matured industries, heuristics are developed based on historical data. These are great inputs to validate time-phased budgets.
3.3 Funding limit reconciliation
Funding the projects phase-wise results in better cost control than end-to-end funding of the project. Always, the funds dispersed must be proportional to the progress accomplished. Funding risks are addressed better by ensuring that funds dispersed are directly proportional to the Budgeted Cost Of Work Performed (BCWP). In the earned value management vocabulary, the budgeted cost of work performed (BCWP) is also known as Earned Value (EV). As a rule of thumb, money dispersed must be proportional to the work completed.
The next challenge is to get the funding. Who will finance the project?. Timely funding is critical to the successful completion of the project. Projects can have either a single sponsor or multiple sponsors. Proper financing will prevent projects from lagging behind due to a lack of funds during the execution phase.
Arriving at the correct budget, management of the budget, ensuring the disbursement of funds based on project progress, and then managing the project within the approved budget need specialized skills, tools, and techniques. One starts with planning for cost management and developing the Cost Management Plan for the project. Actual Estimation of costs is performed by leveraging the detailed work breakdown structure.
The tools and techniques used for estimation are included in the cost management plan. Once the costs are estimated, they are aggregated to arrive at the cost baseline and then the budget baseline.
List of tools and techniques used for Project cost estimation and budgeting
- Analogous estimation
- Parametric estimation
- Three-point estimation
- Delphi technique
- Reserve analysis
- Top-down estimation
- Bottom-up estimation
- Cost of quality
- Historical data
- Funding limit reconciliation etc.
Application of appropriate estimation methods that suit best for your project and phase will help you to improve the accuracy and availability of project budgets.