Institute of Management Studies

Project Management Lecture-4

Project Cost Management.

By Dr. Muhammad Ali Noor Assistant Professor

21st Jan 2013

Exercise
For each row on the following chart, enter the letter of the project you would select if the following information were provided.
Project A Net Present Value (NPV) $95,000 Project B $75,000 Which Would you Pick?

Internal Rate of Return (IRR)

Payback Period Benefit Cost Ratio (BCR)

13%
16 months 2.79

17%
21 months 1.3

NET PRESENT VALUE (NPV) means the present value of the total benefits (income or revenue) less the costs INTERNAL RATE OF RETURN (IRR) is the rate (read it as interest rate) at which the project inflows (revenues) and project outflows (costs) are equal. PAYBACK PERIOD is the number of time periods it takes to recover your investment in the project before you start accumulating profit BENEFIT COST RATIO (BCR) a BCR of>l means the benefits are greater than the costs. A BCR of<l means the costs are greater than the benefits. A BCR = 1 means the costs and benefits are the same. OPPORTUNITY COST is the opportunity given up by selecting one project over another

Exercise
For each row on the following chart, enter the letter of the project you would select if the following information were provided.
Project A Net Present Value (NPV) $95,000 Project B $75,000 Which Would you Pick? A

Internal Rate of Return (IRR)

Payback Period Benefit Cost Ratio (BCR)

13%
16 months 2.79

17%
21 months 1.3

NET PRESENT VALUE (NPV) means the present value of the total benefits (income or revenue) less the costs INTERNAL RATE OF RETURN (IRR) is the rate (read it as interest rate) at which the project inflows (revenues) and project outflows (costs) are equal. PAYBACK PERIOD is the number of time periods it takes to recover your investment in the project before you start accumulating profit BENEFIT COST RATIO (BCR) a BCR of>l means the benefits are greater than the costs. A BCR of<l means the costs are greater than the benefits. A BCR = 1 means the costs and benefits are the same. OPPORTUNITY COST is the opportunity given up by selecting one project over another

Exercise
For each row on the following chart, enter the letter of the project you would select if the following information were provided.
Project A Net Present Value (NPV) $95,000 Project B $75,000 Which Would you Pick? A

Internal Rate of Return (IRR)

Payback Period Benefit Cost Ratio (BCR)

13%
16 months 2.79

17%
21 months 1.3

NET PRESENT VALUE (NPV) means the present value of the total benefits (income or revenue) less the costs INTERNAL RATE OF RETURN (IRR) is the rate (read it as interest rate) at which the project inflows (revenues) and project outflows (costs) are equal. PAYBACK PERIOD is the number of time periods it takes to recover your investment in the project before you start accumulating profit BENEFIT COST RATIO (BCR) a BCR of>l means the benefits are greater than the costs. A BCR of<l means the costs are greater than the benefits. A BCR = 1 means the costs and benefits are the same. OPPORTUNITY COST is the opportunity given up by selecting one project over another

Exercise
For each row on the following chart, enter the letter of the project you would select if the following information were provided.
Project A Net Present Value (NPV) $95,000 Project B $75,000 Which Would you Pick? A

Internal Rate of Return (IRR)

Payback Period Benefit Cost Ratio (BCR)

13%
16 months 2.79

17%
21 months 1.3

B
A

NET PRESENT VALUE (NPV) means the present value of the total benefits (income or revenue) less the costs INTERNAL RATE OF RETURN (IRR) is the rate (read it as interest rate) at which the project inflows (revenues) and project outflows (costs) are equal. PAYBACK PERIOD is the number of time periods it takes to recover your investment in the project before you start accumulating profit BENEFIT COST RATIO (BCR) a BCR of>l means the benefits are greater than the costs. A BCR of<l means the costs are greater than the benefits. A BCR = 1 means the costs and benefits are the same. OPPORTUNITY COST is the opportunity given up by selecting one project over another

Exercise
For each row on the following chart, enter the letter of the project you would select if the following information were provided.
Project A Net Present Value (NPV) $95,000 Project B $75,000 Which Would you Pick? A

Internal Rate of Return (IRR)

Payback Period Benefit Cost Ratio (BCR)

13%
16 months 2.79

17%
21 months 1.3

B
A A

NET PRESENT VALUE (NPV) means the present value of the total benefits (income or revenue) less the costs INTERNAL RATE OF RETURN (IRR) is the rate (read it as interest rate) at which the project inflows (revenues) and project outflows (costs) are equal. PAYBACK PERIOD is the number of time periods it takes to recover your investment in the project before you start accumulating profit BENEFIT COST RATIO (BCR) a BCR of>l means the benefits are greater than the costs. A BCR of<l means the costs are greater than the benefits. A BCR = 1 means the costs and benefits are the same. OPPORTUNITY COST is the opportunity given up by selecting one project over another

Project cost management

Project

cost management includes the processes required to ensure that the project is completed within an approved budget.

Cost management processes

Resource

planning

The process of determining what physical resources and what quantities of each should be used to perform project activities.
Cost

estimating

The process of developing an estimate of the costs of the resources needed to complete project activities.

Cost management processes

Cost

budgeting

The process of allocating the overall cost estimates to individual work items in order to establish a cost baseline for measuring project performance.
Cost

control is the process of:

Influencing the factors which create changes to the

cost baseline to ensure that changes are beneficial Determining that the cost baseline has changed Managing the actual changes when and as they occur.

Cost management concepts

Estimates Cost estimating Vs. Pricing
Cost Estimating involves developing an assessment of how much it will cost the performing organization to provide the product or service. Pricing is a business decision -- how much the performing organization will charge for the product or service.

Basic Principles of Cost Management

Tangible costs or benefits are those costs or benefits that an organization can easily measure in monetary terms. 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; when deciding what projects to invest in or continue, you should not include sunk costs. WORKING CAPITAL: Current assets minus current liabilities, or the amount of money the company has to 11 invest, including investment in projects.

Basic Principles of Cost Management

Learning curve theory states that when many items are produced repetitively, the unit cost of those items decreases in a regular pattern as more units are produced. Reserves is 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 (sometimes called known unknowns) and are included in the project cost baseline. Management reserves allow for future situations that are unpredictable (sometimes called unknown unknowns). LAW OF DIMINISHING RETURNS: The more you put into something, the less you get out of it. For example, adding twice as many resources to a task may not get the task done in half the time.

Types of Costs:

Capital Cost:
Expenses related to the initial establishment:
Land acquisition, including assembly, holding and

improvement Planning and feasibility studies Architectural and engineering design Construction, including materials, equipment and labor Field supervision of construction Construction financing Insurance and taxes during construction Owner's general office overhead Equipment and furnishings not included in construction Inspection and testing etc. etc. etc

Operating and Maintenance Cost:

The operation and maintenance cost in subsequent

years over the project life cycle includes the following expenses: Land rent, if applicable Operating staff Labor and material for maintenance and repairs Periodic renovations Insurance and taxes Financing costs Utilities Owner's other expenses

The magnitude of each of these cost components depends on the nature, size and location of the project as well as the management organization, among many considerations. The owner is interested in achieving the lowest possible overall project cost that is consistent with its investment objectives. 14

Contingencies provisions:
In most budgets, there is an allowance for contingencies or

unexpected costs occurring during construction. This contingency amount may be included within each cost item or be included in a single category of contingency The amount of contingency is based on historical experience and the expected difficulty of a particular construction project For example, one construction firm makes estimates of the expected cost in five different areas:
Design development changes, Schedule adjustments, General administration changes (such as wage rates), Differing site conditions for those expected, and Third party requirements imposed during construction, such as new

permits.
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Life Cycle Costing (LCC)

Project Cost Management is primarily concerned with the cost of the resources needed to complete the project.
Life Cycle Costing includes acquisition, operating, maintenance, and disposal costs.

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

Cost Estimating

Project managers must take cost estimates seriously if they want to complete projects within budget constraints.

Its important to know the types of cost estimates, how to prepare cost estimates, and typical problems associated with cost estimates.

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ACCURACY OF ESTIMATES The three levels of estimating are:

1.

ROUGH ORDER OF MAGNITUDE ESTIMATE - This type of estimate is usually made during the initiating phase and is in the range of-25% to +75% from actual.

2.

BUDGET ESTIMATE - This type of estimate is usually made during the planning phase and is in the range of-10% to +25% from actual.
DEFINITIVE ESTIMATE - This type of estimate is also made during the planning phase and is in the range of-5% to +10% from actual.

3.

Cost Estimating: Tools and Techniques

Analogous Estimating: Using the actual cost of previous, similar projects as the basis for estimating the cost of the current project. Analogous cost estimating uses expert judgment. Analogous cost estimating is frequently used to estimate costs when there is a limited amount of detailed information about the project Generally less costly than other techniques Generally less accurate Determine Resource Cost Rates For each resource to estimate schedule activity costs. Standard rates with escalation factors can be included in the contract. Obtaining data from commercial databases and seller published price lists is another source of cost rates. Gathering quotes

Bottom-up Estimating
This technique involves estimating the cost of individual work packages

or individual schedule activities with the lowest level of detail. The cost and accuracy of bottom-up cost estimating is typically motivated by the size and complexity of the individual schedule activity or work package. Generally, activities with smaller associated effort increase the accuracy of the schedule activity cost estimates.

Parametric Estimating
Parametric estimating is a technique that uses a statistical relationship

between historical data and other variables (e.g., square footage in construction This technique can produce higher levels of accuracy depending upon the sophistication, as well as the underlying resource quantity and cost data built into the model. A cost-related example involves multiplying the planned quantity of work to be performed by the historical cost per unit to obtain the estimated cost.

Project Management Software

Project management software, such as cost estimating software

applications, computerized spreadsheets, and simulation and statistical tools, are widely used to assist with cost estimating.

Vendor Bid Analysis

Other cost estimating methods include vendor bid analysis and an

analysis of what the project should cost. In cases where projects are won under competitive processes, additional cost estimating work can be required of the project team to examine the price of individual deliverables, and derive a cost that supports the final total project cost.

Reserve Analysis
Many cost estimators include reserves, also called contingency

allowances, as costs in many schedule activity cost estimates. This has the inherent problem of potentially overstating the cost estimate for the schedule activity.

Typical Problems in Cost Estimates

Developing an estimate for a large software project is a complex task that requires a significant amount of effort. People who develop estimates often do not have much experience. Human beings are biased toward underestimation. Management might ask for an estimate, but really desire a bid to win a major contract or get internal funding.

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Cost Budgeting:

Cost budgeting involves aggregating the estimated costs of individual schedule activities or work packages to establish a total cost baseline for measuring project performance.

Cost Aggregation
Schedule activity cost estimates are aggregated by work packages

in accordance with the WBS.

Reserve Analysis
Reserve analysis establishes contingency reserves, such as the

management contingency reserve, that are allowances for unplanned, but potentially required, changes. Such changes may result from risks identified in the risk register.

Funding Limit Reconciliation

Large variations in the periodic expenditure of funds are usually

undesirable for organizational operations. Therefore, the expenditure of funds is reconciled with the funding limits set by the customer or performing organization on the disbursement of funds for the project.

Cost Budgeting: Outputs

Cost Baseline
The cost baseline is a time-phased budget that is used as a basis

against which to measure, monitor, and control overall cost performance on the project.

Project Funding Requirements

Funding requirements, total and periodic (e.g., annual or quarterly), are

derived from the cost baseline and can be established to exceed, usually by a margin, to allow for either early progress or cost overruns. Funding usually occurs in incremental amounts that are not continuous, and, therefore, appears as a step function.

Cost Control

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.

Many organizations around the globe have problems with cost control.

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Cost Control Tools:

Cost Change Control System

A cost change control system, documented in the cost

management plan, defines the procedures by which the cost baseline can be changed. It includes the forms, documentation, tracking systems, and approval levels necessary for authorizing changes.

Performance Measurement Analysis

Performance measurement techniques help to assess

the magnitude of any variances that will invariably occur. The earned value technique (EVT) compares the cumulative value of the budgeted cost of work performed (earned) at the original allocated budget amount to both the budgeted cost of work scheduled (planned) and to the actual cost of work performed (actual). This technique is especially useful for cost control, resource management, and production.

Earned Value Management (EVM)

EVM is a project performance measurement technique that integrates scope, time, and cost data.

It is a method measuring project performance by comparing the amount of work planned with actually accomplished, in order to determine if cost and schedule performance as planned.
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.
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Earned Value Management Terms

The planned value (PV), formerly called the budgeted cost of work scheduled (BCWS), also called the budget, is that portion of the approved total cost estimate planned to be spent on an activity during a given period. Actual cost (AC), formerly called actual cost of work performed (ACWP), is the total of direct and indirect costs incurred in accomplishing work on an activity during a given period. The earned value (EV), formerly called the budgeted cost of work performed (BCWP), is an estimate of the value of the physical work actually completed. EV is based on the original planned costs for the project or activity and the rate at which the team is completing work on the project or activity to date.

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Earned Value Management (EVM)

To perform EVM, three values need to be determined
Planned Value (PV or BCWS)

Actual Costs (AC or ACWP)

Earned Value (EV or BCWP)

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Earned Value Chart for a Project after Five Months

If the EV line is below the AC or PV line, there are problems in those areas.

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Glossary of Terms
EV
PV
Earned value for a task is simply the percent complete times its original budget. Stated differently, EV is the percent of the original budget that has been earned by actual work completed.
The planned time-phased baseline of the value of the work scheduled. An approved cost estimate of the resources scheduled in a time-phased cumulative baseline [BCWSbudgeted cost of the work scheduled]. Actual cost of the work completed. The sum of the costs incurred in accomplishing work. [ACWPactual cost of the work performed]. Cost variance is the difference between the earned value and the actual costs for the work completed to date where CV = EV AC.

AC
CV

SV
BAC EAC ETC VAC

Schedule variance is the difference between the earned value and the baseline line to date where SV = EV PV.
Budgeted cost at completion. Total budgeted cost of the baseline or project cost accounts. Estimated cost at completion. Estimated cost to complete remaining work. Cost variance at completion. VAC indicates expected actual over- or under-run cost at completion.

TABLE 13.1
1332

Variance Calculations:

Cost variance (CV).

CV equals earned value (EV) minus actual cost (AC).

The cost variance at the end of the project will be the difference

between the budget at completion (BAC) and the actual amount spent. Formula: CV= EV AC A negative value of CV would mean Cost over run

Schedule Variance:
SV equals earned value (EV) minus planned (PV). Schedule

variance will ultimately equal zero when the project is completed because all of the planned values will have been earned. Formula: SV = EV PV Negative SV would mean Time over run.

Cost Variance % (CV%)

CV% = CV / EV
If CV% value is positive, the project is currently under budget by the CV%
If CV% value is negative, the project is currently over budget by the CV%

Schedule Variance % (SV%)

SV% = SV / PV
If SV value is positive, the project is currently ahead of schedule
If SV value is negative, the project is currently behind schedule

Performance Indices
Cost performance index (CPI). A CPI value less than 1.0 indicates a cost overrun of the estimates. A CPI value greater than 1.0 indicates a cost under run of the estimates. CPI = EV /AC. CPI is the most commonly used cost-efficiency indicator. Formula: CPI = EV/AC Schedule performance index (SPI). The SPI is used, in addition to the schedule status , to predict the completion date and is sometimes used in conjunction with the CPI to forecast the project completion estimates. SPI equals the ratio of the EV to the PV. Formula: SPI = EV/PV If SPI value is >1 or =1, the project schedule trend is currently ahead or on planned schedule. If SPI value <1, the project schedule trend is currently behind schedule Estimated Cost At Completion EAC. EAC= BAC/CPI

Cost and Schedule Forecasting

Exercises: Exercise #1:Schedule Variance Example. PV = $ 42000 EV = $ 38000 AC = $ 48000 Budget at Completion BAC = $80000 SV = EV PV = $38000 42000 = - $4000 SV % = SV/PV = -4000/42000 = -9.5 % Hence there is schedule overrun of 9.5%

Exercise #2: Cost Variance Example. CV = EV- AC = 38000 48000 = - 10000 CV% = CV/EV = -10000/38000 = -26 % Schedule overrun by 26%

 Exercise # 3 Cost Performance Index ( CPI)

CPI = EV/AC = 38000/48000 = 0.79

Hence $0.79 worth of work was done for every $ 1 spent.

Exercise #4 Schedule Performance Index: SPI

SPI = EV/PV = 38000/42000 = 0.90

$ 0.90 worth of work has been for each done for each $1.00

worth of work that was planned to be done.

Exercise #5. Estimate at Completion and Variance

at Completion
EAC = BAC/CPI = 80000/0.79 = $101265 VAC = BAC EAC = 80000-101265 = - $ 21265. The project

will exceed the planned budget by $21265

Exercise #6

CPI and SPI can be charted each month to show the project trends. Based on the following, what would you be more concerned about, cost or schedule, if you were taking over this project from another project manager?
Answer: The answer is schedule. As of today, SPI is closest to 1.

Exercises #7

You have a project to build a new fence. The fence is four sided. Each side is to take one day to build and is budgeted for US $1,000 per side. . The sides are planned to be completed one after the other. Today is the end of day three. Using the project status chart, calculate EV, PV AC, CV, SV, BAC, EAC, ETC, VAC, SPI, CPI?

S-Actual Start; PS-Planned Start; F-Actual Finish; PF-Planned Finish

Answer to Exercise #7

Using Software to Assist in Cost Management

Spreadsheets are a common tool for resource planning, cost estimating, cost budgeting, and cost control. Many companies use more sophisticated and centralized financial applications software for cost information.

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Chapter Summary

Project cost management is traditionally a weak area in projects, and project managers must work to improve their ability to deliver projects within approved budgets. Main processes include:
Cost estimating Cost budgeting

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Cost control