PMP Exam Prep – Part 10: Project Cost Management
In this Section, we will address issues relating to cost at a project management level. It is very helpful to have as broad a background as possible in addressing questions on cost, as questions on cost in the exam are rather diverse, ranging from Earned Value Analysis (EVM) to Accelerated Depreciation, Cost Risk and Contract Types and so on.
Cost Activities throughout the Project Lifecycle
There are three processes that relate to cost when it comes to the Project Lifecycle:
- Estimate Costs
- Define Budget
- Control Costs
Questions really focus on how we build our cost, structure our cost, map our cost, and keep track of our cost.
There are a number of different ways to estimate costs and they are tested in the exam. We can build estimates from the bottom-up or from the top-down.
Where do we start looking at when we come up with the estimates for a project’s costs? If you are building an estimate from the bottom-up with the very tiny, finite details, then you will use the WBS. We look directly at where all the work is done, at the work package level.
We would do this because we have the work already broken down into small amounts and it is always easier to estimate something that is smaller in magnitude rather than something that is larger. We typically do not report out our costs to the organization at the granular level of the work package. We commonly do so at one level above the work package, known as the Cost Account level. Our estimates tend to be pretty accurate when we start at the work package level.
The definitive estimate is what you would have if you created an estimate starting at the work package level. The definitive estimate is also known as a bottom-up estimate; a grass-roots estimate or even an engineering estimate. The order of accuracy here is from (–5 to +10%)†. The range of percentages used by PMI to describe the range of accuracy of the various estimates has been used for many years and this range comes primarily from the construction industry.
Definitive estimates are the ideal, but the big down side is that a large amount of time that has to be invested in creating this estimate. Furthermore, Customers and Management may also want estimates in earlier stages of the project, where the project team hasn’t yet defined the WBS at the work package level.
Budgetary estimates are also known as top-down estimates; or analogous estimates. An analogous estimate can be created when we look at past projects or elements of past projects and we try to draw an analogy or parallel between how costs looked like at that time and how the costs might look like in our current situation for similar projects. The range of accuracy here is from (–10 to +25%)†. The range of accuracy has expanded more compared to the definitive estimate because we do not have a lot of the detailed information that we need in order to come up with a more accurate estimate from a work breakdown structure.
There are many things to consider with the analogous estimate and one of the things we need to capture are the lessons learned. If your organization had not captured the lessons learned previously, then you might not have this data. We look at past projects and we look at what was similar to the projects that we are doing now and what are the differences that would be significant to the cost differences between the previous project and what we are doing today. This is a kind of estimate that can be done much earlier on in the project.
Order of Magnitude Estimates
Order of magnitude estimates are also referred to as classic estimates; ballpark estimates; ‘guesstimates’ or S.W.A.G.s (Scientific Wild Anatomical Guesses). A simple situation where a project manager is asked to come up with this type of estimate is when the boss calls you in and says, “I have a meeting that is starting in 10 minutes and I need an estimate from you and don’t worry, I won’t hold you to it.” The order of accuracy here is from (–25 to +75%)†. Remember that this range had an order of magnitude that is a 100%.
†A note on the ranges of accuracy
As we look at the range of estimates, you will notice that the ranges tend to be of higher magnitude on the positive site and lower on the negative side. In other words, we tend to assume that we are going to foul things up and so we build our estimates that tend to be more accurate on the downside. People tend to be optimistic and therefore we see a greater range of accuracy on the positive side than on the negative side.
When coming up with a parametric estimate, we look at the parameters or dimensions of the estimate itself. By looking at the parameters of the estimate, we can come up with the Parametric Estimate fairly quickly. This is an estimation method that takes specific values; combines them with other values and then uses this relationship to come up with an estimate.
For example, a contractor was asked to give a quotation for some construction work on a site. He was observed to do the following: He went to the site, looked at the site, paced around the site in a square area by taking broad steps across the site, looked at the customer and then subsequently offered an estimate of forty-five thousand dollars. When asked for where that figure came from, he said that was his basic parametric estimate of $225 per square foot.
The contractor was using his experience and his knowledge to come up with the estimate, but there are a lot of formal parameters.
For example, in construction, if you are building an office in a particular location, you may use a parametric estimate in terms of dollars per square foot. In the software business, it could be dollars for lines of code. In the construction engineering business if you were building a highway for example, a common parametric estimate would be based on dollars per lane mile or kilometer.
Ultimately, you are comparing one variable to another variable and finding a relationship between the two. Such that when a variable moves in one direction, the other variable is going to move along with it.
Parametric estimating is something that is very commonly used for order of magnitude estimates or for budget estimates. Parametric estimating is something that is very commonly used for budgetary estimates as well.
Function Point Analysis
Function Point Analysis is a type of parametric estimate. Function Point Analysis is commonly used when estimating the costs of software application development. Specific functions or features are determined and are aligned with cost factors associated with building these features.
The functions are things that the software is going to do. It is a function of the software application itself and the software engineer will determine the number of functions that a particular software application will have and then come up with an estimate based on the number of functions.
Function Point Analysis is one of the more common types of cost estimating methods where software is being developed as opposed to using a parametric of lines of code.
The Learning Curve is a concept that states that over time, the costs of doing more work should decrease because we’ve gotten more proficient at performing the work. For example, when I first started learning how to roller blade, it took me about three weeks of practice to be able to roller blade a complete mile. It took me another three hours of practice to rollerblade a two mile distance and the third mile came down to another thirty minutes. As you can see, we are getting better at doing things as we move along. This is the meaning of the Learning Curve.
Law of Diminishing Returns
The Law of Diminishing Returns identifies a basic economic situation where as you put more and more of anything into something you get proportionately less out of it. For example if it costs you a million dollars to get 99% of quality out of a process, it might cost you another million dollars to get to 99.9%, the question is if it is really worthwhile to do that?
Different types of Costs
In the exam, you will be given a scenario and then asked what type of cost the question is referring to. One such example is to distinguish between variable and fixed costs
- Variable Costs: Variable costs rise in proportion to the amount of work done. For example the costs associated with skilled labor or materials consumed directly by the project are variable costs. As you progress through the project, you consume more materials and you expend more labor. If you stop working, then you don’t consume any more materials or labor.
- Fixed Costs: Fixed costs are a non-recurring cost and relate to one-time expenditures. PMI likes to use equipment as an example of fixed costs in the exams.
- Direct Costs: Direct Costs are the costs that are directly ascribable to a given project. You can point to a component and say that it is one of your costs and you are paying for it. When you are painting a room, the paint is a direct cost. It is something that you have to incur when doing that project
- Indirect Costs: Indirect Costs can be defined as the cost of doing business aside from the actual cost of conducting the business itself. Commonly known as overheads, lighting, heating and rental costs are examples of indirect costs.
Defining a Budget
Cost Accounting is a fundamental notion that transfers over from the section on Project Scope Management. Recall that the Cost Account or Control Account exists at one level above the work package in the WBS. The Control Account is commonly used for tracking the finances of a project by the functional organization.
At the project level, we can monitor our costs at the work package level. At the functional level or the organizational level, we want to track costs one level higher at the Cost Account level. This is because it is not efficient for management to monitor costs at the detailed level of the individual work packages.
Cost Management Plan
Cost management is a subsidiary element of the project plan. The cost management plan describes how cost variances will be managed in the project. Variances can occur on both the positive side and as well as the negative side. Candidates must understand the difference between the Cost Management Plan and a Budget.
From a practical point of view we cannot address variances as something which is ‘one size fits all’; We can have major variances and then minor variances depending on the nature of the related work packages. The cost management plan describes how each of these will be managed.
The Cost Control Process is similar to the Scope and Schedule control processes in that it is concerned with the factors that can potentially change the cost baseline. We need to determine if changes have occurred to the cost baseline and we need to manage those changes when they occur.
You need a cost management plan in place to address issues of cost control. It is one of the key inputs to the actual cost control effort. All project team members should know how the project manager is going to handle such variances when they occur.
Stakeholders don’t like to get caught off guard with variances and if we are looking at some cost reports and we have a cost overrun of %200, then there has to be a plan in place in order to address that.
Earned value is tested extensively in the exam. This is is a difficult concept for many candidates because Earned Value is commonly not used by many candidates prior to studying for the exam. There are a number of questions on the exam relating to Earned Value, but they tend not to ask you to perform any calculation, but require you to understand the various formulas and identify which formula to apply in a given situation.
Cost Schedule Control Systems Criteria (CSCSC)
Earned Value is a component of CSCSC. This came out of the US Federal Government back in the 60s and 70s when an entire system of cost control and reporting was formed. So there might be an example of that in the exam.
Example calculations for EV
The examples given on the exam are rudimentary. However, if you do not know what the formulas are, then you might not be able to answer the questions correctly.
- Planned Value (PV): This is also known as the Budgeted cost for the Work that was scheduled (BCWS). Planned Value refers to how much money has been planned into the project at one point in time. How much money has been set aside for the project as of a given data-date. The ‘data-date’ is a point in time we are looking at in evaluation. It is an estimate. When you are estimating the work that has to be done for a job, you are really estimating the Planned Value for the work. This can be figured out at any given point in time for the project.
- Actual Cost (AC): Also known as the Actual Cost for the Work Performed (ACWP). The Actual Cost is how much work we have actually spent on so far. In other words, it is the actual cost for the work done.
- Earned Value (EV): Also known as the Budgeted Cost set aside for the Work Performed. (BCWP) How much we had planned to spend for the work that we had actually gotten done.
Budget at Completion (BAC)
- : BAC represents the total cost of the project. The total of all the planned value estimates
- Estimate at completion (EAC): EAC is what we now expect the total job to cost based on our performance to date.
- Estimate to Complete (ETC): How much more do we expect the project to cost based on our performance to date. We are not concerned with what you have spent so far. You are only concerned with how much you have left to spend to complete the project.
Candidates tend to find some confusion between EAC and ETC. Make sure you can distinguish between these terms.
Earned Value Formulas
You will be required to understand and apply the following formulas. Exam focuses on the basic formulas. EV is always the first acronym in any equation when it comes to calculating cost. All values are expressed in dollars and not days or weeks. Also, be wary as to how negative numbers are represented in the exam. For example, negative 200 can be expressed either by (200) or “-200”.
Negative Variances are bad and Positive Variances are good
- Cost Variance (EV – AC):How much you planned to spend less how much you actually spent at that point in time.
Positive Cost Variance: Earned Value (Budgeted Cost) is greater than Actual Costs.
Negative Cost Variance: Spent more than you budgeted for.
- Is a negative cost variance bad? Typically a negative value is bad, but depending on where you are in the project you might be able to recover. The earlier in the project where you find the cost variance, the more time that you will have to correct the problem. If you are on the last activity for a project and you find out that you are having a negative cost variance, then that is not good news.
- Schedule Variance (EV – PV):The work that we scheduled and we are subtracting from that the work that we have done.
Positive Schedule Variance: I have performed $200 dollars of work and I had planned to do $400 of work done by now. Scheduled variance is -$200. I am behind by $200 worth of work. That is BAD
Cost Performance Index
We want to be able to look at how we are performing on this project. Is everything going as planned? We want to find out how much we are extracting from each dollar that we had invested. Most of the questions tend to have nice round numbers when it comes to CPI questions. PMI is not trying to test your mathematical abilities. They are trying to test your understanding of the concepts behind the Earned Value management system.
- Cost Performance Index (CPI) (EV /AC): If I have an earned value of $200 and I have an Actual cost of $400, then I have a CPI of 50 cents. For every dollar of effort that you are putting into this particular effort or activity, you are only getting back 50 cents worth of work. That is BAD
- Total Budget (BAC) (Σ PV ): The sum of all the Planned Value amounts in the project a.k.a. total budget
- Estimate to Complete (ETC) (ETC = EAC – AC):ETC is the Estimate At Completion minus the Actual Costs. How much more money we need to complete the project at this point in time.
- Estimate at Completion (EAC): What the job is going to cost based on a number of different factors. We may see a variety of formulas to come up with different ways to calculate EAC, all of which will give you varying answers to the same question. They will describe a prospective situation for which the EAC will be:
EAC = BAC/CPI
EAC = (AC + Remaining Budget) / CPI
The first formula for EAC is used when the current variances are seen as typical of future variances.
EAC = (AC + New Estimate for All Remaining Work)
The Second formula is based on the fact that when past performance shows that original estimates were not only flawed or are no longer relevant because of a change in the conditions.
EAC = (AC + Remaining Budget)
The third formula for EAC is based on the fact that when our current variances are seen as atypical.
The key in knowing which formula to apply is by looking at the question and looking at the descriptive clues as to what formula should be used to determine the value of EAC.
The fundamental idea behind EAC is in what we now expect the total job to cost. We have to understand that the value of the Earned Value Management System is in collecting this information to help us to look to the future.
- Variance at completion (VAC) (VAC = BAC – EAC):Variance is a measure of how far off the mark we are. It is the one thing that management is always concerned about.
We are looking into the future and assuming that based upon our current performance, how much our variance is going to be at the end. i.e. continuing at this rate, given our actual costs, what are the variances going to be at the end? Positive is good in this case.
Applying Earned Value concepts
How do we go about applying Earned Value and how we go about tracking our progress? A question that we might often find ourselves asking team members is ‘how far along are you with the work?’ and Earned Value may help us to answer that question to a certain degree.
For Example: You are painting a room. According to Earned Value estimates, how far along are you in this Painting project?
- 50/50 rule
If I had started the project, I would report 50% complete. In other words, once I start the project, I would report 50% of the work complete. So my earned value is 50% of whatever the planned value is. This applies even though I just put my brush to the wall. I opened up a paint can. I am 50% complete for earned value purposes.
Conversely, if I have almost finished painting the room and I have completed 99% of the work, according to Earned Value, I have still only completed 50% of the work. Only when I have completely finished the job, can I report the other 50% complete for Earned Value purposes.
- 20/80 rule
When I start a project or activity, I report 20% done and only when I complete the job, I report the other 80%.
- 0/100 rule
This is the most conservative among the 3 reporting rules. I cannot report any of the work as being complete until the work has been completed 100%. This is normally reported at the work package level.
Present Value represents the value to us today of future cashflows. Payment today is worth more than payment sometime in the future. For example getting a thousand dollars in your hand today is more valuable than getting the same sum tomorrow or 2 years from now, because we could spend the money today or simply invest it and get some interest back from the original sum. Conversely, at 10% interest, the sum of $1000 a year from now is worth nine hundred and ninety dollars today.
While you don’t have to do many calculations on present value for the exam, you will have to be aware of the fundamental concepts behind Present Value. Present Value is a way where we can try to determine which projects have to be done. It is the context generally in which present value will be used.
Benefit Cost Ratio (BCR) (Benefit / Cost)
BCR is used as a project selection technique. A BCR value of ‘one’ means that we are at a breakeven point in the project. If the BCR is smaller than one, it means that we are spending more money than we are investing into the project. A BCR of ‘greater than one’ means that our project is profitable.
Example: We are going to make 2 million dollars on this project but it will cost us a million dollars. The BCR is calculated as follows:
BCR = Benefit / Cost
= $2m / $1m
The BCR is a ratio and has no units. This means that it’s not a good tool to compare between different projects. For example, another project costs promises a return of $200 in return for an investment of $50.
BCR = $200/$50 = 4
On paper the BCR of this second project seems much higher than the first project which has a BCR of 2. However one project provides us with a return of $1m and the other with a return of $200. It is misleading to compare between the two.
Internal Rate of Return
IRR is not a simple mathematical calculation-based concept like EV. You won’t have to calculate it on the exam because there is no ready formula to use in the examination environment. IRR is standard way of calculating the return on an investment or project and is calculated the same way regardless of which company we are looking at. Different companies do NOT come up with their own ways of calculating IRR. IRR is based on the concept of Present Value. A larger percentage value of IRR is more desirable. It is similar to a basic investment.
Key points to be aware of when it comes to the exam: IRR is consistent across organizations. It is a basic financial measure. There is no ready formula for use when it comes to calculating IRR.
A Payback Period is measured in terms of time and not dollars. When you look at your project, you look at the number of time periods up to where your cumulative revenues exceed your cumulative costs, i.e. your project has turned a profit. The Payback period is the amount of time it takes for us to turn a profit.
The shortest payback period is usually the best answer. The most attractive is to have it shorter because we want to see those returns as soon as possible. We don’t want our investment to be hanging there and want a return as soon as is reasonable or possible.
Opportunity Cost refers not so much to what we didn’t do, but more about what we could have gained had we done so. A simple example to illustrate this concept can be derived from a dollar bill.
The dollar bill that I hold in my hands is here because I forgot to pick up a lottery ticket. I was supposed to pick up the lottery ticket yesterday and I always make it a point to pick up a lottery ticket. By virtue of opportunity cost, I have a dollar that I could have invested in a lottery ticket. Because I know that this would have been the time that I won the lottery, I missed out on winning the lottery prize that is 100 million dollars.
My opportunity cost associated with this dollar bill is ninety nine million nine hundred and ninety nine thousand, nine hundred and ninety-nine dollars, of course less what ever I would have to pay in taxes.
If you see a question that involves opportunity costs, then expect to see these terms – ‘would have’, ‘should have’, ‘could have’, ‘might have’, or ‘may have’. If the question uses these terms, then it might be leading you towards opportunity cost.
For example: “We could have gone after this work; we should have gone after this work; our competition went after this work. If we had done this, then it would have made us this much money or generated us this much revenue.”
Sunk Cost requires you to forget the past or the money that you have spent to date as you are looking forward towards the end of the project and this is very difficult for a lot of people to do.
Example: A co-worker has a nasty habit of buying beat up cars and putting a lot of money into them in order to restore them. In the process of maintaining his 1959 vintage Ford Truck, he sunk a total of $40,000.00 before finally giving up the car. A lot of people asked why he was throwing so much money into this car.
The answer to that lies in Sunk Cost. The notion is that you forget about the money that you sunk into something and you look ahead and you make an evaluation based on how much additional investment you make from this point forward.
Instead of looking at the 38 or 39 thousand dollars that he had spent so far, he asked questions such as how much was this little piece of equipment such as a water pump or air filter.
We apply this to projects when we look at a project that we invested four million dollars into in order to get one million dollars return out of it. We ask ourselves if it is worth it to spend the last two hundred thousand dollars’ worth of work. The answer is that we have to complete this project. The rationale here is that we are almost at the end of the project and for a couple more hundred thousand dollars we will see the final return of a million dollars and at the very least minimize our losses.
Emotionally, people are tied to the amount of money that they have already spent and they have to get over that barrier to realize the benefits.
Contingency Reserve is defined for something like a risk generally that has been planned for and some money has been set aside to take care of that risk should that occur A contingency reserve is something that you had on hand as a contingency in case anything happened. You also usually have the contingency reserve as part of your budget and you would probably show that as part of your overall project budget
Management Reserve is a pot of money or time set aside to address risks that turned into problems that you did not plan for. I.e. Murphy ’s Law would be a type of risk that would be covered by management reserve. Management reserve is where you usually have to go around begging for money from the powers that be. So you have to supplant yourself to management because you had to go spend this money.
PMI is trying to get away from their term of management reserve, they are trying to work their way towards the term reserve as being a more generic term. You may still run into management and contingency reserve during the exam.
Working Capital is defined as Current Assets less the Current Liabilities. You need to know the fundamental definition of working capital and what it is. This is generally good for one question in the exam.
Depreciation of Capital
For accounting purposes, a company may want to depreciate the value of an asset over time. This has a direct impact on the amount of tax that a company has to file in its return. You need to know of the various types of depreciation.
- Straight-line Depreciation: Things that we are willing to make a long term investment in. for example if you see that Dark Cherry furniture in your Boss’s office, then chances are they are using that straight line depreciation because they don’t mind taking their time writing that stuff off.
- Accelerated depreciation: We perform accelerated depreciation on things that we want to get our return out of very quickly. For example, computers and hardware or some of the large-scale software are generally depreciated using accelerated depreciation. For example, I am buying a used piece of equipment. I should use accelerated depreciation, because I want to depreciate my investment fast and get the potential tax benefits from the depreciation itself.
For the exams, one of the examples that you are going to see on accelerated depreciation is in items such as technology that become quickly obsolete. And if it is a very old building, then you want to use accelerated depreciation. The terms Double Declining Balance and Sum of the Years-digits may come up in the exam. These are various methods of performing depreciation on an asset.
Value Analysis can be defined as simply looking at an item and trying to establish if it is worth paying for.
For example, if you were to buy a new car and I told you that it would cost $400 for a full set of the cup holders that went into your car, would you be willing to spend that amount of money? Most people would not want to pay that money. I would be willing to pay that amount of money in a heartbeat and that is a classical example of value analysis. I put a high value on those cup holders. I know how much it is going to cost me to clean the stains on the carpets because there were no cup holders.
Life-cycle costs are different from project costs because it includes every cost associated with the project, including acquiring, operating and maintaining and disposing of the final project deliverables over the lifecycle of the project.
Summary: Project Cost Management
- Accuracy of estimates
- Values of estimates
- Benefit cost ratios
- Internal rate of return
- Payback period
- Different types of cost estimating
- Earned value
In this section, we looked at the different ways of coming up with a cost estimate and then using that estimate to build a budget, which is another baseline in the project. When it comes to controlling costs, we need to be very familiar with the concepts of Earned Value, and also some basic cost accounting concepts such as IRR and depreciation.
In the next section, we will cover Project Quality Management.
Ook! Road Chimp, reaching for a banana.