Organizations aim for their projects to succeed and to meet client expectations, as well as their internal objectives. But what is the reality on the ground? In a PMI report, 14% of the surveyed IT projects were deemed as failures. Only 57% of the projects were finished within their initial budgets, with the others exceeding the target they had set for themselves.
This is not good news for enterprises as cost overruns not only impact their margins, but also hinder the ability to execute future projects. Understanding what project cost management is and how to be effective at it can be beneficial for organizations to stay on track.
In this article, we look at what project cost management is, its benefits and the steps involved in its implementation.
What is Project Cost Management?
Project cost management is the process of estimating, budgeting and controlling costs throughout the project life cycle, with the objective of keeping expenditures within the approved budget.
For a project to be considered a success, it’s necessary that
- it delivers on the requirements and scope
- its execution quality is of a high standard
- it’s completed within schedule and
- it’s completed within budget.
Hence, project cost management is one of the key pillars of project management and is relevant regardless of the domain, be it manufacturing, retail, technology, construction and so on. It helps to create a financial baseline against which project managers can benchmark the current status of their project costs and realign the direction if needed.
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Why is Project Cost Management Important?
The importance of cost management is easy to understand. To take a simple, real-life example, if you decide to build a house, the first thing to do is set the budget. When you have a sense of how much to spend on the project, the next step is to divide the high-level budget into expenses for sub-tasks and smaller line items.
The budget will determine critical decision points such as: which designer to hire — someone who will construct and deliver the project end-to-end, or someone who can help with a few elements and be able to work for a smaller budget? How many stories should the structure have? What quality of materials should be used?
Without a predefined budget, not only is it difficult to answer these questions, but it becomes impossible to assess whether you are progressing in the right direction once the project is underway. In large organizations, the scale of this problem is further heightened due to concurrent running of multiple projects, change in initial assumptions and the addition of unexpected costs. That’s where cost management can help.
By implementing efficient cost management practices, project managers can:
- Set clear expectations with stakeholders
- Control scope creep by leveraging transparencies established with the customer
- Track progress and respond with corrective action at a quick pace
- Maintain expected margin, increase ROI, and avoid losing money on the project
- Generate data to benchmark for future projects and track long-term cost trends
The Four Steps in Project Cost Management
While cost management is viewed as a continuous process, it helps to split the function into four steps: resource planning, estimation, budgeting and control. They are mostly sequential, but it’s possible that some resource changes happen midway through the project, forcing the budgets to be adjusted. Or, the variances observed during the control process can call for estimate revisions.
Let us look at each of these four steps in detail.
1. Project Resource Planning
Resource planning is the process of identifying the resources required to execute a project and take it to completion. Examples of resources are people (such as employees and contractors) and equipment (such as infrastructure, large construction vehicles and other specialized equipment in limited supply).
Resource planning is done at the beginning of a project, before any actual work begins.
To get started, project managers first need to have the work-breakdown structure (WBS) ready. They need to look at each subtask in the WBS and ask how many people, with what kind of skills are needed to finish this task, and what sort of equipment or material is required to finish this task?
By adopting this task-level approach, it becomes possible for project managers to create an accurate and complete inventory of all resources, which is then fed as an input into the next step of estimating costs.
A few tips to consider during the process:
- Consider historical data—past schedules and effort—before determining sub-tasks and the corresponding resources.
- Take feedback from SMEs and team members—a collaborative approach works well especially in projects that do not have past data to use.
- Assess the impact of time on resource requirements. For instance, a resource may be available only after a few months, dragging the project’s schedule. This could have an impact on cost estimation.
- Although this step happens at the planning stage, project managers need to account for ground realities. For example, you may identify the need for a resource with certain expertise, but if such a resource is not available within the organization, you have to consider hiring a contractor or training your team to get them up to speed. All of these variables impact cost management.
2. Cost Estimation
Cost estimation is the process of quantifying the costs associated with all the resources required to execute the project. To perform cost calculations, we need the following information:
- Resource requirements (output from the previous step)
- Price of each resource (e.g., staffing cost per hour, vendor hiring costs, server procurement costs, material rates per unit, etc.)
- Duration that each resource is required
- List of assumptions
- Potential risks
- Past project costs and industry benchmarks, if any
- Insight into the company’s financial health and reporting structures
Estimation is arguably the most difficult of the steps involved in cost management as accuracy is the key here. Also, project managers have to consider factors such as fixed and variable costs, overheads, inflation and the time value of money.
The greater the deviation between estimation and actual costs, the less likely it is for a project to succeed. However, there are many estimation models to choose from. Analogous estimation is a good choice if you have plenty of historical cost data from similar projects. Some organizations prefer mathematical approaches such as parametric modeling or program evaluation and review technique (PERT).
Then there is the choice between employing a top-down versus bottom-up approach. Top-down typically works when past costing data are available. In this, project managers usually have experience executing similar projects and can therefore take a good call. Bottom-up works for projects in which organizations do not have a lot of experience with, and, therefore, it makes sense to calculate a cost estimate at a task-level and then roll it up to the top.
Cost Estimation as a Decision Enabler
It’s useful to remember that cost estimation is done at the planning stage and, therefore, everything is not yet concrete. In many cases, project teams come up with multiple solutions for a project, and cost estimation helps them decide how to proceed. There are many costing methodologies, such as activity-based costing, job costing, and lifecycle costing that help perform this comparative analysis.
Lifecycle costing, for instance, considers the complete end-to-end lifecycle of a project. In IT projects, for example, maintenance costs are often ignored, but lifecycle costing looks long-term and accounts for resource usage until the end of the cycle. Similarly, in manufacturing projects, the goal is to minimize future service costs and replacement charges.
Sometimes the estimation process also allows teams to evaluate and reduce costs. Value engineering, for example, helps to gain the optimal value from a project while bringing costs down.
3. Cost Budgeting
Cost budgeting can be viewed as part of estimation or as its own separate process. Budgeting is the process of allocating costs to a certain chunk of the project, such as individual tasks or modules, for a specific time period. Budgets include contingency reserves allocated to manage unexpected costs.
For example, let’s say the total costs estimated for a project that runs over three years is $2 million. However, since the budget allocation is a function of time, the project manager decides to consider just the first two quarters for now. They identify the work items to be completed and allocate a budget of, say, $35,000 for this time period, and these work items. The project manager uses the WBS and some of the estimation methods discussed in the previous section to arrive at this number.
Budgeting creates a cost baseline against which we can continue to measure and evaluate the project cost performance. If not for the budget, the total estimated cost would remain an abstract figure, and it would be difficult to measure midway. Evaluation of project performance gives an opportunity to assess how much budget needs to be released for future phases of the project.
Another reason to firm up budgets is that organizations often rely on expected future cash flows for their funding. During the initial phases, the project manager has a limited financial pool and has to set targets accordingly. It’s similar to building the foundation and one floor of the house in the initial few months and later completing the rest of the project, as you save more.
4. Cost Control
Cost control is the process of measuring cost variances from the baseline and taking appropriate action, such as increasing the budget allocated or reducing the scope of work, to correct that gap. Cost control is a continuous process done throughout the project lifecycle. The emphasis here is as much on timely and clear reporting as measuring.
Along with the cost baseline, the cost management plan is an essential input for cost control. This plan contains details such as how project performance will be measured, what is the threshold for deviations, what actions will be done if the threshold is breached, and the list of people and roles who have the executive authority to make decisions.
Earned value management (EVM) is one of the most popular approaches to measuring cost performance. Let’s take an example.
At the end of a week, you measure the progress of task X and find that it’s 25% complete. Now, how do you assess if you are on track to meet the task budget?
First, a project manager calculates the planned value for this task (at the planning stage). Let’s say, Task X has a budget of $4000 and is expected to be 50% complete by the week.
Planned value (PV) of task X by the week = $4000 * .5 = $2000
Earned value (EV) of task X by the week = $4000 * .25 = $1000
Now, you also determine the actual cost (AC) of the work, which involves other variables such as equipment and material costs (say, $800).
Schedule variance = EV – PV = $1000 – $2000 = -$1000.
Cost variance = EV – AC = $1000 – $800 = $200.
The negative schedule variance indicates that the task is falling behind, but the positive cost variance indicates that it’s under budget.
While dealing with hundreds of tasks in huge projects, cost control can provide the level of transparency that decision makers require to respond quickly to the situation.
Project Cost Software
Cost management, similar to other aspects of project management, becomes complex with many variables in play. The process itself is elaborate and demands attention to detail along with a rigorous approach. The use of project management software can simplify this process considerably.
Let’s look at a few advantages of using project cost management software:
- Automation of cumbersome quantitative analysis during estimation and measurement helps avoid manual errors
- Integration of data across planning, estimation, budgeting, and control enables continuous monitoring and quick, proactive responses, rather than one-off interventions
- Decision-making is made easier as cost software helps evaluate alternate solutions using scenario forecasting and what-if analysis
- Clear and easy reporting in the form of dashboards and other rich UIs
- The complexity of multicurrency management in projects across different geographical locations is simplified with project cost software
- Many project cost solutions allow third-party integrations, so data can be pooled and analyzed
- Benchmarking and standardization are possible with the availability of performance data across multiple projects
Cost Management and Enterprise Project Performance
In the 2018 PMI Pulse of the Profession Report, 41% of respondents said that their projects are of high complexity. It’s no surprise then that 40% of the survey participants consider “investing in technology to better enable project success” as a top priority.
Cost management is closely tied to the capability of an organization to succeed in current as well as future projects. Investing in a reliable cost management software can result in huge savings. A good solution to cost management will not treat it as a siloed function but leverage it as vital to project and portfolio performance, and correlate data across projects.
Visit these additional resources for more information on project cost management:
Solutions: Project Portfolio Management, Project Controls & Project Management, Earned Value Management
Process Area: Cost Control
Blog: 6 Best Practices for Project Controls, Foundations of Good Earned Value Management