Managing Project Finances
Understanding and Controlling Project Costs
A well-managed project is completed on time, on spec, and on budget.
It's generally the case that cost is one of the major factors in determining the success of a project – and no one wants to be responsible for a cost overrun. With that in mind, how do you make sure that you keep "on budget" with your project?
The simple answer is "control." If you're going to have any chance of staying within budget then you need to manage the project costs proactively and systematically. Thankfully, there are many tools and ideas that can give you this control.
Project cost management includes three basic processes:
- Cost estimating – Making your best assessment of the costs of the resources needed to complete a project.
- Cost budgeting – Assigning cost estimates to individual work items, and establishing a baseline for measuring performance.
- Cost control – Controlling changes to the project budget.
By managing these processes, and their inputs and outputs, you can develop an effective system to ensure that your resource costs remain within the approved budget. In short, project cost management is the process of doing the following:
- Communicating budget limits to project designers, and to the people who are implementing the project.
- Collecting actual cost data.
- Comparing actual costs to the original budget.
- Taking corrective action as needed.
Let's look at the three project cost management processes in turn.
1. Cost Estimating
Estimating is a critical part of managing project finances. Estimates are used for all sorts of activities, including budgeting, forecasting, resource planning, and staffing. It's important that you estimate the costs for all resources that will be charged to the project – including items such as labor, materials, and supplies – as well as any contingency costs.
A cost estimate is an assessment of how much it will cost for all resources necessary to complete project activities. It's also a good idea to identify and consider cost alternatives, and include these in the estimate.
To determine which costs to estimate, you can use a variety of inputs, the most of common of which is the work breakdown structure (WBS). This is a detailed list of all the things that need to be delivered, and the activities that need to be carried out to complete the project. The project scope statement also has information related to resource requirements, restrictions, and assumptions – which can help you identify cost alternatives, if appropriate.
To complete your estimates, there are a variety of tools and techniques you can use:
- Analogous estimating – Use data from previous projects to build an estimate of costs for the current project. This can help if you have limited information or detail on your current costs. For example, look at similar, or analogous, items in the previous project, add 5 percent for inflation, and you may have a reasonable estimate.
- Resource cost rates – Establish unit costs for hours and materials by using the various quotes and planning documents you've received. For example, if labor costs for a construction project are an average of $12 per hour, and you need 10 people to work 160 hours each, the labor cost estimate is $19,200. Add the costs of materials, and you have an estimate for the total construction.
- Bottom-up estimating – Use the smallest work component in the work breakdown structure, and estimate the cost of each. Then combine these, as you move up the levels, to determine an overall cost estimate. For our construction example, you need to build walls, add plumbing and electrical, add doors and windows, finish floors, and paint. Estimate the cost of each of those items, and add them together.
- Parametric estimating – Use the statistical relationship between cost and some other characteristic of the item being estimated. Square footage of a building or the number of words written per page – these are examples of elements used to create a cost estimate. If our construction project is 800 square feet, and it costs about $60 per square foot to build and finish office space, then the total estimate is $48,000.
- Computer software – Many project management programs can calculate estimates for you using statistics or simulations.
Once you've determined your cost estimate, make sure you record the information, and document your estimation process. When providing supporting detail, you may need to include the following:
- A description of the activity.
- Documentation of your methods and calculations.
- A list of assumptions made, and restrictions applied.
- A typical range for a reasonable margin of error in your estimate.
2. Cost Budgeting
Once you have put together your activity cost estimates, you can now prepare a budget. This is the document that can help you get the funds you need to complete the project. You'll probably have to stay within your original budget, so it's best to build in an adequate reserve – a little extra – for unexpected expenses.
What you are looking to create through the budgeting process is a cost baseline. This represents the approved budget, and is used to compare and contrast with the actual project costs over time. The cost baseline serves as confirmation of what the project's cost structure looked like when the project was originally approved. Using the baseline, you can determine if cost performance to date is within acceptable parameters. As the project progresses, costs are monitored against the baseline, and any changes are expressed relative to the baseline. The baseline serves as a primary metric for evaluating performance, so it remains stable, and changes are reflected relative to it.
It's important to keep a good balance here. If you budget too high, you may not succeed in securing funding for your project. If you budget too low, it may be impossible to stay within those costs, and you'll risk a poor outcome.
The following tools will help you prepare a reasonable budget for your project:
- Cost aggregation – Aggregate, or add up, the figures in your activity cost estimates to determine an overall budget amount. For example, to build a fully operational help desk, add the estimated costs of renting the space, hiring and training the support desk staff, and purchasing and installing the equipment.
- Reserve analysis – Build in a contingency budget – some extra funds – in addition to the estimates for the actual activity costs. This reserve account will help you deal with unplanned changes and unexpected expenses that may be necessary at some point during the project.
- Parametric estimating – Use predetermined parameters to add budget amounts for elements of the plan that aren't part of the activity estimates. For example, historical data may tell you that the average project in your organization runs 4 percent over budget. If you add an extra 4 percent, you'll probably improve the accuracy of your total budget.
Funding limit reconciliation – When preparing your budget, be aware of the expected cash flow. You probably won't be given all of the money up front, to be spent whenever and however you want. It's more likely that you'll be expected to spread your total budget over the duration of the project. This means that you need to consider cash flow, and possibly adjust the project schedule accordingly. A well-planned budget looks at how and when work is done, not just the total costs.
Project managers use funding limit reconciliation to avoid large variations in the periodic expenditure of project funds. They do this by reconciling project expenditures with the funding limits set by the customer. Reconciliation may require the revision of project schedules to regulate expenditures; this, in turn, affects the allocation of resources.
Bear in mind that the overall budget not only sets a cost baseline for the project, it also establishes a funding schedule. Remember to include reserve amounts in each funding increment, because requests for changes – and unexpected expenses – will almost certainly arise.
3. Cost Control
People may come to you and ask for changes to be made, or for extra features to be added to the project. If you agree to those changes because they're nice to have, rather than because they were overlooked in the original scoping of the project, then you will quickly go over budget.
Change requests are one reason why cost control is so important, but there are many other activities that are part of controlling costs. These include monitoring actual expenditures, and analyzing the variances between budget and actual costs. It is therefore important to create and establish an effective control system, so you can respond to changes appropriately, and communicate cost changes in a timely manner.
Key elements of cost control include the following:
Change control – This is a process that describes how changes to the baseline costs can be suggested and implemented. It outlines procedures that people have to use if they want to request changes. This includes what paperwork they need to complete, how changes requests are tracked, and what approval process they can expect.
Without a clear change process, people often keep asking for more and more from the project. If you have no structured way of dealing with these requests, your costs will quickly go over budget. Do bear in mind that project cost management isn't just about numbers; it's also about managing project scope, and dealing with people. Learn to be firm, and recognize which changes are really necessary.
Performance measurement analysis – This activity is all about the numbers. You assess the significance of the variances from the budget baseline, as well as the cause, and the corrective action that is needed. The Project Management Institute recommends the earned value technique (EVT), which is described in the PMBOK (Project Management Body of Knowledge).
There are a variety of calculations you can use:
- Planned Value (PV) = Budgeted cost for the work scheduled for an activity or component of the Work Breakdown Structure.
- Earned Value (EV) = Budgeted amount for the work actually completed on an activity or component of the Work Breakdown Structure.
- Actual Cost (AC) = Total cost incurred to accomplish the work completed on an activity or component of the Work Breakdown Structure.
- Cost Variance = EV - AC
- Schedule Variance = EV - PV
- Cost Performance Index (CPI) = EV / AC (a CPI less than 1 indicates a cost overrun).
- Schedule Performance Index (SPI) = EV / PV (an SPI equal to or greater than 1 indicates the project is in a favorable condition).
For example, the budgeted cost (planned value) for a project at the end of month five is $40,000. The budgeted amount for the work completed (earned value) is only $35,000. However, the actual costs incurred to date are $38,000.
Consider the following calculations:
- Cost variance = EV - AC = $35,000 - $38,000 = -$3,000
- Schedule variance = EV - PV = $35,000 - $40,000 = -$5,000
- Cost performance index = EV / AC = $35,000 / $38,000 = 0.92 (there is a cost overrun).
- Schedule performance index (SPI) = EV / PV = $35,000 / $40,000 = 0.875 (the project is behind schedule).
- Forecasting – This involves predicting the project's future based on the performance to date. Completing forecasts periodically over the course of a project will help you to do this. Forecasts provide valuable information to help you deal proactively with variances. For example, a forecast can help you estimate that your project will be 10 percent over budget, so you can make plans accordingly.
Estimate to complete – You can estimate the cost to complete the project based on what has been completed so far, compared with your budget at completion.
To calculate the estimate to complete (ETC), use either of these formulas (BAC means Budget At Completion and is equal to the Planned Value at completion): when current variances are seen as atypical and not expected to occur in the future use:
ETC = BAC – EV
When current variances are seen as typical of future variances use:
ETC = (BAC – EV) / CPI
In our example, if the total project budget is $60,000, and variances are seen as typical the calculation would be as follows:
ETC = ($60,000 – $35,000) / 0.92 = $27,174
You need $27,174 to complete the work remaining.
- Estimated actual cost – This is a forecast of the most likely total value of the completed project. The most basic formula, which assumes cost variances to date were atypical, for estimated actual cost (EAC) is:
EAC = AC + BAC – EV
In our example, this is calculated as follows:
EAC = $38,000 + $60,000 – $35,000 = $63,000
If cost variances to date are typical, though, use:
EAC = AC + ETC
In our example, this is calculated as follows:
EAC = $38,000 + $27,174 = $65,174
- Project Performance Reviews – These compare cost performance over time, as well as against milestones. Some techniques are variance analysis, trend analysis, and earned value (described above).
All of these analyses are typically included as regular updates in project reporting, as well as in project completion documents. Cost control is very useful for future project planning, so the more complete your analysis is before you start, the better your project planning can be in the future.
Project cost management helps you make sure that your project is completed within the approved budget. It includes the processes of cost estimation, cost budgeting, and cost control. Many of the project planning activities are used as key inputs to financial management.
Managing a project's finances is an extremely important part of overall project management. Cost is a key measure of project success, so be aware of your actual costs compared with the budget. The quicker you recognize variances, the better you'll be able to make the necessary adjustments.