Professional Documents
Culture Documents
Project Time and Cost Notes
Project Time and Cost Notes
Project Time and Cost Notes
TABLE OF CONTENTS
Course Content................................................................................................................................................................4
Inputs required in sequence activities........................................................................................11
Tools and methods used in sequence activities.........................................................................12
Types of Dependency Determination in Project Management..................................................12
Types of Dependencies or Logical Relationships.....................................................................14
Schedule Network Diagrams.....................................................................................................15
Arrow Diagramming Method (Activity on Arrow Method)......................................................15
Arrow Diagramming Method – Dummy Activity.................................................................16
When to Use the Arrow Diagramming Method (ADM)...........................................................16
How to Use the Arrow Diagramming Method (ADM).............................................................16
Summary................................................................................................................................17
Leads and Lags..........................................................................................................................18
Outputs of sequence activities...................................................................................................19
Product-based planning.............................................................................................................19
Detection of activities and dependencies in product-based planning........................................20
1.4 ACTIVITY RESOURCE ESTIMATION...............................................................................................................29
1.5 ACTIVITY DURATION ESTIMATING................................................................................................................31
Activity Duration Estimating technique include:......................................................................32
a) Analogous Estimating.........................................................................................................32
b) Parametric Estimating.........................................................................................................32
c) Three-Point Estimating.......................................................................................................33
Basic concepts used in PERT and CPM.......................................................................................................................33
Step 1: Forward Pass Calculation..........................................................................................35
Step 2: Backward Pass Calculation.......................................................................................35
Step 3: Float Calculation for Each Activity / Arrow Diagramming Method Example.........36
Step 4: Identifying the critical path / Arrow Diagramming Method Example......................36
Summary................................................................................................................................36
Guidelines for construction of network diagrams.........................................................................................................37
The purpose of the course is to make the student understand the processes required to make the
most effective use of time and costs involved in project.
COURSE OBJECTIVES
At the end of the course the student will be able to:
Course Content
Wk Topic Key Coverage Methodology Evaluation
Introduction - The Triple Constraint Theory (Time, Cost - Power Point - Interactive
and Scope) Presentations questions
- Discussions - Assignments
1 Written 1. Critically evaluate the progress of - Research - To be
assignment major Jubilee government submitted by
projects in relation to the triple end of the
constraint theory focussing much semester
on time and cost since it took over
power.
2. Discuss portfolio theory
INSTRUCTIONAL MATERIALS/EQUIPMENT
Texts, audio and video DVD’s, computer software, case studies
ASSESSMENT
Coursework 40%
Final Written Examination 60%
Total 100 %
COURSE TEXTBOOKS
Gray, C. F., Larson, E. W. (2008). Project Management: The Managerial Process, (4th ed.).
Boston: McGraw-Hill Irwin.
Hopkinson, M. (2011). The project risk maturity model, (2nd). Farnham: Gower Publishers.
REFERENCE TEXTBOOKS
Turner, R. (2008). Project Review Assurance and Governance. Farnham UK: Gower Publishers.
Hill, Gerard M. (2008). The Complete Project Management Office Handbook, Second Edition.
New York, NY: Auerbach Publications.
PMBOK Guide (2008). Guide to the Project Management Body of Knowledge: Fourth Edition
COURSE JOURNALS
Journal of Construction project management
Journal of Construction project management and innovation
Practical project management journal
REFERENCE JOURNALS
Project Management connection
Project Management Journal
1.1 Introduction
Cost and time estimation is crucial in project management. When getting started in a project, it is
important to set accurate cost and timelines so that progress can be made and goals can be met
successfully. When too much time is allocated for a project, things might not get done as quickly
as they could have otherwise been. If enough time is not permitted, the team may get frustrated
by constantly falling behind and work could suffer.
The ability to accurately forecast project schedule and cost is developed with experience and
through trial and error. If time and cost is not managed successfully, resources or opportunities
are to be wastes. The more time employees are spending on a specific project, the more
expensive that project becomes. When a one-month project ends up taking two, the costs in some
areas of the budget are likely to be doubled – potentially turning the success endeavor into
failure. Its isn’t good enough in most cases to just get the project finished. Rather it needs to be
finished and kept on time and on budget in order to be deemed a success. Thus, the need for
proper time and cost estimation.
What is time and cost estimation?
It is the process of forecasting or approximating the time and cost of completing project
deliverables.
It is the task of balancing expectations of stakeholders and need for controls while the
project is implemented.
Introduction
Project has to be done within a limited time. Furthermore, when it comes to the main constrains
of the project, time, cost and scope require careful attention throughout the whole project life
cycle; during planning phase, executing and monitoring and control before closing the project.
Time management process happens mainly in the planning phase, although the project duration
and the milestones are already decided in the initiation phase, but it is still the project manager’s
responsibility to plan the project activities and to meet the set project duration within the planned
budget.
These processes interact with each other and with the processes in the other knowledge areas as
well. Each process may involve effort from one or more individuals or groups of individuals
based on the needs of the project. Each process generally occurs at least once in every project
phase. Although the processes are presented here as discrete elements with well-defined
interfaces, in practice they may overlap and interact in ways not detailed here. On some projects,
especially smaller ones, activity sequencing, activity duration estimating, and schedule
development are so tightly linked that they are viewed as a single process (e.g., they may be
performed by a single individual over a relatively short period of time). They are presented here
as distinct processes because the tools and techniques for each are different.
At present, there is no consensus within the project management profession about the
relationship between activities and tasks:
• In many application areas, activities are seen as being composed of tasks. This is the most
common usage and also the preferred usage.
• In others, tasks are seen as being composed of activities. However, the important consideration
is not the term used, but whether or not the work to be done is described accurately and
understood by those who must do the work.
1. ACTIVITY DEFINITION
This process includes defining the activities need to be implemented to achieve the project
deliverables. Activity definition involves identifying and documenting the specific activities that
must be performed in order to produce the deliverables and deliverables identified in the work
breakdown structure. Implicit in this process is the need to define the activities such that the
project objectives will be met.
The main tools and techniques used in defining activities process are;
Decomposition.
Rolling wave planning.
Templates.
Decomposition in project management means to divide the project into smaller pieces that can be
easily managed and controlled. It is a technique used in Work Breakdown structure (WBS)
creation and to define the required activities.
The work breakdown structure (WBS) is a checklist of every activity that must be performed to
create the end product. This checklist becomes the foundation for the schedule, resource
allocation, and budget plans. WBS is created using questionnaire, one-to-one personal
interviews, or group sessions.
Rolling Wave Planning is a technique that enables you to plan a project as it unfolds. This
technique, then, requires you to plan iteratively. Essentially, when you use Rolling Wave
Planning, plan until you have visibility, implement, and then re-plan. It is usually be used when
you have clarity for the activities of the first months of the project
2. ACTIVITY SEQUENCING
Activity sequencing involves identifying and documenting interactivity dependencies. Activities
must be sequenced accurately in order to support later development of a realistic and achievable
schedule. Sequencing can be performed with the aid of a computer (e.g., by using project
management software) or with manual techniques. Manual techniques are often more effective
1. Schedule Management Plan (SMP): The SMP is a pre-project preventive thinking to identify
several points, including the scheduling process involved in the project, thus helping the
sequence activities.
2. Activity List : The activity list contains a critical pathway and basically a detailed
documentation of all schedule activities required and sequenced for a particular project. The
sequence activities can be affected by the dependencies and limitations that exist on the path to
these activities.
3. Activity Attributes : Activity attributes generally refer to active components associated with
an activity, which may be pivotal for sequencing for details like events, predecessors or
successor.
4. Milestone List : The milestone list as a project management document may schedule all
specific project milestones influencing sequence activities.
5. Project Scope Statement: The project scope statement is a good mean to describe the key
deliverables of a project, including product properties involved in sequence activities like
physical lineament of a project being implemented or the nature of a software project. Other
scope statements of project can detail constraints and assumptions associated with sequence
activities. Although these are mostly recorded in the activity list, their accuracy is explored as
product scope description.
Project Dependencies
Dependencies in project management are well-defined as connections among the projects that
decide the sequence in which project management activities should be executed. These tasks
might be multiple preceding tasks which mean that two activities can be appropriate at the same
time. Furthermore, they are described by the four types of dependencies such as discrete,
mandatory, external and internal dependency. Dependency is a method utilized in recognizing
the proper sort of dependency that is used to make the relationship between two activities. The
activities are named as predecessor (which alludes to the principal action) and successor (the
work that goes before the first).
One of the most critical aspects of creating a strong project schedule is to understand the types of
dependencies that are inherent in the workspace. Characterized into mandatory or discretionary,
internal or external dependency determination attributes can be utilized at the same time in the
following ways:
1. Mandatory dependencies are those that are lawfully necessary as an integral part of the
workplace. Regularly involving physical impediments, the project team figures out the
dependencies that are required to implement amid the process of sequencing the tasks.
Mandatory Dependencies also denoted as hard logic, or hard dependencies should not be
mistaken for relegating plan imperatives in the scheduling tool.
Two activities must be performed at the same time (starting and/or finishing at the same
time)
An activity cannot begin until another activity is completed
2. Discretionary dependencies also referred as preferential logic, are set up based on the
learning of best practices inside a specific application area of the project where a
particular sequence is needed, even though there might be other sequences that are
adequate. Discretionary dependencies can make random float values that can restrict
advanced scheduling options, hence, needs to be documented.
Activity will take place at the same time along with another group of activities
Activity will begin after few days of the completion of another activity
3. External dependencies include a connection between project activities and non-task
activities. Mostly outside the project team’s control, the project management group
figures out which dependencies are external during the process of sequencing the tasks.
Get approval from the external organization must be gotten before beginning an activity.
Finishing of a project milestone is connected to the completion of a milestone within
another project.
For instance,
The Precedence Diagramming Method (PDM) includes four types’ dependencies, and each one
has its specific area of application.
Finish-to-Start
Finish-to-Finish
Start-to-Start
Start-to-Finish
Finish-To-Start: Until the predecessor activity is complete, the successor activity cannot start.
Finish-To-Finish:The successor activity can't be completed until the point that a predecessor
activity is complete.
Start-To-Start:Unless the predecessor activity has not started a successor activity cannot start.
Start-To-Finish:Until the predecessor activity has not begun, a successor activity cannot finish.
Network Diagrams
A network diagram is a schematic display of the logical relationships among, or
sequencing of, project activities.
Network diagrams are the preferred technique for showing activity sequencing.
The two main formats are the arrow and precedence diagramming methods
Arrow Diagramming Method (ADM Also called activity-on-arrow (AOA) network diagrams
Activities are represented by arrows
Nodes or circles are the starting and ending points of activities
Can only show finish-to-start dependencies
Can omit activities that have no dependencies
The circles numbered 1, 2, 3 and 4 are the nodes of this network system. They are the definable
achievement in the project. Nodes have neither duration nor resource. Activities A, B, C, D are
represented by the arrows. Each activity has a duration and allocated resource.
Identify all the activities required to complete the project and list them.
Estimate the activity durations considering the crews and quantity of work. Estimating
activity durations is an important process because activity durations affect the length
of the critical path. There are some techniques to estimate activity durations. Expert
judgment, analogous estimating, parametric estimating and three-point estimating are
the techniques widely used to estimate the activity durations. Unlike other techniques,
three-point estimates provide most likely, optimistic and pessimistic estimates that are
used for the PERT method.
Determine the predecessor, successor activities and logical sequences. While
performing this step ask the questions below while using the arrow diagramming
method;
– Which activity will start first?
– Which activities will be performed simultaneously?
– Which activity will finish after this activity?
– Which activity will start after this activity?
Creating a table and organizing the columns with this information may be useful to save time.
Draw the network diagram by using the data created in former steps. Draw the nodes
for events that represent the beginning or end of an activity. These nodes separate the
activities. Use dummy activities when needed and show them as dashed lines.
Determine the critical path of the network diagram by performing forward pass and
backward pass calculations.
Calculate the ES (Earliest Start), EF (Earliest Finish), LS (Latest Start), LF(Latest
Finish) dates for each activity.
Calculate the Total Float and Free Float for each activity. Total float is the duration
that a task (or an activity) can be postponed without delaying the project. Free float is
the duration that a task can be postponed without delaying the ES of the successor
activity. Float is also known as slack.
Total Float (TF) :LS – ES , LF – EF
Free Float (FF) : ES (of successors) – EF of current activity -1
Summary
The Arrow Diagram was a common visible and practical network diagramming method used in
the past which was developed after the Gantt Charts (or bar charts). It was widely used in the
In a logical relationship of FS, a successor activity can be advanced when the predecessor
activity has finished; for instance, the ceremony of awards (the successor activity) can be
advanced when the competition (the predecessor activity) has elapsed.
In a logical relationship of FF, a successor activity can finish when a predecessor activity
has finished; for instance, a document editing (the successor activity) can end when a
document writing (the predecessor activity) has finished.
1. Project Schedule network diagrams: The logical relationships are graphically drawn called
as project schedule network diagram, also referred to as dependencies among the project
schedule activities, which is prepared by manual manner or project management software. The
diagram can represent full details or summarized activities of the project. A summary narrative
can be illustrated with a diagram to show the used fundamental strategy in sequencing the
activities, and to describe any abnormal sequence of activity on the network.[2]
2. Updates of project documents: There are needs to update the project documents, such as
activity lists, activity attributes, milestone list and risk register.
Only, the project product description should be prepared for a small project.
Careful thinking is necessary to achieve quality criteria in order to distinguish whether a
product is acceptable or not. A way to test quality criteria is to scrutinise the distinction
between completed or stopped working on this product.
Product-based planning
Product-based planning is a method for identifying first a product requirements and second all
activities, dependencies and necessary resources to deliver that product. This method has
different applications such as Project planning, Stage planning and Team planning. The
sequence involved in the development of products of the plan will be developed and the
identification of their dependencies should be detected and defined, which is possible using a
product flow diagram (PFD). The dependencies on any non-project products can be detected
through this diagram, thereby providing the required activities and data for other planning
approaches like estimating and scheduling.
Some essential items should be considered to draw the PFD:
The PFD is generated by the Project or Team Manager. However, the people responsible for
developing or helping the plan products can be involved rationally.
When the product breakdown structure (PBS) has been drawn, some planners will decide to
generate the PFD along with the PBS.
There is need for very few symbols in drawing the PFD. It is essential to detect any
developed product (for instance, enclosure in a rectangle), and to exhibit any required
sequence (for instance, interconnection of rectangles by arrows) in the plan. Moreover, the
external products should be clear as any existing or non-project ongoing products (for
instance, enclosure in a different shape like ellipse).
Activities:
It is inadequate to merely identify products for scheduling and controlling the objectives. To
completely illustrate the workload of a plan, it is necessary to detect all the activities needed to
establish or modify any of the planned products. The identification of activities can be achieved
through multiple approaches, as follows:
A separate list of the activities can be provided in spite of the use of PFD as the information
source.
The required activities can be detected by using the products from the PBS or the work
breakdown structure (WBS).
The activities involve management and quality-checking activities, and those required for
developing the specialist products or for interacting with external parties like those that a product
obtained from an outside source or for transforming external products into targeted ones. It is
needed to shield the spread of activities unnecessary for the plan. Things should be kept simple if
there is any doubt.
Dependencies:
It is necessary to identify any internal and external dependencies of activities and products. For
example, Activity C cannot start unless activities A and B are completed (as an internal
dependency). Dependency of a delivery of a product needed for a project by another project,
Written and compiled by Dr. Muchelule Yusuf Wanjala Page 20
suggestion of a purchase order by the user and decision-making by the program manager are
examples of the external dependencies.
Activity sequence:
In the wake of detecting the activities, and estimating related dependencies, duration and effort,
the subsequent step is to approximate the optimal sequence required. This is an iterative step
because the estimated effort and duration may be influenced by actual resource allocation. Float
or slack refers to the amount of time by which a given task in a project network can be delayed
with no influence on the deadline for the project, which can be considered as both provision
within the plan and spare time. Zero float means a condition with no excess time between
activities, which defines a critical activity through the diagram (critical path). In fact, it can be
claimed that any delay in the completion of an activity in the critical path (s) will result in
delayed completion of the entire project. The project manager will be able to monitor the plan’s
activities by detecting the critical path (s) of the plan. Such activities should be timely completed
in order to complete the whole plan in accordance with scheduling. Delay can occur for these
activities for a period if resources are re-allocated to compensate for lost activities.
4. SCHEDULE DEVELOPMENT
Schedule development means determining start and finish dates for project activities. If the start
and finish dates are not realistic, the project is unlikely to be finished as scheduled. The schedule
development process must often be iterated (along with the processes that provide inputs,
especially duration estimating and cost estimating) prior to determination of the project schedule.
shared resources can be especially difficult to schedule since their availability may be highly
variable.
5. SCHEDULE CONTROL
Schedule control is concerned with (a) influencing the factors which create schedule changes to
ensure that changes are beneficial, (b) determining that the schedule has changed, and (c)
managing the actual changes when and as they occur. Schedule control must be thoroughly
integrated with the other control processes.
The project Schedule outlines the tasks and activities of the project; the duration; start and end
dates for each individual task and the project as a whole; and the resources and effort required.
For most projects there will be at least two separate Schedules developed. One will be for the
Initiation Phase (Initial Schedule) and the other for the Planning, Execution and Closure
phases. All schedules are added to Eclipse for tracking and updating.
The Initial Schedule is developed in the Initiation Phase of the project to help produce the
Project Charter. At this point, the Schedule is not expected to be very accurate or contain firm
dates; rather it gives the Project Manager (PM) a rough idea of the project timeline and the
assignment of resources. When the Charter is approved, a second Schedule is developed, with
the approval date as the Project “start date”.’
In the Planning Phase, a Project Management Plan is created (from the Charter), and the second
Schedule is updated with a more accurate and realistic timeline. In effect, the start and end dates
of the first Schedule will be replaced by the start and end dates of the second Schedule. Eclipse
allows for the development and saving of multiple schedules. This feature can help in creating
“what if” schedules without disturbing the “active” schedule.
b) Work Packages
Work packages are the lowest level in a WBS decomposition where activity duration can be
reliably estimated and managed. A Work Package can be created where a Project Manager (PM)
deems it necessary to help develop the project Schedule. A work package details a level of work
to be completed. It would contain a description of the work, details of constraints, and agreement
between the PM and the team or individual doing the work, that the work can be done within the
constraints. Assumptions would be defined in the work package depending on the needs of the
project.
Work packages are particularly useful where contractors or other departments are involved in the
project. A work package should define durations of 4 to 6 weeks. The PM would assign the work
package and authorize the work to be completed according to the project Schedule. The PM
would monitor and control the project at the work package level and not necessarily at the task
level.
c) Activities and Tasks
Tasks are the lowest level of work defined in a schedule. A task is the work to be done and
contains a description, the start and end dates, the resource assigned to work on the task and any
dependencies on other tasks. A collection of similar tasks are grouped together and summarized
as an Activity. This aids in the management of progress reporting and communication to
stakeholders, where each task does not need to be communicated individually in detail.
Tasks are usually defined by the person who will perform the task. The Project Manager,
Resource Manager and others who have knowledge of the work required, would be involved
with identifying the tasks and the tolerances for how long they will take using the estimation .
The PMs are currently using the PERT (Project Evaluation and Review Technique method to
determine the effort and duration required on a task or activity.) PERT Analysis uses a weighted
average of three duration estimates to calculate an estimated duration for a task. This is a great
tool when you don't have a specific duration but do have duration estimates from reliable
sources. Who are reliable sources? A reliable source is anyone with experience working with the
particular type of task, including, but not limited to, skilled project managers, the people who
Once this estimated duration is determined, a personal fatigue factor (PFD) should be applied.
This is typically 20% of the estimate, and will allow for factors such as; experience level and
issues which could impact the person not spending full time on the task.
d) Schedule
Once the tasks and activities are developed, the Schedule is produced. The schedule is a living
document and needs to be monitored and kept up to date. Once complete, project milestones
should be identified and incorporated into the Schedule. A “milestone” is a point in time in the
project which identifies the end of a significant set of related activities indicating the completion
of a major deliverable. A milestone has no duration or effort.
A final step in the development of the Schedule is to determine a contingency factor to be
applied to the schedule. Typically, a contingency of 10% is applied at the overall schedule level
and not at the task level. On a large project contingency can be applied at a phase, sub-phase or
activity level. Once initial and subsequent schedules are developed, they should be “baselined”.
In most cases, this is done at the completion of the Project Management Plan. A baseline
establishes a point of reference from which a comparison can be made against the plan.
During the development of the Schedule it is important for the PM to keep in mind any
“Assumptions” and “Constraints” identified in the Project Charter and/or Plan, and how they
may impact the timeline. As well, risks and issues should be taken into consideration when
creating the project schedule. Analyzes activity sequences, durations, resource requirements, and
schedule constraints to create the project schedule. No matter the size or scope of a project, the
schedule is a key part of project management. The schedule tells you when each activity should
be done, what has already been completed, and the sequence in which things need to be finished.
Because of the uncertainty involved, the schedule is reviewed regularly, and it is often revised
while the project is in progress. It continues to develop as the project moves forward, changes
arise, risks come and go, and new risks are identified. The schedule essentially transforms the
project from a vision to a time-based plan.
The five key points of using project milestones include the following:
1. Define milestones early in the project and include them in the Gantt chart to provide a
visual guide
2. Keep milestones small and frequent
3. The set of milestones must be all-encompassing
4. Each milestone must be binary, meaning it is either complete or incomplete
5. Carefully monitor the critical path
Schedule compression
Project Crashing
Initially, you will get a greater reduction in duration with less input cost. However, as you
continue further, the cost will increase and the reduction will dwindle.Therefore, do a cost-
benefit analysis. A few examples of crashing techniques are:
Overtime
More resources
Monetary rewards
Crashing cannot be applied to all activities.
For example, you have to wait until the concrete dries before you can start your next activity.
Example
You are constructing a room. According to the duration estimate, two masons will take four days
to complete it. You have to reduce the duration of this activity by crashing. You add two more
masons to complete the task in two days. Sometimes, crashing may not produce the desired
result. Getting skilled resources is not easy. and they take time to settle. You cannot bring in a
new group of people and expect them to perform immediately. Therefore, it is possible that the
cost will increase without any significant gain. Perform due diligence before using crashing.
You should monitor other paths whose durations are close to the critical path. If any other path
becomes critical, you will reduce the duration of the new critical path. In this case, your current
path will no longer be critical. Afterward, you will rearrange the fast-tracked activities and
reanalyze the schedule.To compress the schedule, project managers start with fast-tracking
because it does not cost more. However, it increases risk as activities are overlapping.
As a rule of thumb, you can fast track sequential activities by 33%. This means you can start the
next activity when the previous is 66% complete. Both activities partially overlap. It will
increase the risk but within acceptable limits. Fast-tracking helps you compress the schedule up
to certain limits. Continuing beyond the limit will increase the risk, which may lead to rework
and further delays.
Example
Let’s say that you are building a school and construction work is about to finish. Afterward, you
will start carpentry and electrical works. When you review your progress, you see that you are
behind schedule; you have to move faster to complete the project on time. You will review the
carpentry and electrical work activities and see if you can perform them in parallel. Then, you
can apply fast-tracking. In this case, you can start the electrical and carpentry work at the same
time.
On a compressed network diagram, activities with lead and fast-track activities look the same.
Hence, many aspirants often think the lead is the same as fast-tracking. Lead is a type of
dependency that you use while developing a network diagram. It is already factored into the
schedule. On the other hand, fast-tracking is a forced overlap. You do it to shorten the schedule.
Fast-tracking increases risks and possible rework, while lead is a dependency type on the
network diagram and it does not affect the risk.
Difference Between Fast Tracking and Crashing
This depends on your situation and requirements. For example, if the client wants to complete
the project early and is willing to pay, you use crashing. Generally, you will start with fast-
tracking to shorten the schedule. Once you are done, you can go for crashing if necessary.
Sometimes you may use both techniques. For example, the client is threatening to fine you for
the delay. To avoid this, you will compare the cost of crashing with the fine. If the crashing cost
outweighs the fine, you will use it with fast-tracking for maximum schedule compression.You
may also use crashing if the project delay can affect the company’s image or credibility.
As the name suggests, these are schedule compression techniques. The schedule is based on the
critical path, the longest path of the network diagram and its duration is that of the project.
Reducing other paths won’t reduce the duration of your project. You will just give those paths
more float. If you want to reduce the duration of schedule, you will shorten the duration of the
critical path.
Summary
Projects often get delayed and you have to compress the schedule, fast-tracking and crashing are
two ways to do that. These techniques help you decrease the duration of your project. Fast-
tracking does not involve cost, but it increases risks. Crashing does not significantly increase
risk, but it is a costly process. Use these techniques carefully because you are dealing with
critical activities. Any wrong step can affect your project negatively.
Critical Chain
Like a chain with its weakest link, any complex system at any point in time often has only one
aspect or constraint that limits its ability to achieve more of its goal
For the system to attain any significant improvements, that constraint must be identified and the
whole system must be managed with it in mind
For example, two tasks originally scheduled to be done in parallel, require the same resource
100% of the time. CCS acknowledges that either one of the tasks must be delayed or a similar
resource must be found in order to keep to the original schedule.
The tasks estimates in critical chain scheduling should be shorter than traditional estimates
because they do not include their own buffers. Not having tasks buffers should mean less
occurrence of Parkinson’s Law - work expands to fill the time allowed. Feeding and project
buffers protect the date that really needs to be met – the project completion date. Buffer
gives project managers a leeway when unforeseen events occur and is often associated
with scheduling in project management. A buffer can be temporal, financial or qualitative in
Types of buffers
Project Buffer. The project buffer is placed between the final scheduled task of the critical
chain and the estimated project end-date...
Feeding Buffer. Adding such a buffer to the schedule makes it possible to avoid situations
when missed completion dates of non-critical chain tasks have an impact to individual tasks
of the critical chain...
Resource Buffer. It is a portion of time required by critical resources to complete their critical
chain tasks...
Capacity Buffer (optional). This type of buffers assumes that for a multi-project environment
there is a need to plan for on-call resources by adding more costs covering the resources to
the overall budget...
Project scope.
Sequence of activities.
Tasks grouped into 5 project phases (conception, definition & planning, launch,
performance, close)
Task dependencies map.
Critical path analysis.
Project milestones.
Before estimating activity durations, you must have a good idea of the quantity and type of
resources that will be assigned to each activity. Consider important issues in estimating
resources.
A resource breakdown structure is a hierarchical structure that identifies the project’s resources
by category and type.
Duration includes the actual amount of time worked on an activity plus elapsed time
Effort is the number of workdays or work hours required to complete a task
Effort does not normally equal duration
People doing the work should help create estimates, and an expert should review them
Estimating projects activities is hard. Why? Because the only time you know precisely how long
it takes to complete a project is when it’s done. Up to the point of delivery, teams use educated
guesswork to predict the future. And the bigger and more complex a project is, the hazier that
future is. Faulty estimates mean missing deadlines and breaking budgets—two of the main
symptoms of project failure.
Being a skilled estimator is a crucial part of setting schedules, establishing budgets, managing
resources and running a thriving team and business. Using the best online project management
software for the job is a huge help, but knowing the methods and learning how to do them well is
how you become a great estimator. There are a number of activity resource estimation
methodologies to choose from that work for all types of projects.
1. Expert judgment
This is probably the most common way people get an estimate. Talk to the men and women with
the best hands-on experience and understanding of the project requirements. Just make sure that
everyone has the same understanding of what needs to be delivered. And try to find experts who
will actually be working on the project. Experts, with expertise appropriate to the concerned
activity, are asked to estimate the resources and/or duration and/or cost. Experts may be available
within the organization or may be provided from outside the organization.
If your current project is similar to past ones, take the data from previous work and extrapolate it
to provide your estimates for the new job. Before proceeding, make sure to check whether those
projects were successful. Analogous estimating is a technique where you refer to those previous
projects which were having, scope or activities, similar to your current project. Then you figure
out how much time and/or these activities have taken earlier, during that project, to make
estimation for duration and/or cost of similar activities in your project. This technique,
sometimes, also called as “Top Down Estimating” because you try to estimate the duration or
cost for whole of the activity, with reference to previous project activities, without breaking it to
3. Bottom-up Estimating
Using this technique you estimate resources or costs by breaking down complex activities into
smaller pieces and working out resource or cost assignments for these smaller activities using
other resource / cost estimating tools and techniques. It is based on detailed WBS (Work
Breakdown Structure). Here you estimate each piece and add them up. When individual
estimates are added up it becomes the project estimates. This method uses a detailed work
breakdown structure and is best for projects you’re committed to. Each task is estimated
individually, and then those estimates are rolled up to give the higher-level numbers. (If you use
the right project management software, it will roll up the estimates for you). This process makes
you think about what’s required in order to take a step back to see if the big picture still makes
sense. You’ll receive more accurate results than the top-down method, but it’s also a greater
investment of time.
This is a more scientific method that essentially auto-calculates estimates using detailed data
from previous activities. This estimation, like analogous estimation technique, requires historical
information gathered from previous projects. This technique is used for both cost and time
estimates calculations. But, unlike analogous estimation technique, parametric estimation
requires plugging the historical data into a formula, spreadsheet, database, or computer program
to come up with an estimate. Let’s say you have data from your last three office network
installation projects. You can use this to get a days-per-workstation value or something similar.
You then plug in the number of workstations for your new installation and out pop the estimates.
When you need to determine what would be the total cost of construction when you have cost
per square foot or the units of work multiplied by productivity unit rate to estimate activity
duration. This can be a quick method but needs robust data to feed it. And because it’s all about
the math, it’s hard to adjust for the environmental, political and cultural differences between
projects.
7. Published Estimating Data: This technique is used only for estimating activity resources.
This published data can include articles, books, journals and periodicals from various industries
that have proven data with similar projects. Using the Published Estimating Data Project
Managers can make a rough estimation of how many resources they need.
Estimate activity durations is the process of estimating the number of work periods needed to
complete individual activities with estimated resources. The key benefit of this process is that it
provides the amount of time each activity will take to complete, which is a major input into the
develop schedule process. The aim of effective project management is to bring the project to
completion on time and on schedule. Estimating project duration is a key function of scheduling.
Individual activities make up the schedule, and the estimates of their duration determine the
project timetable. The accuracy of the overall schedule depends on the accuracy of these
estimates.
Aspiring project managers must learn how to perform a variety of tasks in order to get a project
started and estimating activity duration is one of them. It’s not always an easy task to estimate
the project duration, because doing so needs a project manager’s knowledge of some theory,
along with application of some best practices and methodologies. To estimate activity duration is
a lengthy process and it takes time for a long-term project. Ideally, you should involve your core
project team in estimating the duration. You should involve the project team, who will work on
the project to achieve the project objectives, project management team, and all the identified key
stakeholders to make a consensus on the milestone dates, and delivery schedules. Depending on
this duration, you can develop a schedule, with milestones for your project. Estimating activity
duration can be for a project phase or product phase and is iterative in nature.
a) Analogous Estimating
This is a very important methodology that gives you the entire duration estimation. Based on the
information of past projects that are similar, you can get a ballpark idea of the entire duration
estimation. If the company has carried out a similar activity, it may be possible to adapt the
duration to the current case. Project managers have to study the similarities of the two activities
and adjust for any features that may result in differences in duration. Even small businesses can
often find such similar activities on which to base estimates. You may be able to get this
information from the Project Management Office or another project manager; you can use this
template for your current project.
Analogous estimating the activity duration is not so accurate in nature; however, it is less costly
and less time consuming than other methods. You can frequently use this method when you
Key points
b) Parametric Estimating
This method is more accurate in nature. It is based on a statistical calculation of historical data
and other variables. For example, in the design phase in case of a construction project, you may
already have the activity duration: cutting 1,000 stones will take 8 hours and so on. If your
project is of a similar nature to one performed in the past, it is worth your while to find existing
activity duration estimates and historical data from the past project.
Key points
c) Three-Point Estimating
This kind of estimating is based on considering various options like the assignment of the
resources, uncertainty, and the risk associated—such as best scenario-based and worst-scenario
based. The three-point estimating concept is originated from PERT (Program Evaluation and
Review Technique). It gives a weighted average of these three to arrive at a more realistic
estimate. Through PERT, we generally estimate three types of duration:
Of these, Most Likely (M) is based on the resources assigned and Optimistic (O) is based on the
best scenario-based analysis. And the last one—Pessimistic (P)—is based on the worst possible
scenario-based analysis. Once you have these, you can use some very useful formulas to derive
the expected duration.
Here, TE is expected time, and O, M, P are Optimistic, Most Likely, and Pessimistic duration
respectively. In this way, you can understand the importance of PERT in estimating the duration
for your project. These estimate values are usually taken from subject matter experts in
respective activity area.
Start Finis
Eve Activity h
Event
nt
Types of events.
i. Merge events: it’s where one or more activities join an event.
ii. Burst event: it’s where more than one activity leaves an event.
iii. Merge and burst event: It’s where more than one activity join and leave an event.
Step 3: Float Calculation for Each Activity / Arrow Diagramming Method Example
Summary
The Arrow Diagramming Method (ADM) and The Precedence Diagramming Method (PDM) are
two network scheduling techniques. The first one is the traditional one used widely in the past.
The second one is the current method that we are using widely now. In this simple arrow
diagramming method example we show how to make forward, backward, total float and critical
path calculation. Nowadays the arrow diagramming lost its popularity because of the
introduction of software solutions but in order to use this software successfully, it is important to
understand both scheduling techniques.
Example 1
Solution
E
I
A C
G H J K
B D
F
Example 2
Draw a network diagram from the following activities.
Activit Immediate predecessor Activit Immediate predecessor
y y
A None G C
B A H C&D
C A I E&F
D A J G&H
E B K I&J
F C
Solution
Advantages of CPM
1. Helps the top management to concentrate their attention to the critical activities and their
completion in time.
2. Provides the knowledge of critical and non-critical activities. This helps the management
to divert the resources from non-critical to critical activities.
3. Provides a best way of planning and scheduling a construction project knowing the critical
path.
4. Gives the complete information about the importance, duration, size and performance of
an activity.
The total float can be calculated by subtracting the Early Start date of an activity from its Late
Start date or Early Finish date from its Late Finish date.
Summary
In real life, projects are not executed as it was planned all the time. Risks, unexpected events,
uncertainty, and subjective estimates are significant reasons for deviations. PERT is helpful for
estimating the project completion time in case of uncertainty. However, it may be difficult to use
without software. In this example, we talked about the pert definition and calculated the expected
duration for each activity. By making forward, backward calculations, we determined the critical
path. Accuracy of expected durations which affect the critical path depends on the optimistic,
pessimistic and most likely duration estimates. By the help of PERT software, it is easy to make
these calculations efficiently for many combinations.
Exercises
1. A small project consisting of eight activities has the following characteristics:-
Time estimates in weeks
Activity Preceding Most optimistic Most Most pessimistic
activity (a) likely (m) (b)
A None 2 12
B None 10 26
C A 8 10
D A 10 20
E A 7 11
F B, C 9 9
G D 3 7
H E, F, G 5 5
Required;
i. Draw the PERT network for the project.
ii. Determine the critical path
iii. Prepare the activity schedule for the project.
iv. If a 30 weeks deadline is imposed, what is the probability that the project will be
finished within the time limit?
v. If the project manager wants to be 99% sure that the project is completed on the
schedule date, how many weeks before that date should he start the project work?
Activity
Required:
i. Draw the PERT network diagram.
ii. Identify the critical path.
iii. Determine the mean project completion time.
iv. Find the probability that the project is completed in 36 weeks.
v. If the project manager wishes to be 99% sure that the project is completed on the
scheduled date, how many weeks before should he start the project?
2. A project has the following characteristics
Activity Preceding Time estimates in weeks
activity
Most Most likely Most pessimistic
optimistic
A None 3 7 11
B None 2 2.5 6
C A 2 3 4
D A 6 7 14
E A 2 3 4
F C 2.5 3 3.5
G D 2.5 4 5.5
Shortcomings of PERT
1. Emphasizes on time only and not on costs.
2. Time estimates to perform activities constitute a major limitation of this technique.
3. Calculation of probabilities under PERT approach is done on the assumption that a large
number of independent activities operate on critical path and as such the distribution of
total time is normal but this may not be true in real life situations.
4. Using PERT for active control of a project requires frequent updating and revising the
PERT calculations and this proves quite costly.
- PERT analysis does not usually - CPM deals with costs of project
consider costs. schedules and their minimization.
Key Points
It uses three estimates (most likely, optimistic, and pessimistic) to calculate the average
value of activity duration
It reduces the bias, risks, and uncertainties from the duration calculation
It is more accurate than the rest
d) Heuristic Estimating
This is also known as Rule of Thumb. You can roughly guess that entire design phase can take
45% of your entire project time and so on…this is a very useful technique in case of known
phases where you can put an imaginary figure based on the experience.
e) Reserve Analysis
Reserve analysis includes estimation of additional time to the project schedule (to allow time for
unexpected delay) and additional cost to the project budget (in case of activity cost overruns). It
is more of like analysis for the contingency or adding buffers to the estimations. A reserve
analysis is a type of contingency reserve. After fixing a schedule for each activity level
depending on the activity attributes, you can create contingency reserve timing by adding some
percentage in the derived schedule of each activity. It can be changed as work progresses;
reducing or increasing depending on the situation.
f) Work Breakdown
g) Historical
An effective way of estimating activity duration is to use historical data. If data on the duration
of the same activities is available, project managers take the average duration of the historical
records and use that in the project schedule. For small businesses which have not completed
many projects, other methods are preferable.
h) Expert Judgment
If expert judgment is available at reasonable cost, a project manager will often use such duration
estimates as superior to internally generated ones. Expert judgment means using specialists who
have a reputation for knowledge of the particular field and experience in estimating activity
duration within it.
i) Effort required
A project manager who knows what resources are necessary for an activity may calculate the
effort the activity requires and arrive at duration. He adds the amount of time it takes to obtain
materials to the labor time it takes to complete the tasks. Such an estimate has the advantage that
it allows the project manager to track resource use and compare it to the estimate.
j) Units to produce
Calculation based on units of activity is a method available to both the largest and smallest
businesses. Typical units are numbers of products or size of the product. Project managers can
calculate how much time it took to produce a certain number or a certain size and adjust for the
number or size they want to produce. Project managers have to adjust for economies of scale for
these calculations.
Network diagram (sequencing the activities). It can be changed as work progresses and as new
activities identified in your project. Initially, you can estimate your project based on the network
diagram (sequencing the activities). It can be further modified based on the changes done in the
project during the execution, controlling and monitoring process. While project managers can't
During control schedule process, project managers must measure against the plan and control the
project. If there is a variance based on the schedule performance control, and if the project
cannot be completed on time, corrective actions must be planned and taken. For instance,
schedule compression can be planned to complete the remaining project activities earlier than
planned to complete the project on time. During project execution, if factors causing lots of
changes are found, these factors must be eliminated to prevent the root cause of changes. If
they cannot be eliminated, the impact of these factors must be minimized by taking preventive
actions.
Re-estimate the remaining components of the project at least once over the life of the project to
make sure you can still meet deadline, budget, and objectives. In the planning phase of your
project, you have planned the project activities appropriately. You have got a cost baseline, you
And based on your actual values, you have to do frequent re-evaluations, frequent reviews, and
frequent re-estimation on your project to check whether you will be able to still meet your
project schedule and whether you will be able to still meet your target budget at the end of
your project. If there are problems, for instance, if there is any variance that is showing that you
will exceed your budget or that you will exceed the agreed end date of the project, then, you
have to take corrective actions to meet the schedule baseline and to meet the cost baseline of
your project.
In order to detect these variances and then take corrective actions respectively, you have to do re-
estimating in your project frequently, and these should be determined at the beginning of your
project. For example, you might say that I will be doing re-estimating each month or I will be
doing re-estimating in every two weeks. Because re-estimation will take a time and you need
to determine the appropriate frequency for re-estimating. And, based on this frequency, you
have to do re-estimating and check whether you are still meeting the baselines of your project.
1.0 Introduction
Cost estimation may be defined as ‘a study which attempts to predict the relationship between
costs and the activity level or cost driver that causes those costs. In practice, managers frequently
encounter such cost drivers (what is a cost driver?) as machine hours, number of transaction,
work cells, labour hours, and units of output e.t.c.
Types of Costs
• Direct Costs
– Costs that are clearly chargeable to a specific work package. Labor, materials, equipment, and
others.
• Direct (Project) Overhead Costs
– Costs incurred that are directly tied to an identifiable project deliverable or work package.
Salary, rents, supplies, specialized machinery
• General and Administrative Overhead Costs
– Organization costs indirectly linked to a specific package that are apportioned to the project
Will the CER be used to estimate price, cost, labor hours, material cost, or some other measure
of cost? Will the CER be used to estimate total product cost or estimate the cost of one or more
components? The better the definition of the dependent variable, the easier it will be to gather
comparable data for CER development.
The dependent variable is the cost to be predicted and it is choice depends on the purpose of the
cost function. It may also be referred to as response variable.
Be especially wary of any CER based on 2 or 3 data observations. If there is a choice between
developing a CER based on performance or physical characteristics, performance characteristics
is generally the better choice, because performance characteristics are usually known before
design characteristics.
Step 3. Collect data concerning the relationship between the dependent and independent
variables.
Collecting data is usually the most difficult and time-consuming element of CER development. It
is essential that all data be checked and double checked to ensure that all observations are
relevant, comparable, relatively free of unusual costs. A sufficient number of past observations
must be obtained to derive an acceptable cost function. This should be adjusted to reflect any
change of circumstances e.g. changes in price levels caused by inflation, changes in types of
equipment used, etc. The time period used to measure the dependent variable and the cost driver
should be the same.
Step 5. Select the relationship that best predicts the dependent variable.
After exploring a variety of relationships, you must select the one that can best be used in
predicting the dependent variable. Normally, this will be the relationship that best predicts the
values of the dependent variable. A high correlation (relationship) between a potential
independent variable and the dependent variable often indicates that the independent variable
will be a good predictive tool. However, you must assure that the value of the independent
variable is available in order for you to make timely estimates. If it is not, you may need to
consider other alternatives.
There are various methods that can be used to estimate the cost function. Examples include:
There are three main tests that should always be done. These include:
a) Logical relationship tests
b) Goodness of fit test
c) Specification tests (Tests of the assumptions of the model)
A single average unit cost figure is selected for the items categorized as variable whereas a single
total cost for the period is used for the items categorized as fixed. Mixed costs are decomposed
into their variable and fixed components.
Dividing the project into smaller tasks lets a project manager get an overview of cost. One
method that accomplishes such a simplification is the work breakdown structure. Once the
project is broken up into small tasks, the project manager can assign costs. For equipment that he
has to purchase, he can contact suppliers to get accurate estimates. For other tasks, he can
estimate the number of hours and use an hourly rate.
d) Resource Costing
Written and compiled by Dr. Muchelule Yusuf Wanjala Page 56
A common technique for cost estimating is to list the resources you need for the project and to
total their costs. Typical resources include equipment, material, services and labor. You can get
costs for equipment, material and services by consulting price lists or by going out for bids for
the larger pieces. Labor costs are hourly, and you can base the total costs on estimates from
similar projects or ask for bids to carry out the work. Small businesses use resource costing for
larger or more complicated projects.
e) Unit Costs
Small or simple projects can be evaluated using a cost-per-unit that is characteristic of the
project. The characteristic unit is a measure of the size of the project that is indicative for the
particular project. It might be a cubic foot, a square foot or a work station. Typical applications
are for building costs, paving, renovating or for standard systems such as data processing. Costs
are a dollar amount per unit. To get the total cost, you decide how large the building or surface is
or how many people will be working on the data. Multiply that by the unit cost to get the total.
You can get typical unit costs from prospective suppliers or from industry associations.
f) Historical Costing
One of the most transparent ways of estimating the cost of a project is to base it on previous
work. If your company has completed a similar project recently, all the required costing
information is available from the project files. If you don't have such a project, other work your
company has done in the past can help determine the cost of similar work on the new project. If a
local business that is not a competitor has completed a similar project, it might be willing to help.
Where available, historical data often gives the most accurate prediction of future costs.
1. Cost of Quality: Cost of Quality estimation is used for determining overall cost
estimates. It includes Cost of Conformance ( i.e money spend on Quality training,
studies, surveys, inspection, validation & audits) and Cost of Non Conformance ( i.e
money spent on rework , scrap, inventory and warranty costs ).
2. Vendor Bid Analysis: This technique is usually used when you need to work with
external vendor or contractor to get your project activities done. This technique helps you
to analysis what the project cost should be based on the bids from vendors and estimate
the price of individual deliverables.
Required:
Estimate the cost function using the high low method
Solution
Highest point X Y
49 416
Lowest point 21 180
Difference 28 236
Y= a + bx
i. if X=45 units
Y = 3 + 8.43*45
= Sh.382.35
i. if X =34
Y = 3 + 8.43(34)
= Sh.289.62
Note:
The main problems of the high low method are:
a. Reliability is low
b. It ignores all the other points except the highest and lowest which in most cases are
outliners.
h) Regression Analysis
A regression equation identifies an estimated relationship between a dependent variable (the
cost) and one or more independent variables (the cost driver). When the equation includes only
one independent variable then it is referred to as simple regression and its form is:
Ỹ= a + bx
The equation can be solved by the use of normal equations and these are:
1. y = na + b (x)
xy = a (x) + b (x2)
Illustration:
Assume a firm has total costs of 8m, 4m and 1m respectively when the output units are 400,000
200,000 and 0 respectively. Estimate its cost equation using the visual fit method.
10
9
Dependant 8 X
Variable 7 X X X
(Total Cost) 6 X X X
5 X X X X X
4 X
1m X
X2 X3
0 200,000 400,000
Independent Variable
(Output Level)
Fixed Cost X
0 1m
Note : Change in Y
Gradient Y3 - Y2 Variable Cost Per Unit
Change in X X3 X2
Net present value in its simplest form can be explained as the calculation that compares the
amount invested today to the present value of the future cash receipts from the investment. In
other words, the amount invested is compared to the future cash amounts after they are
discounted by a specified rate of return. When assessing any given project or initiatives,
where C is the expected cash flow per period, R is the required rate of return and T is the number
of periods over which the project is expected to generate income.
However, many projects generate revenue at varying rates over time. In this case, the formula for
NPV is: NPV = {C for Period 1 / (1 + R) ^ 1} + {C for Period 2 / (1 + R) ^ 2} ... - Initial
Investment. Besides, there are other ways to compute the NPV as follows in the examples below
using the even cash inflows and the uneven cash inflows.
Intenal Rate of return is used to evaluate the beauty of a assignment or investment. If the IRR of
a new project exceeds a enterprise’s required fee of return, that venture is fascinating. If IRR
falls under the desired cost of return, the mission must be rejected.
Advantages of IRR
The various advantages of internal rate of return method of evaluating investment projects are as
follows:
Time Value of Money: The first and the most important thing is that it considers the time value
of money in evaluating a project which is a big lacking in accounting rate of return.
Simplicity: The most attractive thing about this method is that it is very simple to interpret after
the IRR is calculated. It is very easy to visualize for managers and that is why this is preferred
till the time they come across certain occasional situations such as mutually exclusive projects.
Hurdle Rate / Required Rate of Return has Not Required: The hurdle rate is a difficult and
subjective thing to decide. In IRR, the hurdle rate or the required rate of return is not required for
finding out IRR. It is not dependent on the hurdle rate and hence the risk of a wrong
determination of hurdle rate is mitigated.
IRR also allows managers to rank projects by means of their total rates of return rather than their
web reward values, and the investment with the absolute best IRR is most often favored. Ease of
comparison makes IRR attractive, but there are limits to its usefulness.
Payback interval is the time in which the preliminary money outflow of an funding is anticipated
to be recovered from the cash inflows generated by means of the investment. It is among the
simplest investment appraisal strategies.
Formula
The formula to calculate payback period of a project depends on whether the cash flow per
period from the project is even or uneven. In case they are even, the formula to calculate payback
period is:
Initial Investment
Payback Period =
Cash Inflow per Period
When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period
and then use the following formula for payback period:
:Payback Period = A B
+ C
A is the final interval with a bad cumulative money go with the flow;
B is the absolute value of cumulative money flow on the end of the interval A;
Decision Rule
Accept the project only if its payback period is LESS than the target payback period.
Examples
Solution.
Company XYZ is planning to undertake another assignment requiring initial funding of $50
million and is expected to generate $10 million in year 1, $13 million in 12 months 2, $16
million in year three, $19 million in year four and $22 million in year 5. Calculate the payback
price of the project
Solution
(cash flows in millions)Cumulative
Year Cash Flow Cash Flow
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30
Payback Period
= 3 + (|-$11M| ÷ $19M)
= 3 + ($11M ÷ $19M)
≈ 3 + 0.58
≈ 3.58 years
a. Pay back period gives more importance on liquidity for making decision about the investment
proposals.
b. Pay back period deals with risk. The project with a shortest PBP has less risk than with the
project with longest PBP.
c. The short term approach of pay back period is an added advantage of calculation of capital
expenditure
Demerits are;
a. Pay back period gives high emphasis on liquidity and ignores profitability.
b. Only cash flow before the pay back period is considered. Cash flow occurred after
the PBP is not considered.
Advantages
Example: Suppose a tunnel is proposed to be built to save travel time and road construction cost
around a mountain. In order to save on first cost, a twin tunnel system is proposed with 1/2
capacity in each shaft.
Construction = $3,000,000 --- Shaft 1 -- Now
$4,000,000 --- Shaft 2 --Built in 20 years ( N = 20 )
Maintenance (Shaft lining) = $160,000/Half -- every 10 years
Benefits = $260,000/yr N = 1-20
$300,000/yr N = 21-50
If i = 5% and N=50yrs, is the project justified?
Solution : 1st cost PW = $3,000,000 + $4,000,000(P/F,5,20) = $4,507,600
Relining cost PW = $160,000(P/F,5,10+20) + $320,000(P/F,5,30+40)
= $160,000(0.9908) + $320,000(0.3734)
= $278,016
Note: (P/F,5,10 + 20) = (P/F,5,10) + (P/F,5,20)
Earned Value Management (EVM) is a project management technique that objectively tracks
physical accomplishment of work. More elaborately:
EVM is used to track the progress and status of a project and forecasts the likely future
performance of the project.
EVM integrates the scope, schedule, and cost of a project.
EVM answers a lot of questions to the stakeholders in a project related to its
performance.
EVM can be used to show the past and the current performance of a project and predict
the future performance of the project by the use of statistical techniques.
Good planning coupled with effective use of EVM will reduce a lot of issues arising out
of schedule and cost overruns.
EVM has emerged as a financial analysis specialty in United States Government programs in the
1960s, but it has since become a significant branch of project management. In the late 1980s and
early 1990s, EVM emerged as a project management methodology to be understood and used by
managers and executives, not just EVM specialists. Today, EVM has become an essential part of
every project tracking.
Planned Value
Actual Cost
All the three elements are captured on a regular basis as of a reporting date.
Planned Value
Planned value (PV) is also referred to as Budgeted Cost of Work Scheduled (BCWS). PV or
BCWS is the total cost of the work scheduled/planned as of a reporting date.
Actual Cost
Actual cost (AC) is also referred to as Actual Cost of Work Performed (ACWP). AC or ACWP
is the total cost taken to complete the work as of a reporting date. It is calculated as:
Earned Value
Earned value (EV) is also referred to as Budgeted Cost of Work Performed (BCWP). EV or
BCWP is the total cost of the work completed/performed as of a reporting date.It is calculated as:
All these three elements can be derived from Work Breakdown Structure by associating the costs
to each of the tasks. For a big project, it will be a tedious task to calculate these elements
manually. Scheduling software tools like Microsoft Project is used to calculate these three
elements.
% Completed Planned
The percentage of work which was planned to be completed by the Reporting Date. It is
calculated using the following formula:
The percentage of work which was actually completed by the Reporting Date. It is calculated
using the following formula:
Cost Variance (CV) is a very important factor to measure project performance. CV indicates how
much over - or under-budget the project is.
OR
Cost Variance %
Cost Variance % indicates how much over - or under-budget the project is in terms of
percentage.
OR
CV % = CV ⁄ BCWP
Cost Performance Indicator (CPI) is an index showing the efficiency of the utilization of the
resources on the project. CPI can be calculated using the following formula:
OR
The formula mentioned above gives the efficiency of the utilization of the resources
allocated to the project.
A CPI value above 1 indicates the efficiency of utilizing the resources allocated to the
project is good.
A CPI value below 1 indicates the efficiency of utilizing the resources allocated to the
project is not good.
To Complete Cost Performance Indicator (TCPI) is an index showing the efficiency at which the
resources on the project should be utilized for the remainder of the project. It can be calculated
using the following formula:
OR
The formula mentioned above gives the efficiency at which the project team should be
utilized for the remainder of the project.
A TCPI value above 1 indicates the utilization of the project team for the remainder of
the project can be stringent.
A TCPI value below 1 indicates the utilization of the project team for the remainder of
the project should be lenient.
Schedule Variance (SV) indicates how much ahead or behind the schedule a project is running.
OR
The formula mentioned above gives the variance in terms of cost which indicates how
much cost of the work is yet to be completed as per schedule or how much cost of work
has been completed over and above the scheduled cost.
A positive SV indicates we are ahead of schedule.
A negative SV indicates we are behind schedule.
Schedule Variance %
Schedule Variance % indicates how much ahead or behind the schedule a project is running in
terms of percentage.
OR
SV % = SV ⁄ BCWS
The formula mentioned above gives the variance in terms of percentage which indicates
how much percentage of work is yet to be completed as per schedule or how much
percentage of work has been completed over and above the scheduled cost.
Positive Variance % indicates % ahead of schedule.
Negative Variance % indicates % behind of schedule.
Schedule Performance Indicator (SPI) is an index showing the efficiency of the time utilized on
the project. SPI can be calculated using the following formula:
OR
To Complete Schedule Performance Indicator (TSPI) is an index showing the efficiency at which
the remaining time on the project should be utilized. It can be calculated using the following
formula:
OR
The formula mentioned above gives the efficiency at which the project team should
utilize the remaining time allocated for the project.
A TSPI value below 1 indicates the project team can be lenient in utilizing the remaining
time allocated to the project.
A TSPI value above 1 indicates the project team needs to work harder in utilizing the
remaining time allocated to the project.
Budget at Completion
Estimate to Complete (ETC) is the estimated cost required to complete the remainder of
the project.
ETC is calculated and applied when the past estimating assumptions become invalid and
a need for fresh estimates arises.
ETC is used to compute the Estimation at Completion (EAC).
Estimate at Completion
Estimate at Completion (EAC) is the estimated cost of the project at the end of the project.
There are three methods to calculate EAC:
Variances are typical - This method is used when the variances at the current stage are
typical and are not expected to occur in the future.
Past estimating assumptions are not valid - This method is used when the past
estimating assumptions are not valid and fresh estimates are applied to the project.
Variances will be present in the future - This method is used when the assumption is
that the current variances will continue to be present in the future.
The formulas for calculation of the three methods are as given below:
AC + (BAC − EV)
AC + ETC (Estimate To Complete)
AC + (BAC − EV) ⁄ CPI
Variance at Completion
Variance at completion (VAC) is the variance on the total budget at the end of the project.
This is the difference between what the project was originally expected (baselined) to cost versus
what it is now expected to cost. VAC is calculated using the following formula:
% Completed Planned
The percentage of work which was planned to be completed by the Reporting Date. It is
calculated using the following formula: % Completed Planned = PV ⁄ BAC
The percentage of work which was actually completed by the Reporting Date. It is calculated
using the following formula: % Completed Actual = AC ⁄ EAC
EVM - Examples
To illustrate the concept of EVM and all the formulas, assume a project that has exactly one task.
The task was baselined at 8 hours, but 11 hours have been spent and the estimate to complete is 1
additional hour. The task would have been completed already.
EAC = AC + ETC
* indicates over-budget
PORTFOLIO THEORY
Definition:
A portfolio is a combination of assets held by the investor for investment purposes. Portfolio
theory therefore attempts to show an investor how to combine a set of assets to maximise the
assets' returns as well as minimise the assets' risk (Risk Diversification).
Diversification is defined as combining assets whose returns are not perfectly positively correlated
to reduce the aggregate risk of the total asset holdings (or the portfolio).
Not also that α + ß = 1. This is because all the investor's wealth is invested in either asset A or
asset B.
Illustration
Consider two investments, A and B each having the following investment characteristics;
REQUIRED:
Compute the expected return of a portfolio of the two assets.
Solution
Using formula (3.b)
= 13.3%
Note that the expected return is a weighted average of the expected return of assets held in
isolation.
Remember that standard deviation is a measure of risk of the investment. Portfolio standard
deviation therefore measure the risk of investing in a combination of assets.
The portfolio standard deviation is not a weighted average of standard deviations of assets held in
isolation. This is because of the inter-relatedness of the assets, which reduces the risk when assets
are held together. This relationship is measured by the correlation co-efficient (τ),
The coefficient of correlation (τ) lies between -1 and +1. Therefore -1 τ +1.
If τAB = +1, this means that A and B are perfectly positively correlated and therefore the outcomes
of A and B move in the same direction at the same time.
If τAB = -1, then A and B are perfectly negatively correlated and their results are inversely related.
That is they move in opposite directions simultaneously.
If we consider the two asset case, then the portfolio standard deviation (δ A+B) can be given by the
following formula.
Illustration
REQUIRED:
Compute the portfolio standard deviation if the correlation coefficient between the assets is
Solution
δ A+B =
√( )
22
3
(20% )2 +
1 2
3 ()
( 40%)2 + 2( γ AB )
2 1
3 3( )( )
(20% )(40%)
12
Using
formula (3.c) we can compute the portfolio standard deviation as follows:
Usually investors will not hold only 2 assets. If the assets held in the portfolio are more than 2 then
the following general formulas may be used:
δP =
∑∑ t=1
¿
j=1
¿ α i α j γ ij δ i δ j . . .(3. e ) ¿¿
14
E (R P ) =
∑t=1
¿ α t E (R t ) .. .( 3 . d ) ¿
15
Where δP is the portfolio standard deviation.
Note: we shall not spend much time on analysis of more than 2 assets due to the complication
involved. It is however, assumed that the student can be able to extend the two asset case to
more assets.
We have already introduced the correlation coefficient. We shall consider the Covariance and its
relationship with the correlation coefficient.
The covariance is a measure which reflects both the variance of an asset's returns and the tendency
of those returns to move up and down at the same time other assets move up or down. The
covariance between two asset's return can be given by the following formula:
Cov ( AB ) =
∑ i=1
¿ ( R Ai - E ( R Ai ) ) ( R Bi - E( R B ) ) Pi ¿
16
Where Cov(AB) is the covariance between And B
RAi is the return on asset A under the Ith state.
E(RA) is the expected return of A
RBi is the return on asset B under the ith state
E(RB) is the expected return of B
Pi is the probability of the ith state.
Illustration:
Four assets have the following distribution of returns.
REQUIRED:
Solution
δA =
∑ i=1
2
¿ ( R Ai - E ( R A )) Pi ¿
18
= 0 since (RAi - E(R)A) = 0%
b. i.
Cov( AB ) =
∑ i=1
¿ ( R Ai - E( R A ) )( R Si - E( R B ) ) P i ¿
20
Note that since (RAi - ERA) = 0
Cov(AB) = 0
= -4.8
= 10.8
Assets B and C tend to move in opposite directions and therefore their covariance is negative
while Assets B and D tend to move in the same directions and therefore their covariance is
positive.
c. Correlation coefficient
i. τAB = Cov(AB) = 0 = 0
δAδB (0)(2.2)
Therefore Assets B and C are perfectly negatively correlated while B and D have a strong
positive correlation.
Efficient portfolios can be defined as those portfolio which provide the highest expected return for
any degree of risk, or the lowest degree of risk for any expected return.
The investor should ensure that he holds those assets which will minimise his risk. He should
therefore diversify his risk.
The diversifiable risk is that risk which the investor can be able to eliminate if he held an efficient
portfolio.
The non-diversifiable risk on the other hand is those risks that still exist in all well diversified
efficient portfolios.
The investor therefore seeks to eliminate the diversifiable risk. This can be shown below:
From the graph shown above as the number of assets increases, the portfolio risk reduces up to
point M. At this point the lowest risk has been achieved and adding more assets to the portfolio
will not reduce the portfolio risk.
Note: The non-diversifiable risk can also be referred to as the market risk.
If consider many assets, the feasible set of investment will be given by the following graph
The shaded area is the attainable set of investment. However, investors will invest in a portfolio
with the highest return at a given risk or the lowest risk at a given return. The efficient set of
investment, therefore, will be given by the frontier B C D E. This frontier is referred to as the
Efficient Frontier. Any point on the efficient frontier dominates all the other points on the feasible
set.
The Capital Asset Pricing Model (CAPM) specifies the relationship between risk and required rate
of return on assets when they are held in well-diversified portfolios.
1. Investors are rational and they choose among alternative portfolios on the basis of each
portfolio's expected return and standard deviation.
2. Investors are risk averse.
3. Investors maximise the utility of end of period wealth. Thus CAPM is a single period model.
Ri = RF + [E(RM - RF)]ß
Note ßi = Cov(im)
δ²m
Where Cov(im) is the covariance between asset i and the market return.
δ²m is the variance of the market return.
Assume that the risk free rate of return is 8%, the market expected rate of return is 12%. The
standard deviation of the market return is 2% while the covariance of return for security A and the
market is 2%.
REQUIRED:
Solution
Ri = RF + (E(RM) - RF)ß
ß = Cov(AM) = 2 = 2 = 0.5
Written and compiled by Dr. Muchelule Yusuf Wanjala Page 89
δM² 2² 4
b. CAPM is a single period model—it looks at the end of the year return.
c. CAPM cannot be empirically tested because we cannot test investors expectations.
d. CAPM assumes that a security's required rate of return is based on only one factor (the stock
market—beta). However, other factors such as relative sensitivity to inflation and dividend
payout, may influence a security's return relative to those of other securities.
APT assumes that, in equilibrium, the return on an arbitrage portfolio (i.e. one with zero
investment, and zero systematic risk) is zero. If this return is positive, then it would be
eliminated immediately through the process of arbitrage trading to improve the expected
returns. Ross (1976) demonstrated that when no further arbitrage opportunities exist, the
expected return (E(Ri)) can be shown as follows:
CAPITAL STRUCTURE
Factors That Affect Capital Structure
1. Availability of securities – This influences the company’s use of debt finance which
means that if a company has sufficient securities, it can afford to use debt finance in large
capacities.
2. Cost of project finance (both implicit and explicit) – If low, then a company can use more
of debt or equity finance.
3. Company gearing level – if high, the company may not be able to use more debt or equity
finance because potential investors would not be willing to invest in such a company.
4. Sales stability – If a company has stable sales and thus profits, it can afford to use various
finances in particular debt in so far as it can service such finances.
5. Competitiveness of the industry in which the company operates – If the company
operates in a highly competitive industry, it may be risky to use high levels of debt
because chances of servicing this debt may be low and may lead a company into
receivership.
I.e. if flotation costs are given per share then this will be knocked off or deducted from the
market price per share. If they are given for the total finance paid they are deducted from the
total amount paid.
Cost of Retaining Finance
This will include dividends for share capital and interest for debt finance (tax deducted) or
effective cost of debt. However, when computing the Cost of project finance apart from
deducting implicit costs, explicit costs are the most central elements of cost of finance.
Importance of Cost of Finance
The cost of capital is important because of its application in the following areas:
i) Long-term investment decisions – In capital budgeting decisions, using NPV method, the
cost of capital is used to discount the cash flows. Under IRR method the cost of capital is
compared with IRR to determine whether to accept or reject a project.
ii) Capital structure decisions – The composition/mix of various components of capital is
determined by the cost of each capital component.
iii) Evaluation of performance of management – A high cost of capital is an indicator of high
risk attached to the firm. This is usually attributed to poor performance of the firm.
iv) Dividend policy and decisions – E.g if the cost of retained earnings is low compared to
the cost of new ordinary share capital, the firm will retain more and pay less dividend.
Additionally, the use of retained earnings as an internal source of finance is preferred
because:
It does not involve any floatation costs
It does not dilute ownership and control of the firm, since no new shares are issued.
v) Lease or buy decisions – A firm may finance the acquisition of an asset through leasing
or borrowing long-term debt to buy an asset. In lease or buy decisions, the cost of debt
(interest rate on loan borrowed) is used as the discounting rate.
Factors That Influence the Cost of project Finance
1. Terms of reference – if short term, the cost is usually low and vice versa.
2. Economic conditions prevailing – If a company is operating under inflationary
conditions, such a company will pay high costs in so far as inflationary effect of finance
will be passed onto the company.
3. Risk exposed to venture – if a company is operating under high risk conditions, such a
company will pay high costs to induce lenders to avail finance to it because the element
of risk will be added on the Cost of project finance which may compound it.
The relationship between short and long interest rates is important to corporate managers
because:
1. They must decide whether to buy long term or short term bonds and whether to borrow
by issuing long-term or short-term bonds.
2. It enables them to understand how long term and short term rates are related and what
causes the shift in their relative positions.
Several theories had been advanced to explain the nature of yield curve – These are:
i) Investors generally prefer short term bonds to long-term securities because such
securities are more liquid in the sense that they can be converted to cash with little danger
Taking together this two sets of preferences implies that under normal conditions, a positive
maturity risk premium exist which increases with maturity thus the yield curve should be upward
sloping. Lenders prefer liquidity (short term hands) while borrowers prefer long term bonds and
are willing to pay a “premium” for long term borrowing.
2. Expectation Theory
This theory states that the yield curve depends on the expectation about future inflation rates. If
inflation rate is expected to increase, then the rate on long-term bonds will exceed that of short-
term loan. The expected future interest rates are equal to forward rates computed from the
expectations with regard to future interest rates are. Other factors which affect the expectations
with regard to future interest rates are:
Political stability
Monetary policy of the government
Fiscal policy of the government (government expedition)
Other economic related factors including social factors.
The following conditions are necessary for the expectation theory to hold.
i) Perfect capital markets exists where there are many buyers and sellers of security with
non having a significant influence on the interest rates.
ii) Investors have homogeneous expectations about future interest rates and returns on all
investments.
iii) Investors are rational wealth maximizers
iv) Bankruptcy of firms due to use of borrowing is unlikely.
A person saving for retirement 20 years ahead would probably buy long-term security in L.T
market. The thrust of market segmentation theory is that the slope of yield curve depends on
demand and supply mechanism. An upward sloping curve would occur if there was a large
supply of funds relative to demand in the short term marketing but a relative shortage of funds in
the long-term market would produce an upward sloping curve.
1. Supply and demand conditions in the short and long term market.
2. Liquidity preferences of lenders and borrowers
3. Expectation of future inflation. While any of the 3 factors may dominate the market
all the 3 effect the term structure of interest rate.
There are four most important factors that influence interest rates and the shape of yield curve.
i) Risk adjusted discounting rate – This technique is used to establish the discounting rate to
be used for a given project. The cost of capital of the firm will be used as the discounting
rate for a given project if project risk is equal to business risk of the firm. If a project has a
ii) Market Model – This model is used to establish the percentage cost of ordinary share capital
cost of equity (Ke). If an investor is holding ordinary shares, he can receive returns in 2
forms:
Dividends
Capital gains
Capital gain is assumed to constitute the difference between the buying price of a share at the
beginning of the (P0), the selling price of the same share at the end of the period (P1). Therefore
total returns = DPS + Capital gains = DPS + P1 – P0.
The amount invested to derive the returns is equal to the buying price at the beginning of the
period (P0) therefore percentage return/yield =
Illustration:
For the past 5 years, the MPS and DPS for XYZ Ltd were as follows:
Required
Determine the estimated cost of equity/shareholders percentage yield for each of the years
involved.
Solution
2000 53 8 4 8+4 12
= x 100=27 %
45 45
2001 50 -3 3 −3+3 0
= x 100=0 %
53 53
2002 52 2 - 2+0 2
= x 100=4 %
50 50
iii) Capital asset pricing model (CAPM) – CAPM is a technique that is used to establish
the required rate of return of an investment given a particular level of risk. According to
CAPM, the total business risk of the firm can be divided into 2:
Systematic Risk – This is the risk that affects all the firms in the market. This risk cannot be
eliminated/diversified. It is thus called undiversifiable risk. Since it affects all the firms in the
market, the share price and profitability of the firms will be moving in the same direction i.e.
systematically. Examples of systematic risk are political instability, inflation, power crisis in the
economy, power rationing, natural calamities – floods and earthquakes, increase in corporate tax
rates and personal tax rates, etc. Systematic risk is measured by a Beta factor.
Unsystematic risk – This risk affects only one firm in the market but not other firms. It is
therefore unique to the firm thus unsystematic trend in profitability of the firm relative to the
profitability trend of other firms in the market. The risk is caused by factors unique to the firm
such as:
CAPM is only concerned with systematic risk. According to the model, the required rate of
return will be highly influenced by the Beta factor of each investment. This is in addition to the
excess returns an investor derives by undertaking additional risk e.g cost of equity should be
equal to Rf + (Rm – Rf)BE
Illustration
KK Ltd is an all equity firm whose Beta factor is 1.2, the interest rate on T. bills is currently at
8.5% and the market rate of return is 14.5%. Determine the cost of equity Ke, for the company.
Solution
Rf = 8.5% Rm = 14.5% Beta of equity = 1.2
Ke = Rf + (Rm – Rf)BE
= 8.5% + (14.5% - 8.5%) 1.2
= 8.5% + (6%)1.2
= 15.7%
iv) Dividend yield/Gordon’s Model – This model is used to determine the cost of various
capital components in particular:
Cost of equity - Ke
Cost of preference share capital (perpetual) – Kp
Cost of perpetual debentures – Kd
d0
Zero growth firm – P0 = d0 Therefore = P0
R = Ke
Where:d0 = DPS
R0 = Current MPS
d 0 ( 1+ g )
Constant growth firm – P0 = Ke g
c) Cost of perpetual debenture (Kd) – Debentures pay interest charges, which an allowable
expenses for tax purposes.
Int .
( 1−T )
Therefore Kd = V d
1
Int ( 1−T ) + ( M −V d )
n
K d / VTM / RY = 1
( M +V d ) 2
W.A.C.C =
Ke ( VE )+K ( VP )+K (1−T )( VD )
p d
Where:Ke, Kp and Kd = Percentage cost of equity, preference share capital and debt capital
respectively
E, P and D = Market value of equity, preference share capital and debt capital
respectively.
NB: Market value = Market price of a security x No. of securities.
V = Total market value of the firm = E + P + D.
Illustration
The following is the capital structure of XYZ Ltd as at 31/12/2002.
Shs.M
Ordinary share capital Sh.10 par value 400
Retained earnings 200
10% preference share capital Sh.20 par 100
value 200
12% debenture Sh.100 par value 900
Additional information
1. Corporate tax rate is 30%
2. Preference shares were issued 10 years ago and are still selling at par value MPS = Par
value
3. The debenture has a 10 year maturity period. It is currently selling at Sh.90 in the
market.
4. Currently the firm has been paying dividend per share of Sh.5. The DPS is expected to
grow at 5% p.a. in future. The current MPS is Sh.40.
Required
d0 = Sh.5 P0 = Sh.40 g = 5%
d 0 (1+ g ) 5 ( 1+0 . 05 )
K e= + g= +0 . 05=0 .18125=18. 13 %
P0 40
Cost of perpetual preference share capital (Kp) – preference shares are still selling at par
thus MPS = par value. If this is the case, Kp = coupon rate = 10%.
DPS d p Sh. 2
K p= = = =10 %
MPS P p Sh. 20
Cost of debentures (Kd) – the debenture has a 10 year maturity period. It is thus a
redeemable fixed return security thus the cost of debt is equal to yield to maturity.
Redemption yield:
1
Int ( 1−T ) + ( M −V d )
n
K d =YTM =RY =
( M +V d ) ½
Sh.200 Mdebentures
Sh.90 x
= Sh .100 parvalue = 180
=
Ke ( VE )+K ( VP )+K ( 1−T ) ( VD )
p d
=
18 .13 % ( 1,1, 600880 )+10% (1001,880 )+10 %( 1801,880 )
= 15.43 + 0.5319 + 0.9574
= 0.169193
≈ 16.92%
318 .08
x 100
Therefore WACC = 1,880 = 16.92%
Market values
Book values
Replacement values
Intrinsic values
Market Value – This involves determining the weights or proportions using the current market
values of the various capital components. The problems with the use of market values are:
The market value of each security keep on changing on daily basis thus market values can be
computed only at one point in time.
The market value of each security may be incorrect due to cases of over or under valuation in the
market.
Book values – This involves the use of the par value of capital as shown in the balance sheet.
The main problem with book values is that they are historical/past values indicating the value of
a security when it was originally sold in the market for the first time.
Replacement values – This involves determining the weights or proportions on the basis of
amount that can be paid to replace the existing assets. The problem with replacement values is
that assets can never be replaced at ago and replacement values may not be objectively
determined.
Intrinsic values – In this case the weights are determine on the basis of the real/intrinsic value of
a given security. Intrinsic values may not be accurate since they are computed using
historical/past information and are usually estimates.
Note
When using market values to determine the weight/proportion in WACC, the cost of retained
earnings is left out since it is already included or reflected in the MPS and thus the market value
of equity. Retained earnings are an internal source of finance thus, when they are high there is
low gearing, lower financial risk and thus highest MPS.