Chapter 7:Project Cost Management

Learning Objectives
• Understand the importance of project cost management
• Explain basic project cost management principles,
concepts, and terms
• Discuss different types of cost estimates and methods
for preparing them
• Understand the processes involved in cost budgeting and
preparing a cost estimate and budget for an information
technology project

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 What is Cost and Project Cost
Management?
• Cost is a resource sacrificed or foregone to achieve a
specific objective or something given up in exchange
• Costs are usually measured in monetary units like
dollars, yen, Rs etc
• Project cost management: the processes to ensure
that the project is completed within an approved
budget

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 Why cost overruns in IT projects
• Unclear requirements
• Many IT professionals think that preparing cost
estimates is a responsibility of accountants
• IT projects are mostly new business or new
technology project

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 Project Cost Management Processes
• Resource planning: determining what resources and
quantities of them should be used
• Estimating costs: developing an approximation or
estimate of the costs of the resources needed to
complete a project
• Determining the budget: allocating the overall cost
estimate to individual work items to establish a
baseline for measuring performance
• Controlling costs: controlling changes to the project
budget

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 Resource Planning
• The nature of the project and the organization will
affect resource planning
• Some questions to consider:
– How difficult will it be to do specific tasks on the project?
– Is there anything unique in this project’s scope statement
that will affect resources?
– What is the organization’s history in doing similar tasks?
– Does the organization have or can they acquire the people,
equipment, and materials that are capable and available for
performing the work?

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Figure 7-1. Project Cost Management
Summary

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 Basic Principles of Cost Management
• Most members of an executive board are more
interested in financial terms than IT terms, so IT
project managers must speak their language
– Profits are revenues minus expenditures
– Profit margin is the ratio of revenues to profits
– Life cycle costing considers the total cost of ownership, or
development plus support costs, for a project
– Cash flow analysis determines the estimated annual costs
and benefits for a project

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 Basic Principles of Cost Management

• Tangible costs or benefits are those costs or benefits

that an organization can easily measure in dollars
• Intangible costs or benefits are costs or benefits that
are difficult to measure in monetary terms. For
example productivity, employee moral, reputation or
brand value
• Direct costs are costs that can be directly related to
producing the products and services of the project
• Indirect costs are costs that are not directly related to
the products or services of the project, but are
indirectly related to performing the project. For
example, the cost of electricity.
• Sunk cost is money that has been spent in the past.

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 Basic Principles of Cost Management
• Learning curve theory states that when many items are
produced repetitively, the unit cost of those items decreases
in a regular pattern as more units are produced
• Reserves are dollars included in a cost estimate to reduce cost
risk by allowing for future situations that are difficult to
predict
– Contingency reserves allow for future situations that may
be partially planned (sometimes called known unknowns).
For example, if an organization knows it has a 20 percent
rate of revenue for information technology personnel, it
should include contingency reserves to pay for recruiting
and training costs for information technology personnel.
– Management reserves allow for future situations that are
unpredictable (sometimes called unknown unknowns).
For example, if a project manager gets sick for two weeks
or an important supplier goes out of business,
management reserve could be set aside to cover the
resulting costs.
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 Estimating Costs
• Project managers must take cost estimates
seriously if they want to complete projects
within budget constraints
• Important to know the types of cost
estimates, cost estimation tools and
techniques, and typical problems associated
with IT cost estimates

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 Types of Cost Estimates
• A rough order of magnitude (ROM) estimate provides an estimate of
what a project will cost. This type of estimate is done very early in a
project or even before a project is officially started. Project managers and
top management use this estimate to help make project selection
decisions.
• A budgetary estimate is used to allocate money into an organization s
budget. Budgetary estimates are made one to two years prior to project
completion.
• A definitive estimate provides an accurate estimate of project costs.

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 Cost Estimation Tools and Techniques
• Basic tools and techniques for cost estimates:
– Analogous or top-down estimates: use the actual cost of a
previous, similar project as the basis for estimating the cost
of the current project
– it is also less accurate.
– Analogous estimates are most reliable when the previous
projects are similar in fact, not just in appearance.
– In addition, the groups preparing cost estimates must have
the needed expertise to determine whether certain parts
of the project will be more or less expensive than
analogous projects.

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 Cost Estimation Tools and
Techniques
• Bottom-up estimates: involve estimating individual work
items or activities and summing them to get a project total
– The size of the individual work items and the experience of
the estimators drive the accuracy of the estimates.
– If a detailed WBS is available for a project, the project
manager could have each person responsible for a work
package develop his or her own cost estimate for that
work package, or at least an estimate of the amount of
resources required.

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 Typical Problems with IT Cost Estimates
• Estimates are done too quickly
– Developing an estimate for a large software project is a complex
– Many estimates are mostly done before clear system
requirements have been produced.
• Lack of estimating experience
– The people who develop software cost estimates often do not
have much experience with cost estimation for large projects.
– There is also not enough accurate, reliable project data available
on which to base estimates.

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 Typical Problems with IT Cost
Estimates
• Human beings are biased toward
underestimation
– senior information technology professionals or project
managers might make estimates based on their own abilities
and forget that many junior people will be working on a
project.
• Management desires accuracy
– Management might ask for an estimate, but really wants a
more accurate number to help them create a bid to win a
major contract or get internal funding.

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 Sample Cost Estimate
• Before creating an estimate gather as much
information as possible, and clarify the
assumptions for the estimate
• If possible, estimate costs by major WBS
categories
• Create a cost model to make it easy to make
changes to and document the estimate

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Figure 7-2. Surveyor Pro Project Cost Estimate

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Project Duration=12 months
• Project Management:
Labor rate for P.M=$100/hr
Labor rate for team members=$75/hr
Average working hours for P.M (960/12) =80hrs/month
Average working hours for team members (1920/12)= 160hrs/month
• Hardware:
Hardware devices required= 100
Per device price= $600
No. of servers required= 4
Per unit server price= $4000

• Software
Licensed software required= 100
Per unit price= $200
Software development: This estimate will use two approaches: a labor
estimate and a function point estimate. The higher estimate will be used.
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• Testing
Testing will be estimated as 10 percent of the total hardware and
software cost.

• Training and support:

Total no. of trainee= 100
Cost per trainee= $500
No. of days to travel= 12
Cost per day= 700
Working hours of team members= 1920
Average rate per hour= $75

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 Function Point Analysis
• FPs of an application is found out by counting the number and types of
functions used in the applications. Various functions used in an application
can be put under
• five types, as shown in Table:

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Function Point Calculation
FP=Total UAF * language factor

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COCOMO Model
The COCOMO model is a good measure for estimating the number of
person-months required to develop software. My project, the Statistical
analysis package is an application program. The table below presents the
COCOMO formulae for different types of programs:

Approach based on paper by William Roetzheim, “Estimating

Software Costs,” Cost Xpert Group, Inc. (2003) using the COCOMO
II default linear productivity factor (3.13) and penalty factor (1.072).

Total labor hours= 29.28 * 160 = 4684.65

Cost/labor hour= $120
Total function point estimate= 4684.65*120= $562,158
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Figure 7-2. Surveyor Pro Project Cost Estimate

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 Determining the Budget
• Cost budgeting involves allocating the project
cost estimate to individual work items over time
• The WBS is a required input to the cost
budgeting process since it defines the work
items
• Important goal is to produce a cost baseline
– A time-phased budget that project managers use to
measure and monitor cost performance

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Figure 7-4. Surveyor Pro Project Cost Baseline

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 Controlling Costs
• Project cost control includes:
– Monitoring cost performance
– Ensuring that appropriate project changes are
included in a revised cost baseline
– Informing project stakeholders of authorized
changes to the project that will affect costs
• Many organizations around the globe have
problems with cost control

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 Earned Value Management
• A project performance measurement technique that
integrates scope, time, and cost data. Given a cost
performance baseline, project managers and their
teams can determine how well the project is meeting
scope, time, and cost goals by entering actual
information and then comparing it to the baseline.
• A baseline is the original project plan plus approved
changes.

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 Earned Value Management
• Earned value management involves calculating three values
for each activity or summary activity from a project s WBS.
• The planned value (PV), also called the budget, is that portion
of the approved total cost estimate planned to be spent on an
activity during a given period.
• The actual cost (AC) is the total direct and indirect costs
incurred in accomplishing work on an activity during a given
period.
• The earned value (EV) is an estimate of the value of the
physical work actually completed.
• The rate of performance (RP) is the ratio of actual work
completed to the percentage of work planned to have been
completed at any given time during the life of the project or
activity.
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 Earned Value Management
• Cost variance (CV) is the earned value minus the actual cost. If cost
variance is a negative number, it means that performing the work cost
more than planned(over budget). If cost variance is a positive number, it
means that performing the work cost less than planned(under budget).
• Schedule variance (SV) is the earned value minus the planned value. A
negative schedule variance means that it took longer than planned to
perform the work(over schedule), and a positive schedule variance means
that it took less time than planned to perform the work(under schedule).
• The cost performance index (CPI) is the ratio of earned value to actual
cost and can be used to estimate the projected cost of completing the
project. If the cost performance index is equal to one, or 100 percent,
then the planned and actual costs are equal the costs are exactly as
budgeted. If the cost performance index is less than one or less than 100
percent, the project is over budget.

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 Earned Value Management
• The schedule performance index (SPI) is the ratio of earned value to
planned value.
• Used to estimate the projected time to complete the project.
• If the schedule performance index is greater than one or 100 percent,
then the project is ahead of schedule.
• If the schedule performance index is less than one or 100 percent, the
project is behind schedule

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 Earned Value Analysis Example-1
• Suppose you have a budgeted cost of a project at $900,000. The project is
to be completed in 9 months. After a month, you have completed 10
percent of the project at a total expense of $100,000. The planned
completion should have been 15 percent.
• Now, let’s see how healthy the project is.
• From the scenario, you can extract the following:
– Budget at completion (BAC) = $900,000
– Actual cost (AC) = $100,000
– Actual completion=10%
– Planned completion=15%
– Original Time Estimate (OTE)=9 months
• To Calculate:
– Cost Variance (CV) = ?
– Schedule Variance (SV) = ?
– Cost Performance Index (CPI) = ?
– Schedule Performance Index (SPI) = ?

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• Formulas
– CV = EV – AC
– SV = EV – PV
– CPI = EV / AC
– SPI = EV / PV
– PV = Planned Completion * BAC
– EV = Actual Completion * BAC

• The Planned Value (PV) and Earned Value (EV) can then be computed as follows:
– Planned Value = Planned Completion (%) * BAC = 15% * $ 900,000 = $ 135,000
– Earned Value = Actual Completion (%) * BAC = 10% * $ 900,000 = $ 90,000

• Compute CPI & SPI:

– Cost Performance Index (CPI) = EV / AC = $90,000 / $100,000 = 0.90  90%
– Schedule Performance Index (SPI) = EV / PV = $90,000 / $135,000 = 0.67  67%

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 Earned Value Analysis Example-1
• CV=EV-AC  -10,000
– cost variance is a negative number, it means that
performing the work cost more than planned (over
budget).
• SV=EV-PV  -45000
– Negative schedule variance means that it took longer than
planned to perform the work (Over Schedule)
• Estimate at Completion(EAC)=BAC/CPI 1,000,000
• Estimate Time Completion (ETC) =OTE/SPI  14

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 Interpretation
• Since both Cost Performance Index (CPI index) and
Schedule Performance Index (SPI index) are less than
1, it means that the project is over budget and over
schedule. This example project is in major trouble
and corrective action needs to be taken.

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Earned Value Analysis – Example 2
• Suppose you are managing a software
development project.
• The project is expected to be completed in 8
months at a cost of $10,000 per month.
• After 2 months, you realize that the project is
30 percent completed at a cost of $40,000.
You need to determine whether the project is
on-time and on-budget after 2 months

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Earned Value Analysis – Example 2
• Step 1: Calculate the Planned Value (PV) and Earned
Value (EV)
• From the scenario,
– Budget at Completion (BAC) = $10,000 * 8 = $80,000
– Actual Cost (AC) = $40,000
– Planned Completion = 2/8 = 25%
– Actual Completion = 30%
• Therefore,
– Planned Value = Planned Completion (%) * BAC = 25% * $ 80,000 = $ 20,000
– Earned Value = Actual Completion (%) * BAC = 30% * $ 80,000 = $ 24,000

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Earned Value Analysis – Example 2
• Step 2: Compute the Cost Performance Index (CPI) and
Schedule Performance Index (SPI)
– Cost Performance Index (CPI) = EV / AC = $24,000 / $40,000 = 0.6= 60%
– Schedule Performance Index (SPI) = EV / PV = $24,000 / $20,000 = 1.2 120%
• CV=EV-AC  -16,000
– cost variance is a negative number, it means that performing the work
cost more than planned.
• SV=EV-PV  4,000
– a positive schedule variance means that it took less time than planned
to perform the work.
• EAC=BAC/CPI 133,333.333
• ETC=OTE/SPI  7

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 Interpretation
• Since Cost Performance Index (CPI) is less than one, this
means the project is over budget.
• Since Schedule Performance Index (SPI) is more than one, the
project is ahead of schedule.
• However, this has come at a cost of going over budget. If
work is continued at this rate, the project will be delivered
ahead of schedule and over budget. Therefore, corrective
action should be taken.

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Earned Value Analysis – Example 3
• You have a project to be completed in 12 months.
The budget of the project is 100,000 USD. Six months
have passed and 60,000 USD has been spent, but on
closer review, you find that only 40% of the work has
been completed so far.

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Earned Value Analysis – Example 3
• Step 1: Calculate the Planned Value (PV) and Earned
Value (EV)
• From the scenario,
– Budget at Completion (BAC) = 100,000 USD
– Actual Cost (AC) = 60,000 USD
– Planned Completion = 6/12 = 50%
– Actual Completion = 40%
• Therefore,
– Planned Value = Planned Completion (%) * BAC = 50% * 100,000= 50,000
– Earned Value = Actual Completion (%) * BAC = 40% * 100,000= 40,000

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Earned Value Analysis – Example 3
• Step 2: Compute the Cost Performance Index (CPI) and
Schedule Performance Index (SPI)
– Cost Performance Index (CPI) = EV / AC = 40,000/ 60,000= 0.6= 60%
– Schedule Performance Index (SPI) = EV / PV = 40,000/ 50,000 = 0.8 80%
• CV=EV-AC  -20,000
– cost variance is a negative number, it means that performing the work
cost more than planned.
• SV=EV-PV  -10,000
– Negative schedule variance means that it took longer than planned to
perform the work
• EAC=BAC/CPI 1166,666
• ETC=OTE/SPI  15

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Using Software to Assist in Cost Management

• Spreadsheets are a common tool for resource

planning, cost estimating, cost budgeting, and
cost control
• Many companies use more sophisticated and
centralized financial applications software for
cost information

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 Chapter Summary
• Project cost management is a traditionally
weak area of IT projects, and project
managers must work to improve their ability
to deliver projects within approved budgets
• Main processes include:
– Estimate costs
– Determine the budget
– Control costs

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