Lesson 5

 Project Estimation

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Estimating

1-2
 Estimating Projects
• Estimating
– The process of forecasting or approximating the time
and cost of completing project deliverables.
– The task of balancing expectations of stakeholders
and need for control while the project is
implemented.
• Types of Estimates
– Top-down (macro) estimates: analogy, group
consensus, or mathematical relationships
– Bottom-up (micro) estimates: estimates of elements
of the work breakdown structure
Factors Influencing the Quality of
Estimates
Planning Horizon

Other
Project
(Nonproject)
Duration
Factors

Quality of
Organization Estimates People
Culture

Padding Project Structure

Estimates and Organization
 Estimating Guidelines for
Times, Costs, and Resources
1. Have people familiar with the tasks make the estimate.
2. Use several people to make estimates.
3. Base estimates on normal conditions, efficient methods,
and a normal level of resources.
4. Use consistent time units in estimating task times.
5. Treat each task as independent, don’t aggregate.
6. Don’t make allowances for contingencies.
7. Adding a risk assessment helps avoid surprises
to stakeholders.
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 Cost estimate
• Recent experience in similar work
• Professional and reference material
• Market and industry surveys
• Knowledge of the operations and
processes
• Estimating software and databases if
available
• Interviews with subject matter experts

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 Cost Estimation Tools and Techniques
• 3 basic tools and techniques for cost estimates:
– analogous or top-down: use the actual cost of a
previous, similar project as the basis for the new
estimate
– bottom-up: estimate individual work items and sum
them to get a total estimate
– parametric: use project characteristics in a
mathematical model to estimate costs
 Top-Down versus Bottom-Up
Estimating
• Top-Down Estimates
– Are usually are derived from someone who uses
experience and/or information to determine the
project duration and total cost.
– Are made by top managers who have little knowledge
of the processes used to complete the project.
• Bottom-Up Approach
– Can serve as a check on cost elements in the WBS
by rolling up the work packages and associated cost
accounts to major deliverables at the work package
level.
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 Top-Down versus Bottom-Up
Estimating
Conditions for Preferring Top-Down or Bottom-up
Time and Cost Estimates

Condition Macro Estimates Micro Estimates

Strategic decision making X
Cost and time important X
High uncertainty X
Internal, small project X
Fixed-price contract X
Customer wants details X
Unstable scope X

TABLE 5.1
5–9
 CLASSES OF ESTIMATES

Class Types Accuracy

I Definitive ±5%
II Capital cost ±10–15%
III Appropriation (with some capital cost) ±15–20%
IV Appropriation ±20–25%
V Feasibility ±25–35%
VI Order of magnitude > ±35%

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 Estimating Projects: Preferred
Approach
• Make rough top-down estimates.
• Develop the WBS/OBS.
• Make bottom-up estimates.
• Develop schedules and budgets.
• Reconcile differences between top-down
and bottom-up estimates

5–11
 Top-Down Approaches for Estimating
Project Times and Costs
• Consensus methods
• Ratio methods
• Apportion method
Project Estimate
• Function point methods for Times
Costs
software and system projects
• Learning curves
Apportion Method of Allocating Project Costs
Using the Work Breakdown Structure
Bottom-Up Approaches for Estimating
Project Times and Costs
• Template methods
• Parametric procedures
applied to specific tasks
• Range estimates for
the WBS work packages
• Phase estimating: A hybrid
Phase Estimating over Product Life Cycle

FIGURE 5.3
5–15
Top-Down and Bottom-Up Estimates

FIGURE 5.4
5–16
 Types of Costs
• Direct Costs
– Costs that are clearly chargeable
to a specific work package.
• Labor, materials, equipment, and other
• 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
 Types of cost
• Costs related to time constraint
+ Equipment rent
+ Electricity and water
+ Extra wages for extra time
+ Irregular employment costs

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 Project Cost Estimate
• Step 1. Choose one task in work breakdown
structure to estimate the cost
• Step 2. Identify criteria for doing this task
• Step 3. Identify the resources for doing this task
• Step 4. Consider the consequences of time
extension
• Step 5. Estimate the costs for this task

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 In-house projects
The type of estimate can vary over the life cycle of a project:

• Conceptual stage: Venture guidance or feasibility studies for

the evaluation of future work. This estimating is often based
on minimum-scope information.
• Planning stage: Estimating for authorization of partial or full
funds. These estimates are based on preliminary design and
scope.
• Main stage: Estimating for detailed work.
• Termination stage: Re-estimation for major scope changes or
variances beyond the authorization range.

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Time Value of Money
 Why TIME?

Why is TIME such an important

element in your decision?

TIME allows you the opportunity to

postpone consumption and earn
INTEREST.
Why we have to consider time value of
money
• Present Amount of money can be
invested in some businesses and get
more money
• Inflation
• Financial Management
 Which you one?
• 100.000 USD now • 100.000 USD after 5
• 100.000 USD now years
you can get 100.000
x(1+i)^5 after 5 years
by only putting your
money in a bank.
 Types of Interest

 Simple Interest
Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
• Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the principal
borrowed (lent).
 Types of Interest

 Simple Interest
Put an amount of money in a bank and
receive monthly interest
• Compound Interest
Put an amount of money in a bank, but not
receive monthly interest, the interest of next
month is calculated based on original money
and interest of this month.
 Types of Interest
 Simple Interest
If you put 100.000 USD in a bank and receive
interest of 1%. Each month, you get
1000USD. After 5 months you can get
105000 USD
• Compound Interest
Interest paid (earned) on any previous interest
earned, as well as on the principal borrowed (lent).
With 100000 USD, after 5 years, you can get
100.000 x(1+0.01)^5=105.101 USD
 Future Value vs. Present Value
• Future Value is the • Present Value is the
value at some future current value of a
time of a present future amount of
amount of money, or money, or a series of
a series of payments, payments, evaluated
evaluated at a given at a given interest
interest rate. rate.
 Future Value
Single Deposit (Graphic)
Assume that you deposit $1,000 at a
compound interest rate of 7% for 2
years.
0 7% 1 2

$1,000
FV2
 Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1 = $1,000 (1.07)
= $1,070
Compound Interest
You earned $70 interest on your $1,000
deposit over the first year.
This is the same amount of interest you
would earn under simple interest.
 Future Value
Single Deposit (Formula)
FV1 = P0 (1+i)1 = $1,000 (1.07)
= $1,070
FV2 = FV1 (1+i)1
= P0 (1+i)(1+i) = $1,000(1.07)
(1.07) = P0 (1+i)2 =
$1,000(1.07)2
= $1,144.90
You earned an EXTRA $4.90 in Year 2 with
 General Future
Value Formula
FV1 = P0(1+i)1
FV2 = P0(1+i)2

etc. Value Formula:

General Future
FVn = P0 (1+i)n
or FVn = P0 (FVIFi,n)
 FV

Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
 Story Problem Example
Oanh wants to know how large her deposit of
$10,000 today will become at a compound annual
interest rate of 10% for 5 years.

0 1 2 3 4 5

10%
$10,000
FV5
 Overview of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .

R R R
R = Periodic
Cash Flow

FVAn
FVAn = R(1+i) + R(1+i) +
n-1 n-2

... + R(1+i)1 + R(1+i)0

 Present Value
Single Deposit (Graphic)
Assume that you need $1,000 in 2 years.
Let’s examine the process to determine how
much you need to deposit today at a discount
rate of 7% compounded annually.
0 1 2
7%

$1,000
PV0 PV1
 Present Value
Single Deposit (Formula)
PV0 = FV2 / (1+i)2 = $1,000 / (1.07)2 = FV2 /
(1+i)2 = $873.44

0 1 2
7%

$1,000
PV0
 General Present
Value Formula
PV0 = FV1 / (1+i)1

PV0 = FV2 / (1+i)2

etc.
General Present Value Formula:
PV0 = FVn / (1+i)n
or PV0 = FVn (PVIFi,n) -- See Table II
 PV

Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
 Present Value
PV2 = $1,000 (PVIF7%,2) =
$1,000 (.873) = $873 [Due
to Rounding]
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
 Story Problem Example
Yen wants to know how large of a deposit to
make so that the money will grow to $10,000
in 5 years at a discount rate of 10%. She can
use this money as a dowry.
0 1 2 3 4 5

10%
$10,000
PV0
 Overview of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .

R R R

R = Periodic
Cash Flow
PVAn
PVAn = R/(1+i)1 + R/(1+i)2
+ ... + R/(1+i)n
 Paid under the Annuity

Oanh Xinh bought a car paid under

the annuity in 5 years with price of
850.000.000 VND. Calculate amount
of money Oanh Xinh have to pay
each year for her car.
 Paid under the Annuity
10%
0 1 2 3 4 5
850 tr VND P P P P P

850= P/(1+i)^1 + P/(1+i)^2 + P/(1+i)^3 + P/(1+i)^4 +

P/(1+i)^5
 Paid under the Annuity

850= P/(1+i)^1 + P/(1+i)^2 + P/(1+i)^3 + P/(1+i)^4 +

P/(1+i)^5
850 x(1+i)^5= Px(1+i)^4 + Px(1+i)^3 + Px(1+i)^2 +
Px(1+i)^1 + P
850 x(1+i)^5= Px(1+i)^4 + Px(1+i)^3 + Px(1+i)^2 +
Px(1+i)^1 + P
850 x(1+i)^6= Px(1+i)^5 + Px(1+i)^4 + Px(1+i)^3 +
Px(1+i)^2 + Px(1+i)
850 x(1+i)^6 – 850x(1+i)^5= Px [(1+i)^5 -1]
850*i*(1+i)^5= P* [(1+i)^5 -1]

P= 225 triệu
 Net Present Value
• Capital Budgeting Decision
– We have just developed a way of evaluating an
investment decision which is known as Net Present
Value (NPV).
– NPV is defined as the PV of the cash flows from an
investment minus the initial investment.
NPV = PV – Required Investment (C0)
= [$400,000/(1+.07)] - $350,000
= $23,832
 Net Present Value
• Capital Budgeting Decision
– This discount rate is known as the opportunity cost
of capital.
• It is called this because it is the return you give up by
investing in the project.
• In this case, you give up the money you could have used to
buy a 7% tbill so that you can construct a building.
– But, a Tbill is risk free! A construction project is not!
– We should use a higher opportunity cost of capital.
Net Present Value
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Net Present Value

• Valuing long lived projects
– The NPV rule works for projects of any duration:
• Simply discount the cash flows at the appropriate opportunity cost of
capital and then subtract the cost of the initial investment.

– The critical problems in any NPV problem are to determine:

• The amount and timing of the cash flows.
• The appropriate discount rate.
NPV Rule: Accept Projects with Positive NPVs
 7-50

Other Investment Criteria

• Internal Rate of Return (IRR)
– IRR is simply the discount rate at which the NPV of the project
equals zero.

– You can calculate the rate of return on a project by:

1. Setting the NPV of the project to zero.
2. Solving for “r”.
– Unless you have a financial calculator, this calculation must be
done by using trial and error!
 Other Investment Criteria
• Internal Rate of Return (IRR)
Discount Rate NPV of Project
7% $23,382
12% $7,143

At what rate of return will the NPV

of this project be equal to zero?
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Other Investment Criteria

• Internal Rate of Return (IRR)
– If we solve for “r” in the equation below, we find the
IRR for this project is 14.29%:

• IRR Decision Rule: Accept Projects with IRR

r
which exceeds the opportunity cost of capital
 How to calculate IRR
Interpolation Method can be applied:
+ Calculate discount rate (r1) that make NPV
> 0 but approximately equal to 0.
+ Calculate discount rate (r2) that make NPV
<0 but approximately equal to 0
 Other Investment Criteria
• Internal Rate of Return (IRR) vs NPV:
– The NPV Rule states that you invest in any project which
has a positive NPV when its cash flows are discounted at
the opportunity cost of capital.
– The Rate of Return Rule states that you invest in any
project offering a rate of return which exceeds the
opportunity cost of capital.
• i.e., if you can earn more on a project than it costs to undertake,
then you should accept it!
– The NPV and IRR rules will give the same accept/reject
answer about a project as long as the NPV of a project
declines smoothly as the discount rate increases.
– Do not confuse IRR and the opportunity cost of capital
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 Other Investment Criteria
• Payback
– Payback is the time period it takes for the cash flows generated
by the project to recover the initial investment in the project.
– Example: You are paying $150 a month to park a car in your
apartment’s garage. You can purchase a parking spot for
$5,400. What is the payback for this “project”?
3 years  $5,400 / (12 * $150)
– The Payback Rule states that a project should be accepted if its
payback is less than a specified cutoff period.
• For example, if your cutoff were 4 years to payback, then you would
buy the parking spot.
• If it were 2 years, you wouldn’t buy the parking spot:
– 3 years is longer than you consider desirable to get your money
out of a project.

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