The Project Cost Baseline

What do you get when you cross a project budget with a schedule? It's something that gives you an idea of the total budgeted costs of project activities per time period—otherwise known as the project's cost baseline.

A cost baseline, which is an output of the cost budgeting process, is a time-phased budget that is used to measure and monitor cost performance on a project. It is developed by summing the estimated costs by period. The cost baseline takes the form of a cumulative cost curve, or an S-curve.

Why does a project's cost baseline look like a curve? It has to do with the typical spending pattern, or "burn rate," of project funds. A cost baseline usually takes an "S" shape, when plotted on a graph, for the following reasons.

• Costs in the planning or design phase are usually low.
• Once production begins, costs increase quickly relative to the passing of time.
• Costs decrease toward the end of the project during wrap-up and delivery.

But why stop at just one type of curve? You also can plot and display the values of expected cash receipts and actual project costs. Plot these curves next to the cost baseline for comparative purposes.
Plot expected receipts next to the cost baseline to display a forecast of the project's cash flow. You may have several periods of time during the project where you have significant expenses but have not received payment for that work, especially if you are paid only for deliverables.

If this creates a need for short-term financing to cover bills, you will want to know the likely time frame in which this will occur. Then you will be able to predict the terms for any necessary loans.

Plotting budgeted costs and actual costs side by side enables you to quickly see whether cost performance is good, evaluate the size of cost variances, and easily report cost performance to stakeholders.

Before you can plot planned costs over time, you have to establish the coordinates—that is, what costs should be per time period. If you are using a computerized scheduling tool, simply input the data and generate a cost report by time period. The software will probably create the cost curve for you.

In the absence of computerized tools, you can use a bar-chart of your schedule to establish cumulative costs over time. Follow these steps.

1. Draw a chart of activity durations.
2. Assign a budget to each activity.
3. Measure the accumulated costs per time period.
4. Plot cost-per-time data on a graph with duration on the x axis and cost on the y axis.
5. Connect the dots to see the curve.

The cost baseline for your project is the plan against which you will measure, monitor, and control costs. Use the cumulative cost curve as a graphical representation of the baseline when comparing planned costs to actual costs.

Tools and Techniques for Cost Budgeting

Budgeting for your project is not simply a matter of taking the cost estimates for various activities and saying, "This is the budget for this task." Estimates provide merely the base or frame upon which you will build a finalized project budget.

You can use a number of tools and techniques to take your bare-bones estimates and create the budget that will guide all your cost-control efforts. The tools and techniques of budgeting are based on the tools and techniques for cost estimating. Several tools and techniques you can use for cost budgeting are described below.

1. Create contingency funds and a management reserve.
The main difference between an estimate and a budget is the additional cushion a budget has built into it. Budgeting takes your estimates a step further by adding contingencies based on previous experience and risks related to particular activities.

Contingency funds are specific provisions for unforeseen increases in costs at the project activity level. In other words, contingencies are added to work packages and activities at the lower level of the work breakdown structure.

While cost budgeting takes place at the project activity level, it also takes place at the project management level. General project budgeting takes into account overall risk and establishes a management reserve for the project. This account contains a percentage of the project's funds that are set aside for potential problems.

The management reserve is held over and above the budgets for individual work packages. The size of a management reserve depends on the type of project, industry standards, and the guidelines for establishing reserves found in the project's risk management plan.

Although a number of factors must be weighed when developing a management reserve, you can follow this general rule of thumb: find the optimal add-on percentage that will minimize risk and yet not be overly cautious. You want to ensure that actual costs don't exceed your estimates, but you also want to remain competitive and avoid creating a "fat" budget.

2. Identify the ranges of accuracy for each of the cost-estimating techniques.
You developed the cost estimates for your project using one or more of the cost-estimating tools and techniques that are listed below. How accurate do you think your estimates are? It depends on the method you used, since the degree of accuracy varies between estimating techniques. Cost budgeting uses the deemed accuracy of your estimates to come up with appropriate contingencies.

• Parametric modeling. Parametric models provide a rough order of magnitude. These estimates could have a range as great as plus or minus 35 percent. To increase accuracy for budgeting purposes, you may want to run project activities through a more detailed methodology, such as bottom-up estimating.
• Analogous estimating. The accuracy of estimates improves somewhat if you have based cost estimates on a similar project. An analogous, or top-down, estimate may be accurate to plus or minus 15 percent to 20 percent. The range will decrease relative to an increase in similarity between the two projects.
• Bottom-up estimating. Bottom-up estimates are the most reliable (plus or minus five percent to 10 percent) since you have examined each activity in the work breakdown structure. When preparing a budget based on detailed and finalized estimates, you can reduce contingencies and overrun allowances due to the reduction in risk.
• Computerized tools. Project management software greatly simplifies cost budgeting. You can use statistical analysis and simulation to generate a budget based on the probability that actual costs will be over or under the base estimates, giving you an accuracy range as low as plus or minus five percent.

3. Use cost-budgeting techniques based on the cost-estimating techniques you used.
As you work with your base estimates to develop a project budget, remember how your estimates were developed and their level of accuracy, since you will use cost-budgeting techniques based on the cost-estimating techniques you used.

For example, you may have used a parametric model or analogous estimating to develop your cost estimates. If you based estimates on another accurate budget or used an accepted model, why not base the new budget on these, making allowances for any differences? You can use the accuracy range of your estimates to find the "most likely" total cost of your project. Set your budget somewhere between the low and high cost.

If accuracy is not paramount and you are looking for a general contingency, you can use the formula: Most Likely = Estimate + (x percent ÷ 2). Take the maximum cost based on the range of results, divide it in half, and use it as the "most likely" amount. This dollar figure, or percentage amount, is what you add over and above the estimated amount.

Have you used the bottom-up technique to develop the cost estimates for your project? If so, you can use statistical sums to develop the cost budget. The most common approach is to use the Expected Value calculation for each estimate. This formula is: Expected Value = (a + 4m + b) ÷ 6.

In this formula, Expected Value is the mean or average of the base, most likely, and maximum values, a = low or most optimistic forecast, m = the most likely estimate, and b = high or most pessimistic forecast for cost outcomes. Sum up the values for each estimate and base your budget on the total.

You can follow a number of guidelines for setting base budgets when you have used an estimating technique other than bottom-up estimating. Use computerized tools to assess risk and determine appropriate contingencies. You can also use the contingencies from other similar projects as a benchmark. The most likely cost will fall somewhere between the maximum and the base estimate.

In summary, cost budgets are based on the general accuracy of, and statistical information about, cost estimates. Budgeting depends on the assessed risk related to individual activities and the project as a whole. Appropriate contingencies are based on known risks. The higher the impact and probability of the risk, the more contingency you will want to allocate in your budget.

Four Inputs to Project Cost Budgeting

You will want to enter the cost budgeting phase of a project well-equipped. To do this, you will need to know what the inputs to cost budgeting are, and you should understand their importance to the budgeting process.

During cost budgeting, a number of project elements come together to form the project's cost baseline. The following four inputs are used in the cost budgeting process.

1. The project's work breakdown structure (WBS)
The project's work breakdown structure is important in cost budgeting because it organizes all project activities into work packages. Cost budgeting involves assigning a budget, or cost account, to each work package.

Can you imagine trying to assign budgets to project elements if the work was not organized in some way? Without reference to the WBS, vital costs may be overlooked. Any omissions would cause variances later on between planned and actual costs, and cost performance may be reported as "poor."

Part of creating the work breakdown structure is assigning accounting codes to project tasks and activities based on the organization's chart of accounts. Budgeting is simplified when the cost accounts are integrated in this way.

2. The cost estimates for the work
You have made predictions about the costs of the resources required to complete your project's activities. These cost estimates are another important input to cost budgeting.

The budget for each work package is based on the estimates you have prepared. For budgeting purposes, you should be using budget or control estimates with a range of 15 percent or better. The budgeting process may increase an estimate's range by adding an appropriate allowance or contingency to cover the risk of overruns.

3. The project schedule
The third input to cost budgeting is the project schedule. In fact, it is the application of the schedule to the project budget that produces your main tool for cost control: the project's cost baseline.

Once budgets have been assigned to work packages, use the schedule to distribute the predicted costs over time. The project schedule includes the expected start and finish dates for each activity to which costs will be allocated. This information is important to the cost budgeting process because allocated funds must be assigned to the time period in which the costs will be incurred.

As you develop the control budget for your project, you'll find that a bar-chart diagram can be useful. Use it to measure the total costs that fall within each week for planning or comparative purposes. You can easily measure the cumulative costs as the project progresses.

Time-phasing the budget in this way provides the project's cost baseline. Information about cumulative costs over time is also used to determine the project's "burn rate"—that is, the rate at which funds are expended.

4. The risk management plan
Finally, the risk management plan is an important input to cost budgeting. It outlines strategies for dealing with potential risks that could cause project cost overruns. It also can include cost contingencies that are based on the reliability of your cost estimates. You will build contingencies into the budget to compensate for potential cost overruns.

An accurate and appropriate budget is one of a project manager's greatest assets when it comes to cost management. Understanding the inputs to cost budgeting will help you to create such a budget.

The Project Cost Management Plan

Besides the cost estimates themselves, the most important output from estimating project costs is the cost management plan. This is the document that outlines how project costs will be kept on track.

As excellent as your cost estimates may be, you must have an adequate plan for managing cost variances and dealing with problems. A good cost management plan (CMP) clearly outlines how to implement corrective action in order to reduce or eliminate cost variances.

The main purpose of a cost management plan is to provide direction to project management teams. It must contain guidelines to follow, outlining what to do when positive or negative cost variances occur. Cost problems are usually handled according to their severity. Variances that pose no real threat to overall cost performance may require no action at all.

Cost management plans can be structured differently depending on the performing organization and the needs of the project stakeholders. The points below describe a broadly-based plan and a detailed plan.

• In a broadly-based plan, costs are estimated, monitored, and reported at the high-level work breakdown structure (WBS) elements. Tasks are not complex.
• A detailed plan will deal with costs at the lowest level of the WBS, making it easier to obtain timely and accurate information.

You also must decide whether your cost management plan will have a formal or informal structure. Bureaucratic structures are much more formal than project-based companies. Design a CMP that is consistent with the organizational culture of your company and with the authority that project managers hold. More details are provided below.

• Bureaucratic. Does your company have a bureaucratic and inflexible structure? If so, you likely will require formal forms, processes, approvals, and reviews for every step of the cost management process.
• Mixed. Your project team may work within a formally structured organization that answers to upper management but has the authority to manage project costs at its own discretion and without all the red tape.
• Project-based. The cost management plans of small, entrepreneurial companies typically reflect the increase in decision-making authority held by project managers. Processes are flexible, depending on particular projects and situations.

With the four options available—broad-based and detailed, bureaucratic (or formal) and project-based (or informal)—for structuring cost management plans, a type of matrix is formed from the combinations.

• Formal-detailed. This type of plan would be appropriate for a large institution with rigid accounting procedures.
• Formal-broad. The processes are vigorous but costing categories are general.
• Informal-detailed. The cost of every team activity is outlined but loosely monitored.
• Informal-broad. Costs aren't closely monitored or very detailed.

The two extreme situations are easy to identify. For the others, you need to look at organizational structure, level of detail, degree of decision-making authority, and the important of auditability.

How will you know if your project's cost management plan is a good one? Assess whether or not it meets the needs of the project stakeholders. Stakeholders are the people involved in producing the project or who are affected by the project's end result. They include the project team, investors, and the customer. Stakeholder needs may vary from one project to another.

Remember, as you develop cost estimates for your project, keep in mind that your project also needs a cost management plan to help you manage project costs after the budget is developed and project activities are under way.

Supporting Detail for Cost Estimates

A civil engineer will tell you that the supports that uphold a bridge and keep it in place are as important as the structure itself. For project cost estimates, the same holds true. Your estimates must be accompanied by supporting detail, which is an output of project cost estimating.

Any additional information that accompanies a cost estimate provides supporting detail. You did not establish your cost estimates in a vacuum. Supporting detail provides context for your estimates, and should include the following documentation.

1. A description of the scope of the work estimated
Every project file should contain a description of the scope of the work performed. You could include the project's entire work breakdown structure (WBS), or simply a written description of the work for which you have estimated costs.

This information will be useful in the future if you want to use the cost estimates in another project. Use project or product scope statements to assess the similarity between projects when you want to use analogous estimating.

2. A description of how the estimates were developed
You also should record how the cost estimates were developed. Which of the estimating techniques did you use? Perhaps you used one method for a particular phase or task of the project and a different method for another phase.

If the estimates prove to be off, you may want to revisit the process you went through in developing them to check for problems in your methodology. Provided below are examples of supporting detail you may want to provide when using specific estimating techniques.

• Analogous estimating. You'll want to know exactly which former project or projects were used as a basis for establishing cost estimates for the current project. Record how costs were established for aspects of the project that differ from the others.
• Parametric modeling. List all of the activities or resources for which you used a mathematical formula in estimating costs. If any resource rates change drastically during the project, this list will enable you to quickly pinpoint the estimates affected and make the necessary revisions.
• Bottom-up estimating. If you estimate project costs "from scratch," or from the bottom up, hold on to notes about the sources you used. This would include names, phone numbers, prices, and other information that would form an audit trail.

3. Any assumptions that were made about costs
Assumptions are factors that, for planning purposes, are considered to be true. Keep a record of assumptions that you or team members make during cost estimating in case they turn out to be false. You make assumptions about such things as resource rates, resource availability, and activity durations.
False assumptions usually cause cost variances because your actual costs will deviate from the planned costs. Hold on to the assumptions upon which estimates are based in case you have to account for discrepancies later on.

4. The range of possible results
The supporting detail for a cost estimate also should include an indication of the range of possible results for each resource, activity, or task. For example, an estimate of $10,000 plus or minus $1,000 indicates that an item is expected to cost between $9,000 and $11,000. The relative size of the range indicates whether it is a rough estimate or if it is accurate enough to be considered a finalized estimate (that is, with an accuracy of plus or minus five percent).

There are two other ways to express the accuracy of an estimate besides "plus or minus" a certain dollar figure. Sometimes you see the accuracy range for an estimate given as a percentage. Other times, estimates are tagged with a range that shows the probability that actual costs will under- or overrun the estimate.

• If you had an estimate of $1,000 plus or minus 15 percent, the range for the estimate would be plus or minus 15 percent of $1,000, or plus or minus $150. You are estimating that actual costs will fall between $850 and $1,150.
• When you express an estimate as $1,000 -10 percent, +25 percent, you are saying there is a 10 percent chance the estimate will be less than $1,000, and a 25 percent chance of it being more than $1,000. This risk factor is considered during the cost budgeting stage.

The amount and type of supporting detail varies by project application area. Keeping even rough notes may prove to be valuable by providing a better understanding of how the cost estimates were developed.

Attributes of Effective Cost Estimates

Cost estimates, which are outputs of the project cost estimating process, are quantitative assessments that you, as a member of a project management team, make. You assess the likely costs of the resources required to complete project activities and then present them in summary or in detail.

Once you've estimated a total project cost, how can you determine if the estimate is good? You'll know its good if it includes the three attributes of an effective cost estimate. Good cost estimates should have the following three attributes.

1. They should include all the resources for a project.
To be accurate, an overall estimate must include all the resources that will be charged to a project. Study the project's work breakdown structure (WBS). The more resources you overlook, the less accurate your estimate will be.

To ensure you include all the resources for a project in your cost estimates, you may want to develop a checklist. This can help you ensure that all costs related to labor, materials, supplies, and special categories, such as inflation, are included in your estimates.

If you are unsure whether your finalized cost estimates truly reflect every resource that can and should be charged to your project, go back to the WBS and verify that the estimate is complete. As long as each work package for your project has been fully decomposed, you should be able to tell from the WBS if any resource has been omitted from the estimates.

2. They are expressed in the appropriate units.
Cost estimates are most typically expressed in a unit of currency, such as dollars, pounds, or yen. Use the currency that most simplifies estimating, measurement, and reporting. For example, use the currency of the country where costs are incurred or the home currency of the parent organization.

Expressing costs in a consistent unit of measure makes it easier to compare costs both within, and across, projects. Multinational corporations will find comparative analysis much easier if they convert costs into one currency.

Some types of estimates are commonly indicated in units of time. Labor costs, for example, are usually expressed in hours, days, or weeks. Your cost estimates may include two columns: one for total "work effort," or duration, and one for total costs in dollars. Reporting labor costs in units of time provides the following benefits.

• You still can produce estimates even if you do not yet know who will be making up the project team. All you need to know is how long tasks should take to perform.
• Using work effort to report cost estimates allows you to tie into the automated scheduling tool that has been used to estimate and report activity durations.

3. They should include an appropriate contingency.
Cost estimates should include contingencies, or allowances, to cover specific risks and expected inefficiencies or problems. They reduce the necessity of revising cost estimates later on when one or more of your figures are causing unacceptable cost variances.
You should make every effort to produce accurate cost estimates, but don't forget that a good project manager will plan for the risk of change occurring during a project. Adding contingencies to cost estimates is one way you can do this.

Most project management software applications contain cost estimating and budgeting functions that select appropriate contingencies for you. They are based on risk factors and statistical analysis of data from previous projects.

In summary, examine your cost estimates closely for accuracy before relying on them. They will form the basis of the budget, the cost baseline, procurement planning, and the entire cost control system for your project.

Computerized Cost-estimating Tools

Whichever cost-estimating technique you choose for your project, you'll find that performing cost estimates manually can consume a lot of time and resources. If you feel you would rather be spending your valuable time actually managing your project, you'll want to consider using computerized cost-estimating tools.

Even the simplest tool can dramatically speed up cost estimating by totaling long columns or rows of figures in a split second. Which tools do you use in the workplace now? Perhaps you use a basic spreadsheet program, or you may use project management software.

A computerized spreadsheet of project costs allows for easy reference and analysis from a single page. Most basic applications also enable you to create simple charts and graphs for reporting purposes.

Project management software applications are specifically designed to aid in the planning and controlling of project activities. These programs are designed to make schedule and cost control much easier for project management teams.

Most software applications contain cost-estimating features that enable you to develop your cost estimates quickly and accurately. More details on how project management software can benefit your project are provided below.

• Triangulation. Triangulation is the act of using two points in space to accurately position yourself. You can use your computer to run two or more sets of cost estimates using different approaches in order to verify and affirm their accuracy.
• Simulation. There are some fairly sophisticated software products on the market that perform simulations. These programs enable you to develop various cost performance scenarios based on a few key inputs.
• Integration. Computer software enables you to integrate your cost estimates with your company's coding system for cost accounts. Your project team will also benefit from having cost information about current and past projects available on-line through a computer network.

There is a range of project management software available, from low-end software you can use to manage simple projects to high-end software that will enable you to handle multiple or complex projects. You should choose the product that best meets your needs.
Computerized tools have a number of advantages when used in cost estimating. They can save you time and money in the following ways.

1. They can simplify the use of other costing techniques.
Computerized tools simplify the use of other cost-estimating techniques, including analogous estimating, parametric modeling, and bottom-up estimating. Cost estimating often relies on statistical analysis that is simplified by computers. Totaling and rolling-up costs is also quicker and more accurate if you use computerized tools. More details are provided below.

• Analogous estimating. Analogous estimating means using the actual cost of a previous, similar project as the basis for estimating the cost of a current project. With the right software, you can easily use computerized databases to aid in cost estimating.
• Parametric modeling. You know how well computers crunch mathematical formulas. Put this power to use if your project lends itself to parametric modeling as the best cost-estimating technique to use.
• Bottom-up estimating. Even the most basic of applications can make bottom-up estimating much easier and faster. Automated spreadsheets would be ideal for totaling individual work items, and then rolling-up the individual estimates to find the project total.

2. They can calculate cost estimates quickly and accurately and enable you to perform simulations and "what if" analyses.
Computerized tools make preparing a variety of costing alternatives easy. You can decide which estimates are most feasible and achievable in the current project. Computer applications can also run simulations and do this much more quickly and accurately than most humans can.
Plus, you can use your computer to consider costing alternatives and to perform "what-if" analyses. For example, you could "ask" your software, "What if I add five percent to all production estimates?" or "What if I used this type of metal?"

Speed, accuracy, and the ability to run simulations are all characteristics that make computerized tools both time-savers and money-savers when developing cost estimates for a project.

Using Bottom-up Cost Estimating

If you were to begin your project cost estimates at the very lowest level of your work breakdown structure and then "roll them up" through the project to finally arrive at total estimated costs, you would be performing a bottom-up estimate. You will want to use this type of cost estimating when the following conditions exist.

1. You have enough detail about the project.
The accuracy of a bottom-up estimate is driven by the level of detail it contains. This technique relies heavily on a well-decomposed work breakdown structure (WBS). Low-level activities should include a list of required resources, resource rates, and activity duration estimates.

If you do not have specific information about your project at the outset, either choose another estimating technique or be prepared to revise your estimates as the project progresses and more information becomes available.

2. You have the time necessary to use this technique.
Your project team is starting a new project. There is a lot of detail in the WBS, so the bottom-up technique is an option. Now you have to make sure that you have budgeted sufficient time to produce the estimates.

Why does bottom-up estimating take more time to perform than other cost estimating techniques? It takes time to calculate costs for every activity and every resource, especially for large and complicated projects. Unique projects may require you to research prices and dig for rates.

3. You require a high degree of accuracy.
Bottom-up estimating is perhaps the most time- and labor-intensive way to estimate project costs. The "up side," however, is the high degree of accuracy you obtain using this technique. No other estimating technique enables you to better narrow down your range of possible results than this one.

Bottom-up estimates are generally considered to be accurate within five percent to 10 percent. They can be used as "control" estimates, meaning they are used during the cost control process to measure cost performance once actual costs are known.

4. You have little historical information upon which to base cost estimates.
There is a final type of project that would call for the bottom-up cost estimating technique: one for which there is little or no historical information. There are several reasons why you would not find historical information, including cost estimates, from other projects.

• Your project is unique. You may have a project that is unlike any that has gone before, and there are no similar projects upon which to base your cost estimates. Perhaps you are working in an emerging field or discipline for which no established history exists.
• You are using new technology. Have you implemented new technology into your processes? It may alter actual costs to the extent that previous cost estimates will not be accurate for the new project. New technology may either increase or decrease actual costs.
• You choose not to consult commercial databases of cost information. There are commercial databases of cost information available for many different industries. However, there are costs involved in purchasing a database plus the periodic upgrades. You may find it more worthwhile to develop your own database over time.

In summary, the bottom-up estimating technique is one that you will want to use to produce accurate cost estimates when there is little historical data about similar projects, a real need for accuracy, and adequate detail and time available.

Using Parametric Cost Modeling

Certain industries have been around long enough that project managers who work in those industries have developed standardized mathematical formulas for estimating project costs. The use of mathematical formulas in cost estimating is called parametric modeling.

For most projects, the main parameters, or characteristics, that affect costs are time and materials. A good example of a parametric model is the cost of residential home construction. Builders often base cost estimates for a house on so many dollars per square foot of living space. Examples of simple and complex parametric models are provided below.

• Simple. The costs to build a road are based on a standard cost per mile. The cost to blast through bedrock is based on the volume of rock to be removed.
• Complex. A model for estimating software development may incorporate several adjustment factors for each function within an application.

Some parametric models are meant to give a rough estimate of costs, while others are designed to provide more accurate estimates. You can use parametric modeling when the following three criteria are in place.

1. Your project has quantifiable parameters.
Since a parametric model is a mathematical formula, the variables or parameters of a project that you use must be readily quantifiable. This means that the component or components upon which you base costs must have a unit of measurement, such as weight, length, number, or grade.

Most types of projects contain quantifiable variables. For example, a training company could estimate costs to be so many dollars per hour of instruction, or a food manufacturer could estimate so many dollars per pound of finished product.

2. The parametric model is scalable.
To be reliable, a parametric model must also be scalable, meaning that it must apply to a large project as well as it does to a small one. Most projects, even those of a similar nature, vary in terms of product scope, so you need a model that allows for a range in the number or size of products delivered.

Some models, though perfectly scalable, may have upper and lower limits that invalidate the model if project scope exceeds the limits. For example, economies of scale may come into effect for a large project, reducing costs proportionately. For other models or types of projects, larger scale means extra work, thereby increasing costs.

3. Accurate historical information has been used to develop an appropriate model.
The third main criteria for determining whether using a parametric model is appropriate for your project is whether there is an existing model, or the potential to build one, based on historical information. The accuracy of your estimates increases with the accuracy of the data used in the model.

Many companies develop their own parametric models specific to the types of projects they perform. All you need is enough data from previous projects to establish the mean costs of products or services provided in the past.

Many industries have used historical information to develop parametric models in the form of software applications. The time that the software saves you in estimating costs quickly, and the accuracy it provides, are worth the cost.

In summary, you can use parametric modeling when your project has quantifiable characteristics and there is sufficient accurate historical data to develop a scalable and dependable mathematical formula for estimating costs.

The Analogous Estimating Technique

One of the most common methods of estimating project costs enables you to take advantage of the similarities between a current project and projects that have been performed in the past. This technique is called analogous estimating.

An analogy is a set of comparisons you draw between two things with similar characteristics. Analogous estimating is also known as "top-down" estimating because you apply the total costs from a previous project in order to estimate the total costs of a new one. Just keep breaking the budget down according to the new work breakdown structure (WBS).

The main benefit of using the analogous estimating technique is that it is less costly than other estimating techniques. The down side of using this technique is that it is also generally less accurate.

You may be wondering, "If analogous estimating is not considered to be accurate, why would I use this technique?" However, before you disregard analogous estimating altogether, you should be aware of the circumstances under which it is most reliable. It is particularly beneficial when the following conditions are present.

1. The new and previous projects are similar
There are two situations in which analogous estimating is used. One is when your project is similar to other, previous projects. The more similar the projects are, the more accurate the estimates will be. You also can base estimates on a similar project when you don't have detailed information about a new project. More details are provided below.

• Are they similar? To determine the degree of similarity between the past and current projects, examine the scope and purpose of the former project to ensure the projects are alike in fact, and not just in appearance.
• Not enough detail. Sometimes important costing information becomes available only after a project has begun. A similar project's budget will provide a general baseline to go by.

2. The individuals preparing the estimates have the necessary expertise
Knowledge about, and experience with, the subject matter determines whether the individuals preparing the estimates have the needed expertise. You may want to hire one or more external experts to help with cost estimating.

3. The estimating team has access to adequate information about the previous project
If your current project lends itself to the analogous estimating technique, you'll want to furnish your cost estimating team with everything they will need to produce accurate results. Listed below are some types of information they should have on hand when they are developing cost estimates using analogous estimating.

• Scope statements. The team will not know whether two projects are in fact similar unless it can compare descriptions of the project and product scopes.
• Work breakdown structure. The work breakdown structure from the previous project is also necessary to ensure that similar processes and steps will be followed in the current project. Differences in the two projects could affect the accuracy of cost estimates.
• Performance reports. Actual costs are the most important information from the old project. Your team will use them to determine which of the previous estimates were accurate. It should use the actual costs to revise any inaccurate estimates before copying them into the new project.

Remember the analogous estimating technique as a less costly way of estimating project costs when your team has the needed information and expertise to effectively compare the current project to previous, similar projects.

Potential Risks to Cost Estimation

When developing your project cost estimates, do you take potential risks into consideration? Risks are uncertain occurrences that can affect the outcome of a project.

Since they can have a significant effect on project costs, risks are an important input when developing your project cost estimates. Risks can be divided into two types: internal and external.

• Internal risks are occurrences within the company that can affect the project cost. These can include labor shortages, poor planning, or low productivity.
• External risks are generally outside influences that the company can do little to control. These can include supply delays, material costs, or natural disasters.

Identifying risks as either internal or external is a very basic way to organize them. Project managers who are developing cost estimates must specifically identify as many project risks as possible to plan for their effects on project costs. Internal and external risks can be separated into the following five categories.

1. Predictable risks
Predictable risks are manageable by the project team, but their extent and direction is uncertain. These risks can include market shifts, late shipments, cost and availability of materials, currency changes, inflation, and taxation.

2. Unpredictable risks
Unpredictable risks are unforeseeable and are beyond the control or influence of the project team. Unpredictable risks include vandalism, sabotage, natural hazards or disasters, and surprise actions taken by governments.

3. Technical risks
Technical risks are associated with the use and application of technology. Some of these risks can be controlled by the project team. Technical risks can include changes in technology, technical performance, and software design.

4. Non-technical risks
Non-technical risks are other events that can affect costs but are not directly related to technology. Human resource issues, schedule delays, inadequate planning, and management difficulties are all non-technical risks.

5. Legal risks
Legal risks relate to or are concerned with the law. Legal risks that could affect project costs include licenses, patent rights, contracts, and lawsuits.

Identifying and planning for potential project risks is an important input to cost estimating. Including risks will help project teams develop accurate cost estimates and keep their projects on track.

Historical Information Sources for Cost Estimating

Have you ever made an important project decision based on a similar situation in the past? Historical information and estimating publications are important inputs to cost estimating because they serve as benchmarks.

In project management, historical information is information about previous projects that can be used to help with a current project. Four sources of historical information a project management team can use for cost-estimating purposes are discussed below.

1. Project files
In all likelihood, your current projects are not that different from projects your company has done in the past. Each of these finalized projects should have a file, whether it is a "hard copy" file in a cabinet somewhere, or an electronic file.

You should consider both similarities and differences between past and current projects when consulting closed-out project files. One way to do this is to carefully compare the project scope statements.

An essential part of project management is keeping complete files of all planning inputs, work results, performance reports, and correspondence. If external organizations also worked on a project, you could obtain copies of their records for the project as well.

The documents most relevant to cost estimating are previous cost estimates, budgets, reports on cost performance that include actual costs, and documents that show the rationale behind revised cost estimates and budget changes.

Knowing how useful project files are to future projects should motivate you to keep every output your project management process generates. For example, you could implement a system for document retention within your project team, make sure that all stakeholders know that you want to keep all documentation in a central project file, set up a shared directory on your company's computer network where documents can be stored and backed up, and keep records of the reasons for cost variances, even when it causes embarrassment for the cost estimators.

2. Project team knowledge
The knowledge of your project team members is another form of historical information. Employees with experience and maturity are a great asset when it comes to cost estimating. They can draw on their experiences when cost estimating, since they likely will recall cost information about the various projects on which they have worked.

3. Commercial cost-estimating databases
Commercial databases are another source of historical information from which you can obtain cost information about previous projects. Publicly-owned corporations are required to make such information available. Other companies charge fees for access to databases that compile this information.

If you find a number of projects similar to yours in a database, compare them to your project and make adjustments for differences. You should be able to arrive at fairly accurate cost estimates for your project. Remember that certain factors, such as inflation, need to be considered when basing current cost estimates on former projects.

4. Estimating publications
Estimating publications are similar to commercial databases, as they contain commercially available analyses of raw data that can be used to prepare estimates. These publications help team members who are preparing cost estimates customize general information to their specific project. This streamlines the cost estimating process and increases efficiency.

Estimating publications can include such resources as computer software programs, industry-specific case studies, and periodical articles. These resources can provide you with useful project data in a reasonably short amount of time.

Of the four sources discussed above, project files contain the most reliable cost information. Project team recollections are useful, but they are generally far less reliable than documented results. Historical information and estimating publications are a great starting point for cost estimating. Remember to use the cost estimates that were proven accurate so you can avoid making the same errors again.

Estimating Costs Using Activity Durations

By establishing the forecasted time it will take to complete various tasks in the work breakdown structure for your project, you will have prepared another important input to cost estimating: activity duration estimates. Activity duration estimates are primarily an input to schedule development, but they are used in project cost estimating as well.

An activity duration estimate is a quantitative assessment of the likely number of work periods that will be required to complete an activity. An activity's duration is important when you are estimating labor costs, for example, or when estimating the costs of financing over the total project duration.

To estimate an activity's total cost, multiply the rates for the activity by the estimated duration. When you estimate activity duration for each project activity and then sum the results, you can determine a cost estimate for the entire project. Knowing the time it will take to complete all project activities makes estimating total project time and costs easier.

There are three things to remember when using activity durations to calculate cost estimates.

• Include range of results. One is that activity duration estimates often include a range of possible results. They are, after all, just estimates.
• Convert units for time. Sometimes you have to convert months or weeks into "working days" or "working hours" to calculate costs. Your company or industry likely has conventions for figuring out how many production hours are in a week, month, or year.
• Allow for down time. Finally, remember to consider down time in your calculations. Remember that people do not work "24/7." Include weekends and holidays in your calculations.

Your activity duration estimates will include a range of possible results. Naturally, when activity durations have a range, your cost estimates will have a range, too. The points below illustrate the steps in estimating costs using activity duration estimates, indicating how a pharmaceutical company would estimate costs for clinical trials of a new drug.

• Establish the activity duration estimate. The duration of the clinical trials is estimated to be six months, plus or minus two weeks, assuming that three laboratory technicians are working on the testing.
• Check the resource rates that apply to this activity. Labor rates for this project are $18 per hour for each technician. If the company did not own the laboratory and equipment that will be used during the trials, it also would need to know the rental rates for these resources.
• If necessary, convert units of time. One year has 52 weeks, so six months has 26 weeks. To find the working hours in six months plus or minus two weeks, assume that technicians work a 40-hour week: 26 x 40 = 1,040 hours. Then, 2 x 40 = 80 hours. You could say there are 1,040 hours plus or minus 80, or that there are 960 to 1,120 hours in this time frame.
• Multiply the estimated duration by the rate for the activity. Multiply the labor rate ($18 per hour) by each end of the spectrum, and you get an estimated cost of between $17,280 and $20,160 per technician, or $18,720 plus or minus $1,440. Multiply again by three for each worker, and you get a total estimate of $56,160 plus or minus $4,320.

Activity duration estimates are estimates of how long it will take to complete each activity in the work breakdown structure. Without this vital information, you cannot accurately estimate project costs.

Three Inputs to Cost Estimating

Resource requirements, resource rates, and the chart of accounts are three important inputs to project cost estimating. Details about these three closely linked inputs to cost estimating are provided below.

1. Resource requirements
A project's resource requirements come in the form of a list of items needed to complete a project. The list is produced during the resource planning phase.

Resource requirements refer to the types and quantities of resources needed to complete each activity listed in a work breakdown structure (WBS). Resource types, and the quantities needed to complete an activity, help determine project costs.

Project managers obtain the necessary human resources through staff acquisition and obtain materials through procurement. Typically, a project's resource requirements fall into five categories.

• Labor. Labor includes all of the human resources needed for a project, such as receptionists, computer programmers, engineers, and managers.
• Materials. Materials include the inputs you need for production or for delivery of a service. You will usually purchase materials from an external supplier, or from another division of your firm if it owns the raw resources you need for production.
• Equipment. Equipment includes machinery, hardware, software, and methods of transportation you need in order to complete the work. When estimating costs, consider how long equipment will be useful before it must be replaced.
• Overhead costs. Overhead costs can include costs associated with the facilities in which your project is carried out and interest payments on loans or leases.
• Contingency costs. Contingency costs are allowances made for risk and uncertainty. A project budget should contain a buffer to allow for unexpected costs, such as those that can result from natural disasters, computer viruses, accidents, strikes, or unexpected increases in the cost of supplies.

2. Resource rates
Another input to cost estimating is resource rates. Resource rates refers to the per-unit cost for each resource required to complete a project. If exact rates are not known, the rates themselves may have to be estimated.
Cost estimating is virtually impossible without the unit rates for each resource required. Examples of resource rates are staff costs per hour, printing costs per copy, lease costs per day, interest costs per year, utilities costs per month, and component costs per part. You will benefit from having accurate cost estimates based on accurate resource rates early in the project.

3. The chart of accounts
When calculating your cost estimates, you should allocate resources to the project based as closely as possible on your organization's chart of accounts. This is a table that contains the coding or numbering system that is used by the accounting department to monitor expenses. Categories of expenses can include staffing costs, office supplies, equipment, rent, and insurance costs.

Divide your project costs into categories that match the categories in your company's general ledger. This will save you time during your cost management efforts later in the project, especially if you use project management software that is integrated with your company's accounting system.

Perhaps part of your performance reporting efforts and postmortem analysis for your project will involve comparing the cost performance of different projects. This will be much easier if all projects use the same coding system.

You will need your company's accounting codes, as well as your project's WBS, resource requirements, and resource rates, to calculate cost estimates. Remember, determine resource requirements and resource rates before you begin estimating project costs to ensure the accuracy of your estimates. Integrate cost estimates with your company's chart of accounts to simplify cost control.

Cost Estimating and the Work Breakdown Structure

Do you often find it easier to solve a large problem by breaking it down into smaller parts? This is what the work breakdown structure (WBS) does for a project manager. The WBS itemizes the many tasks that make up a project.

The work breakdown structure contains the entire project scope—all the work you need to complete in order to deliver the product. Throughout the cost estimating process, you should refer back to the WBS to ensure that you have included each activity. The WBS enables you to:

• organize your cost estimates
• identify each project activity that generates cost
• illustrate the project scope in a summarized, graphical representation.

A work breakdown structure is a type of tree diagram that enables you to see the project scope all on one page. It depicts a hierarchical listing of the work, showing how the work elements are broken down (or decomposed) into tasks, work packages, and detailed activities. The WBS is organized as follows:

• The top line of the WBS contains the name of your project.
• The first level of the WBS contains the major elements of the project. Most projects within a given organization will have similar project life cycles.
• The lower levels of the WBS show the continued decomposition of the phases. The third level usually contains tasks. Lower levels would be comprised of work packages and ultimately, individual activities.

The work breakdown structure is developed as an output of defining the project scope. When creating a work breakdown structure for a project, use the scope statement to identify each of the project's major phases or elements.
Each phase will have its key deliverables, which are further decomposed into tasks and then into work packages or activities. Keep in mind that different elements may have different levels of decomposition.

For each project you manage, you'll have to decide to what degree you will decompose your work breakdown structure. If you want to develop detailed, accurate cost estimates, you will need to fully decompose the work.

As a guideline, ask yourself: "Can adequate cost and duration estimates be derived at this level?" If the answer is no, then you must continue to break tasks into work packages, and these into specific activities. The steps below summarize the process of decomposition.

1. Identify the major elements of the project.
2. Decompose elements into tasks, work packages, and detailed activities.
3. Ensure that the lowest level items are tangible and can be measured for completion.
4. Verify the correctness of the decomposition by comparing it to similar projects or having a qualified person review it.
5. Assign a unique identifier to each item that corresponds to your firm's code of accounts.

Step 3, in which you verify that each bottom-level work package or activity is measurable, is the most important step to cost estimating. Ask yourself: "Can each item be appropriately scheduled, budgeted, and assigned to a specific department, team, or person who will be responsible to complete it?" You'll be able to produce fairly accurate and detailed cost estimates if each activity is measurable—if it can be assigned a duration and a list of required resources, including human resources, materials, and equipment.
The work breakdown structure makes it easy to find the total cost estimates. Once the work of your project is sufficiently broken down into measurable, verifiable activities, assign a cost to each item. The process of totaling bottom-level activities, assigning a total to the task, totaling all tasks belonging to a deliverable, and so on, is called "rolling up" the estimates.

In summary, project managers and their teams will refer frequently to the work breakdown structure during the life of a project. However, at no other stage is the WBS more important than when cost estimates are being prepared.