Project Cost: Why is it important for Project Managers?

Introduction

There are many articles and books have been written about project management. Equally, there are many more articles and books about project cost and its importance. This is because, apart from other project components such as Time, scope and Quality, Project Cost Management is always considered as one the key components of project management.

As rightly said by Joe Biden,

“Don't tell me what you value, show me your budget, and I'll tell you what you value.”

As a project manager, it’s an expected basic quality to manage the projects within the project budget. Most of the times, project managers are valued based on the number of projects he/she has completed within the project budget.
In this article particularly I would like to discuss what project cost, why it’s important, types of project costs, the impact of the total project cost, how to manage the project budget and how to mitigate the risk.

What is Project cost?

The project cost is a cost required to procure all the needed products, services and resources to deliver the project successfully.

Example: In an example of a construction project, the cost estimation starts from land acquisition cost, construction cost, materials cost, administration cost, labor cost and other direct and indirect costs.

Now you have an understanding of what is project cost. Next, let’s look at why it is important.

Why it is important.

No project starts without a budget. Project success is decided by how well the project cost has been handled in the project. Many times it happens that, the project may not be completed within the project cost. It means that when compared the Project Cost Vs Project Profit, Project Cost might have exceeded and it is of course considered as a project failure.

Hence it’s very important to come up with the correct cost estimation needed for the project.

To come up with accurate cost estimation, it’s requiring to understand the types of project costs involved in the project.

Types of Project Costs.

There are 5 types of project costs incurred in any project. They are

Fixed Cost
Variable Cost
Direct Cost
Indirect Cost
Sunk Cost

Fixed Cost:

Any Cost which is fixed throughout the project life cycle and would not change by quantity, time or any other project factors called for a fixed cost.
Fixed cost Example: In a software project, rent for the company space, systems cost, software license cost, salaries are considered as a fixed cost.
Note that fixed costs are not fixed permanently. They will change over a period of time. Here we are referring to the project fixed cost which means that they are fixed in relation to the delivery of the project. To conclude “In short term, the costs are fixed, however, the costs are variable in the long term”

Variable Cost:

On the contrary to fixed cost, the Variable cost is a cost which varies or changes in proportion to product or service that the project produces.
Variable Cost Example 1: Let’s understand it with a simple example. Imagine you are running a pizza shop. Once you make, boxed and delivered the pizza to the customer, you have encountered several variable costs. Which are (prices mentioned below are just for the sake of illustration),

Pizza base: 50cents
Pizza sauce: 10cents
Pizza seasoning: 10cents
Pizza topping (any): $1
Box to deliver:50cents

Based on the mentioned information, you are spending $2.20 on every pizza. All these costs are variable. Selling pizza less than $2.20 means it’s a loss. And, also these costs are directly proportionate to the numbers of pizzas are sold.
Variable Cost Example 2: Let’s take an example of a small software company. To complete a specific project on schedule, they need 25 full-time resources, whereas the company has only 15 FTE’s. They have decided to hire the additional resources externally when needed. Which means that these additional resources will be paid based on the number of hours they have worked or the output they have produced.

Note that the salary for the permanent employees will be considered as a fixed cost, while the wages of the additional resources will be considered as a variable cost.

Direct Costs:

Costs which are directly visible and accountable to produce the project output are called direct costs.
Direct Cost Example: Materials which are used to produce a product can be considered as the direct cost. Logistics, Human Resources, project development cost used specifically to the project can also be considered as a direct cost.

Indirect Costs:

Costs which do not directly contribute or specific to the output of the project are called indirect costs. It may be either variable or fixed.

Indirect Cost Example: Overhead Cost, Electricity consumption, rent, salary, administrative, security cost. These costs are not directly related to the production. A project manager is considered as an overhead cost or indirect cost as he is not directly involved in the production whereas developer of a project will be considered as a direct cost.

Sunk Costs:

Sunk Costs are costs which are already spent, but failed to incur any business value and cannot be recovered and permanently lost.

Example for Sunk Cost:

Let me take an example from our day to day life. Just imagine, you have bought few vegetables and kept it in the fridge. However, you forgot to use one of them and you found it only when cleaning the fridge. By the time you see it, it has got totally spoiled and hence you threw it away. The cost of the vegetable is called a sunk cost. This cost did not solve any purpose and also cannot be recovered and permanently lost.

Total Project Cost:

Calculating Total Project Cost (TPC) is a vital step for any project. TPC should include all the costs (fixed and variable) of the project. The calculation should include total estimated cost (TEC) and other project costs (OPC). I.e., it includes but not limited to activities Costs such as pre-planning, feasibility, operating cost, commissioning, risk analysis, contingency, design, development, maintenance etc.

If Total Project Cost is not estimated precisely, the project will have to face serious consequences. It will have a direct impact on the project schedule, quality, and scope. This will lead to cost overrun.

For an example, While calculating project cost, if few of the activities are not included, then the scope has to be updated, timeline (schedule) for the project might need to be extended and cost of quality will also be increased. At the same time, Compromising quality and scope to meet the project schedule which would lead to customer dissatisfaction. Due to these reasons, project managers are forced to exceed their budget.

2 Tips to manage project budget and mitigating the risk:

Steve Jobs strongly believed that importance and realized the benefits of “doing it right the first time” he said that

"We had a fundamental belief that doing it right the first time was going to be easier than having to go back and fix it. And I cannot say strongly enough that the repercussions of that attitude are staggering. I've seen them again and again throughout my business life."

Yes. Doing things right at the first time is not that easy that too in the area of project cost management. It requires lots of efforts and involvement from the project manager and project team.

Tip 1: Setup the project budget precisely from the beginning.

Setting up project budget correctly at the beginning of a project is a critical step. During the project initiation, the project manager would be doing the planning estimation or budgetary estimation. Which includes getting the feasibility study done and the business case is approved. Once these activities are done project manager will get an idea of what the project is and what are all the activities would incur the cost. Mostly the cost estimation is +25% or -10% of what the actual project budget might be.

There is three effective cost estimating methods can be used to calculate project cost.

Parametric Estimation:

This estimation uses the historical data to calculate the cost estimation. Most of the time this estimation works well as it’s based on the real data and saves lots of time.

Eg: In a construction project, how much cost spent per square feet in the same locality for a similar project, would help to calculate the cost estimation for the new project.

Bottom-up approach:

Bottom-up approach otherwise called as definitive technique is all about breaking up all the activities of the project to the micro level and do the cost estimation.

This is the most accurate method to calculate the cost estimation. However might be time-consuming and a costly technique.

Three-point Estimation:

This estimation is commonly called as PERT (Program Evolution and Review Technique). It includes all the possibilities, assumptions and uncertainties in cost estimation. They are,

Most Likely cost (Cm): It refers the regular case where everything goes well.
Pessimistic Cost (Cp): It refers the worst case where everything goes against the plan.
Optimistic Cost (Co): It refers to the scenario where everything works better than planned.

PERT formula is Expected cost = (Co+ Cp+4 Cm)/6 .

This method is considered as a best and accurate method to calculate the project cost estimation.

As a project manager, it’s your responsibility to identify which method would work better for your project. Sometimes combination of all three would work well again it’s at discretion of the project manager

Importance of identifying risks:

While discussing cost estimation precisely at the beginning of the project, it’s also important to identify all the possible risks at the beginning of the project itself. Most of the times only these unidentified risks cause project failure. Risks cause lots of issues and resolving issues needs money. Not only money might need more time and scope expansion.

Hence project manager has to involve the project team and experts to identify all the risks at the initial stage itself.

Following the mentioned steps would help to kick off the project at the right direction with the accurate and realistic project cost estimation.

Tip 2: Monitor and Manage the project budget frequently.

Once the project is successfully kicked off with the best-done cost estimation, during the execution phase, it should be monitored and managed without any compromises by the project manager. When monitoring and managing the project cost project manager has to ensure the following rules.

Creating project budget awareness in the team:

As a project manager if you are the only one who knows about the project budget, then there is likelihood in declining the success rate of the project.

Every team member in the team should aware of the project cost and budget. It’s a responsibility of a project manager to conduct regular meetings to make the team understand where the project stands in terms of cost. Also, make them understand how individual effort proportionate to the cost of the project. If actual cost exceeds the planned cost, discuss the ways to control the cost.

If the team realizes and understands the project cost, it certainly makes the project and project manager’s life much easier.

Don’t compromise:

A regular inspection would help to project manager to understand what the team does and identify if there are any deviations. Since oversight in the budget would cost more at the end of the project. Do not compromise the inspection at any cost, identifying and resolving the issues then and there in the team would help to avoid and the deviation of actual cost vs. planned cost.

Reporting the fact and figure:

Another Important way of controlling cost is to publishing reports. There are many types of reports prepared for different purposes. Here I would like to highlight much about reports which are published for the team. These reports should be visually good and simple at the same time should contain all the relevant information about the project cost. It’s important that the reports are not manipulated and should display the actual status of the project.

Good Reports are one of the best ways to mitigate the project risk to a greater extent. Sometime we might oversee few issues but when it is visually published, every team member has an opportunity to analyze and highlight the expected risks.

Hope this article helped you to understand all about project cost and how to estimate it and mitigate the project cost related risk. Yes. It might seem tricky to estimate and manage the project cost. However, with the right experience, tools and team’s support, certainly project manager can meet key project constraints Cost, quality, time and scope.

I would like to end this article with a beautiful quote from L. R. Sayles

“Project Managers function as bandleaders who pull together their players, each a specialist with individual score and internal rhythm. Under the leader's direction, they all respond to the same beat.”

Here are few sample questions to check your understanding:

Question 1:

A software company has developed a software in the mainframe. However, the customer wanted few other features which are not possible with a mainframe. A software company couldn’t accommodate them with the existing software developed using the mainframe, hence with the customer approval they started a fresh project using JAVA. The costs spent for the mainframe project are

A) Variable
B) Direct
C) Indirect
D) Sunk

Answer D

Question 2:

To prevent your project from over budget, which of the following needs to be done in the planning stage of the project?

A) Allocating extra time for every activity in the schedule
B) Allocating extra cost for all the activities
C) Allocating extra cost buffer for high-risk activities
D) Provide extra time for each activity in the schedule

Answer C

Question 3:

In Three-point estimating techniques, what are the three points referring?

A) Planned, Actual, Approximate
B) Optimistic, Pessimistic, Most likely
C) Optimistic, Pessimistic, Actual
D) Historical, Actual, Planned

Answer B

Question 4:

All of the following are true about cost estimates EXCEPT:

A) Cost estimates is a summary of individual cost elements, using the established tools, techniques and methods calculating the future cost based on what is known today.
B) Cost estimates are done by the project manager with the team.
C) While doing cost estimation, risk register should not be considered as it can be either threats or opportunities and hence their impact might be balanced out.
D) Cost estimates should be prepared as precisely as possible to avoid stakeholder dissatisfaction and project failure.

Answer C

Question 5:

Parametric estimation is:

A) Estimating cost or time parameters of the project life cycle.
B) Calculating cost for every activity in the work package and sum it up to come up with the project cost estimation
C) Estimating cost using the feedback and data received from the experts and the project managers who have worked on the similar projects
D) Estimating for activity parameters i.e. cost, budget, and schedule, using statistical relationship between historical data and other project variables