Managing Project Finances
Tuesday, November 26, 2013
A well-managed project is completed on time,
on spec, and on budget.
It's generally the case that cost is one
of the major factors in determining the success of a project – and
no one wants to be responsible for a cost overrun.
With that in
mind, how do you make sure that you keep 'on budget' with your
project?
The simple answer is 'control'. If you're
going to have any chance of staying within budget then you need to
manage the project costs proactively and systematically.
Thankfully, there are many tools and ideas that can give you this
control.
Project cost management includes three basic
processes:
Cost estimating – Making your best
assessment of the costs of the resources needed to complete a
project.
Cost budgeting – Assigning cost estimates to individual work
items, and establishing a baseline for measuring performance.
Cost control – Controlling changes to the project budget.
By managing these processes, and their inputs
and outputs, you can develop an effective system to ensure that
your resource costs remain within the approved budget. In short,
project cost management is the process of doing the following:
Communicating budget limits to project designers, and to the people who are implementing the project.
Collecting actual cost data.
Comparing actual costs to the original budget.
Taking corrective action as needed.
Let's look at the three project cost management processes in turn.
1. Cost Estimating
Estimating is a critical part of managing project finances.
Estimates are used for all sorts of activities, including
budgeting, forecasting, resource planning, and staffing. It's
important that you estimate the costs for all resources that will
be charged to the project – including items such as labor,
materials, and supplies – as well as any contingency costs.
A cost estimate is an assessment of how much it will cost for all
resources necessary to complete project activities. It's also a
good idea to identify and consider cost alternatives, and include
these in the estimate.
To determine which costs to estimate, you can use a variety of
inputs, the most of common of which is the work breakdown
structure (WBS). This is a detailed list of all the things that
need to be delivered, and the activities that need to be carried
out to complete the project. The project scope statement also has
information related to resource requirements, restrictions, and
assumptions – which can help you identify cost alternatives, if
appropriate.
To complete your estimates, there are a variety of tools and
techniques you can use:
Analogous estimating – Use data from previous projects to build
an estimate of costs for the current project. This can help if you
have limited information or detail on your current costs. For
example, look at similar, or analogous, items in the previous
project, add 5% for inflation, and you may have a reasonable
estimate.
Resource cost rates – Establish unit costs for hours and
materials by using the various quotes and planning documents
you've received. For example, if labor costs for a construction
project are an average of $12 per hour, and you need 10 people to
work 160 hours each, the labor cost estimate is $19,200. Add the
costs of materials, and you have an estimate for the total
construction.
Bottom-up estimating – Use the smallest work component in the
work breakdown structure, and estimate the cost of each. Then
combine these, as you move up the levels, to determine an overall
cost estimate. For our construction example, you need to build
walls, add plumbing and electrical, add doors and windows, finish
floors, and paint. Estimate the cost of each of those items, and
add them together.
Parametric estimating – Use the statistical relationship between
cost and some other characteristic of the item being estimated.
Square footage of a building or the number of words written per
page – these are examples of elements used to create a cost
estimate. If our construction project is 800 square feet, and it
costs about $60 per square foot to build and finish office space,
then the total estimate is $48,000.
Computer software – Many project management programs can
calculate estimates for you using statistics or simulations.
Once you've determined your cost estimate, make sure you record
the information, and document your estimation process. When
providing supporting detail, you may need to include the
following:
A description of the activity.
Documentation of your methods and calculations.
A list of assumptions made, and restrictions applied.
A typical range for a reasonable margin of error in your estimate.
2. Cost Budgeting
Once you have put together your activity cost estimates, you can
now prepare a budget. This is the document that can help you get
the funds you need to complete the project. You'll probably have
to stay within your original budget, so it's best to build in an
adequate reserve – a little extra – for unexpected expenses.
What you are looking to create through the budgeting process is a
cost baseline. This represents the approved budget, and is used to
compare and contrast with the actual project costs over time. The
cost baseline serves as confirmation of what the project's cost
structure looked like when the project was originally approved.
Using the baseline, you can determine if cost performance to date
is within acceptable parameters. As the project progresses, costs
are monitored against the baseline, and any changes are expressed
relative to the baseline. The baseline serves as a primary metric
for evaluating performance, so it remains stable, and changes are
reflected relative to it.
It's important to keep a good balance here. If you budget too
high, you may not succeed in securing funding for your project. If
you budget too low, it may be impossible to stay within those
costs, and you'll risk a poor outcome.
The following tools will help you prepare a reasonable budget for
your project:
Cost aggregation – Aggregate, or add up, the figures in your
activity cost estimates to determine an overall budget amount. For
example, to build a fully operational help desk, add the estimated
costs of renting the space, hiring and training the support desk
staff, and purchasing and installing the equipment.
Reserve analysis – Build in a contingency budget – some extra funds
– in addition to the estimates for the actual activity costs. This
reserve account will help you deal with unplanned changes and
unexpected expenses that may be necessary at some point during the
project.
Parametric estimating – Use predetermined parameters to add
budget amounts for elements of the plan that aren't part of the
activity estimates. For example, historical data may tell you that
the average project in your organization runs 4% over budget. If
you add an extra 4%, you'll probably improve the accuracy of your
total budget.
Funding limit reconciliation – When preparing your budget, be aware of the expected cash flow. You probably won't be given all
of the money up front, to be spent whenever and however you want. It's more likely that you'll be expected to spread your total
budget over the duration of the project. This means that you need to consider cash flow, and possibly adjust the project schedule
accordingly. A well-planned budget looks at how and when work is done, not just the total costs.
Project managers use funding limit reconciliation to avoid large
variations in the periodic expenditure of project funds. They do
this by reconciling project expenditures with the funding limits
set by the customer. Reconciliation may require the revision of
project schedules to regulate expenditures; this in turn affects
the allocation of resources.
Bear in mind that the overall budget not only sets a cost baseline
for the project, it also establishes a funding schedule. Remember
to include reserve amounts in each funding increment, because
requests for changes – and unexpected expenses – will almost
certainly arise.
3. Cost Control
People may come to you and ask for changes to be made, or for
extra features to be added to the project. If you agree to those
changes because they're nice to have, rather than because they
were overlooked in the original scoping of the project, then you
will quickly go over budget.
Change requests are one reason why cost control is so important,
but there are many other activities that are part of controlling
costs. These include monitoring actual expenditures, and analyzing
the variances between budget and actual costs. It is therefore
important to create and establish an effective control system, so
you can respond to changes appropriately, and communicate cost
changes in a timely manner.
Key elements of cost control include the following:
Change control – This is a process that describes how changes to
the baseline costs can be suggested and implemented. It outlines
procedures that people have to use if they want to request
changes. This includes what paperwork they need to complete, how
changes requests are tracked, and what approval process they can
expect.
Without a clear change process, people often keep asking for more
and more from the project. If you have no structured way of
dealing with these requests, your costs will quickly go over
budget. Do bear in mind that project cost management isn't just
about numbers; it's also about managing project scope , and
dealing with people. Learn to be firm, and recognize which changes
are really necessary.
Performance measurement analysis – This activity is all about
the numbers. You assess the significance of the variances from the
budget baseline, as well as the cause, and the corrective action
that is needed. The Project Management Institute recommends the
earned value technique (EVT), which is described in the PMBOK
(Project Management Body of Knowledge).
There are a variety of calculations you can use:
Planned Value (PV) = Budgeted cost for the work scheduled for an activity or component of the Work Breakdown Structure.
Earned Value (EV) = Budgeted amount for the work actually completed on an activity or component of the Work Breakdown Structure.
Actual Cost (AC) = Total cost incurred to accomplish the work completed on an activity or component of the Work Breakdown Structure.
Cost Variance = EV - AC
Schedule Variance = EV - PV
Cost Performance Index (CPI) = EV / AC (a CPI less than 1 indicates a cost overrun).
Schedule Performance Index (SPI) = EV / PV (an SPI equal to or greater than 1 indicates the project is in a favorable condition.
For example, the budgeted cost (planned value) for a project at the end of month 5 is $40,000. The budgeted amount for the work completed (earned value) is only $35,000. However, the actual
costs incurred to date are $38,000.
Consider the following calculations:
Cost variance = EV - AC = $35,000 - $38,000 = -$3,000
Schedule variance = EV - PV = $35,000 - $40,000 = -$5,000
Cost performance index = EV / AC = $35,000 / $38,000 = 0.92 (there is a cost overrun).
Schedule performance index (SPI) = EV / PV = $35,000 / $40,000 = 0.875 (the project is behind schedule).
Forecasting – This involves predicting the project's future
based on the performance to date. Completing forecasts
periodically over the course of a project will help you to do
this. Forecasts provide valuable information to help you deal
proactively with variances. For example, a forecast can help you
estimate that your project will be 10% over budget, so you can make plans accordingly.
Estimate to complete – You can estimated the cost to complete
the project based on what has been completed so far, compared with your budget at completion.
To calculate the estimate to complete (ETC), use either of
these formulas (BAC means Budget At Completion and is equal to the
Planned Value at completion):When current variances are seen as atypical and not expected to
occur in the future use:
ETC = BAC – EV
When current variances are seen as typical of future variances use:
ETC = (BAC – EV) / CPI
In our example, if the total project budget is $60,000, and
variances are seen as typical the calculation would be as follows:
ETC = ($60,000 – $35,000) / 0.92 = $27,174
You need $27,174 to complete the work remaining.
Estimated actual cost – This is a forecast of the most likely
total value of the completed project. The most basic formula,
which assumes cost variances to date were atypical, for
estimated actual cost (EAC) is:
EAC = AC + BAC – EV
In our example, this is calculated as follows:
EAC = $38,000 + $60,000 – $35,000 = $63,000
If cost variances to date are typical, though, use:
EAC = AC + ETC
In our example, this is calculated as follows:
EAC = $38,000 + $27,174 = $65,174
Project Performance Reviews – These compare cost performance
over time, as well as against milestones. Some techniques are
variance analysis, trend analysis, and earned value (described
above).
All of these analyses are typically included as regular updates in
project reporting, as well as in project completion documents.
Cost control is very useful for future project planning, so the
more complete your analysis is before you start, the better your
project planning can be in the future.
Key Points
Project cost management helps you make sure that your project is
completed within the approved budget. It includes the processes of
cost estimation, cost budgeting, and cost control. Many of the
project planning activities are used as key inputs to financial
management.
Managing a project's finances is an extremely important part of
overall project management. Cost is a key measure of project
success, so be aware of your actual costs compared with the
budget. The quicker you recognize variances, the better you'll be
able to make the necessary adjustments.
Tags:
Project Management, Skills
on spec, and on budget.
It's generally the case that cost is one
of the major factors in determining the success of a project – and
no one wants to be responsible for a cost overrun.
With that in
mind, how do you make sure that you keep 'on budget' with your
project?
The simple answer is 'control'. If you're
going to have any chance of staying within budget then you need to
manage the project costs proactively and systematically.
Thankfully, there are many tools and ideas that can give you this
control.
Project cost management includes three basic
processes:
Cost estimating – Making your best
assessment of the costs of the resources needed to complete a
project.
Cost budgeting – Assigning cost estimates to individual work
items, and establishing a baseline for measuring performance.
Cost control – Controlling changes to the project budget.
By managing these processes, and their inputs
and outputs, you can develop an effective system to ensure that
your resource costs remain within the approved budget. In short,
project cost management is the process of doing the following:
Communicating budget limits to project designers, and to the people who are implementing the project.
Collecting actual cost data.
Comparing actual costs to the original budget.
Taking corrective action as needed.
Let's look at the three project cost management processes in turn.
1. Cost Estimating
Estimating is a critical part of managing project finances.
Estimates are used for all sorts of activities, including
budgeting, forecasting, resource planning, and staffing. It's
important that you estimate the costs for all resources that will
be charged to the project – including items such as labor,
materials, and supplies – as well as any contingency costs.
A cost estimate is an assessment of how much it will cost for all
resources necessary to complete project activities. It's also a
good idea to identify and consider cost alternatives, and include
these in the estimate.
To determine which costs to estimate, you can use a variety of
inputs, the most of common of which is the work breakdown
structure (WBS). This is a detailed list of all the things that
need to be delivered, and the activities that need to be carried
out to complete the project. The project scope statement also has
information related to resource requirements, restrictions, and
assumptions – which can help you identify cost alternatives, if
appropriate.
To complete your estimates, there are a variety of tools and
techniques you can use:
Analogous estimating – Use data from previous projects to build
an estimate of costs for the current project. This can help if you
have limited information or detail on your current costs. For
example, look at similar, or analogous, items in the previous
project, add 5% for inflation, and you may have a reasonable
estimate.
Resource cost rates – Establish unit costs for hours and
materials by using the various quotes and planning documents
you've received. For example, if labor costs for a construction
project are an average of $12 per hour, and you need 10 people to
work 160 hours each, the labor cost estimate is $19,200. Add the
costs of materials, and you have an estimate for the total
construction.
Bottom-up estimating – Use the smallest work component in the
work breakdown structure, and estimate the cost of each. Then
combine these, as you move up the levels, to determine an overall
cost estimate. For our construction example, you need to build
walls, add plumbing and electrical, add doors and windows, finish
floors, and paint. Estimate the cost of each of those items, and
add them together.
Parametric estimating – Use the statistical relationship between
cost and some other characteristic of the item being estimated.
Square footage of a building or the number of words written per
page – these are examples of elements used to create a cost
estimate. If our construction project is 800 square feet, and it
costs about $60 per square foot to build and finish office space,
then the total estimate is $48,000.
Computer software – Many project management programs can
calculate estimates for you using statistics or simulations.
Once you've determined your cost estimate, make sure you record
the information, and document your estimation process. When
providing supporting detail, you may need to include the
following:
A description of the activity.
Documentation of your methods and calculations.
A list of assumptions made, and restrictions applied.
A typical range for a reasonable margin of error in your estimate.
2. Cost Budgeting
Once you have put together your activity cost estimates, you can
now prepare a budget. This is the document that can help you get
the funds you need to complete the project. You'll probably have
to stay within your original budget, so it's best to build in an
adequate reserve – a little extra – for unexpected expenses.
What you are looking to create through the budgeting process is a
cost baseline. This represents the approved budget, and is used to
compare and contrast with the actual project costs over time. The
cost baseline serves as confirmation of what the project's cost
structure looked like when the project was originally approved.
Using the baseline, you can determine if cost performance to date
is within acceptable parameters. As the project progresses, costs
are monitored against the baseline, and any changes are expressed
relative to the baseline. The baseline serves as a primary metric
for evaluating performance, so it remains stable, and changes are
reflected relative to it.
It's important to keep a good balance here. If you budget too
high, you may not succeed in securing funding for your project. If
you budget too low, it may be impossible to stay within those
costs, and you'll risk a poor outcome.
The following tools will help you prepare a reasonable budget for
your project:
Cost aggregation – Aggregate, or add up, the figures in your
activity cost estimates to determine an overall budget amount. For
example, to build a fully operational help desk, add the estimated
costs of renting the space, hiring and training the support desk
staff, and purchasing and installing the equipment.
Reserve analysis – Build in a contingency budget – some extra funds
– in addition to the estimates for the actual activity costs. This
reserve account will help you deal with unplanned changes and
unexpected expenses that may be necessary at some point during the
project.
Parametric estimating – Use predetermined parameters to add
budget amounts for elements of the plan that aren't part of the
activity estimates. For example, historical data may tell you that
the average project in your organization runs 4% over budget. If
you add an extra 4%, you'll probably improve the accuracy of your
total budget.
Funding limit reconciliation – When preparing your budget, be aware of the expected cash flow. You probably won't be given all
of the money up front, to be spent whenever and however you want. It's more likely that you'll be expected to spread your total
budget over the duration of the project. This means that you need to consider cash flow, and possibly adjust the project schedule
accordingly. A well-planned budget looks at how and when work is done, not just the total costs.
Project managers use funding limit reconciliation to avoid large
variations in the periodic expenditure of project funds. They do
this by reconciling project expenditures with the funding limits
set by the customer. Reconciliation may require the revision of
project schedules to regulate expenditures; this in turn affects
the allocation of resources.
Bear in mind that the overall budget not only sets a cost baseline
for the project, it also establishes a funding schedule. Remember
to include reserve amounts in each funding increment, because
requests for changes – and unexpected expenses – will almost
certainly arise.
3. Cost Control
People may come to you and ask for changes to be made, or for
extra features to be added to the project. If you agree to those
changes because they're nice to have, rather than because they
were overlooked in the original scoping of the project, then you
will quickly go over budget.
Change requests are one reason why cost control is so important,
but there are many other activities that are part of controlling
costs. These include monitoring actual expenditures, and analyzing
the variances between budget and actual costs. It is therefore
important to create and establish an effective control system, so
you can respond to changes appropriately, and communicate cost
changes in a timely manner.
Key elements of cost control include the following:
Change control – This is a process that describes how changes to
the baseline costs can be suggested and implemented. It outlines
procedures that people have to use if they want to request
changes. This includes what paperwork they need to complete, how
changes requests are tracked, and what approval process they can
expect.
Without a clear change process, people often keep asking for more
and more from the project. If you have no structured way of
dealing with these requests, your costs will quickly go over
budget. Do bear in mind that project cost management isn't just
about numbers; it's also about managing project scope , and
dealing with people. Learn to be firm, and recognize which changes
are really necessary.
Performance measurement analysis – This activity is all about
the numbers. You assess the significance of the variances from the
budget baseline, as well as the cause, and the corrective action
that is needed. The Project Management Institute recommends the
earned value technique (EVT), which is described in the PMBOK
(Project Management Body of Knowledge).
There are a variety of calculations you can use:
Planned Value (PV) = Budgeted cost for the work scheduled for an activity or component of the Work Breakdown Structure.
Earned Value (EV) = Budgeted amount for the work actually completed on an activity or component of the Work Breakdown Structure.
Actual Cost (AC) = Total cost incurred to accomplish the work completed on an activity or component of the Work Breakdown Structure.
Cost Variance = EV - AC
Schedule Variance = EV - PV
Cost Performance Index (CPI) = EV / AC (a CPI less than 1 indicates a cost overrun).
Schedule Performance Index (SPI) = EV / PV (an SPI equal to or greater than 1 indicates the project is in a favorable condition.
For example, the budgeted cost (planned value) for a project at the end of month 5 is $40,000. The budgeted amount for the work completed (earned value) is only $35,000. However, the actual
costs incurred to date are $38,000.
Consider the following calculations:
Cost variance = EV - AC = $35,000 - $38,000 = -$3,000
Schedule variance = EV - PV = $35,000 - $40,000 = -$5,000
Cost performance index = EV / AC = $35,000 / $38,000 = 0.92 (there is a cost overrun).
Schedule performance index (SPI) = EV / PV = $35,000 / $40,000 = 0.875 (the project is behind schedule).
Forecasting – This involves predicting the project's future
based on the performance to date. Completing forecasts
periodically over the course of a project will help you to do
this. Forecasts provide valuable information to help you deal
proactively with variances. For example, a forecast can help you
estimate that your project will be 10% over budget, so you can make plans accordingly.
Estimate to complete – You can estimated the cost to complete
the project based on what has been completed so far, compared with your budget at completion.
To calculate the estimate to complete (ETC), use either of
these formulas (BAC means Budget At Completion and is equal to the
Planned Value at completion):When current variances are seen as atypical and not expected to
occur in the future use:
ETC = BAC – EV
When current variances are seen as typical of future variances use:
ETC = (BAC – EV) / CPI
In our example, if the total project budget is $60,000, and
variances are seen as typical the calculation would be as follows:
ETC = ($60,000 – $35,000) / 0.92 = $27,174
You need $27,174 to complete the work remaining.
Estimated actual cost – This is a forecast of the most likely
total value of the completed project. The most basic formula,
which assumes cost variances to date were atypical, for
estimated actual cost (EAC) is:
EAC = AC + BAC – EV
In our example, this is calculated as follows:
EAC = $38,000 + $60,000 – $35,000 = $63,000
If cost variances to date are typical, though, use:
EAC = AC + ETC
In our example, this is calculated as follows:
EAC = $38,000 + $27,174 = $65,174
Project Performance Reviews – These compare cost performance
over time, as well as against milestones. Some techniques are
variance analysis, trend analysis, and earned value (described
above).
All of these analyses are typically included as regular updates in
project reporting, as well as in project completion documents.
Cost control is very useful for future project planning, so the
more complete your analysis is before you start, the better your
project planning can be in the future.
Key Points
Project cost management helps you make sure that your project is
completed within the approved budget. It includes the processes of
cost estimation, cost budgeting, and cost control. Many of the
project planning activities are used as key inputs to financial
management.
Managing a project's finances is an extremely important part of
overall project management. Cost is a key measure of project
success, so be aware of your actual costs compared with the
budget. The quicker you recognize variances, the better you'll be
able to make the necessary adjustments.
