PMP Project Management Professional Study Guide, Third Edition (Certification Press)

Cost estimating is the process of calculating the costs of the identified resources needed to complete the project work. The person or group doing the estimating must consider the possible fluctuations, conditions, and other causes of variances that could affect the total cost of the estimate.

There is a distinct difference between cost estimating and pricing. A cost estimate is the cost of the resources required to complete the project work. Pricing, however, includes a profit margin. In other words, a company performing projects for other organizations may do a cost estimate to see how much the project is going to cost to complete. Then, with this cost information, they’ll factor a profit into the project work, as shown here:

Considering the Cost Estimating Inputs

Cost estimating relies on several project components from the Initiation and Planning process groups. This process also relies on historical information and policies from the performing organization.

Using the Work Breakdown Structure

Of course the WBS is included—it’s an input to five major planning processes: cost estimating, cost budgeting, resource planning, risk management planning, and activity definition.

Relying on the Resource Requirements

The only output of resource planning serves as a key input to cost estimating. The project will have some requirement for resources—the skills of the labor, the ability of materials, or the function of equipment must all be accounted for.

Calculating Resource Rates

The estimator has to know how much each resource costs. The cost should be in some unit of time or measure—such as cost per hour, cost per metric ton, or cost per use. If the rates of the resources are not known, the rates themselves may also have to be estimated. Of course, skewed rates on the estimates will result in a skewed estimate for the project. There are four categories of cost:

• Direct costs These costs are attributed directly to the project work and cannot be shared among projects (airfare, hotels, and long distance phone charges, and so on).

• Variable costs These costs vary depending on the conditions applied in the project (number of meeting participants, supply and demand of materials, and so on).

• Fixed costs These costs remain constant throughout the project (the cost of a piece of rented equipment for the project, the cost of a consultant brought onto the project, and so on).

• Indirect costs These costs are representative of more than one project (utilities for the performing organization, access to a training room, project management software license, and so on).

Estimating Activity Durations

Estimates of the duration of the activities, which predict the length of the project, are needed for decisions on financing the project. The length of the activities will help the performing organization calculate what the total cost of the project will be, including the finance charges. Recall the formula for present value? It’s PV= FV/(1+R)^n; PV is the present value, FV is the future value, R is the interest rate, and n is the number of time periods. The future value of the monies the project will earn may need to be measured against the present value to determine if the project is worth financing, as shown here:

Calculations of the duration of activities are needed in order to extrapolate the total cost of the work packages. For example, if an activity is estimated to last 14 hours and Suzanne’s cost per hour is $80, then the cost of the work package is $1,120. The duration shows management how long the project is expected to last and which activities will cost the most and provides the opportunity to re-sequence activities to shorten the project duration—which consequently shortens the finance period for the project.

Another aspect the project manager and management may have to determine is the long-term worth of a product in regard to tax deductions. There are three approaches to deduct the product’s cost:

• Straight-line depreciation allows the organization to write off the same amount each year. The formula for straight-line depreciation is Purchase Value minus Salvage Value divided by Number of Years in Use. For example, if the purchase price of a photocopier is $7,000 and the salvage value of the photocopier in five years is $2,000, the formula would read 7,000–2,000/5=$1,000.

• Double-declining balance is considered accelerated depreciation. This method allows the organization to double the percentage written off in the first year. In our preceding example, a single deduction was $1,000 per year, which is 20 percent of the total deduction across the five years. With double-declining, the customer would subtract 40 percent the first year, and then 40 percent of the remaining value each subsequent year. In our example, the deducted amount for year one would be $2,000. For year two it would be $1,200, and year three it would be $720. This is a great method for equipment that you don’t anticipate to have around for a very long time—such as computer equipment.

• Sum of the years depreciation is like a magic trick. It works by writing out the number of years the equipment is in production and adding each year to the year before. In our example it was five years, so we’d do this: 5+4+3+2+1=15 (note the largest to smallest). The sum of the years, 15, becomes our denominator; the five, for the first year, is our numerator. So for the first year, we’d deduct 5/15ths (or one third) of the photocopier cost after the salvage amount, which would be $1,650. The second year the four would be the numerator and we’d deduct $1,250, and so on. Each year we’d deduct a slightly smaller percentage than the year before.

Exam Watch

You may encounter a general question on straight-line versus double-declining depreciation on the PMP Exam. You should be familiar with the concept, but don’t invest too much time memorizing these formulas for the exam.

Using Estimating Publications

There are, for different industries, commercial estimating publications. These references can help the project estimator confirm and predict the accuracy of estimates. If a project manager elects to use one of these commercial databases, the estimate should include a pointer to this document for future reference and verification.

Using Historical Information

Historical information is proven information and can come from several places:

• Project files Past projects within the performing organization can be used as a reference to predict costs and time. Caution must be taken that the records referenced are accurate, somewhat current, and reflective of what was actually experienced in the historical project.

• Commercial cost-estimating databases These databases provide estimates of what the project should cost based on the variables of the project, resources, and other conditions.

• Team members Team members may have specific experience with the project costs or estimates. Recollections may be useful, but are highly unreliable when compared to documented results.

Exam Watch

The project team members’ recollections of what things cost should not be trusted as fact. It’s advice and input, but documented information is always better.

Referencing the Chart of Accounts

This is a coding system used by the performing organization’s accounting system to account for the project work. Estimates within the project must be mapped to the correct code of accounts so that the organization’s ledger reflects the actual work performed, the cost of the work performed, and any billing (internal or external) that was charged to the customer for the completed work.

Acknowledging the Cost of Risk

The impact of risks, for positive or negative effect, must be evaluated and considered in the cost estimates. Risks, which we’ll cover in Chapter 11, can impact the cost of the project. For example, should a risk come into play, the mitigation of the risk may require adding several activities to squelch the risk. The expense of the activities would add cost to the project.

Estimating Project Costs

Management, customers, and other interested stakeholders are all going to be interested in what the project is going to cost to complete. There are several approaches to cost estimating, which we’ll discuss in one moment. First, however, understand that cost estimates have a way of following the project manager around—especially the lowest initial cost estimate.

The estimates you’ll want to know for the PMP exam, and for your career, are reflective of the accuracy of the information the estimate is based upon. The more accurate the information, the better the cost estimate will be.

Using Analogous Estimating

Analogous estimating relies on historical information to predict the cost of the current project. It is also known as top-down estimating. The process of analogous estimating takes the actual cost of a historical project as a basis for the current project. The cost of the historical project is applied to the cost of the current project, taking into account the scope and size of the current project as well as other known variables.

Analogous estimating is a form of expert judgment. This estimating approach takes less time to complete than other estimating models, but is also less accurate. This top-down approach is good for fast estimates to get a general idea of what the project may cost.

Here’s an example of analogous estimating: The Carlton Park Project was to grade and pave a sidewalk around a pond in the community park. The sidewalk of Carlton Park was 1,048 feet by 6 feet, used a textured surface, had some curves around trees, and cost $25,287 to complete. The current project, King Park, will have a similar surface and will cover 4,500 feet by 6 feet. The analogous estimate for this project, based on the work in Carlton Park, is $108,500. This is based on the price per foot of material at $4.02—note that $4.021 is not the same as $4.21.

Using Parametric Modeling

Parametric modeling uses a mathematical model based on known parameters to predict the cost of a project. The parameters in the model can vary based on the type of work being completed. A parameter can be cost per cubic yard, cost per unit, and so on. A complex parameter can be cost per unit with adjustment factors based on the conditions of the project. In addition, the adjustment factors may have additional modifying factors depending on additional conditions.

To use parametric modeling, the factors the model is based on must be accurate. The factors within the model are quantifiable and don’t vary much based on the effort applied to the activity. And finally, the model must be scalable between project sizes. The parametric model using a scalable cost-per-unit approach is depicted here:.

There are two types of parametric estimating:

• Regression analysis This is a statistical approach to predict what future values may be, based on historical values. Regression analysis creates quantitative predictions based on variables within one value to predict variables in another. This form of estimating relies solely on pure statistical math to reveal relationships between variables and predict future values.

• Learning curve This approach is simple: the cost per unit decreases the more units workers complete; this is because workers learn as they complete the required work. The more an individual completes an activity, the easier it is to complete. The estimate is considered parametric, as the formula is based on repetitive activities, such as wiring telephone jacks, painting hotel rooms, or other activities that are completed over and over within a project. The cost per unit decreases as the experience increases because the time to complete the work is shortened.

Using Bottom-Up Estimating

Bottom-up estimating starts from zero, accounts for each component of the WBS, and arrives at a sum for the project. It is completed with the project team and can be one of the most time-consuming methods to predict project costs. While this method is more expensive, because of the time invested to create the estimate, it is also one of the most accurate. A fringe benefit of completing a bottom-up estimate is the project team may buy into the project work as they see the cost and value of each cost within the project.

Exam Watch

Don’t worry too much about regression analysis for the exam. Learning curve is a topic you’ll more likely have questions on.

Using Computer Software

While the PMP examination is vendor-neutral, a general knowledge of how computer software can assist the project manager is needed. There are several different computer programs that can streamline and make accurate estimates for the project work. These tools can include project management software, spreadsheet programs, and simulations.