Project Cost Management: Steps, Basics and Benefits

Organizations aim for their projects to succeed and to meet client expectations, as well as their internal objectives. But what is the reality on the ground? In a PMI report, 14% of the surveyed IT projects were deemed as failures. Only 57% of the projects were finished within their initial budgets, with the others exceeding the target they had set for themselves.

This is not good news for enterprises as cost overruns not only impact their margins, but also hinder the ability to execute future projects. Understanding what project cost management is and how to be effective at it can be beneficial for organizations to stay on track.

In this article, we look at what project cost management is, its benefits and the steps involved in its implementation.

What is Project Cost Management?

Project cost management is the process of estimating, budgeting and controlling costs throughout the project life cycle, with the objective of keeping expenditures within the approved budget.

For a project to be considered a success, it’s necessary that

• it delivers on the requirements and scope
• its execution quality is of a high standard
• it’s completed within schedule and
• it’s completed within budget.

Hence, project cost management is one of the key pillars of project management and is relevant regardless of the domain, be it manufacturing, retail, technology, construction and so on. It helps to create a financial baseline against which project managers can benchmark the current status of their project costs and realign the direction if needed.

Why is Project Cost Management Important?

The importance of cost management is easy to understand. To take a simple, real-life example, if you decide to build a house, the first thing to do is set the budget. When you have a sense of how much to spend on the project, the next step is to divide the high-level budget into expenses for sub-tasks and smaller line items.

The budget will determine critical decision points such as: which designer to hire — someone who will construct and deliver the project end-to-end, or someone who can help with a few elements and be able to work for a smaller budget? How many stories should the structure have? What quality of materials should be used?

Without a predefined budget, not only is it difficult to answer these questions, but it becomes impossible to assess whether you are progressing in the right direction once the project is underway. In large organizations, the scale of this problem is further heightened due to concurrent running of multiple projects, change in initial assumptions and the addition of unexpected costs. That’s where cost management can help.

By implementing efficient cost management practices, project managers can:

• Set clear expectations with stakeholders
• Control scope creep by leveraging transparencies established with the customer
• Track progress and respond with corrective action at a quick pace
• Maintain expected margin, increase ROI, and avoid losing money on the project
• Generate data to benchmark for future projects and track long-term cost trends

The Four Steps in Project Cost Management

While cost management is viewed as a continuous process, it helps to split the function into four steps: resource planning, estimation, budgeting and control. They are mostly sequential, but it’s possible that some resource changes happen midway through the project, forcing the budgets to be adjusted. Or, the variances observed during the control process can call for estimate revisions.

Let us look at each of these four steps in detail.

1. Project Resource Planning

Resource planning is the process of identifying the resources required to execute a project and take it to completion. Examples of resources are people (such as employees and contractors) and equipment (such as infrastructure, large construction vehicles and other specialized equipment in limited supply).

Resource planning is done at the beginning of a project, before any actual work begins.

To get started, project managers first need to have the work-breakdown structure (WBS) ready. They need to look at each subtask in the WBS and ask how many people, with what kind of skills are needed to finish this task, and what sort of equipment or material is required to finish this task?

By adopting this task-level approach, it becomes possible for project managers to create an accurate and complete inventory of all resources, which is then fed as an input into the next step of estimating costs.

A few tips to consider during the process:

• Consider historical data — past schedules and effort — before determining sub-tasks and the corresponding resources.
• Take feedback from SMEs and team members — a collaborative approach works well especially in projects that do not have past data to use.
• Assess the impact of time on resource requirements. For instance, a resource may be available only after a few months, dragging the project’s schedule. This could have an impact on cost estimation.
• Although this step happens at the planning stage, project managers need to account for ground realities. For example, you may identify the need for a resource with certain expertise, but if such a resource is not available within the organization, you have to consider hiring a contractor or training your team to get them up to speed. All of these variables impact cost management.

2. Cost Estimation

Cost estimation is the process of quantifying the costs associated with all the resources required to execute the project. To perform cost calculations, we need the following information:

• Resource requirements (output from the previous step)
• Price of each resource (e.g., staffing cost per hour, vendor hiring costs, server procurement costs, material rates per unit, etc.)
• Duration that each resource is required
• List of assumptions
• Potential risks
• Past project costs and industry benchmarks, if any
• Insight into the company’s financial health and reporting structures

Estimation is arguably the most difficult of the steps involved in cost management as accuracy is the key here. Also, project managers have to consider factors such as fixed and variable costs, overheads, inflation and the time value of money.

The greater the deviation between estimation and actual costs, the less likely it is for a project to succeed. However, there are many estimation models to choose from. Analogous estimation is a good choice if you have plenty of historical cost data from similar projects. Some organizations prefer mathematical approaches such as parametric modeling or program evaluation and review technique (PERT).

Then there is the choice between employing a top-down versus bottom-up approach. Top-down typically works when past costing data are available. In this, project managers usually have experience executing similar projects and can therefore take a good call. Bottom-up works for projects in which organizations do not have a lot of experience with, and, therefore, it makes sense to calculate a cost estimate at a task-level and then roll it up to the top.

Cost Estimation as a Decision Enabler

It’s useful to remember that cost estimation is done at the planning stage and, therefore, everything is not yet concrete. In many cases, project teams come up with multiple solutions for a project, and cost estimation helps them decide how to proceed. There are many costing methodologies, such as activity-based costing, job costing, and lifecycle costing that help perform this comparative analysis.

Lifecycle costing, for instance, considers the complete end-to-end lifecycle of a project. In IT projects, for example, maintenance costs are often ignored, but lifecycle costing looks long-term and accounts for resource usage until the end of the cycle. Similarly, in manufacturing projects, the goal is to minimize future service costs and replacement charges.

Sometimes the estimation process also allows teams to evaluate and reduce costs. Value engineering, for example, helps to gain the optimal value from a project while bringing costs down.

3. Cost Budgeting

Cost budgeting can be viewed as part of estimation or as its own separate process. Budgeting is the process of allocating costs to a certain chunk of the project, such as individual tasks or modules, for a specific time period. Budgets include contingency reserves allocated to manage unexpected costs.

For example, let’s say the total costs estimated for a project that runs over three years is $2 million. However, since the budget allocation is a function of time, the project manager decides to consider just the first two quarters for now. They identify the work items to be completed and allocate a budget of, say, $35,000 for this time period, and these work items. The project manager uses the WBS and some of the estimation methods discussed in the previous section to arrive at this number. Budgeting creates a cost baseline against which we can continue to measure and evaluate the project cost performance. If not for the budget, the total estimated cost would remain an abstract figure, and it would be difficult to measure midway.

Thus, different capital budgeting techniques are used for this. Capital budgeting technique is the company’s process of analysing the decision of investment/projects by taking into account the investment to be made and expenditure to be incurred and maximizing the profit by considering following factors like availability of funds, the economic value of the project, taxation, capital return, and accounting methods.

Capital Budgeting Techniques:

Profitability Index:

The formula for Profitability Index is calculated by dividing the present value of all the future cash flows of the project by the initial investment in the project.

• Profitability Index = (Net Present value + Initial investment) / Initial investment
• Profitability Index = 1 + (Net Present value / Initial investment)

Example:

Let us take the example of company ABC Ltd which has decided to invest in a project where they estimate the following annual cash flows:

• $5,000 in Year 1
• $3,000 in Year 2
• $4,000 in Year 3

At the beginning of the project, the initial investment required for the project is $10,000, and the discounting rate is 10%.

PV of cash flow in Year 1= $5,000 / (1+10%)1 = $4,545

PV of cash flow in Year 2 = $3,000 / (1+10%)2 = $2,479

PV of cash flow in Year 3 = $4,000 / (1+10%)3 = $3,005

So, Sum of PV of future cash flows will be: 4549 + 2479 + 3005 = $10,030

Profitability Index of the project = $10,030 / $10,000

As per the formula of the profitability index, it can be seen that the project will create an additional value of $1.003 for every $1 invested in the project. Therefore, the project is worth investing since then it is more than 1.00.

Payback Period:

This method of capital budgeting helps to find a profitable project. It is calculated by dividing the initial investment by the annual cash flows. But the main drawback is it ignores the time value of money. By the time value of money, we mean that money is more today than the same amount in the future.

It is calculated by how many years it is required to recover the amount of investment done. Shorter paybacks are more attractive than more extended payback periods.

Payback period Formula = Total initial capital investment /Expected annual after-tax cash inflow.

Example:

For example, there is an initial investment of ₹1000 in a project, and it generates a cash flow of ₹ 300 for the next five years.

Payback period = no. of years — (cumulative cash flow/cash flow)

Payback period = 5- (500/300) = 3.33 years

Therefore, it will take 3.33 years to recover the investment.

Net Present Value:

It is the difference between the present value of incoming cash flow and the outgoing cash flow over a particular time. It is used to analyze the profitability of a project.

The formula for the calculation of NPV is as below:

NPV = [Cash Flow / (1+i)n ] — Initial Investment

Here i is the discount rate, and n is the number of years.

Example:

Let the discount rate be 10%.

NPV = -1000 + 200/(1+0.1)¹ + 300/(1+0.1)²+400/(1+0.1)³+600/(1+0.1)⁴+ 700/(1+0.1)⁵ = 574.731

As NPV is positive, it is recommended to go ahead with the project.

Internal Rate of Return:

The Internal rate of return is also among the top techniques that are used to determine whether the firm should take up the investment or not. It is used together with NPV to determine the profitability of the project. IRR is the discount rate when all the NPV of all the cash flows is equal to zero.

NPV = [Cash Flow / (1+i)n ] — Initial Investment =0

Here we need to find “i” which is the discount rate.

Example:

In the previous example, with a discount rate of 10%, the NPV was 574.7. To make this value 0, we will need to increase the rate.

So, if we increase the discount rate to 26.22 %, the NPV is almost zero.

Thus, for this particular example, it would be a good idea to go ahead with the project if the discount rate is less than 26%.

Modified Rate of Return:

The main drawback of the internal rate of return that it assumes that the amount will be reinvested at the IRR itself, which is not the case. MIRR solves this problem and reflects the profitability in a more accurate manner.

The formula is as below:

MIRR= (FV (Positive cash flows* Cost of capital)​​/ PV (Initial outlays * Financing cost))1/n −1

Where,

• N = the number of periods
• FVCF = the future value of positive cash flow at the cost of capital
• PVCF = the present value of negative cash flows at the financing cost of the company.

Example:

We assume the cost of capital to be 12% and the reinvestment rate to be 14%.

• MIRR= (cash flows from year 0 to 4th year, cost of capital rate, reinvestment rate)
• MIRR= (-1000: 600, 12%, 14%)
• MIRR= 22%

Thus, for this particular example, it would be a good idea to go ahead with the project if the MIRR is less than 22%.

4. Cost Control

Cost control is the process of collecting actual costs and collating them in a format to allow comparison with project budgets. Cost control is necessary to keep a record of monetary expenditure for purposes such as:

• minimizing cost where possible;
• revealing areas of cost overspend.

Cost control information is fundamental to the lessons learned process, as it can provide a database of actual costs against activities and work packages that be used to inform future projects

Cost control is the process of measuring cost variances from the baseline and taking appropriate action, such as increasing the budget allocated or reducing the scope of work, to correct that gap. Cost control is a continuous process done throughout the project lifecycle. The emphasis here is as much on timely and clear reporting as measuring.

Steps of Project Cost Control:

1. Measure differences from baseline budget

First, the project manager understands the baseline budget expectations by reviewing the original budget and any departmental or stage breakdowns. Then, they implement tracking procedures to see how the project’s spending compares to the projected costs, and if it is different, they measure how great the difference is. Tools like specialized software and spreadsheets can help project managers with this tracking process. It’s important that the project manager make sure their information is as accurate as possible in this stage so that cost forecasts are accurate in the next step.

2. Forecast Final Costs

Once the project manager understands the differences from the original budget, they use this information to project what the project’s final cost will be if spending continues along current lines. If the project was over budget in a stage that is now complete, the project manager calculates any costs added during that time or later delays that event may cause. If the project is over budget for a process that is still going on, the project manager calculates how much more over budget that ongoing process will add to final costs.

3. Determine possible corrective actions

Once the project manager has all this information, they can look at their plan for the project and see what potential corrective actions could bring the project back within budget specifications. Depending on the project, this may involve adjusting the schedule, the staffing or the project timeline to reduce costs

4. Implement and evaluate corrective actions

Next, the project manager implements these corrective actions by negotiating with teammates, vendors or contractors. They may also communicate with the client to explain the changes and the reasoning behind them. The project manager then uses the new data and the budget tracking practices to evaluate whether the corrective actions were effective. If not, the project manager creates and implements new corrective actions until they get the desired results.

Steps for implementing Project Cost Control

1. Review the budget frequently

To understand whether project spending is acceptable or whether it’s time to implement corrective measures, it’s important to review your budget frequently, at least every week. This way, you can catch any overspending as soon as it happens and reduce extra costs immediately.

2. Communicate with all team members

You can find out how your team members are spending their hours or what funds they need if you communicate with them frequently. If you are working on a large-scale project, you may also think of new corrective measures by speaking with other department managers or vendors.

3. Control project scope.

You may find your project exceeding labour budgets if your teammates aren’t aware of how much the project or contract involves. Keeping your project within the original contract or agreement can prevent your team from doing free labour for the customer and going over budget with labour costs and delaying the schedule.

4. Track individual components.

To make it easier to understand where overspending happens, track both budget and spending for individual components of larger projects. This may mean tracking contractor spending, tracking labor in different departments or tracking labour and material costs separately.

5. Revise budget if necessary.

If your corrective measures don’t fully get the project’s costs within the estimated costs, review the original estimation and budget process. If there were discrepancies or forgotten costs during that process, work with the client to revise the budget and use that information to make better estimates for future projects.

Cost performance measurement

Along with the cost baseline, the cost management plan is an essential input for cost control. This plan contains details such as how project performance will be measured, what is the threshold for deviations, what actions will be done if the threshold is breached, and the list of people and roles who have the executive authority to make decisions. Thus cost performance measurement is one of the most important aspects of project cost control. Earned value management (EVM) is one of the most popular approaches to measuring cost performance. This methodology measures project performance with an integrated schedule and budget, which is based on the project work breakdown structure (WBS).

Earned Value Management Formulas

There are calculations that can be done quickly and easily to execute EVM. EVM formulas can be divided into two groups: performance indexes and variance analysis formulas. Here they are:

Schedule Variance (SV)

The schedule variance is a way for project managers to figure out how much ahead or behind schedule, they are in the project. The formula to figure this out is as follows.

Schedule Variance (SV) = Earned value (EV) — Planned Value (PV)

Cost Variance (CV)

Cost variance is the difference between the actual cost of the project at that point it’s calculated compared against the planned budget cost for that period of time in the project plan. The formula is below.

Cost Variance (CV) = Earned value (EV) — Actual Cost (AC)

Schedule Performance Index (SPI)

The schedule performance index is a subset of EVM, which shows whether a project is ahead or behind schedule. It calculates the ratio of the performed work to the scheduled work. The formula for this is as follows.

Schedule Performance Index (SPI) = Earned value (EV) / Planned Value (PV)

Calculating the schedule performance index involves dividing the EV by the PV to measure progress achieved against where you expected to progress at a certain point. If you’ve come up with a value less than 1.0, it means that you’ve done less work than you projected for this point. While a value greater than 1.0 means you’ve completed more than was planned.

Cost Performance Index (CPI)

The cost performance index measures how efficient costs are in the project. It’s shown in a ratio of earned value to actual costs.

Cost Performance Index (CPI) = Earned Value (EV) / Actual Cost (AC)

For this calculation, you divide EV by the AC to measure the value of work completed against its actual cost. Project managers use the CPI and SPI to rate the cost and schedule performance of their projects. A poor rating provides a warning signal, allowing for corrective action to be taken before it’s too late. These indexes fall into three categories:

· If equal to 1.0, performance is exactly as planned.

· If greater than 1.0, performance is better than planned i.e the costs are less than budgeted.

· If less than 1.0, performance is poor i.e. costs are higher than budgeted

Estimated At Completion (EAC)

Estimated at completion is the current expectation of what the total costs will be for the project when it is done.

Estimated at Completion (EAC) = Budget at completion (BAC) / Cost performance index (CPI)

With this calculation, you divide the total project budget by the CPI value you figured out above.

Example :

At the end of a week, you measure the progress of task X and find that it’s 25% complete. Now, how do you assess if you are on track to meet the task budget?

First, a project manager calculates the planned value for this task (at the planning stage). Let’s say, Task X has a budget of $4000 and is expected to be 50% complete by the week.

Planned value (PV) of task X by the week = $4000 * .5 = $2000

Earned value (EV) of task X by the week = $4000 * .25 = $1000

Now, you also determine the actual cost (AC) of the work, which involves other variables such as equipment and material costs (say, $800).

Schedule variance = EV — PV = $1000 — $2000 = -$1000.

Cost variance = EV — AC = $1000 — $800 = $200.

The negative schedule variance indicates that the task is falling behind, but the positive cost variance indicates that it’s under budget.

SPI = EV/ PV = $1000 / $2000 = 0.5

CPI = EV/AC = $1000 / $800 = 1.25

EAC = Budget/ CPI = $4000 / $1.25 = 3200

The total cost of the project is estimated to be $3200 according to current expectations

Conclusion:

Project cost management and control is one of the most important functions of project management. Especially large and high value projects need to have solid cost management and cost control mechanisms and processes in place for the projects. Cost management and control requires a very keen eye for detail and sharp vigil on cost expenditures and the work that is getting done. Variances must be identified regularly, and they must not only be rectified, but also the team needs ensure unnecessary variances should not occur in the future.