Welcome back to the continuation of the PMP Series. We have discussed project scope management (http://resources.intenseschool.com/pmp-series-project-scope-management/) and schedule management Part 1 and Part 2 in detail. In this post, we will focus on the third leg of the triple constraint: project cost management. Yes, it is time to talk about money. As a project manager and, indeed, in any kind of business you find yourself, you need to keep costs under control; otherwise, the business might not make any profits or, worse, run into a huge loss.

In this post, we will examine the four processes under project cost management (PMI just added a new one to the existing three) and discuss their inputs, tools and techniques, and outputs. We will spend some time discussing earned value management and some of the important calculations that you need to be familiar with both for the PMP exam and in your role as a project manager.

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Without further ado, let’s dive into project cost management. The four processes under project cost management are;

  • Plan Cost Management
  • Estimate Costs
  • Develop Budget
  • Control Costs

Plan Cost Management

This is the new “housekeeping” process introduced by PMI in the fifth version of the Project Management Body of Knowledge. This process emphasizes the need to have a cost management plan. Basically, you should use a scope and schedule baseline along with other aspects of the project management plan (risk, communication, procurement, HR, etc.) to determine a plan for managing the costs that you will incur on the project.

As a project manager, it is your job to factor in organization-specific procedures (such as financial controls) and external factors (such as market prices) when creating the cost management plan. To do this, you need inputs from experts about various aspects of the projects. The easiest way to harmonize the views of these experts is to hold cost management meetings where everyone can give their opinion.

The output of plan cost management plan is…(Make a guess)…Yes, that’s correct…The cost management plan. The cost management plan is a part of the project management plan that determines how the project costs will be planned, structured and controlled.

Estimate Costs

The second process in project costs management deals with developing approximations of the monetary resources required to complete the project. In order to create appropriate approximations, you need inputs from the scope/schedule baseline, the amount of risks involved, the human resource plan as well as organization specific procedures and insights from previous projects.

To be able to make realistic estimates, you require expert judgment from subject matter experts on matters relating to your project. You will also need to employ some estimation techniques. We already explored three types of estimation techniques in project schedule management (analogus, parametric, and three-point estimates); click here to review the post.

Another kind of estimation that is important in project cost estimate is called bottom-up estimation. In bottom-up estimation, you start from known to unknown by estimating the cost for each work package and then rolling up the sum of the individual estimates in order to determine the overall cost estimate for the project.

You should also create cost reserves to cater for unforeseen developments in the project. In project cost management, there are two kinds of reserves;

  1. Contingency reserve—These are reserves that are set aside to cover identified risks on the project. Contingency reserves are usually a percentage of the estimated project costs and they are within the cost baseline.
  2. Management reserve—This is an amount reserved by management (outside the cost baseline) to cover unknown problems that cause unforeseen work that is still within the scope of the project. Although the management is outside the cost baseline, it is still a part of the overall project budget.

Besides expert judgment, reserve analysis and estimations, other tools used in estimating costs include vendor bid analysis, decision-making techniques, and cost of quality.

The output of the estimate costs process is the cost estimates and the basis of the estimates. You should also update any changes made to the project documents.

Determine Budget

Now that we have the created an estimate of the project costs, the next thing is to determine the budget that will serve as our cost baseline throughout the project. The inputs to this process include cost estimates, basis of estimates, scope baseline, schedule baseline, resource calendars, risk registers, and other relevant parts of the project management plan.

As the project manager, your job here is to aggregate the estimates, add reserves, and ensure funding limit reconciliation. Funding limit reconciliation means ensuring that the total budget is within the funding limit of the project. If the costs go beyond the funding limit, you need to harmonize it by rescheduling the project or, in some extreme cases, changing the scope.

The outputs of the determine budget process are the cost baseline and the project funding requirements. The project documents should also be updated accordingly.

Control Costs

So far, all the processes that we have examined in this knowledge area have been planning processes, but the control costs process is a monitoring/controlling process. The goal of this process is to compare work performance data to the cost baseline and identify variances so corrective actions can be taken.

In order to identify these variances, we use a technique called “earned value management.” Earned value management uses three key metrics to determine project performance. The three metrics are;

  1. Planned value (PV)—At any point in time, the planned value of the project is the budgeted value of the work that has been scheduled to be done on the project. It is also called “budgeted cost of work scheduled” (BCWS).
  2. Earned value (EV)—This is the budgeted cost of the work that has been done at a particular point in time. It is also called “budgeted cost of work performed” (BCWP).
  3. Actual cost (AC)—This is the actual cost of the work that has been performed at a particular point in time. This is also called “actual cost of work performed” (ACWP).

Let’s use an example to understand this. Assuming it should take four days to build a wall that should cost $600 in total. The planned schedule assumes that after two days, you should have spent $300 and built 50% of the wall.

So in this case, for a two-day period, the Planned Value is 50% of the total = 50% x $600 = $300

But what if, after two days, you realize that you have only built 40% of the wall and you have spent $300 building that part of the wall?

The Earned Value = Budgeted cost of the work performed = 40% x Total Budget = 40% x $600 = $240

The Actual Cost = Actual Cost of work performed = $300 (Since that is the actual amount spent)

Variance Analysis

These values can help determine variations from the initial plan.

Schedule Variance = Earned Value – Planned Value.

If the schedule variance is negative then the project is behind schedule. In this case:

SV = $240 – $300 = -$60

This means that the project is behind schedule by $60.

Cost Variance = Earned Value – Actual costs

Similarly, if the cost variance is negative, then the project is running above budget. This is also a red flag.

CV = $240 – $300 = -$60

This means that the project is running $60 above budget.

Besides the schedule and cost variance, another measure of performance of the project is the ratio between actual and planned values. These ratios are called performance indexes. Continuing with our example:

Schedule Performance Index = EV/PV

The SPI measures the efficiency of the project in managing the time.

In this example, SPI = 240/300 = 0.8

Similarly, the cost performance index measures the cost efficiency of budgeted resources. The formula for calculating the cost performance index is;

CPI = EV/AC = 240/300 = 0.8

As a general rule, when analyzing these ratios, values below 1 indicate that the project is either running behind schedule or above budget and this indicates that there is a cause that should be further investigated in order to prevent the project from failing.

Another important tool in controlling costs is forecasting. Forecasting is similar to earned value measurement, but it focuses on determining future cost values. The originally estimated value of a project is called “budget at completion” (BAC). However, it is possible that this value might no longer be realistic due to variances. Project managers might need to compute another estimate of the costs at completion. This estimate is called “estimate at completion” (EAC). The Estimate at completion can vary depending on the nature of the project. Some scenarios include:

  1. Assuming that the cause of the variance has been identified and rectified and subsequent activities would cost the initial budgeted rate. The EAC would be BAC – CV

Using our example; EAC = $600 – (-$60) = $660

  1. Assuming that the project would continue at the same cost efficiency as the previous tasks.

EAC = BAC/CPI

Using our example; EAC = $600/0.8 = $750

  1. A new estimation can be derived for the rest of the project (this is usually done using bottom-up estimations because it is the most accurate form of estimations). The new estimation for the rest of the project is called “estimate to complete” (ETC). In this case, the estimate at completion would be the actual costs incurred till date plus the new estimate of costs required to complete.

EAC = AC + ETC

Using our example, assuming we estimate that the remaining 60% of the project would cost $400, then our new estimate at completion would be;

EAC = $300 + $400 = $700

There are other permutations of project scenarios that can be used to calculate new budgets, but these three are the most common. As a project manager, you should be familiar with forecasting methods and you should not hesitate to seek expert advice it you need any clarification.

You should also manage your contingency reserves as part of the control costs process. If you determine that the contingency reserves are no longer needed, you can remove the funds from the project budget to free up resources for other projects.

The outputs of the control costs process are work performance information (information from the EVM and), forecasts, change requests, and general updates to the project management plan.

As usual a summary of the project cost management diagram is shown below;

So there you have it. What you need to know about project cost management in order to pass the PMP exam. This post also concludes our discussion of the three knowledge areas that form the triple constraint in project management (scope, time and cost). Feel free to drop your questions and thoughts in the comments section. In the next post we will examine some more interesting aspects of project management. See you soon!

References

  1. A Guide to the Project Management Body of Knowledge: PMBOK Guide. Project Management Institute.
  2. Work Breakdown structure from Wikipedia.