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Cost management

Introduction

The essence of project management is the management of human resources, material assets, and other capital, toward the successful completion of a project's goal. Every decision to initiate a project should be based at least in part on the expectation that an important strategic goal will be accomplished by committing limited financial resources, and that the project will deliver value to the sponsor that exceeds the planned cost by an adequate margin.

Cost management processes, interacting with each other and with processes of other project management areas, create accurate estimates and use objective, quantitative methods, such as Earned Value Management (EVM), discussed later in this section, to help monitor and control costs.

 

Cost management plan

The work involved in the cost management starts with a cost management plan that establishes the criteria for structuring, estimating, budgeting and controlling project costs.

A cost management plan can establish the following:

  • Precision level - Cost estimates for schedule activities will adhere to a rounding of the data to a prescribed precision, for example, hundreds of dollars (00) or thousands of dollars (000), based on the scope of the activities and the magnitude of the project and may include an amount for contingencies;

  • Units of measure - Each unit of measurement, such as staff hours, staff days, staff weeks, or lump sum, is defined for each resource;

  • Links to organizational procedures - The work breakdown structure (WBS) component used for project cost accounting is called a control account (CA). Each control account is assigned a code or account number that is linked directly to the performing organization's accounting system. If cost estimates for planning packages are included in the control account, then the method for budgeting planning packages is included;

  • Control thresholds - Variance thresholds (also known as tolerances) for costs or other indicators, for example, person-days or volume of product at designated points in time during the project, can be defined to indicate the agreed amount of variation allowed;

  • Earned Value rules - These are the rules the project management team sets for computing earned value, such as:

    • The formula for determining the estimate to complete;

    • The criteria by which earned value will be recognized according to the completion status of the work package (0-100, 0-50-100, or other)

    • The work breakdown structure level at which earned value analysis will be carried out

  • Reporting formats - Formats for the various cost reports;

  • Process descriptions - Descriptions of each of the steps in the financial management procedure.

 

Cost management plan updates

The cost management plan may be simple or complex. It is a subsidiary of the project management plan. Changes to the cost management plan can modify policies, procedures, and cost or budgets, and they should be documented and authorized. The project team implements the approved changes.

The approach to the cost estimating process may vary depending on specific project requirements, the type of project life cycle chosen, and specific industry and company requirements.

 

Defining the value of a project using Total Cost of Ownership (TCO)

Of special interest when considering cost management is the difference between the cost of the project life cycle and the cost of the product life cycle. As an illustration, consider the example of an electric power plant. The product is the gas-powered electric plant. The initial project is to build the plant.

After this first project has been completed, the plant is turned over to the operators, who now use the plant to produce electricity over the plant's lifetime. At the end of the economic life of the plant, the plant will be shut down, and the salvageable components disposed of.

The Total Cost of Ownership is a financial estimate that reflects not only the cost of the project but also all aspects in the further use and maintenance of the product produced by the project. The decision to initiate a project to create a product, service, or result requires an understanding of the total life cycle cost of the product in order to compare the total costs required to achieve this benefit to the benefits that are expected.

In other words, the value of the project, or in some business and marketing contexts, the value proposition, may be stated as follows:


Annual Value = (Benefits - TCO - Tax) / (1 + R)T

 

Where:

Value

The total value of the product

Benefits

The gross return from the use of the product, in increased revenues or reduced costs, or a combination of both

TCO

The total cost of all outlays for development, operation, support, and maintenance of the product

Tax

Taxes paid by the organization on the gross benefits received

R

Discount rate applied to benefits received in later periods, to reflect the cost of capital and the risk of not receiving the full benefits

T

The number of periods during which the product generates benefits

 

 

Estimating the benefits

The sponsor of the project or the user of the final product must determine the value of the benefit of this new product, service, or result. The project sponsor must strive to express the benefit in terms of revenue less costs, or cash flow, for each time period the product is in service.

 

Estimating the Total Cost of Ownership (TCO)

The explicit methods for computing and analyzing the TCO exceed the scope of this book but the following highlights are presented in order to provide a general understanding.

The TCO consists of a number of costs, specifically the development, operating, and maintenance costs of the item over its lifetime. Disposal cost may also need to be considered. According to some data, the initial cost of developing the item may comprise only 3% to 5% of the Total Cost of Ownership.

 

Accounting for tax

Assuming that this product is generating revenue, such revenue is subject to taxation. This must be taken into consideration by diminishing the total benefit.

 

Discount rate for time

The risk that the product, service, or result will not actually deliver the intended result should be factored into the denominator as a reduction in the overall benefit. In addition, benefits received in the future are not as valuable as benefits received now. To reflect these effects, a 'discount rate' is applied to reduce all future benefits. The rate is applied once for each year into the future the benefit accrues, so it applies three times for a benefit received three years in the future.

The discount rate 'R' is determined by financial analysts. For example, a relatively low risk project might use a rate of 10% to 20%. For high-risk ventures, the opportunity might be discounted at 50% or higher.

Furthermore, the number of time periods, 'T', should be considered. Over how many years is this product expected to be used?

The benefit is computed for each year over the total number of years in the forecasting model. In the first year or so, it is likely that a negative cash flow will be realized, since development costs overwhelm the initial benefits. To arrive at the total value of the business proposition, the annual benefit must be computed for each year of the product's life cycle. The sum of all the years gives a total view of the profitability of the venture.

In the following three sections we will look at estimating costs, developing budgets and controlling costs.

 

 

Thanks to Ignacio Manzanera for providing this book

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Cost management

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