There are various methods used to develop cost estimates, including:
- analogous (or comparative) estimating;
- parametric modeling;
- bottom-up estimating.
The project manager should be aware of the estimating methods that were used to develop the cost estimates because the method chosen dictates the overall accuracy of the estimate, known as the confidence level, and should meet these criteria:
- Consistency with the stage the project has reached and the quality and detail of the available information.
- Degree of accuracy needed at that stage of the project's life cycle.
It is sometimes possible (and appropriate) to employ a combination of cost estimating techniques to produce a more reliable estimate. If two methods can be shown to produce estimates that agree, the project management team can have more confidence that the underlying data was consistent and of high quality, and that no errors were made in the estimating process.
An estimating technique that uses the values of parameters, such as scope, cost, budget, and duration or measures of scale such as size, weight and complexity from a previous, similar activity as the basis for estimating the same parameter or measure for a future activity.
Analogous estimating requires historical data from completed projects. It predicts estimates based on the experience from the previous projects. The accuracy of the estimate depends on the degree to which the current project's characteristics match the historical data.
Analogous estimating takes the previous project's actual results and adjusts them by a multiplier based on a number of possible factors:
- Comparative complexity and design.
- Differences in the way portions of the work will be performed.
- Additions to or omissions from the work of the previous projects.
- Geographical and economic data.
This estimating technique is suitable for early stage estimates, such as planning or feasibility studies, initial project duration and cost estimates, and product life cycle costing.
Analogous estimates are used in these circumstances:
The project's process is generally known but substantially undefined or subject to change.
There is very little engineering design information.
Historical information or organizational process assets contain incomplete information, for example, when published cost rates omit information about health and safety requirements.
There is very little technical data.
Special factors must be taken into account, such as specialized requirements related to health, safety, or security.
The accuracy of analogous estimating is +100% to -50%.
Recall that for analogous estimates, a few similar projects are used as a base, and the estimated costs are then produced by increasing (or decreasing) the historical project's costs by multipliers that depend on factors such as the differences between the projects in comparative complexity, resource types, and optional elements of scope.
For example, if a 100,000-square-foot building was built at a cost of $110 per square foot, and a similar 200,000-square-foot building had been built at a cost of $105 per square foot, an analogous estimate may determine that a similar 150,000-square-foot building could be built for approximately $107.50 per square foot.
An estimating technique that uses a statistical relationship between historical data and other variables (e.g., square footage in construction) to calculate an estimate for activity parameters, such as scope, cost, budget, and duration.
This technique can produce higher levels of accuracy depending upon the sophistication and the underlying data built into the model.
This method relies on the fact that the quantity of work to be performed is directly proportional to some underlying measure of the deliverable. This is often the case for construction projects involving conventional buildings, where the total cost and even the costs of specific materials and labor can be gauged as a price per square foot of the final building.
This method can be used in industries that use standard estimating units for work such as:
- Feet of pavement for a highway.
- Number of storyboards per person for computer-based instruction.
- Lines of code or function points for a software developer.
- Square feet of roofing per roofer.
Parametric modeling requires historical data based on similar projects and reasonable measurements of the quantities or elements of work to be performed.
Parametric modeling is suitable for conceptual or system design phase estimates, when some of the final scope and the project approach have been defined.
Its accuracy is between +75% and -25%.
Examples of parametric cost estimating measures include:
- Cost per square foot of building floor space
- Cost per function point of software code written in the Java language.
The major difference between analogous estimates and parametric estimates is that the parametric estimate uses estimating rules to approximate the likely final estimate of either the entire project or several major components of a larger project.
The parametric estimating method is substantially more accurate when using a database of many completed projects, while the analogous estimate can use data from only a few completed projects.
This is a method for building an estimate from individual components of work.
Firstly, the work is decomposed into more detail. An estimate is prepared of what is needed to meet the requirements of each of the lower, more detailed pieces of work and these estimates are then aggregated into a total quantity for the component of work. The accuracy of bottom-up estimating is driven by the size and complexity of the work identified at the lower levels. Generally smaller work scope increases the accuracy of the estimates.
Bottom-up estimates use a detailed project design to list all the materials and labor required to complete the project. Costs for individual work packages or individual schedule activities are estimated at the lowest level of detail available and then summed up to higher levels for reporting and tracking purposes.
For example, activities associated with installing material and equipment are estimated using detailed cost estimating relationships for each lowest-level activity (e.g., the cost per linear foot to install twenty-four-inch-diameter steel pipes), which are then summed up through higher levels. The schedule activities that are estimated should be complete, measurable and quantifiable lowest-level activities.
Advantages and disadvantages of bottom-up estimating
The advantages of using the bottom-up estimating method are:
- It provides the most accurate estimates of all of the available techniques;
- It establishes an accurate estimate for each activity or element of work, providing the most detailed level of monitoring and control.
The disadvantages are:
- It is the most time-consuming method of estimating;
- It requires the most kinds of information, and the most detailed data, of all of the estimating methods.
Specifically, it requires:
- A completed WBS for the portion of the project being estimated.
- A list of the associated project activities.
- Historic actual data.
- Productivity rates and pricing information.
The accuracy of bottom-up estimating is +/- 20%.
This method is appropriate for estimating construction, testing, and deployment work once the detailed design has been completed.
When you use bottom-up estimating, the cost can be expressed as:
- Labor costs.
- Material costs.
- Equipment and software costs.
- Subcontracting costs.
The estimator must know the unit cost rates, such as staff cost per hour or bulk material cost per cubic yard, in order to estimate schedule activity costs for each resource.
Fully loaded rates
A fully loaded rate considers not only the cost of a staff member's hourly rate but also includes the costs of benefits and vacation time, facilities costs and other costs associated with employing an individual.
The factors that contribute to resource cost rates are classified as direct costs, indirect costs, and fixed overhead costs.
- Direct costs
Organizations often calculate a rate for labor that begins with the hourly equivalent pay. Whether the team member is a contractor or an employee only the method for determining this pay rate is affected; unlike a contractor, who is paid an hourly rate, a salaried employee's hourly rate is calculated as salary divided by the expected annual hours worked. This is the labor's direct cost per hour.
- Indirect costs
In addition, however, there are other costs that each hour of labor entails, including various worker benefits. These costs are considered indirect costs and are added to each labor hour's rate in proportion to the direct cost of that labor rate.
For example, if the direct rate for a particular staff person is $100 / hour and the indirect costs amount to 40% on top of salary, the indirect cost that must be added to the direct labor rate per hour for this staff person will be $40. This additional cost is known as the indirect cost burden.
- Fixed overhead costs
Finally, many organizations that charge clients for their staff services also factor in a portion of the organization's total fixed overhead costs. These costs include the facility cost, utilities, and the cost of administrative staff support. These costs are called fixed because the amount of work the organization performs does not affect the organization's annual cost for these items.
Traditional cost accounting calculates an hourly rate per person for total fixed overhead costs by dividing total overhead costs by the organization's total planned hours of work (headcount x hours per person). The hourly rate for fixed costs can then be added to each project team member's hourly rate, or it can be multiplied by the number of hours of work planned for the project, and charged to the project as a lump sum.
For example, an organization calculates that its fixed overhead costs for the year are $500,000 and the total number of hours worked by everyone in the organization that year will be 100,000 (2,000 hours per person multiplied by a headcount of 50). The hourly charge per person for overhead is thus $5.00 per hour ($500,000 / 100,000), regardless of the person's salary. The hourly cost for each member of the project team will be increased by $5.00.
- Since this cost is based solely on headcount, and not on the staff person's underlying direct labor rate, it might be, for example, as much as $25 per hour, even for a team member making $18.00 an hour. This is the fixed overhead burden.
Blended resource cost rates
Many industries use a blended cost rate for all the resources that will be consumed for each unit of scope. When a parametric cost estimating measure is expressed in terms of cost per unit of scope (e.g., dollars per square foot of hotel space for construction cost), all the resource cost rates are already factored in through this blended rate.
The advantage of this approach is that it eliminates the need to understand the impact of the scope measure on all the types of resources. In hotel construction, these resources would include labor, equipment, and materials. If no blended rate were available, each resource's costs would need to be calculated separately and all their costs added together.
If the parametric cost estimating measure is expressed in terms of work effort, (e.g., labor hours per square foot), the estimator must know the unit cost rates, including staff cost per hour and the bulk material cost for each resource in order to estimate the schedule activity costs.
Fully burdened labor rate
The fully burdened labor rate is the sum of all these kinds of costs: the direct rate, indirect cost burden, and the fixed overhead burden. In our example, the total hourly cost for the staff person is $165 per hour ($100/hour direct rate, indirect cost burden of $40, and fixed overhead burden of $25).
Activity cost estimates
An activity cost estimate is a quantitative assessment of the likely costs of the resource required to complete schedule activities. Costs are estimated for all resources applied, including labor, materials, facilities, equipment, services, information technology and special categories such as inflation allowance or cost contingency reserve.
Activity cost estimates should:
- be traceable to the work breakdown structure (WBS) work package items;
- show all unit costs, pricing factors, and quantities of resources required for each calculation;
- include and distinguish between direct costs and indirect costs;
- include methods for applying indirect costs to the project;
- document all assumptions used during estimate development;
- be prepared in a clear, consistent, comprehensive format.
Activity cost estimate supporting detail
The information that describes the methods and information that were used to arrive at an estimate is often referred to as the basis-of-estimate (BOE). It includes all the supporting elements for a cost estimate that provide a justification for the resulting estimate, including:
A description of the logic behind the estimate.
The method used to calculate the estimate.
Assumptions and uncertainties associated with the estimate. Examples of assumptions to be documented include specific exclusions, such as:
- “Equipment and management facilities are not part of project cost.”
- “Research and development will not be required.”
- “Work will not be performed during holidays.”
“Only a total of five rain delays are assumed.”
Constraints associated with the estimate. Examples of constraints on project activity that should be documented include specific exclusions, such as:
- “Security clearances and access restrictions will be necessary.”
- “Daily storage and inventory of tools and materials will be required.”
“Operations will be continuing while the project is underway, and must not be disturbed.”
Any special conditions that are incorporated into the estimate;
Identified risks that affect the estimate;
The range within which the estimate falls, also known as a confidence level for the estimate.
The documentation for the estimate must include enough detail so that the estimate can be reproduced and it must include a way to identify which work package it originates from. This is known as traceability. Traceability ensures that current project planning documents were used as the basis for the cost estimates. Traceability is typically provided through codes or cost element structures. These include the WBS, organizational breakdown structure, resource breakdown structures and code of accounts.
The basis-of-estimate or cost basis:
helps reconcile funding with the project budget;
allows comparison to estimates for other similar projects;
allows for consistent application and revision of the estimate throughout the project life cycle;
ensures that any changes from an earlier phase of the project can be traced. As the estimate evolves during the project life cycle, the basis should include the reconciliation between the previous version and the current version to account for any changes.
Thanks to Ignacio Manzanera for providing this book