Chapter 4:

Cost Management

 What is the cost baseline?

The cost baseline is the basis for the earned value reporting
system
 Why do we have two separate reserves to take
care of the risks?
There are two kinds of reserves set up to budget for risks: the
contingency reserve and the management reserve. The contingency
reserve contains the money to do the risks that were identified.

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 Why am I concerned with cost budgeting?

Cost budgeting or setting the

cost baseline for a project is
very important since it forms
the foundation for the
measurement of performance
in the project.

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 What is life cycle cost?
Life cycle cost is the cost that is associated with the project from the
beginning of the project to the end of its useful life and beyond.
What is the difference between estimated cost and price?
 Estimating cost means developing the approximate cost of completing

the entire project or part of it

 Selling price is the amount of money the organization will charge to deliver the
project
What is the law of diminishing returns?
The law of diminishing returns says that each time we do something to receive a benefit,
the benefit will be less and less.
What is a cost improvement curve?
A cost improvement curve is based loosely on the idea of a learning curve. In some
contracts, generally large ones, the client may require the vendor to reduce the price
of items supplied later in the project to less than the delivery price of earlier items of
the project.

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Figure 3-3: 70%
IMPROVEMENT CURVE
This is rational since the vendor of a
multi deliverable type of large
project will learn how to deal with
the customer's requirements as
subsequent deliverables are
delivered. There will be a certain
amount of value engineering that
will take place as well, and the
vendor's vendors will have
improvements as well.

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Enter Earned Value Analysis
“Earned Value Analysis” is:
• an industry standard way to:
• measure a project’s progress,
• forecast its completion date and final cost, and
• provide schedule and budget variances along the
way.

By integrating three measurements, it provides

consistent, numerical indicators with which you can
evaluate and compare projects.

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What’s More Important?

Knowing where you are

on schedule?

Knowing where you are

on budget?

Knowing where you are

on work accomplished?

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The Importance of Project Cost
Management
IT projects have a poor track record for meeting budget
goals
The CHAOS studies found the average cost overrun (the
additional percentage or dollar amount by which actual
costs exceed estimates) ranged from 180 percent in 1994
to 43 percent in 2010
A 2011 Harvard Business Review study reported an
average cost overrun of 27 percent. The most important
finding was the discovery of a large number of gigantic
overages or “black swans”

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What is Cost and Project Cost
Management?
Cost is a resource sacrificed or foregone to
achieve a specific objective or something given up
in exchange
Costs are usually measured in monetary units like
dollars
Project cost management includes the
processes required to ensure that the project is
completed within an approved budget

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Project Cost Management Processes
Planning cost management :determining the policies,
procedures, and documentation that will be used for
planning, executing, and controlling project cost.
Estimating costs: developing an approximation or
estimate of the costs of the resources needed to complete
a project
Determining the budget: allocating the overall cost
estimate to individual work items to establish a baseline
for measuring performance
Controlling costs: controlling changes to the project
budget

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Figure 7-1. Project Cost
Management Summary

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What Went Right?
Many organizations use IT to reduce operational costs
Technology has decreased the costs associated with processing
an ATM transaction:
 In 1968, the average cost was $5.
 In 1978, the cost went down to $1.50
 In 1988, the cost was just a nickel.
 In 1998, it only cost a penny.
 In 2008, the cost was just half a penny!
Investing in green IT and other initiatives has helped both the
environment and companies’ bottom lines. Michael Dell, CEO of
Dell, reached his goal to make his company “carbon neutral” in
2008. As of March 2012, Dell had helped its customers save
almost $7 billion in energy costs
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Types of Costs and Benefits
Tangible costs or benefits are those costs or benefits
that an organization can easily measure in dollars
Intangible costs or benefits are costs or benefits that
are difficult to measure in monetary terms
Direct costs are costs that can be directly related to
producing the products and services of the project
Indirect costs are costs that are not directly related to
the products or services of the project, but are indirectly
related to performing the project
Sunk cost is money that has been spent in the past;
when deciding what projects to invest in or continue, you
should not include sunk costs

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More Basic Principles of Cost Management

Learning curve theory states that when many

items are produced repetitively, the unit cost of
those items decreases in a regular pattern as more
units are produced
Reserves are dollars included in a cost estimate to
mitigate cost risk by allowing for future situations
that are difficult to predict
 Contingency reserves allow for future situations that
may be partially planned for (sometimes called known
unknowns) and are included in the project cost baseline
 Management reserves allow for future situations that
are unpredictable (sometimes called unknown
unknowns
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Planning Cost Management
The project team uses expert judgment, analytical
techniques, and meetings to develop the cost
management plan
A cost management plan includes:
 Level of accuracy and units of measure

 Organizational procedure links

 Control thresholds

 Rules of performance measurement

 Reporting formats

 Process descriptions

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Estimating Costs
Project managers must take cost
estimates seriously if they want to
complete projects within budget
constraints
It’s important to know the types of cost
estimates, how to prepare cost
estimates, and typical problems
associated with IT cost estimates
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Table 7-2. Types of Cost
Estimates

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More on Cost Estimates
The number and type of cost estimates vary by
application area. The Association for the Advancement of
Cost Engineering International identifies five types of cost
estimates for construction projects: order of magnitude,
conceptual, preliminary, definitive, and control
Estimates are usually done at various stages of a project
and should become more accurate as time progresses
A large percentage of total project costs are often labor
costs

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Cost Estimation Tools and Techniques

Basic tools and techniques for cost estimates:

 Analogous or top-down estimates: use the actual

cost of a previous, similar project as the basis for

estimating the cost of the current project
 Bottom-up estimates: involve estimating individual

work items or activities and summing them to get a

project total
 Parametric modeling uses project characteristics

(parameters) in a mathematical model to estimate

project costs
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Sample Cost Estimate
See pages 284-289 for a detailed example of creating a
cost estimate for the Surveyor Pro project described in
the opening case
Before creating an estimate, know what it will be used
for, gather as much information as possible, and clarify
the ground rules and assumptions for the estimate
If possible, estimate costs by major WBS categories
Create a cost model to make it easy to make changes to
and document the estimate

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Determining the Budget

Cost budgeting involves allocating the project cost estimate

to individual work items over time
The WBS is a required input to the cost budgeting process
since it defines the work items
Important goal is to produce a cost baseline
 a time-phased budget that project managers use to

measure and monitor cost performance

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 Control Account Plans

A CAP is essentially a Work Package with some added

features:
 Assignment of responsibility
• Organization
• Individual
 Division (if necessary) into lower-level Work Packages.
 Metrics for measuring EV performance
• Milestones
• % complete
• Other

 The sum of the CAPs constitutes the Performance

Measurement Baseline
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 Some New Terms

PV – Planned Value

AC - Actual Cost

EV – Earned Value

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 Earned Value Definitions

PV: “Planned Value”

Planned cost of the total amount of work scheduled

to be performed by the milestone date.

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Earned Value Definitions (cont.)

AC: “Actual Cost of Work Performed”

Cost incurred to accomplish the work that has been

done to date.

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Earned Value Definitions (cont.)

EV: Earned value or Budgeted Cost of Work

Performed

The planned (not actual) cost to complete the work

that has been done.

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 Some Derived Metrics

SV: Schedule Variance (EV-PV)

 A comparison of amount of work performed during a
given period of time to what was scheduled to be
performed.
 A negative variance means the project is behind

schedule

CV: Cost Variance (EV-AC)

 A comparison of the budgeted cost of work
performed with actual cost.
 A negative variance means the project is over

budget.
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 Schedule Variance & Cost Variance

Schedule Variance = EV-PV

$49,000
- 55,000
SV = - $ 6,000

Cost Variance = EV-AC

$49,000
56,000
CV = - $7,000

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 Some More Derived Metrics

SPI: Schedule Performance Index

SPI=EV/PV
 If SPI<1 means project is behind schedule
CPI: Cost Performance Index
CPI= EV/AC
 If CPI<1 means project is over budget

CSI: Cost Schedule Index (CSI=CPI x SPI)

The further CSI is from 1.0, the less likely project
recovery becomes.
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 Performance Metrics

SPI: EV/PV
49,000/55,000 = 0.891

CPI: EV/AC
49,000/56000 = 0.875

CSI: SPI x CPI

.891 x .875 = 0.780

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 Packaging Machine Project
Cost Performance Index

End of Week 8 Determine CPI

• $64,000 was
budgeted • CPI = CEV/CAC
• $68,000 was actually = $54,000/$68,000
expended
= 0.79
• $54,000 was the
earned value of work
actually performed For every $1.00
actually expended,
only $0.79 of earned
• CEV = $54,000
value was received.
• CAC = $68,000
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 class exercise
1.Calculate cost of variance ?
planned value (PV) 500
Earned value ( EV) 400
Actual cost (AC) 300
2.Calculate schedule of variance?
 planned value (PV) 500
Earned value ( EV) 400
Actual cost (AC) 300
3. Calculate actual cost
Complete a project 12 months
total cost the project $100,000
4. Calculate cost variance and schedule variance
PV= 50 EV = 40,000 AC = 60,000

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 Earned Value Analysis

Questions/Discussion

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