Cost Estimation – How to do it? and its various Methods

Cost Estimation in Project Management

Cost estimation is the process of forecasting the cost of completion of a project, task, or operation. It considers all factors related to the resources at disposal to the extent of output delivery required. The question for a cost estimation arises out of the fundamental need to minimize all variances and risks at the stage of execution. Of course, as the name suggests, the output of the cost estimation activity will only be an estimate. However, it gives an almost near picture of the true cost with a plus or minus margin for error.

Whether constructing a building or launching new software, every project involves cost. And as is always the case, the resources – monetary, capital, or human are limited. Therefore, a prudent project manager would always like to have a blueprint of expenses before jumping straight to execution. Cost estimation is like a compass guiding the project managers in the right direction. It is a decision-making tool enabling managers to decide which expense to incur and which to scrap.

Steps in Cost Estimation

Know the Client

A cost estimation exercise must always have the end-user in mind while crafting. Who is going to be the ultimate user of this cost estimation? A project for a client will look much different than that for in-house purposes. Similarly, a project for a private corporation may have to be chalked out much differently than that for a government undertaking. It is also worthwhile to take stock of all limitations or benefits coming with a client. For example, a public enterprise will have the ability to source materials at much cheaper rates than private businesses. This significant cost saving must, therefore, reflect in the cost estimation.

Work With a Budget

Prudent cost estimation cannot manifest out of thin air. Though an estimate, it must be based on certain ground rules and subject to limitations. Therefore, it is always a good idea to be aware of the client’s budget and spending capacity. Working within monetary constraints also paints a realistic picture, and the client does not end up anticipating a Mercedes for the worth of a Ford Fiesta.

Breakdown Your Approach

After gaining familiarity with the project, it would pay to allocate the consolidated budget to various activities and processes making up the project. Identify the specific task areas and allocate man-hours to each to ascertain the level of personnel expertise required. Outsource parts of projects you do not specialize into consultants and determine the level of technology required. All this improves cost-effectiveness.

Have a Wriggle Room

Finally, an estimation, no matter how exhaustive, cannot be watertight. A cost manager must leave some room for contingencies and ensure the client has some spare cash to bank on. Moreover, the components forming a cost estimation are themselves vulnerable to variations. For example, material prices may fluctuate, the technology may become outdated overnight, the execution stage may require more manpower than estimated, etc. A sensitivity analysis of the project to the various dependents involved helps determine the extent of the impact each one will have on the project. Accordingly, the cost manager can account for the same in his estimate.

Cost Estimation

Cost Estimation Methods, Techniques or its Types

There are various cost estimation techniques prevalent in project management. Below is the list of some of those important ones. An explanation of each of these cost estimation methods is given below. You can apply any of the most suitable types of cost estimation methods to your organization.

Top-Down Cost Estimation

This is the quickest and most rudimentary form of cost estimation. As the name suggests, the project manager works from the top with the bulk budgetary boundaries set. This is then broken down to allocate hours or costs to various parts of the project. Of course, this technique is bound by the inherent limitation of assuming the stated budget will be sufficient at the execution stage. However, it comes in handy while providing quick estimates with rough margins to the client or management.

Analogous Cost Estimation

An analogous cost estimation relies on data from similar past projects or similar ventures of the competitor or lateral teams in the organization. It is a straightforward method of computation wherein a project cost estimate is backed by actual of already executed similar ventures. Needless to say, project specifics and scale of operations are accounted for with relevant adjustments. The effectiveness of this method depends on the accuracy of the reference points. Therefore, internal information may be more reliable than those of the competitors or in the public domain.

Parametric Cost Estimation

Parametric estimation is nothing but a sophisticated twist on analogous estimation. An analogous estimate uses historical and comparable data from similar projects. A parametric estimation adds a layer of additional relevant information to arrive at the closest estimate. The actuals are most likely to adhere to this estimate. This method requires data sets and proficiency in using heavy statistical techniques. The use of multiple variables ensures ruling out of tail-ends to present a near-perfect picture.

Three-Point Cost Estimation

A three-point estimation is like conducting a scenario analysis. The basic idea is to offer the client a well-adjusted picture of the anticipated outlay: the best and worst-case scenarios captured therein. There are multiple ways to approach the same. For example, an average of costs is computed by three different methods or a weighted average estimate to indicate the most likely outcome. Consequently, a project is billed basis the classic scenario analysis model of the worst case, most likely, and best-case scenarios.  Thus, making it possible to offer a reliable estimate to the client.

Also, visit Costing Terms for a quick glance at basic cost concepts.

Sanjay Borad

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

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