Cost Estimation Methods – All You Need To Know

Estimating cost is one of the toughest things to do, but it is an essential part as well. In the absence of a cost estimate, it would be challenging to come up with a business plan, prepare budgets, and make other crucial business decisions. For the ease of the cost managers, there are several cost estimation methods.

A cost manager can use either one or more of these methods to estimate the costs. Which method does a manager uses will depend on the amount of information available – in terms of schedule, scope, and resources. Also, the technique gives the relevant cost details important for budgeting and management decisions. Experts recommend using more than one method as it ensures the accuracy of the estimates.

Cost Estimation Methods

Following are the most common and popular cost estimation methods:

Expert Judgement Method

A company must consult individuals or groups that are experts in the field in which the company operates or the project focuses on. The expert judgment, along with the historical data, assists a great deal in cost estimation. A company can also use the expert opinion to decide on whether or not to use more than one cost estimation method and, if yes, then which ones.

Analogous Estimating Method

Under this method, the manager uses the cost information on other similar projects to estimate the cost of the current project. The manager considers parameters such as duration, size, scope, budget, and more similar projects to estimate the cost. This method is simple and does not cost much in terms of time and money. One can apply this method to estimate the cost of the full project or some part.

Parametric Estimating Method

This method is data-dependent. This method calls for using regression or other statistical techniques to estimate the cost. Usually, here the approach is to estimate the cost of a given cost element by the established relationships to their independent variables. These relationships are expressed in the form of mathematical equations. It is one of the most accurate methods to estimate the cost. One can go for this method if they have some comparable data and time to make the estimates.

Bottom-Up Estimation

Under this method, we start to estimate costs from the lower level and then work up to a higher level. This method of cost estimation is very accurate as the estimation work begins from the granular level. However, it consumes too much time.

Three-Point Scenario Estimating Method

This method helps to account for the estimation of uncertainty and risk. For this, it makes use of three estimates to come up with a range of costs. The three forecasts that it uses are:

Most likely (M) – under this, cost estimation is based on practical efforts.

Optimistic (O) – under this, the estimates are based on the best-case scenario.

Pessimistic (P) – in this, the estimates are based on the worst-case scenario.

Based on the range of values from the above three estimates, we calculate the expected cost, cE, using a formula. Two popular formulas are Triangular Distribution E = (O+M+P)/3 and Beta Distribution E = (O+4M+P)/6.

Project Management Information System Method

This method uses the software to come up with cost estimates. Such software can help in planning, organizing, and managing resource pools to estimate the costs. Depending on the capability of the software, one can use data such as resource availability and resource rates and come out with a more accurate cost estimate. Managers go for this method when such software is available and they want to make complex calculations easier.

Decision-Making Method or Group Decision-Making Method

People who work on the project come together to give inputs that would help in estimating the cost. The involvement of diverse people helps in determining the cost more accurately. Moreover, it also helps to develop a sense of commitment and ownership as people feel responsible for completing the project within the estimate that they helped in estimating.

Engineering Estimate

Under this, we break down the total cost system into lower-level components. Then, for each element, the manager estimates the cost of direct labor, direct material, and other costs. Using this method requires an in-depth knowledge of the system’s components, characteristics, and their inter-relationship.

Reserve Analysis

Despite the best estimates, there is always some amount of uncertainty or variance between the actual and estimates. To address the possibility, one needs to put some funds as a contingency reserve. Such reserves add to the cost baseline, and a manager may increase or decrease such reserves as the project moves near completion. In addition to the contingency reserve, a plan may also have a management reserve. Such a reserve does not add to the cost baseline.

Keeping reserves is very important; they help the company to face uncertain and unexpected events. The manager has the power to utilize the contingency reserve, but for using the management reserve, the manager needs the approval of the top authorities.

Cost of Quality

Under this method, assumptions are made about the quality to estimate the cost. Generally, there are two types of costs to ensure quality. One is the cost of conformance, and the other is the cost of non-conformance. The cost of compliance is the budget for prevention and appraisals. A company may need the cost of conformance in case of internal and external failures. Thus, the cost of the Quality method involves estimating the cost of conformance and non-conformance expenses. Managers generally use this method when the focus is on quality.

Vendor Bid Analysis

If the available information is not enough, then the manager may use the bids from the vendors to decide the cost. The bid values may be different, but the average of the proposals will give the manager an idea of how much the cost should be. Managers go for this method when they don’t have much insight or data.

Final Words

A manager may choose to apply these cost estimation methods together or in a combination. It depends on the nature of the project and the amount of data available. Also, a manager must remember that the cost estimation is usually never a single number, preferably a range. Whatever method is preferred, ultimately, it should give the desired data and result for quick decision-making and monitoring.

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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