Estimation of Project Cost

What is Project Cost?

Estimation of Project Cost is a very important step in project planning, evaluation of various opportunities, and prioritizing them. Or selecting one project over the other. For new projects, the Project cost is the total cost that will be incurred over the life of a project. The estimation covers all sorts of direct costs and indirect costs. The main components of project cost are the cost of materials, equipment, and human resources, including labor and new hiring, pre-planning costs, and finally, the operating costs.

Project managers do an estimation of the project cost as per the scope of activities that they plan to perform in the project and as per the timelines that they estimate. Estimation of the project cost is one of the key activities in the initial phases of project planning. Proper budgeting for a project is extremely important for project managers. It impacts the total scope of each and every phase and activity of any project.

What it Serves?

Improper and wrong estimation of the project cost will result in unrealistic expectations from the project. The asset allocation will go faulty, resulting in constant friction between various departments of the organization. And all such friction will lead to the failure of the project or delayed execution with higher costs. Therefore, project cost estimation should be as accurate as possible, with very little scope for variations.

Project cost estimates serve as a yardstick for the performance evaluation of project managers. The management can question the variation between the actuals and the estimates and take corrective measures. The estimates also serve as a tool for control. They push the managers to minimize any variations from the estimates. Therefore, it helps curb wastages and increase overall efficiency in the project processes. A proper estimation does help in the effective implementation and success.

Techniques for Estimation of Project Cost

The process of estimation of project cost varies from one corporation to another. Some big companies may have specific policies for project cost estimation. Elsewhere, it may depend upon the expertise and choice of the project manager in charge. Let us have a look at the key techniques for the estimation of project costs.

Analogous Estimation

The analogous estimation technique uses the past results to estimate the costs of a current project. The managers compare the actual earlier costs in a similar project and prepare current estimates on its basis incorporating the latest prices. Thus, they use historical data along with their judgment to prepare a fresh estimate. This technique is especially useful in cases where we do not have much information about the current project in hand. Or where it is a routine type of project.

In this technique, correct entry and storage of past cost data in a database are essential. Any company cannot use this technique if past data is not available or is incorrect. Also, each project is different from the others. The project managers cannot solely rely upon past results to prepare an estimate of the current project costs. Hence, this technique is useful when only rough estimates are sufficient to prepare project cost estimation. And there is not much change in the structure and condition of the project.

Parametric Estimation

The parametric estimation technique makes use of past data as well as statistical models to estimate project costs. The accuracy of this technique is higher than analogous estimation because of the use of statistical modeling, algorithms, and equations. However, we need more data initially for the estimates to be accurate.

This method first identifies the cost per unit of items the managers will need in the project. We then multiply this unit cost by the total number of units consumed in similar other previous projects. We will also find out the hourly rate of human resources and multiply it with the man-hours taken up in similar other previous projects. The managers will then use algorithms and equations to scale the historical cost to the current project in hand.

Bottom-up Estimation

This estimation technique breaks down a project into many smaller components. The managers will then make a cost estimate for each of these smaller parts. This approach magnifies each process, task, or part of a project, which helps to accurately estimate the project cost.

This method is of use when the requirements in a project are specific, expectations are clear, and the project managers have details of the individual costs of each and every element. Also, the chances of variations should be small or negligible for this technique to be successful.

Top-down Estimation

The top-down estimation technique is of use when the project managers have an actual amount in hand within which they have to complete the project. This can happen in cases when the management directs the managers to complete a project within a specific budget. Also, a client can quote a price that he is willing to pay for a project, and the managers will have to work out the details accordingly.

In this approach, managers will decide the scope of work that can be done within the given budget by using their judgment. They may also pick up details from previous similar projects and prepare an estimate of project cost depending upon the materials and time that the project will need. Therefore, it is a reverse process in which the managers decide the scope of activities by the budget of the project rather than being the other way round. The estimations can be inaccurate and faulty because there is no proper analysis behind them, and historical data may not be valid in the present times.

Estimation of Project Cost

Three-point Estimation

The three-point estimation technique makes use of three different scenarios for the estimation of the project cost. The first scenario presents an “optimistic” estimate in which work is done with minimal hindrances and by spending the funds in the most efficient manner possible. In another scenario, managers prepare a “pessimistic” estimate in which work is done by facing many hindrances and spending the funds in the most inefficient manner possible. The last scenario is the ideal or “most likely” scenario and lies in the middle of the above two scenarios. This scenario is most likely to be true.

This technique is useful in cases when the risk of going over the budget and spending more than the estimate is high. The managers will be ready to face any of the three scenarios and know how to achieve the best possible outcome.

Importance of Estimation of Project Cost

Financial Viability

Estimation of the project cost is essential to decide if the project is financially viable to the company or not. The managers will go ahead with the project if the management finds the estimates feasible, or they may look at other investment options. They may trim it a bit if there is a constraint of resource availability with the company. They may also scrap the project if they feel that they do not have the resources they need and the project is not financially viable for the company.

Evaluation and Control

Estimation of project costs helps the managers to constantly keep a check on their decisions and performance. The estimates serve as a reminder that they have to adhere to the budget. If the expenditure overshoots, the management can always take corrective action to bring the expenditure in control. Also, they can punish those who are guilty of poor planning in case the actuals are significantly more than the estimates.

Summary: Estimation of Project Cost

Correct estimation of the project cost is the lifeline of the project. It is very tricky to get these estimates right since we plan much in advance for the future. If the project is lengthy and will take several years to complete, the managers will have to do more guesswork about the costs that the company will incur after, say three years. Such estimates will most probably be irrelevant then.

Managers may also have a lack of expertise in preparing estimates and budgets. The clients may change the requirements list after starting the project. Moreover, some unfortunate events like a permanent breakdown or a natural catastrophe may occur. They may derail the project and make the estimates irrelevant.

Therefore project managers should take extra precautions and factor in the possibility of the above hindrances in the project while preparing an estimation of the project cost. Only then will the company be able to derive value from the estimates and benefit from them. Moreover, where the project period is long, and price fluctuation is expected, the managers should plan an element of contingency in the overall budget. This is to take care of such uncertainties.

Frequently Asked Question (FAQs)

What happens if the estimation of project cost goes wrong?

In case of wrong or improper estimation of project cost, the profit may turn into a loss. The asset allocation will go faulty, resulting in constant friction between various departments of the organization, which will lead to the failure of the project or delayed execution with higher costs.

List the techniques used for estimating project cost.

1. Analogous estimation
2. Parametric estimation
3. Bottom-up estimation
4. Top-down estimation
5. Three-point estimation

Why it is important to estimate the project cost?

1. To decide if the project is financially viable to the company or not.
2. Serve as a reminder that they have to adhere to the budget.
3. To punish those who are guilty of poor planning.

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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