#PM Cost Management—An Overview of the Determine Budget Process


1. Introduction

There are three PM processes involved with cost management. Two of them, Estimate Costs and Determine Budget, are in the Planning Process Group, and Control Costs is in the Monitoring & Controlling Process Group.

As mentioned in a previous post, some of the planning for cost management takes place in the Develop Project Management Plan process under the Initiation Process Group. Here the Cost Management Plan is created as one of the subsidiary components of the overall Project Management Plan.

Process

Group

Process

Number

Process
Name
Process Description
Planning 7.1 Estimate Costs Developing an approximation of the monetary resources needed to complete project activities.
7.2 Determine Budget Sums up the estimated costs and add reserves to establish an authorized cost baseline.
Monitoring & Controlling 7.3 Control Costs Monitoring the status of the project to update project budget and manage changes to the cost baseline.

2.  Determine Budget

Once the estimates are created in process 7.1 Estimate Costs, the next process 7.2 Determine Budget aggregates or adds together all the costs associated with the project in two steps:

Step 1: Aggregation of the individual activity estimates of the WBS work packages.  These are “rolled up” using the WBS to form the aggregates of the work packages and the control accounts, the accounting placeholders in the WBS where you sum up the work packages beneath them.

(NOTE: Although the aggregation process talks about “rolling up” the estimates, in the schematic I have the arrow going downwards to show the flow of the process.)

Step 2: To the project estimate (direct costs), indirect costs may be added. Then contingency reserves are added for those risks listed in the risk register; these reserves are to be used during the project at the discretion of the project manager. This gives the cost baseline.

Management reserves are then added for all unknown risks (i.e., those not accounted for in the risk register), but this amount, as opposed to the contingency reserves, CANNOT be used by the project manager except with permission of the sponsor of the project. This final figure is the overall cost budget.

Once you understand this overall schematic of how costs are aggregated, then the next posts on the inputs, and the tools & techniques of the Determine Budget process will make more sense.

#PM Cost Management—A Closer Look at the Tools & Techniques of the Estimate Costs Process


1. Introduction

In yesterday’s post, I gave a breakdown of the various inputs to the Estimate Costs Process, organized by the type of the estimate they were to be used for. Today’s post is a breakdown of the various tools & techniques of the Estimate Costs Process given in the PMBOK® Guide, also organized by the type of estimate involved.

2. Accuracy vs. precision of estimates

Before I get to the accuracy of estimates, I realize that there may be confusion between accuracy and precision of estimates. In the cost management plan I summarized on 10/14/2012, I listed the first element out of six to be the units of measure and the level of accuracy of the estimates. This is a mistake; I should have said the precision of the estimates. I changed it in the table, but the mistake remains in the graphic.

So if I ended up forgetting the difference, I realized I need to make sure nobody reading my blog continues to make the same mistake. If you are firing at a target, the level of precision will mean how close the bullets will cluster together; the accuracy will mean how close the bullets get to the bullseye of the target. The cost management plan specifies the precision of the estimates, i.e., whether they will be rounded to the nearest $1,000, $100, or $10. The accuracy of the estimates specifies how far they end up being from the actual costs. One of the conceptual difficulties here is that you will not know the actual costs until the project is over. But you can zero in on them gradually in the course of the project in the following three stages, each of which reduces the range of the estimates:

Estimate type

Range

When used

1. Rough Order of Magnitude (ROM) -50/+ 50% from actual Initiating process group
2. Budget -10/+25 from actual Planning process group
3. Determine -5 or -10/+10 from actual Executing process group

The Rough Order of Magnitude or ROM estimate is basically made to determine the feasibility of the project during the initiating process. For an ROM estimate, analogous, parametric, or other top-down estimates are most appropriate. It is called an ROM estimate because the upper end and lower end of the range differ by a total of 100%, or the same magnitude as the estimate itself.

The next stage, the Budget Estimate, reduces the range from -50/+50 to -10/+25, with the preference being for an overestimate rather than an underestimate to reduce the chance of an unwelcome “surprise” at the end of the project. The methods used for the Budget Estimate are those that are bottom-up estimates rather than the less accurate top-down estimates used to produce a ROM estimate.

The accuracy of the estimates can be further increased during the actual project itself because the uncertainty associated with various risks will gradually be reduced as the risk or opportunities either materialize or not. The range here can be reduced to -5 or -10/+10 from the actual costs. Reserve analysis and three-point estimates are risk-based tools and techniques used to refine the accuracy of the estimate during the executing process group.

3. Tools & Techniques of the Estimate Costs Process

The ninth entry, that of Project Management Estimating Software, is a tool of estimating; the rest can be considered techniques. I have grouped the techniques based on whether they are top-down, bottom-up, or risk-refined techniques.

Tool or Technique

Category

Description

1. Analogous estimates Top-down Uses overall costs based on actual costs of similar projects.
2. Parametric estimates Top-down Uses unit costs based on actual costs of similar projects.
3. Expert judgment Top-down or

Bottom-up

  • Experts find historical information of company or industry to support top-down estimates.
  • Experts use information from previous projects to support bottom-up estimates.
4. Bottom-up estimates Bottom-up WBS is analyzed to determine more accurate estimates.
5. Cost of Quality Bottom-up\ Costs of quality such as

  • Prevention costs (quality assurance, training)
  • Appraisal costs (quality control)

are added to cost estimate.

6. Vendor bid analysis Bottom-up Costs for vendors contracted to supply deliverables are added to cost estimate.
7. Three-point estimates Risk-refined Costs of activities are given in terms of three estimates based on perceived risks and/or opportunities:

  • Most likely
  • Optimistic (best-case scenario)
  • Pessimistic (worst-case scenario)
8. Reserve analysis Risk-refined Contingency reserves are those additional costs incurred if certain risks in the risk register are triggered. These are added to project estimates to get the cost baseline.
9. PM Estimating Software Tool Spreadsheets, statistical tools, simulation tools are all used in obtaining estimates.

You can see by the nature of the techniques that the top-down techniques (analogous, parametric) are more useful for Rough Order of Magnitude estimates to be used in the Initiating process. The bottom-up techniques (based on an analysis of the WBS, plus the costs for quality and procurements) are more useful for the budget estimates to be used in the Planning Process. Although the risk-refined techniques (three-point estimates and reserve analysis) are started in the planning process, they are set up so that during the execution phase of the project, as certain risks either materialize or not, they can be used to refine the costs going forward so that they are useful for the definitive estimates of what the project will actually cost.

4. Summary

I hope that this organization of the various tools & techniques based on the general category of estimates has been useful.

I will not do a separate post on the outputs to the Estimate Costs process. This is because the next process in the Cost Management processes is that of Determine Budget, and the inputs to that process will include the outputs of the Estimate Costs Process.

#PM Cost Management—A Closer Look at the Inputs to the Estimate Costs Process


This post is a closer look at the Inputs to the Estimate Costs Process, and categorizes them according to the particular estimating tools & techniques they will be used for in the process.

1. Introduction

There are six inputs to the Cost Management Process 7.1: Estimate Costs. They come from the Scope Knowledge Area (Scope Baseline), the Time Knowledge Area (Schedule), Human Resources Area (HR Plan), and the Risk Knowledge Area (Risk Register), as well as the all-purpose inputs from Enterprise Environmental Factors (EEF) and Organizational Process Assets (OPA).

Here’s a description of the Inputs to the Estimate Costs.

Inputs How used in Estimate Costs Process
1. Scope baseline (= Scope Statement, WBS, WBS dictionary)
  • Scope Statement contains assumptions on whether estimates include direct project costs only or indirect project costs as well.
  • Scope Statement contains list of constraints, including budget constraints.
  • WBS dictionary contains detailed description of work used to produce deliverables, which is helpful in bottom-up estimates.
2. Project Schedule Activity duration estimates and activity resources estimates are crucial for bottom-up cost estimates.
3. Human Resources Plan This will give info on manpower resource estimates and will give estimates on costs of reward/recognition programs.
4. Risk Register This will assist in creating three-point estimates and reserve analysis.
5. Enterprise Environmental Factors (EEF) Historical information from the marker and published commercial information will be helpful for parametric estimating and analogous estimating.
6. Organizational Process Assets (OPA) Information from previous projects done by the organization will be helpful for parametric and analogous estimating.

There are three orders of refinement of a cost estimate. A top-down estimate is used for a rough estimate, and then a budget estimate is produced with a bottom-up estimate. The accuracy of this is further refined by 3-Point Estimates into a Definitive Estimate.

Note the different inputs that are generally used for each type of estimate below.

The next post will go through the different tools and techniques of cost estimating to compare and contrast them. They also will show the intersection between the cost management knowledge area and the other knowledge areas of the project management process matrix.

#PM Cost Management–Cost Management Plan


1. Introduction—

Let’s start the topic off with a quiz. Under which cost management process is the cost management plan developed:

  1. Estimate Costs
  2. Determine Budget
  3. Control Costs
  4. None of the above

The surprising answer is: D, none of the above. The cost management plan is actually developed as part of the overall project management plan in the integration knowledge area process 4.2 Develop Project Management Plan. So the very first cost management process, 7.1 Estimate Costs, already assumes that the cost management plan has been completed.

2. Purpose

If you give the simple answer to “what is the purpose of the cost management plan” as being “to manage the costs”, you would be right. However, if you were asked to explain your answer, you’d need a little more detail. “Manage costs” really has to do with being able to monitor and control them, where the word “monitor” means “measure.” Here are the components of the cost management plan divided into those elements which are more for monitoring or measuring the costs (those in shades of red), and those which are more for controlling the costs (those in shades of blue).

Here are the descriptions of the elements:

Plan Element

Monitoring or Controlling

Description

1. Units of measure, level of precision Monitoring Are the costs computed in staff hours or days?  What is the level of rounding of the data?
2. WBS & Control Accounts Monitoring WBS has control accounts, where the costs of the WBS elements below it are summed up.
3. Reporting Formats Monitoring Who will get the cost performance reports, and how often?
4. Performance measurement rules Controlling The earned value measurement techniques are specified (i.e., using what formulas, or what percent complete).
5. Control thresholds Controlling Cost control thresholds are the percentage that the costs are allowed to vary from the cost baseline. Actions to be taken are specified in case the cost variance exceeds the cost control threshold.
6 Change control procedures Controlling If the cost baseline itself needs to be changed, the change control procedure is specified.

Here are a few additional remarks about these elements. First let’s discuss those that have to do with monitoring or measuring the costs. These three elements are fairly independent of each other.

1.  Units of measure, level of accuracy

The units of measure may refer to the unit costs (cost per staff hour, for example), or possibly the unit of currency in an international project. The level of accuracy refers to the level of precision in stating each cost. There is a concept having to do with the level of accuracy of the cost estimates, but this has more to do with the process 7.1 Estimate Costs.

2. WBS & Control Accounts

The control accounts are different from other elements below in the WBS in that they do not specify deliverables. They are there for accounting purposes to alert the project manager that, when the activities in the WBS elements below it are completed, the costs for those activities needed to be summed up and reported. Each control account is assigned a unique code or account number for accounting purposes.’

3. Reporting Formats

Once the costs are calculated and the performance measurement calculations are done, who gets the report and how often? This element is pretty straightforward.

Now let’s move on to the elements that have to do with controlling costs. As opposed to the elements involved in monitoring costs, these three elements are actually closely related and should be understood in the following sequence.

4. Performance measurement rules

Okay, this is the heart of controlling the costs; comparing the measured or monitored actual costs and comparing them to the budgeted or estimated costs. How much do they vary?

5. Control thresholds

Similar to control thresholds in quality, but with cost being the operative measurement here, there are specifications for how far the actual costs are to vary from the budgeted costs, usually in terms of a percentage. Then various thresholds are established so that if the variance goes over, say, 5%, the project manager must assemble the team and look for a root cause. If it is more than 10%, management may need to be informed. (These are just examples.)

6. Change control procedures

If the control thresholds are triggered, there will have to be some investigation and possibly a recommendation for a change. It could be in the form of a corrective action, in which there is a change control procedure specified for that scenario. But if the investigation reveals that the estimated costs were based on unrealistic assumptions, the cost performance baseline (i.e., the budget) may need to be changed. This will definitely involve the sponsors and/or customers, and this scenario needs to be covered by the change control procedures as well.

Note that the cost management plan doesn’t tell you how to move towards getting the budget. It only tells you how to monitor and control the costs AFTER you have estimated them. And that is the subject of the next post, the process 7.1 Estimate Costs.

#PM Cost Management—Cost Risk


Cost risk is a concept of the cost management knowledge area that touches upon the knowledge areas of risk and procurements. This is because it refers to which party, the buyer or the seller, is at risk of bearing the additional costs if the cost of the goods or services ends up being more than the amount agreed upon in the procurement contract.

Here’s a chart comparing the three main types of procurement contracts:

Procurement Contract Explanation Cost risk Main use
1. Fixed Price (FP) Buyer pays seller a fixed price for producing goods or services Seller Well-defined scope and resource requirements
2. Time and material (T&M) Buyer pays seller on a per-hour or per-item basis Seller/Buyer Scope defined, but resource requirements uncertain
3. Cost reimbursable (CR) Buyer pays seller costs incurred for producing goods or services Buyer Scope uncertain

Here’s an explanation of why the cost risk is listed as in the above chart:

1. Fixed Price (FP)

Let’s take an example of a fixed price contract where the buyer agrees to pay the seller $5000 for producing a component that the buyer needs to put in the product it is manufacturing. If the actual costs for the seller producing the component end up being $6000, and the seller is still paid only $5,000 by the buyer, this means the seller loses $1,000 in profit on the contract.

So the seller will usually want to see the scope defined in the statement of work to be as clearly defined as possible, and the resource requirements to also be clear to the seller in order to control the cost risk. In this way, the seller will know whether the company can produce the goods or services for a profit or not.

2. Time and material (T&M)

Here the cost risk is somewhere in between that of a fixed price and cost reimbursable contract because the price per hour or per item is fixed, but the amount of resources required from the seller is unknown. The buyer will want to put limits ahead of time on the amount of hours or items it will agree to pay for in order to limit its cost risk.

3. Cost reimbursable (CR)

If the scope is uncertain, especially in cases where the buyer is creating some new product it has never produced before, the cost reimbursable contract is probably the type the seller would prefer because if the costs end up being higher than anticipated, the buyer will pay for those additional costs. Here it is the buyer who will want to define in the contract as clearly as possible what the allowable reimbursable costs are in order to control the cost risk.

Because of the asymmetrical risk between the buyer and seller, they can end up working at cross purposes. Therefore, there are systems of incentives which can be added to the basic contract types in order to make the interests of the buyer and the seller more nearly coincide. The details of these subtypes of contract under the three basic types listed above will be taken up in the posts on the Procurement knowledge area.

The next post will deal with the elements of the cost management plan.

#PM Cost Management—Life Cycle Costing


This is a continuance of my review of the topics of project management covered in our study group.   Although I passed the project management examination last Tuesday, our study group is reconvening so I can work on getting the other members to pass the test.    This next series of posts is on the cost management area of the PMBOK Guide.

Many of the concepts in the cost management area actually touch upon other knowledge areas as well. One such concept is that of “life cycle costing”, which borders on the quality knowledge area.

The idea of life cycle costing is that if your project is developing a product, you need to consider the entire life cycle of the product including the costs of repair when you estimate the costs of quality.

Here’s how it works:

The cost of quality (aka the cost of conformance) is made up of two parts:

1. Prevention Costs

The cost of preventing defects are prevention costs, examples of which are the quality planning process itself (including all the associated documentation), training of the team in quality methods (such as Six Sigma), and the Quality Assurance or quality audit process to make sure the correct quality processes developed during the quality plan are being carried out by the now-trained team.

2. Appraisal Costs

The cost of controlling and monitoring for defects are appraisal costs (think inspection), examples of which are the costs of the quality control process, including the cost, manpower, time and equipment used to do the testing and to analyze the results.

Fig. 1 Cost of Quality or Cost of Conformance

Someone may have the bright idea of reducing the level of quality to reduce these costs, because that will reduce the project costs. This may have the unintended consequence of raising other costs associated with that project. These are the costs of nonconformance, or the costs of poor quality, which also consist of two parts.

3. Internal Failures

What if defects are not prevented? Then if they are detected on the assembly line, these defective parts either have to be scrapped or reworked, which may adversely affect the company’s just-in-time inventory system, on top of the cost of repairing or replacing these parts. The defects have to be tracked and analyzed for the cause of the defect, and this tracking system adds costs as well.

4. External Failures

Even more serious than the internal failure costs, are the costs if the defects are produced and undetected on the assembly line. These get shipped out the door to customers, and become external failures. The customer will want to get the goods returned or repaired under warranty. However, if the failure is of a more serious nature that the customer becomes injured, then the costs escalate if a product liability claim or lawsuit is brought against the company. Customer satisfaction is adversely impacted, and the costs of the help desk or customer service department are increased.

Fig. 2 Cost of Poor Quality or Cost of Nonconformance

Now it is possible that the cost of getting to a certain level of quality may be higher than the cost saved in terms of internal failures or external failures. However, the calculation of life cycle costs of quality has to include all four of these categories. You should not lower the cost of quality on your project at the expense of the increased costs to the company on the overall life cycle costs of the product that is the result of your project.

Tomorrow, I will talk about another cost management area that happens to touch upon other knowledge area: cost risk, that is, cost-related risk involving procurements.

The Six Sigma Steps—DMAIC


In the first week of our class preparing us for the Green Belt Six Sigma exam, our instructor Bob Mehta introduced the 5 basic steps of the Six Sigma method of quality improvement that are summed up in the acronym DMAIC: Define, Measure, Analyze, Improve, Control. These steps are summed up in the table below the diagram.

 

Six Sigma Step

Definition

1. Define Define customer and organizational requirements. Select the “Y” responses to be improved.
2. Measure Measure what is critical to quality, map the process, establish measurement system and determine what is “out of specification” or unacceptable. Measure the “Y” response variable.
3. Analyze Now develop a baseline (the process capability), set objectives, identify the “X” independent variables that are the root causes of defects or “out of specification” measurements of the “Y” response variables.
4. Improve Improve the process by reducing variability in the process or eliminating the cause of the defects or out of spec measurements.
5. Control Establish a system to monitor and control the process to sustain the improvements in the long term.

As you can see, the DMAIC approach takes the requirements of the deliverables to be improved, whether they are internal (organizational) or external (customer), maps the processes that create these desired responses, then analyzes them to identify the root causes or any defects. These root causes are improved, which then improves the responses, and thus increases the satisfaction of the requirements. By showing how the system of causes, responses, and requirements are linked, as in the schematic diagram below, you improve the satisfaction of the requirements (increasing quality) by eliminating the root causes of defects.

This, in a very summary form, is what the DMAIC steps to Six Sigma are all about.