5th Edition PMBOK® Guide—Step 5: Memorizing Tools & Techniques (Cost Knowledge Area)


1. Introduction

This series of posts assumes that you have already memorized the names of the 47 project management processes, and you are ready to go on to the task of memorizing the tools & techniques.    This post covers chapter 7 of the 5th Edition PMBOK® Guide, the Cost Knowledge Area.

2.   Cost Management Processes

Here’s a description of the four processes that are included in the Time Knowledge Area, together with a listing of the Tools & Techniques used in those processes.

Process Name Process Description Tools & Techniques
7.1  Plan Cost Management Establishes policies, procedures, and documentation for all project cost-related processes. 1.  Expert judgement2.  Analytical techniques3.  Meetings
7.2  Estimate Costs Develops an approximation of the monetary resources needed to complete project activities. 1.  Expert judgment2.  Analogous estimating3.  Parametric estimating

4.  Bottom-up estimating

5.  Three-point estimating

6.  Reserve analysis

7.  Cost of quality

8.  Project management software

9.  Vendor bid analysis

10.  Group decision-making techniques

7.3  Estimate Budget Estimates costs of individual activities or work packages to establish an authorized cost baseline. 1.  Cost aggregation2.  Reserve analysis3.  Expert judgment

4.  Historical relationships

5.  Funding limit reconciliation

7.4  Control Costs Monitors the status of the project to update the project costs and manage changes to the cost baseline. 1.  Earned Value Management2.  Forecasting3.  To-Complete Performance Index (TCPI)

4.  Variance Analysis

5.  Performance Reviews

6.  Project documents updates

7.  Reserve analysis

3.   Cost Management Tools & Techniques

a.   Expert judgment (7.1 Plan Cost Management, 7.2 Estimate Costs, 7.3 Determine Budget)

This tool is used on a lot of planning processes in each knowledge area not just for this particular knowledge area.   Remember that for project management, an expert is either someone who is considered a subject matter expert or SME (a consultant) OR someone who is considered an expert on a specific part of the project (a team member).    The subject matter expert has generalized knowledge about a subject, and the team member expert has specialized knowledge about a specific aspect of the project.   You use this expert judgment technique to consult:

  • team members who worked on Cost Management, estimating techniques, and determining the budget on previous projects
  • subject matter experts with information on Cost Management and estimating techniques relevant to the industry and application area

b.  Analytical Techniques, Meetings (7.1 Plan Cost Management)

Analytical techniques are usually used when there is some sort of strategic decision to be considered, and in the planning phase, you may have to decide whether the project will be self-funded (out of revenue), or funded through equity or debt.   Also, the funding for the project may come incrementally throughout the project rather than all at the beginning of the project.

Meetings are needed because of the tremendous number of stakeholders involved in the project’s finances, even if they are not directly involved in the project itself, such as the program and/or portfolio manager, upper management and some departmental heads (especially Finance, but also Human Resources).    Meetings are needed to gather input from as many of those stakeholders as possible, and to obtain buy-in from those stakeholders at the earliest stage of planning in order to prevent as much as possible any changes to the cost baseline from occurring farther down the line.

c.  Analogous Estimating, Parametric Estimating, Three-Point Estimating, Group Decision-Making Techniques, Reserve Analysis (7.2  Estimate Costs)

The keyword that links all of these tools & techniques together is the word estimating.    These are exactly the same techniques used in the Time Management processes 6.5 Estimate Activity Durations, except they are applied to estimating costs of doing activities or completing work packages, rather than estimating time durations.

Analogous Estimating and Parametric Estimating are BOTH based on historical data from previous projects, but analogous estimating is based on the production of the whole project whereas parametric estimating is based on a unit cost of doing the project.    For example, let’s say you want to estimate the cost of building a new house in a subdivision.    There are two ways of going about it:   one is to get an estimate of how much it cost to build an entire house in that subdivision in the past.   If the model of your new house is similar to that of the previously existing one, then you can create an analogous estimate.  However, you can also, figure out how much it cost to build that previous  existing house per square foot of space.    Then you can use that unit cost to estimate how much it will cost to build your new house.

Three-Point Estimating is where the world of risk management starts entering into cost management.    Each estimate of an activity should have three components, the most likely estimate t(M), the pessimistic estimate (tP), and the optimistic estimate (tO).   The pessimistic and optimistic estimate will be based on an analysis of risk assumptions that are either opportunities (+) or threats (-) to the schedule.   How these three estimates are combined into a final estimate (tE) depends on what distribution you are using:

  • Triangular:  tE = (tO + tM + tP/3)
  • Beta:  tE = (tO + 4tM + tP)/6

Group Decision-Making Techniques are used to brainstorm with all of your team members as a group in order to improve estimate accuracy.

Reserve Analysis is another way in which risk management enters into cost management.   Based on analysis of possible risks that may affect the schedule, it use Contingency Reserves in the form of cost reserves called contingency reserves to account for those risk responses which may need to be done for risks that are the “known-unknowns” that have been listed on the risk register.   For the “unknown-unknowns” risks that are not listed on the risk register, there is another set of reserves called management reserves to fund the “ad-hoc ” risk responses called “workarounds” which may have to be developed on the fly if such risks do end up occurring.

The three “total” amounts you have to be concerned with in cost management are

  • project estimate = sum of the estimated costs for all work packages in the project
  • cost baseline = project estimate + contingency reserves
  • cost budget = cost baseline + management reserves

The performance of the project is measured against the cost baseline, NOT the cost budget.

As the name implies, management reserves, as opposed to the contingency reserves, are NOT under control by the project manager and the project manager will have to get approval for them.   If risks that are anticipated at certain points in the project do not materialize, then those contingency reserves can be absorbed into the cost budget as a result.

NOTE:   Reserve analysis can also be used during the 7.4 Control Costs process for this reason.   Let’s say the anticipated risks for which contingency reserves are set aside end up not occurring after all.   Whew!   Well, you dodged a bullet there.   But that is why that portion of the contingency reserves is no longer needed and may be returned, with management approval, to the cost budget, which is not under control of the project manager, or perhaps even returned to the finances of the entire organization, or in other words, taken out of the cost budget altogether, for use on other projects.

d.  Cost of Quality (7.2 Estimate Cost)

Another knowledge area which impinges upon Cost Management is the area of Quality Management.    There are costs of conformity, which are the costs of making sure that the quality of the actual deliverables is that which has been planned for in the Quality Management Plan.   These include costs such as prevention (training, equipment, documentation) and appraisal (inspection, destructive testing).    There are costs of nonconformity, which are the costs which your organization will incur if the quality of the actual deliverables is NOT that which has been planned for in the Quality Management Plan.  These include costs such as internal costs (reworking, scrapping defective deliverables), and external costs (warranty, product liability, lost business).   The costs of conformity should be less than the costs of nonconformity.   If they are, then the costs of conformity may need to be figured into the cost baseline.    Those for training about quality in general may not be attributable to the project itself, but costs of inspection may be.

e.  Vendor Bid Analysis (7.2 Estimate Costs)

Yet another knowledge area that impinges upon Cost Management is the area of Procurement Management.   In addition to the cost of the organization producing the deliverables in the work packages, the costs of the deliverables attained from suppliers also needs to be accounted for in the project costs.

f.  Project Management Software (7.2 Estimate Costs)

This is a tool, not a technique, and is helpful in keeping track of cost estimates, just as it was helpful in keeping track of estimates of activity resources and activity durations in the Time Management knowledge area.

g.  Cost Aggregation, Historical Relationships, Funding Limit Reconciliation (7.3 Determine Budget)

Cost Aggregation is simply taking the costs of individual activities or the work packages they produce and summing them up for the entire project.

First you take the costs for each activity and summing them to get the costs for each work package.    Control accounts are basically placeholders in the work breakdown structure where you calculate all of the work packages below that level.   They are put there in the Planning Process so you can see when the project is actually running and you are in the Monitoring & Controlling Process, you can take a snapshot of where you are, and see whether you are coming in under or overbudget. The next step is to sum up the work packages estimates in each control account to get the control account estimates.  Finally, you sum up the control account estimates, and you get the project estimate.

In reserve analysis, you add contingency reserves to the project estimate to get the cost baseline, which is what the performance of the project is measured against.    You add the management reserves to that, and you get the final cost budget.

h.  Historical Relationships (7.3 Determine Budget)

Previous projects can be used to develop analogous or parametric estimates, which are discussed above in paragraph c.

i.  Funding Limit Reconciliation (7.3 Determine Budget)

As mentioned above in paragraph b under Analytical Techniques, the funding for a project may come all at once at the beginning of the project, or it may come in increments at various times in the project.

The expenditure of funds for a project over the course of the project has to be reconciled with the periodic funding for a project.   It’s not a matter of just the total amount of funds; it is a cash-flow issue of how much money is available during each month of the project.   The variance between the funding limit and the cost budget for the project during each time period (month, quarter, or whatever) needs to be reconciled. If the cost budget exceeds the funding limit for a particular period, work may have to be rescheduled in order to level out the rate of expenditures.   This is similar to the resource leveling technique.

j.  Earned Value Management (7.4 Control Costs)

The three key pieces of work performance data regarding the performance of the work on the project come from Earned Value Management or EVM.    Earned value management can answer the question “where are we now in relationship to the budget?”.

  • Planned value asks “how much of the budget has been assigned to do the work that was supposed to be done by this point?”
  • Earned value asks “how much of the budget has been assigned to do the work that was ACTUALLY DONE by this point?”
  • Actual costs asks “how much did the work that was actually done by this point ACTUALLY COST?

This is work performance data, which is used to derive work performance information in the form of the following:

  • Cost Variance (CV) = Earned Value (EV) – Actual Costs (AC)
  • Cost Performance Index (CPI) = EV/AC

Similar values are used for time management, in particular:

  • Schedule Variance (SV) = Earned Value (EV) – Planned Value (PV)
  • Schedule Performance Index (SPI) = EV/AC

If the CV or SV are negative, that is a bad thing, meaning that the project is either overbudget or behind schedule.

If the CV or SV are positive, that is a good thing, meaning that the project is either under budget or ahead of schedule.

Similarly, if CPI or SPI are < 1, that is a bad thing, meaning that the project is either overbudget or behind schedule, and

if CPI or SPI are > 1, that is a good thing, meaning that the project is either under budget or ahead of schedule.

k.  Forecasting (7.4 Control Costs)

Forecasting can answer the question “given where we are now (which was determined with the EVM), where will we be by the end of the project in relationship to the budget?”

To do forecasting, you need to know the Budget at Completion or BAC, the Estimate at Completion (EAC), the Estimate to Complete or (ETC), and the Variance at Completion or (VAC). Here are the definitions of these terms.

Quantity Formula Definition
Budget at Completion (BAC) (Related to PV) Authorized budget amount of the total project, i.e. what the project was supposed to cost
Estimate at Completion (EAC) (several formulas) Estimated cost of the project at completion, i.e., what the project is now expected to cost
Variance at
Completion
(VAC)
BAC – EAC The difference between what the project was supposed to cost (BAC) and what is now expected to cost (EAC).
Estimate to Complete EAC – AC How much more it is estimated it will cost to complete the project, i.e., the difference between what the total project is now expected to cost (EAC) and how much it has cost until now (AC).

BAC or the Budget at Completion is where the budget is planned to be at the end of the budget, i.e., the total cost budget. The EAC is the estimate of where the budget will be IF the costs keep going as they have up until now, as given by the AC or Actual Costs. The additional amount of money it is estimated to take you from now until the end of the project is the ETC or Estimate to Complete. You can see by the relationships below that by definition, ETC = EAC – AC. Another term is the difference between what the project was supposed to cost (BAC) and what is now expected to cost (EAC), and this is the VAC or Variance at Completion, and by definition, VAC = BAC – EAC.

How do you calculate EAC? Here’s the trick: there are 4 ways to calculate it depending on why your actual costs (AC) are at variance from the budget.

FormulaNo. Formula FormulaName Formula Explanation
1 EAC = AC + ETC New estimate ETC is new bottom-up estimate
2 EAC = AC + (BAC – EV) Original estimate Reason for variance is one-time occurrence
3 EAC = AC + (BAC – EV)/CPIOrEAC = BAC/CPI

 

Performance estimate low Reason for variance will continue at same rate
4 EAC = AC + (BAC – EV)/CPI*SPI Performanceestimate high Reason for variance will continue and effect performance
Formula 1.

EAC = AC + (ETC)

If the original budget is considered totally flawed, or you have no idea why there is such a large variance, then one way to estimate the amount it will now take to do the project is to take the amount spent on the project so far (AC) and then do a more accurate bottom-up estimate of the amount it will take to complete the project (ETC). That’s essentially saying that you have to refigure the budget from scratch starting from now until the end of the project.

Formulas 2-4. The rest of the formulas are similar in that they all start with AC, the actual cost up to now, and then they add an amount called the remaining costs or BAC – EV, modified by some other factor.

Formula 2.

EAC = AC + (BAC – EV)

If the reason for the variance is a one-time occurrence, we don’t expect that it will happen again. Then you just take the remaining costs or (BAC – EV) and add them to what the project has already cost to get the estimate at completion of EAC. Picture the budget as a straight road going from one town to another. The variance is a one-time thing that causes the budget to suddenly vary by a small amount, as if you were driving a car and a sudden gust of wind caused your car to be blown a few feet into another lane, but then your car continues along a straight line to the other side.

Formula 3.

EAC = AC + (BAC – EV) / CPI = BAC/CPI

If the reason for the cost variance is a continuing occurrence, then you take your actual costs and add it to the remaining costs or (BAC – EV) divided by the current cost performance index (CPI). The algebra allows this expression to be simplified to the planned budget amount or BAC divided by the current cost performance index or CPI.

In the analogy of driving a car, let’s say you take a wrong turn onto a road which is going at a certain angle to the road you are driving on. This formula assumes that you are continuing on that same wrong road until you get to the destination.

Formula 4. S

EAC = AC + (BAC – EV)/(CPI * SPI)

If the reason for the cost variance is a continuing occurrence which also effects the schedule variance, you take your actual costs and add it to the remaining costs or (BAC – EV) divided by BOTH the current cost performance index (CPI) and the schedule performance index (SPI).

In the analogy of driving a car, let’s say you take a wrong turn onto a road which is not going at a certain specified angle to the road you are driving on, but is actually curving away from that road. This formula assumes that you are continuing on that same wrong that is curving away from the first road (budget) until you get to the destination.

l.  To-Complete Performance index (TCPI) (7.4 Control Costs)

The To-Complete performance Index or TCPI can answer the question “given where we are now, how fast to we have to go to be within budget by the end of the project?”

Okay, here’s an analogy to tell you how this works. Let’s say you are driving from city A to city B which takes 6 hours normally. You have calculated that you can drive there if you go at the speed limit of 65 mph for the entire trip. You get halfway there and you do a quick calculation which tells you that you have actually only gone an average of 55 mph. How fast will you have to go to make it to your destination on the second half of your trip in the same time frame of 6 hours? Well, the answer is 75 mph. This will increase the risk of getting a speeding ticket, of course.

In a similar way, if your CPI is below 1, then the TCPI will end up giving you an index that is greater than 1, because if you are over budget so far, you will have to be UNDER budget for the rest of the project to make up for the overage you have had so far.

Here is the formula for TCPI:

TCPI = (BAC – EV)/(EAC – AC).

Memorizing this formula is not as crucial as memorizing the other formulas related to earned value management; however, it is important to understand the CONCEPT behind it.

m.  Performance reviews, Variance Analysis (7.4 Control Costs)

This measures the performance of the project compared to the cost baseline.    Let’s say the performance on the project is varying from the cost baseline, and that the project is now overbudget.    In order to suggest a change to the project which will bring it back in line with the cost baseline, you need to do variance analysis to get at the root cause for what is bringing the project overbudget.    In this case, something is costing more than it was expected to cost.

There is a second possibility that might emerge out of variance analysis, and that is that certain costs were not included in the cost baseline.   In this case, you need to change the cost baseline to account for them, so it is a case of bringing the cost baseline in line with the actual project performance, rather than the other way around like in the previous paragraph.

In either case, the result of the performance review and variance analysis will result in making a change request so that the performance of the project improves.    Earned Value Management and Variance Analysis, although not explicitly mentioned as a tool and technique for 7.4 Control Schedule, can be used to figure out what activities are costing more in terms of time than they were originally scheduled for through the quantities SV and SPI rather than CV and CPI.
This post was an exhaustive (and I’m sure exhausting) review of all the tools & techniques used in various processes in Time Management.   Some of them, especially those that deal with estimation, are techniques that are also used in Cost Management for estimation as well.
The next post will cover the tools & techniques of chapter 8 of the 5th Edition PMBOK® Guide, that of Quality Management.
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