Project Cost Estimation Methods

Abstract

Prior to the start of a project, cost estimate is critical. It is an important phase in project management since it is used to calculate and manage the project budget. The cost of a project is estimated for the first time at the start of the project or sometimes even before it starts. Afterwards, the cost is re-estimated on a regular basis to account for new information, scope changes, and the project's timetable . The cost of a project has the potential to impact nearly every area of the project, making it one of the most critical jobs for a project manager. A poorly written budget will result in incorrect asset allocation, unrealistic expectations, and, in the worst-case situation, project failure. Simply said, a project's budget must be accurate for it to succeed. Cost estimation is one of the most helpful tools in a project manager's arsenal for creating an adequate budget. There are different methods of cost estimation available in the literature such as analogue estimation, parametric estimation, bottom up estimation, expert judgement, and three-point estimation. Each method has its own pros and cons for different projects. The application of each cost estimation method varies from project to project and the nature of the project. The article will focus mainly on the three-point estimation as it is the most suitable for all kind of projects. This is due to the fact that the three-point estimation method provides a more precise estimate, hereby reducing the chance of failure and the possibility of unrealistic or excessively high estimates . Throughout the article all cost estimating techniques for different kinds of projects will be examined to determine which approach is most appropriate for whatever type of project and to determine the optimal method for all types of projects.

What is Cost Estimation

A cost estimation is a calculated estimate of the number of resources necessary to accomplish a project or components of a project. These kind of cost estimates are often stated in monetary terms. If the monetary values are not appropriate or irrelevant, alternative units, such as man-days, might be used instead. It comes in a variety of forms. The rough order of magnitude (ROM) and definite estimate are included according to the Project Management Body of Knowledge. Both categories vary in terms of precision, project stages in which they are used, and tools and procedures accessible . Other tools regarding cost estimation includes:

• Analogous estimation
• Parametric estimation
• Bottom up estimation
• Expert Judgement
• Three-point estimation

Types of Cost Estimates

Figure 1: Estimate Ranges

According to PMBOK®, which is a set of standard terminology and guidelines for project management, there are two categories of cost estimates:

• Rough order of magnitude (ROM)
• Definitive estimate

Rough Order of Magnitude vs Definitive Estimate

The rough order of magnitude is a ballpark number established at the very early phases of a project, such as during its inception or even earlier – for example, for the cost-benefit analysis during the project selection process. According to PMBOK, its accuracy range is -25 percent to +75 percent. The range was formerly stated as +/-50 percent in prior versions of the PMBOK®, such as the 4th edition. This suggests that a project's actual cost is usually within the range of the original ROM estimate. ROM estimations are rather inaccurate because of the wide range of probable results. As a result, throughout the project, they are usually replaced by more precise estimates, such as the definitive estimate. The definitive estimate is the PMBOK's most precise sort of estimate . Its precision varies from -5 to +10 percent. This high degree of precision is generally only possible when the project has been meticulously planned and all required information for a credible estimate of the work is available. As a result, definite estimates are often established later in the project, while a rough order of magnitude is more prevalent in the early phases. Progressive elaboration refers to the process of refining preliminary estimations during the life of a project. When a definite estimate is created, it generally takes the place less accurate ROM estimate .

When are Costs Estimated

Costs are calculated at various stages of the project . According to the PMBOK, the procedure is carried out "periodically during the duration of the project as required.“ Cost estimation begins at the beginning phase, for example, when the project charter or business case is being prepared. A project manager must identify the resources necessary to finish these papers. Due to the lack of specificity in the information available at that stage, the project manager is likely to provide a rough order estimate according to the project tasks and its complexity rather than a precise estimate. When further information becomes available later in the project, the rough order estimate is replaced with a definite estimate. Following the project's inception phase, the budget will be reassessed using the approaches described in this article throughout the planning phase. Costs are often re-estimated in succeeding stages as relevant new info and details become available or as the scope of the project or timetable changes. One of the most typical reasons for re-estimating costs is when the project's controlling indicators indicate that the initial budget baseline cannot be fulfilled.

Importance of Cost Estimation

The estimate of project costs is one of the most critical components of project planning and management. The reason for this is because every project must comply to at least three fundamental constraints: scope, budget and timeline. Due to the fact that cost estimates are by their very nature limited in scope, they are essential for project administration. It is common practice to include the initial tentative cost estimate in the project charter as well as in the project's business case when developing a project charter. Cost estimate is also required for calculating the project budget that is directly relevant to project sponsor approval (s). In reality, "determine budget" process employs a method known as "cost aggregation," which refers to the "estimate cost" phase's outputs directly. Cost estimates are used to allocate funding to the deliverables and work packages of the project, which may be politically charged within a project and among its stakeholders. As a result, budget planning and allocation need stakeholder participation, communication, and, in many circumstances, approval.

Project Cost Estimation Techniques

Project managers' cost estimations are influenced by a number of factors. Some companies, for example, require that all projects must be funded in line with strict laws, while others may depend on the project manager's expertise. Similarly, many firms may depend on estimates rather than more accurate forecasts in the early stages of project development. Five of the most prevalent cost estimating approaches include:

Analogous Estimating

Analogous estimating is the process of applying previously observed cost figures and variables to new projects or segments of projects. The kind and structure of the referenced project activities must be similar to the present project in order to ensure accuracy. This method determines the predicted resource needs of a present project by analyzing the past data in terms of numbers and parameters. For the present project, the past values are used, and they may be changed to account for variations in project scope or its complexity. Analogous estimating falls under the category of gross value estimation. Comparable estimates are used when a project has access to previous data on similar types of work but lacks the specifics and resources to make more exact estimates .

Parametric Estimating

A statistical approach for determining the projected amount of funds or time required to complete a project, an activity, or a portion of a project is known as parametric estimation. An estimate is calculated using a statistical or ostensible relationship between a group of factors and a costing or time value. The size of the present project is then scaled in accordance with the observed association. For instance, in highway construction, the cost and timing for constructing a mile in a previous project might be used to estimate the resources and timetable for the current project. This, however, requires statistical proof of the association as well as a comparison of the two projects' features . It is also considered a technique for estimating expenses at various degrees of granularity, the method by which it is implemented differs significantly. Some projects create complicated statistical models and do extensive regression analyses on a variety of variables. They may also create algorithms and provide a large amount of resources to the deployment and testing of such models. This is an approach that can be used for large projects, sometimes known as "large - scale projects," when even minor estimating mistakes can have a huge impact. On the other hand, smaller projects may employ parametric estimate by creating functions or simply using the 'rule of three' if there is proof or a plausible assumption that observable parameters and values correspond. It may also need expert judgement to determine if the predicted regressions are realistic and suitable to the task or the project.

Bottom Up Estimating

Bottom-up estimate is a method for calculating the cost of work units at the granular level. The cost estimates for all project components are then combined to arrive at a total project cost estimate. Generally, these estimations are often made after breaking down the project into smaller work packages and even individual tasks. Whereas there is no specific rule on who should do these estimates, it seems to be a good project management practice to ask those stakeholders who are operationally involved in appropriate activities and work packages to do so. As a result, this method of cost estimate often produces substantially more accurate results than top-down calculations. Getting these granular estimates and integrating them, on the other hand, often needs significant resources and may become a political minefield, particularly for big or complicated projects .

Expert Judgement

Expert judgement may be used in both top-down and bottom-up estimation. Its precision is highly dependent on the quantity and expertise of the professionals participating, the understanding of the activities planned and phases, and the kind of project. If the primary stakeholder and team are familiar with the type of work that will be performed on the project, expert judgement may be used to provide an estimate. This involves a working knowledge of the project's topic and its environment, such as the organization and the industry . Expert judgement may be seen in two ways: • Estimation of the rough order magnitude at the outset of a project. As there are often not many team member at the beginning, and precise estimates are not available due to inexistence of data, estimates are often times performed by top-down estimation approach • Inquiring the people in charge of the various activities or work packages make an estimate of how much time and resources they think it will take to produce the deliverables outlined in the WBS. It is often times possible to get quite precise findings from this kind of expert judgement. Expert judgement, in addition to being an estimating approach in and of itself, is also inherent in the other estimation procedures. Instances include determining if earlier work and the present project are comparable or determining whether revisions to parametric estimation are necessary.

Three-point Estimation

The three-point estimate approach is a simple but efficient way of evaluating work time and cost. It is used in the process groups "Estimate Activity Duration" and "Estimate Costs." In the strategy, three different estimates are employed, which are usually gathered from experienced specialists:

• Optimistic estimate
• Most likely estimate
• Pessimistic estimate

The optimistic estimate is the amount of work or time necessary to perform a job under ideal circumstances. It illustrates what is referred to as the "best-case scenario." Pessimism is based on the notion that the opposite is true — it shows the worst-case scenario. Both estimates are designed to be quite reasonable, despite the fact that they represent the most improbable scenarios. The third point indicates the most likely situation; it is the work or time estimate that is deemed most fair. Without further consideration, one would be inclined to take the average of the pessimistic and optimistic estimates. That, however, may not be appropriate in many situations. In practice, calculating the most likely estimate accurately, like the other estimating elements, is typically beneficial. Three-point estimating produces durations or cost numbers in two ways one is a PERT distribution and the other one is a triangular distribution as shown in figure.

Figure 2: PERT Probability Density Curve and Standard Deviations

PERT

PERT (Program Evaluation and Review Technique) is an advanced project scheduling and management system. PERT is generally utilized as a complement to the Critical Path Method when it comes to activity scheduling. It may, however, be used for single-item and activity estimations. The PERT distribution is based on three-point estimate values. It may be used at all levels of planning, from individual actions to major projects. Finding the correct level of granularity for meaningful estimates, on the other hand, may need considerable critical and conceptual thought. Overweighting the ‘most probable' estimate is part of the PERT technique. It converts a three-point estimate into a bell-shaped curve, allowing probabilities of predicted value ranges to be calculated .

Differences between Triangular and PERT Distribution

The PERT method converts the three-point estimate into a bell-shaped, fairly normally distributed curve, while the triangular distribution consists mostly of the three estimated points. As a consequence, it may be used to calculate the probability of projected time ranges. Figure 1 depicts the differences between the PERT distribution, the triangular distribution, and a presentation of the three-point estimate as if it were a normal distribution. The areas underneath the probability distribution curves indicate the cumulative probabilities of each range of estimates. Typically, these ranges are computed by multiplying the expected value +/- standard deviation by one, two, or three. Figure 2 illustrates this: This triangular distribution has the following formula  :

(O + M + P) / 3

This PERT distribution's formula is as follows:

(O + 4⋅M + P) / 6

where:

E = Expected amount of time or cost

O = Optimistic estimate

M = Most likely estimate

P = Pessimistic estimate

Comparison of Estimation Techniques

	Analogous Estimating	Parametric Estimating	Bottom-up Estimating	Expert Judgment	Three-Point Estimating
Input Data	Data from the past or the market: the values of previous comparable initiatives	Data from the past or the market: the values of previous comparable initiatives	Activities & their scope of work	The professionals' knowledge and experience	Techniques for making estimates
Method	Historic values for comparable sorts of work are adopted and adjusted (top-down)	Using historical data to estimate the present project's cost per parameter unit.	Work breakdown structure (WBS) cost estimations at a granular level and resource needs aggregation for a project or a portion of a project	Experts provide estimates of the resources required to perform the job within the scope of the project, either from the top-down or from the bottom-up.	Three-point cost estimates such as optimistic, pessimistic, and most probable are produced using one of the previously outlined approaches and are then converted into a weighted average value based on the Pert/Beta distribution or triangular.
Output Type	Estimated costs for each activity of the project	Estimated costs for each activity or the project	Estimated costs for each activity or the project	Several	Improved estimates of costs, aswell as the standard deviation of those costs

Limitations

Where the project cost estimation techniques provide a good way to calculate the overall cost of the project, these techniques have some limitations as well. Applications of each techniques varies from project to project and their complexities. In case of analogous estimation, it is applicable at the very basic level of the project and it does not provide the precision estimates. It is appropriate at initial planning phases of the project rather than in execution phases. On the other hand, Parametric estimation undoubtedly is an accurate estimation technique, but it consumes more time and resources in preparing the model and gather historical data from the past projects to apply on current project for estimation. It is the riskiest estimation method as inaccuracy of model will affect the project on which it has been applied.

Bottom up estimation also has limitations in certain dimensions, as it does not provide the accurate estimate of the project as its estimate based on the sum of the activities of the project. It ignores the additional effort required of integrating the activities, while executing the enterprise and complex projects. On the contrary, expert judgement also has some disadvantages as it is also very expensive and time consuming, as the company needs to hire an expert from the outside in this method. Lastly, in three-point estimation, there is not any major limitation, but it a lot of time to provide the estimate for both optimistic, pessimistic and most likely for each task.

Conclusion

The methodologies of cost estimation recommended by the PMBOK have been reviewed in this article. It is worth noting that the estimates' degree of information and complexity tends to rise as the project progresses. Rough orders of magnitude (ROM) estimates is the only kind of estimation available at the start phase. Analogous, bottom-up, and parametric estimating methodologies, which may only be accessible later in a project's life cycle, are frequently required for definitive estimates. The methods that produce the most precise cost estimates are generally parametric and bottom-up estimates. They're typically employed when the budget has to be re-evaluated and a fresh estimate included at the end. Estimates that are more exact, such as parametric estimates based on historical statistical correlations of comparable projects, are not accessible in many projects. In such cases, the three-point estimation method is an effective way to analyse and balance subject matter expert estimates or top down estimation technique. The PERT distribution is undoubtedly the most precise method for condensing these worst-case, best-case, and most likely possibilities into a single value. The standard deviation is used to account for both the inherent errors and the possible dispersion of estimates. This might explain why, despite the fact that PERT has been available for decades and could have been used by our grandparents, it is still a popular tool for project estimating and scheduling.

Annotated bibliography

H. Kwon and C. W. Kang, “Improving Project Budget Estimation Accuracy and Precision by Analyzing Reserves for Both Identified and Unidentified Risks,” Project Management Journal, vol. 50, no. 1, pp. 86–100. This article provides the reader important information about how to estimate the budget accurately, when is the best time to calculate the budget and which cost estimation method is the optimal method for all types of project.

D. A. N. Gregory K. Mislick, Cost Estimation: Methods and Tools. This E-book provides the overview of all cost estimation methods and tools to estimate the cost for all types of project. It has detailed description of estimated tools which can estimate cost of enterprise projects with maximum precision.

R. T. Hughes, “Expert judgement as an estimating method,” Information and Software Technology, vol. 38, no. 2, pp. 67–75, Jan. 1996. This article gives the reader an important information about expert judgment-based estimates of projects specifically in information technology and software domain

C. E. Clark, “Letter to the Editor—The PERT Model for the Distribution of an Activity Time,” Operations Research, vol. 10, no. 3, pp. 405–406, Jun. 1962. This article guides the reader how to use the PERT distribution, estimate the activity duration and cost accurately and how it is efficient method as compared to other estimation methods.