Cost Estimation Techniques for Projects

Abstract

Cost estimation techniques are the methods that all the project managers use in order to calculate the total cost of a project before it even starts. How much the project will cost is a question that all the stakeholders will make when they are going to be informed about the project. So it is important to make use of numerous techniques in order to estimate fast and as accurate as possible the cost.

The estimated cost includes, the cost of human hours that is why it is also necessary to estimate first the duration of the project, the cost of the equipment and the materials that are required for the project, as well as any contingency cost.

Estimating the cost of the project always include a lot of uncertainty. This uncertainty derives from the fact that every project is unique, so important role plays the experience of the manager with similar projects. Moreover, the planning horizon can affect the quality of estimation, meaning that the more distant the project is the less accurate the cost estimation. The complexity and the duration of the project can affect the uncertainty of the estimation too. The longer the duration of the project is, the bigger the uncertainty for the cost estimation. Lastly, the people that are involved with the project always come with an uncertainty as for example if the members of the team have worked together before they will need less time to start performing as a team.

In this article there are going to be analyzed the most important techniques that project managers use in order to estimate the cost of a project. These techniques are the expert judgment technique, the analogous estimating, the parametric estimating, the three point estimating, the bottom up estimating, the reserve analysis and the vendor bid analysis.

These techniques differ to each other, to the point that some need more time to estimate the cost, others are cheaper than others and some are more accurate. Project managers have to consider all the parameters possible and use the appropriate technique for that moment or a combination of techniques.

Cost Estimation Techniques

Expert judgment

This technique is one of the most quick and easy technique to implement and requires no resources. This is why it is mostly used at the very beginning when there are no data available. It is based on the experience and knowledge that the project manager has on this kind of project and his ability to foresee things. If the manager is not so experienced he can still use the expert judgement of other people with hands on experience, but he has to make sure that they will have the same understanding for the project as him.

A disadvantage of this technique is that the manager may not be able to actually find an expert for the specific project and sometimes the expert may be biased for the project and make mistake.

Analogous Estimating

In analogous estimating technique, the cost of the current project is estimated by comparing it with a similar project that has been already finished by the organization. The project manager has to uses historical data in order to find the most relevant project that matches more closely the profile of the current project. Since all the projects are unique the manager most of the times has to make the necessary changes in order to adjust the current cost estimation to the known differences of the two projects, so he is using his expert judgement to this technique too.

For example if a company is developing webpages for other companies and has finished a web page in one moth with cost of 5000 € and now has to build a similar web page, they can estimate the same price and time for the new project.

This technique is also used at the beginning stages of a project when there is not too much detail about it. It can provide managers with fast results with low expenses but its results are not very reliable and they are dependent on the existence of past projects in the company.

Parametric Estimating

The parametric cost estimating technique except from historical data uses also statistical data from other projects. It uses the statistical data of the key cost drivers’ parameters to estimate the cost of the new project.

For example, a software company knows that its cost is 2 € per line of code. So if they estimate that the project will be around 5000 lines they can estimate a total cost of 10.000 €. Many projects have more than one key cost driver parameter that need to be taken into account.

This is a more scientific technique that provides more accurate results due to the usage of average known rates. It is also fast and cheap but its accuracy relies on the quality of the data. If the statistical data are old or obsolete due to changes in the equipment for example, the results may not be accurate enough.

Three point Estimating

In order to reduce as much as possible the uncertainties and risks the three point estimating technique is used. In this technique instead of making one cost estimation, the project manager has to make three different estimations, each one corresponding to one of the following estimate types:

Most Likely Cost (ML): This estimation considers that everything will be executed as usual and the project will run as planned.

Pessimistic Cost (P): This estimation considers the worst case scenario, when everything will go wrong and the cost will be greater than usual.

Optimistic Cost (O): This estimation considers the best case scenario, assuming that everything will roll better than originally planned and the cost will be lower.

After making these three estimations a weighted average of these is calculated. The most likely cost has a weight of 4 while the pessimistic and optimistic cost have a weight of 1. So the final estimated cost is calculated from the next formula:

Final Cost (F) = ( O + 4 * ML + P ) / 6

For example a company that renovates houses know that on average the most likely cost for the renovation of a house is 30.000 €. But if the house is in a very bad condition and needs changes also in the electricals and the water pipes the cost may reach up to 45.000 €. On the contrary if the house is well reserved the cost can be only 25.000 € With the use of the above formula the company can estimate the cost as:

F = (25.000 + 4 * 30.000 + 45.000) / 6 = 31.666 €

The three estimations at the beginning can be made with the use of other techniques that have already described or will be described next. The advantage of this technique is that reduces the uncertainties and sets boundaries on the expectations. Moreover, when considering the worst and the best case scenario it becomes easier to provide a more accurate most likely scenario. The disadvantages are that instead of one, the project manager has to make three estimation which require more work and time and they still remain estimations that can be totally wrong.

Bottom Up Estimating

This technique is used when required more accurate results. The project manager breaks down the project into small activities and estimates with great level of detail the cost for each activity separately. The estimated cost of each activity at the bottom level are then rolled up to calculate the overall cost estimation of the project. The more detailed each activity is the more accurate the result of the technique will be at the end.

For example a company that paints houses when books one new job, will have to separate the house to each room, measure the total surface of each wall and what color it needs to be painted. Then check the prices for each color and calculate the total cost of the paint. After that it needs to estimate how much time will need to paint the whole house in order to calculate the labor hours. Finally, the specific equipment that is required for the job has to be also defined precisely.

The disadvantages of this technique is that requires the most time of all the techniques and the most money as well. Especially for complex projects it can be very challenging to divide the project into small individual activities. Moreover, during the early stages, it may not be possible to perform this technique due to the lack of detail that might exist for the project. But despite all these, this technique provides the most accurate and reliable results of all the techniques.

Reserve Analysis

When estimating the cost of a project it is reasonable to include some contingency reserves in order to account also any uncertainties that exist. These reserves may be a fixed number, a percentage of the estimated cost or even they can be calculated separately.

The manager can allocate the reserves in different points in order to establish buffers for some activities with high risks that can allow the smooth flow of the project. He can allocate them also in different phases of the project in order to match the delivery time as much as possible with the planned timetable. The amount of the reserves that required for each project depends on the level of uncertainty for the projects. It is common to use reserves of 10% – 20% for project with high risks and uncertainties while it may only require 0% - 5% for projects with low uncertainties.

An example in which is necessary to make use of this method is the following. A software company that writes code for its customers always aims to deliver a code without problems. But as the manager knows it is almost impossible to come up with a bug free code from the first time. So he has to estimate an amount of time and resources that are required in order to fix the bugs of the code. These bugs are not known from the beginning and they were not made intantionally. But when using the reserve analysis and taking into account the uncertainties the manager will consider them.

Vendor Bid Analysis

The last technique is referred to specific cases when a product is provided by vendors or a service has been outsourced. When vendors exist the company can make a request for proposal to the vendors in order to estimate the cost for the specific product or service. The proposal is sent to some vendors that the company knows that they are qualified and reliable for this kind of work. This request for proposal should describe the job in deep detail and the level of quality that is required in order the vendors to make an accurate estimation. So, after the proposal is sent, it is the vendors’ job to do the cost estimation.

Then the project manager collects all the responses with the estimated cost and the duration that is required for the job from the vendors. It is now his job to evaluate the proposals and determine the range of the cost for the service.

An example of this technique is when a company wants to move its offices to another building but does not want to spend time on doing it on its own. At this case it can contact some transportation companies and ask them to give a proposal for the specific movement. After gathering their replies the project manager can decide which vendor fits best their requirements.

The disadvantage of this method is that relies on the capability and the knowledge of the vendors and the company does not gain any knowledge for future project estimation. On the other hand, all the job is done by the vendors so the company does not have to spend any resources in order to estimate the specific cost.

Estimating Pitfalls

When making estimations there are some common pitfalls that the project managers fall into. The most common of them are the following:

• Insufficient defined scope of project: This can occur when the project is not broken down far enough or some works have been misinterpreted.

• Omissions: This happens when the estimator forgets to take into account important things that may result in different final cost.

• Rampant optimism: It occurs when in the estimation is consider only the best case scenario.

• Failure to conclude risks and uncertainty: When ignoring the risks and uncertainties of the project, can lead to a very false estimation.

• Time pressure: Most of the times the project managers are working under restrict deadlines that can lead to mistakes in the cost estimation.

• External pressure: Moreover many times they are told to achieve specific cost, timeline and quality that they may be unrealistic.

• Estimator and task performer fail to communicate: When the estimator and the task performer are two different persons they may have different level of skills or different view for the task that might lead to problems

Application

The big question now is which technique for cost estimation should a manager use. The point is that there is not a method that is better than the others in all the aspects. So the project manager has to consider some parameters first in order to decide which technique to use.

The first criteria that the manager has to consider is in which phase of the project are they currently are. At early stages of the project there are not too much details and information about it, so the manager has to use one of the top down techniques like the expert judgement, the analogous estimating or the parametric estimating if he has access to statistical data. In later stages, when the project is defined in details he can use a bottom up technique in order to gain more accurate results.

The other criteria is how much accuracy in the estimation is required. There are some projects that additional accuracy in the estimation will not make any difference, so the manager can use on of the top down techniques. The accuracy is also analogue to the cost and time spent on the estimation. The more accurate a method is the more expensive and time consuming it is too. So the manager has to consider if it will add any value by making a more accurate estimation, or he will add only cost and time to the project.

Lastly, the manager has to recognize how much uncertainty is there in the project. If there is too much uncertainty a reserve analysis is mandatory and a top down technique will provide a better perception of the total cost. On the other hand, while the project continues the uncertainties are getting smaller and a bottom up technique can be used for accurate results.

If there are important vendors in the project, a vendor bid analysis will be very useful.

Overall, only one estimation technique will not give the best result all the time. So the project manager has to consider of using a combination of them that each one will fit his requirement better for that phase of the project.