Cost Estimation Techniques for Projects

Developed by Nikolaos Gavriilidis

Cost estimation techniques are methods, used by project managers 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 stakeholders will make when they are being advised about the project. Therefore, it is important to make use of numerous techniques in order to estimate cost fast and accurately.

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

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

Introduction

Figure 1: Accuracy of Estimating

It is crucial for the project managers to estimate the cost of the project. This cost includes:

• the cost of human hours and in accordance necessary prior estimation of the duration of the project
• the cost of the equipment and
• the cost of materials that are required for the project, as well as any
• contingency cost.

Estimating the cost of the project always includes a lot of uncertainty. This uncertainty derives from the fact that every project is unique, so the experience of the manager with similar projects plays important role. Generally, the bigger the size of the project, the more accuracy required but also the most difficult to achieve this accuracy. Moreover, 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, the bigger the uncertainty for the cost estimation. Lastly, people involved with the project always come with an uncertainty, as for example if the members of a team have worked together before, they will need less time to start performing as a team.

Cost Estimation Techniques

Expert Judgment

This technique is one of the most quick and easy techniques to implement and requires no resources. It is mostly used at the very beginning, when there are no data available. It is based on the experience and knowledge 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 with 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 mistakes.

Analogous Estimate

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 use historical data in order to find the most relevant project that matches closely the profile of the current project. Since all the projects are unique, most of the times the manager has to make the necessary changes, so as to adjust the current cost estimation to the known differences of the two projects, thus he uses his expert judgement to this technique, too.

For example, we assume that a company that develops webpages for other companies, has finished a web page in one month with cost of 5000 €. Now, the same company has to build a similar web page for another company, so 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 much detail available. 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 same company.

Parametric Estimate

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 driver parameters to estimate the cost of the new project.

For example, a software company knows that the cost is 2 € per line of code. Hence, 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 parameters that need to be taken into account.

This is a more scientific technique that provides more accurate results due to the use 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 Estimate

The three point estimating technique is used, in order to reduce as much as possible the uncertainties and risks. 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 same is calculated. The most likely cost has a weight of 4, while the pessimistic and optimistic cost have a weight of 1. Therefore, the final estimated cost is calculated from the next formula:

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

For example, a renovation company knows 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 preserved the cost may only be 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 different estimations can be made by using other techniques that have already been described. The advantage of this technique is that it 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 estimations, which require more work and time, but still remain estimations that can be totally wrong.

Bottom Up Estimate

This technique is used when more accurate results are required. 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 is then rolled up, to calculate the overall cost of the project. The more detailed each activity is presented, the more accurate the result of the technique will be at the end.

For example, a painting company intends to paint a house. First, they 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 how much time is required for painting the whole house needs to be estimated, in order to calculate the labor hours. Finally, the specific equipment that is required for the job has to be defined precisely.

A disadvantage of this technique are that it 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 take into 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 is required for each project, depends on the level of uncertainty for the projects. It is common to use reserves of 10% – 20% for projects with high risks and uncertainties while it may only require 0% - 5% for projects with low uncertainties.

An example in which it is necessary to make use of this method is the following. A software company that develops codes for its customers always aims to deliver a code without problems. But the manager knows that it is almost impossible to come up with a bug free code from the first time. Therefore, 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 intentionally, but by using the reserve analysis and taking into account the uncertainties, the manager can now consider them, too.

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 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, so that the vendors can make an accurate estimation. After the proposal is sent, it is the vendors’ job to do the cost estimation.

Then the project manager collects all the responses from the vendors with the estimated cost and the duration. 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 it 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 project managers fall into. The most common 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 only the best case scenario is considered.

• Failure to conclude risks and uncertainty: 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 strict 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 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

Figure 2: Comparing the Cost Estimation Techniques

The big question now is which cost estimation technique should a manager use. The point is that there is not a technique that is better than the others in all the aspects. Hence, 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 they currently are. At early stages of the project, there is lack of details and information about it, thus the manager has to use one of the top down techniques like the expert judgement, the analogous estimate or the parametric estimate, if he has access to statistical data. In later stages, when the project is defined with details, he can use a bottom up technique in order to gain more accurate results.

Other criteria is the level accuracy required for the estimation. There are some projects that additional accuracy in the estimation will not make any difference, so the manager can use one of the top down techniques. The accuracy is also analogue to the cost and time spent for the estimation. The more accurate a method is, the more expensive and time consuming it is. Therefore, 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 the amount of uncertainty existing 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 would be very useful.

In conclusion, only one estimation technique will not give the best result all the times. Hence, the project manager has to consider using a combination, so that each one fits better his requirement for each specific phase of the project.

Annotated Bibliography

• Paul Newton (2015), Managing the Project Budget, Project Skills.

Summary: This book describes how to manage your budget when you take over a project. At the beginning, it provides information concerning how a manager can estimate the cost of a project, in order to set the budget. Then it describes how to manage the cost during the project, thus it will remain inside the budget that has been set.

• Gary R. Heerkens, PMP (2002), Project Management.

Summary: This book describes project management tools and techniques used during the entire project management process. But instead of providing information only about their proper use, it describes also the principles behind their use. Thus, project managers can understand both how and why they need to do things.

• Saylor Foundation, Project Management in a Complex World.

Summary: This book provides an overview of project management and introduces the challenges that come with project complexity. It provides also a tool for profiling a project based on the complexity, and describes the different project management approaches for each project profile.