EM660 PROJECT MANAGEMENT

Class 6

Class 6 Agenda • Finish Crashing • Case Study 3• Chapter 14 Pricing and Estimating• Chapter 15 Cost Control• Chapter 16 Trade-off Analysis

Chapter 14 Cost Estimating (p. 574)

Cost estimating is derived from prior experience.- Similar work- Professional reference material- Market surveys- Operations and process knowledge- Estimating software & databases- Interviews with subject experts.Estimating tools can be formalized in manuals.

Types of EstimatesCost estimates fall into two groups: conceptual estimates and detailed estimates. Each can be broadly defined as follows:Conceptual Estimate

Conceptual estimating or parametric estimating is the process of establishing a project’s cost, often before a drawing of a facility has been developed.

Detailed EstimateThe detailed construction estimate is the product of a process whereby the cost of a proposed construction project is predicted. The estimate is prepared by breaking down the items of work in an orderly and logical basis, determining the cost of each item from experience, and summarizing the total.

Most Accurate• Estimates based on quotations

Classes of Estimates (p. 575)Class Types Accuracy

I Definitive +/- 5%

II Capital Cost +/- 10 to 15%

III Appropriation with some Capital Cost

+/- 15 to 20%

IV Appropriation +/- 20 to 25%

V Feasibility +/- 25 to 35%

VI Order of Magnitude > +/- 35%

Inputs to Estimating

• Project Scope• WBS• Network Diagram• Schedule• Pricing Policy• Culture & Systems

Once costs have been estimated, it’s time to have a kick-off meeting to further define them.

Types of Costs

• Costs can either be Variable or Fixed.– Variable costs change with the amount of

use or consumption (labor & materials).– Fixed costs do not change (set-up costs).

• Costs can either be Direct or Indirect.– Direct costs are directly attributable to the

project work.– Indirect costs benefit more than one

project.

Direct Costs

Costs usually charged directly:• Project staff • Consultants • Project supplies • Publications • Travel • Training

Indirect Costs

Costs usually allocated indirectly:• Utilities • Rent • Audit and legal • Administrative staff • Equipment rental • Petrol • Maintenance • Generator • Security • Telephone

Labor and OverheadFunctional managers determine the labor hours required for each project task, then calculate the dollars using the appropriate labor rates.

-Projecting labor rates over projects longer than one year are done with historical averages.

Overhead rates generally remain fairly constant, but management decides how to best distribute the cost.

- New projects may have lower overhead rates so more of their budget is available for R&D.

Materials/Support Costs (p. 586)Calculating material costs is time consuming. A costed bill of material is prepared for all vendor purchased parts, including scrap factors and shelf life of perishable products.

-A procurement plan is then developed to monitor spending, forecast inventory, and look for variances.

Support costs, such a travel, freight, computer hours and consulting are budgeted as a percentage into the cost of materials.

Pricing out the Work (p. 589)• Detailed WBS costs – pricing out each task creates a cost summary sheet• Manpower curves – the project manager

needs to smooth out peaks and valleys; this is preferred by the functional managers

Components of the Cost BudgetPlanning Steps Examples

8. Cost Budget Compilation of individual cost estimates

7. Management Reserve Off-sets salary, price, material increases

6. Cost Baseline Baseline; only changes are approved ones

5. Contingency Reserve Used to off-set opportunities or threats

4. Project Projected project costs

3. Control Account Higher level oversight by function/dept.

2. Work Packages Detailed cost for each WBS element

1. Activities Lowest component possible for estimating

The rolling up process is called cost aggregation.

Dangers of Low-Ball Pricing (p. 599)While being the lowest cost bidder may attract business, customers are increasingly concerned about cost realism and the ability to perform under contract. A compliant, sound, technical and management proposal, based on past experience with realistic, well-documented cost figures, is often chosen over the lowest bidder, who may project a risky image regarding technical performance, cost, or schedule.

Cost vs. Quality (p. 606)When faced with inflexible schedules or cost overruns, executives are tempted to sacrifice quality to keep costs in line. While they assume cost and quality are linearly related, the following chart tells the tale:

If cost cutting is necessary, conduct an impact study or eliminate non-competitive projects.

Project Costs 85-90% 10-15%

Tangible Quality 10% 90%

Time

Time Value of Money (p. 614)The time value of money says $1 now (cash in hand) is worth more now than at some future date.Looking at it a different way, companies having a future cash target want to know how much they need to invest today to hit that target.Three methods to evaluate project cash flows are:

1. Net Present Value (NPV)2. Internal Rate of Return (IRR)3. Payback Period

Which Project to Choose?Available Funds = $3,000,000

Project Cost Payback PeriodUpgrade Production Line $2 M 2 yrEmissions Reduction $1.5M ---Reduce Safety Risks $1M ---Upgrade packaging sys. $2M 1 yr

Net Present Value

$10,000 target, with 10% interest

Year Cash Inflow Present Value

1 $1,000 $909

2 $2,000 $1,653

3 $2,000 $1,503

4 $5,000 $3,415

5 $2,000 $1,242

Present value of inflows $8,722

Less initial investment $10,000

NET PRESENT VALUE - $1,278

Where: FV = Future Value PV = Present Value k = Interest Rate n = Number of yrs

The decision criteria for using NPV is:1)If the NPV is > 0, accept the project.2)If the NPV is negative, reject the project.

Internal Rate of Return• Companies that use IRR to compare projects, purchases or investments typically have a calculation template to make decisions.

• The general rule is that you choose the project with the highest IRR, especially if it is more than your target or desired interest rate.

Example: You have 2 projects to choose from; Project A with an IRR of 21% or Project B with an IRR of 15%. Which do you prefer?

Payback PeriodPayback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. Uncertainties in future cash flows (which are typically estimates or extrapolations) make companies shy away from long-term payback periods.

Another reason to prefer short-term paybacks is the rapid obsolescence rate of technologies.

Example: You have 2 projects to choose from; Project A has a payback period of 6 months or Project B with payback period of 18 months. Which do you prefer?

Graphical Analysis of Discounted Cash Flows

Low Bid Dilemma

• The low cost may be perceived by the customer as unrealistic• May be unnecessarily low thus eroding profits• Price may be irrelevent to the bid objective, such as entering new markets• Low pricing without market information is meaningless, price level is relative to competitive prices, customer’s budget, and the

bidder’s cost estimate• The customer may have budgeted for a higher price

Chapter 15 Cost Control

Cost Control is not only monitoring costs and recording data, but also analyzing the data in order to take corrective action before it is too late.

Additionally, cost control should be practiced by all personnel involved in the project, not just the project manager.

Cost Controls (p.634)The WBS is where all costs and controls emanate. If you want to know where the money is going, go to the lowest denominator. Cost controls provide:

1.Verification – compare the actual to plans.2.Decision making – reports provide feedback, identify deviations and variances, and highlight opportunities to take corrective action sooner.

Generating cost codes(p. 637)

A cost account (or control account) is an established level where the work breakdown structure costs get assigned to functional departments. This is where the actual direct labor, material and overhead costs are compiled for management control purposes.As the work is completed, the costs are assigned to a specific cost account (see figures 15-4 thru 15-6 – page 638). The result is reported (p. 643).

Budgets (p. 644)A budget is a compilation of individual cost estimates. Meeting the cost baseline is a measure of project success.

The project budget must be SMART and based on contractually negotiated costs, historical data, best estimates, or industrial engineering standards. The budget must identify planned manpower requirements, contract allocated changes, and dips into the management reserve.

Variance and Earned Value (p. 647)Cost account reports (pages & pages of rows & rows of figures) make it difficult to determine project status, except in a “bottom line” respect.• Looking only at cost variances ignores work scheduled vs. work accomplished.• Looking only at work performance and you miss the cost impact.

The Earned Value calculations join work & cost.

Variance and Earned ValueThe PMP certification test stresses knowing the following terms and formulas (next slide).

Acronym Term Interpretation

PV Planned Value Estimated value of planned work.

EV Earned Value Estimated value of actual work.

AC Actual Cost What is the actual cost of the work?

BAC Budget @ Completion How much did we budget for the project?

EAC Estimate @ Completion What is our current expectation of budget?

ETC Estimate to Complete How much more do we expect to spend?

VAC Variance @ Completion How much over or under did we end up?

Acronym Term Interpretation

Cost Variance (CV)

EV - AC NEGATIVE is over budget, POSITIVE is under budget.

Schedule Variance (SV)

EV – PV NEGATIVE is behind schedule, POSITIVE is ahead of schedule.

Cost Performance Index (CPI)

EV/PC We are getting $ ______worth of work for every $1 spent. Over 1 is good, under 1 is under performing.

Schedule Performance Index (SPI)

EV/PV We are (only) progressing at _________% of the original rate planned. Over 100% is good, less is under performing.

Estimate at Completion (EAC)

BAC/CPI As of now, how much do we expect the total project to cost? ________________What is our current expectation of budget?

Estimate to Complete (ETC)

EAC – AC How much more will the project cost?

Variance at Completion (VAC)

BAC - EAC How much over or under did we end up?

Cost Justification (p. 668)Project pricing is often based upon best guesses rather than concrete estimates.• If cost is not your primary driver, then hitting your budget may be enough.• If you are in a competitive bid process, costing is generally scrutinized & justified for approval.

Forward pricing, weighted averages, margins and allowances can help cover hidden costs.

Reporting Variances & Controls

The earned value system creates reports:

• Performance Reports• Status Reports• Projection Reports• Exception Reports

Once reviewed, management may:1) Approve2) Authorize3) Take Action

Cost Overrun Dilemma

• Alternatives:• Cut costs-reduce scope, reduce quality• Pull the plug and cancel Project• Accept Overrun

Chapter 16 Trade Off AnalysisThe project manager constantly works to keep the “triple constraints” in line. Situations arise that make this difficult, requiring trade-offs.

Many factors go into trade-off decisions; sometimes it is not possible to sacrifice one item withoutaffecting the others.

MethodologyProject managers need to identify the problem, determine what needs to change, and then find a win-win situation if possible.

Situation 1: Performance Must HoldCustomer is demanding or quality reputation must be maintained.• Add extra resources.• Change scope to delete work.• Shift labor from slack to critical path.• Try concurrent engineering; parallel paths.

It may be possible that additional resources and overtime may be used to meet the time target; costs will likely go up as a result.

Situation 2: Costs Remain Fixed

When costs are fixed, performance will vary as a function of time. Performance requirements must be clearly written to determine what may be excluded or included.• Cut down on unnecessary paperwork.• Cross train; become more cross-functional.• Farm work out or delegate.To maintain costs & not let performance suffer, system improvements need to be sought.

Situation 3: Time Remains FixedWhen time is fixed, performance will vary as a function of cost. The question will become: can we pass off the cost/quality problem to the customer, and do we want any repeat business?

Work with the customer to see if they can help.

• See if the customer is really ready for product.• Give early warning & coordinate w/customer.• They may be flexible to certain suggestions.

Situation 4: No Constraints Fixed

This is where your project is suffering (or is trending that way) one or more triple constraint issues.Generally, brainstorming will create a list of potential corrective actions, which will be compared to the project and/or company objectives. Trade-offs are determined and approved, then the entire project team commits to the revision.

Project Planning: A Roadmap• Develop project charter• Establish work breakdown structure• Analyze sequencing relationships• Estimate “normal” activity durations• Perform network calculations and validate/revise initial• schedule• Perform time-cost tradeoff analysis• Load resources to activities and resolve any resource/workload

imbalances• Develop budget and cash flow plan based on analysis of direct and

indirect costs• Analyze schedule risk• Monitor and control project

Crashing the Network toShorten the Project Duration

• It always makes sense to focus on activities that are on the critical path

• That being said, there are numerous heuristics for choosing activities to crash

• In this class, we will focus what is called the lowest acceleration cost heuristic

• Think of this as “where can I get the most bang for my buck” i.e., what is most cost effective

Other Heuristics for ConsideringWhat to Crash

• Crashing so-called bottleneck activities (i.e., activities that are on multiple critical paths)

• Crashing activities that occur relatively early in the project and are labor intensive

• Crashing activities with relatively long durations

• Crashing activities that are not likely to cause quality problems if crashed

Time/Cost Trade-off Analysis

• You might think that total project costs will increase when we begin to crash activities

• But, total project costs consist of both indirect (project-based) costs (PBC) and activity-based costs (ABC)

• – ABC goes up when we crash activities in an effort to finish the project early

• – But, PBC (the indirect costs) goes down if we finish the project early

Steps for PerformingTime/Cost Trade-off Analysis

• Estimate project-based (indirect) cost per unit time• Select critical activity (or activities, if there are multiple critical

paths) that are good candidates for crashing (use lowest acceleration cost heuristic)

• Incrementally crash (i.e., shave a day off of) the selected activity where that is possible (or activities, if there are multiple critical paths and no bottleneck activities that are economical to crash)

Steps for Performing Time/CostTrade-off Analysis

• Keep track of the activity-based (direct) cost of crashing the selected activity (or activities) and indirect cost savings associated with reducing overall project duration

• Recalculate the forward pass and check for changes in critical path

• Continue until acceptable duration is reached or it becomes uneconomical to continue crashing the project

Using the Lowest AccelerationCost Heuristic to Figure out What

to Crash• Considers both the normal cost and the crash cost• Normal cost is defined as the cost associated with the most

economical way of doing something and results in what we call the normal activity duration

• Crash cost is defined as the cost associated with the fastest way of doing something and results in what we call the crash duration

• Acceleration cost = (Crash Cost – Normal Cost)• ($/day) (Normal Duration – Crash Duration)

The Project Trade-Off Twinkie• Think of projects as cream

filled Twinkies. When we squeeze one corner of the Twinkie the filling oozes out the others. That’s an elegant example of a project trade-off

Project Trade-Off Twinkie

• Take away resources and duration will increase

• Increase the delivered business value, the cost and duration will both rise.

• Increase the certainty of the finishing date, the cost will increase as we “buy” risk insurance.

Other Possible Actions to Utilize

• Overtime• Double shifts• Expediting• Additional Manpower• More Money• Change vendors• Change specifications• Shift of project resources• Waiving equipment inspections• Change in statement of work• Change in work breakdown structure

Next week

• Chapter 17 Risk Management• Case Study 4 Presentation• Project Proposals are Due March 26th• Quiz 2 Next Week on March 5th