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Chapter Outline
PROJECT PROFILE
Sochi Olympics – What’s the Cost of National Prestige?
8.1 COST MANAGEMENT
Direct vs. Indirect Costs
Recurring vs. Nonrecurring Costs
Fixed vs. Variable Costs
Normal vs. Expedited Costs
8.2 COST ESTIMATION
Learning Curves in Cost Estimation
Software Project Estimation – Function Points
Problems with Cost Estimation
PROJECT MANAGEMENT RESEARCH IN BRIEF
Software Cost Estimation
PROJECT MANAGEMENT RESEARCH IN BRIEF
“Delusion and Deception” Taking Place in Large Infrastructure Projects
8.3 CREATING A PROJECT BUDGET
Top-Down Budgeting
Bottom-Up Budgeting
Activity-Based Costing
Summary
Key Terms
Solved Problems
Discussion Questions Problems
Case Study 8.1: The Hidden Costs of Infrastructure Projects – The Case of Building
Dams
Case Study 8.2: Boston’s Central Artery/Tunnel Project
Internet Exercises
PMP Certification Sample Questions
Integrated Project Developing the Cost Estimates and Budget
Notes
1. DIRECT VS. INDIRECT COSTS
2. RECURRING VS. NON-RECURRING COSTS
3. FIXED VS. VARIABLE COSTS
4. NORMAL VS. EXPEDITED COSTS
1. LOW INITIAL ESTIMATES
2. UNEXPECTED TECHNICAL DIFFICULTIES
3. LACK OF DEFINITION
4. SPECIFICATION CHANGES
5. EXTERNAL FACTORS
8.1 Describe an environment in which it would be common to bid for contracts with low profit margins. What does this environment suggest about the competition levels?
Low barriers to entry, a lack of economies of scale, easier access to technology and, often times, powerful buyers commonly characterize an environment with very low profit margins. The relative ease of competing in such industries increases competition levels both domestically and internationally.
8.2 How has the global economy affected the importance of cost estimation and cost control for many project organizations?
Globalization of the economy has resulted in lower barriers to trade, market-driven economies, deregulation and privatization. These effects have created greater competition and larger markets. With the ease of competing internationally, companies need to be sure to provide accurate, competitive bids. Bids need to be low in order to be competitive in the heightened competition of the global economy. Secondly, accuracy takes on new complications when consider bids abroad. Exchange rates, transportation and trade costs all need to be accounted for in the bid. These added costs make cost control in other controllable areas of the project vital. Without tight cost control, the company will not be able to compete with bids of domestic firms.
8.3 Why is cost estimation such an important component of project planning? Discuss how it links together with the Work Breakdown Structure and the project schedule?
Cost estimation, if done correctly, enables a firm to determine if the project will be profitable, if the company can afford the project, and if the project is worth pursuing in general. It also provides the company with a cost range for bidding (in the case of a customer-oriented project). With respect to Work Breakdown Structure and project
schedule, cost estimation is important because it leads to budgeting of monetary and other resources (both material and human). These allocations must coordinate with the Work Breakdown Structure and project schedules prepared by management to figure out if the required resources will be available as needed.
8.4 Imagine you were developing a software package for your company’s intranet. Give examples of the various types of costs (labor, materials, equipment and facilities, subcontractors, etc.) and how they would apply to your project.
Potential costs of creating software package include costs of labor, materials, subcontractors, equipment and facilities, and travel. Software engineers, developers, computer technicians, trainers (for end users), and technical writers would incur labor costs. Material costs may come from printing and creating installation CDs/disks, additional mainframe hardware, memory or accessories, and any printing and paper requirements for user manuals. Developers and contractors may require extra space or equipment. Subcontractors may be used to consult on design and implementation, and may require costs associated with travel if the firm is not local.
8.5 Give reasons both in favor of and against the use of personal time charge as a cost estimate for a project activity.
Using a personal time charge can create a more accurate assessment of time by including a reasonable amount of downtime in estimates of work time. By using the personal time charge, a company can be better compensated for its labor resources, as all time (productive or not) spent on a particular job is a use of human/intellectual resources. However, this charge may appear unwarranted from a customer’s perspective. The personal time charge allows time for unproductive breaks. Customers will most likely be reluctant to pay for unproductive time, resulting in payment disputes.
8.6 Think of an example of parametric estimating in your personal experience, such as the use of a cost multiplier based on a similar, past cost. Did parametric estimating work or not? Discuss the reasons why.
This is a personal example question and should only be applied to students with some project experience.
8.7 Suppose your organization used function point analysis to estimate costs for software projects. How would the expertise level of a recently hired programmer affect your calculation of their function points on a monthly basis when compared to an older, more experienced programmer?
Function point analysis assumes that there are differential challenges with software functions depending upon the resource. A newly hired programmer might rate more of the functions to which he or she is assigned as “Higher Complexity,” which would add extra hours to the time (and therefore, cost) estimates. Complexity estimates determine the costs of variance program features, so the more seasoned and expert the programmer, the lower the overall cost of the sequence.
8.8 Put yourself in the position of a project customer. Would you insist on the cost adjustments associated with learning curve effects or not? Under what circumstances would learning curve costs be appropriately budgeted into a project?
As a customer, the student may not accept fees when the repetitive work (that accounts for the learning curve) is a routine job for the supplier. The reason for this is that the student would be paying for learning effects from which others would reap the benefit. Also, learning effects associated with new employees would be unreasonable to include in project billing. On the other hand, if the repetitive work/learning curve effects were project or customer specific, then budgeting the costs into the project would be appropriate.
8.9 Consider the common problems with project cost estimation and recall a project with which you have been involved. Which of these common problems did you encounter most often? Why?
This is a personal example question and should only be applied to students with some project experience.
8.10 Would you prefer the use of bottom-up or top-down budgeting for project cost control? What are the advantages and disadvantages associated with each approach?
Top-down budgeting would be preferred because it more often results in better cost control. It also draws on experience of top management for reasonable project estimates (e.g., historical costs, etc.). However, these advantages come at a cost. Top-down budgeting can result in friction between top, middle, and lower level managers as the approach results in a zero-sum game (i.e., what one manager receives, another loses).
Bottom-up budgeting has the benefit of being detailed from the very beginning. Costs can be directly tied to WBS and individual tasks. Unfortunately, this process can be time consuming and removes control from top management, which may lead to variances from strategic goals of the project.
8.11 Why do project teams create time-phased budgets? What are their principle strengths?
Time-phased budgets all teams to match the project schedule with the project’s budget. They can also identify milestones for completion of work and budget expenditures. This enables teams to see when and where money was spent. This creates a better idea of where variances occurred and creates better control mechanisms. Moreover, time-phased budgets result in better documentation for future project planning.
8.12 Project contingency can be applied to projects for a variety of reasons. List three of the key reasons why a project organization should consider the application of budget contingency.
First, changes in scope and specifications can occur, creating increased costs. Secondly, rework and interaction fees can be difficult to predict in the initial planning stages. For example, a project may require communication between departments or office branches, which may lead to travel and coordination costs that are unseen prior to implementation (e.g., shipping, etc.). Lastly, uncertainty (especially related to the environment or politics) is a known complication of project work. Changes can occur that restrict the use or availability of resources, which may cause delays in production or create the need for additional accommodations.
A fascinating study that was recently completed by a research group at Oxford University (headed by Professor Bent Flyvbjerg) found that many developing countries engage in large infrastructure projects under the assumption that these are the key to future economic success. A particular case in point is building large scale dams. Demand for electricity has gone up dramatically, particularly in third world countries that are assumed could benefit greatly from the hydropower generated by dams. Flood control, crop irrigation, transportation, and other reasons support the idea that large dams are a universal benefit. However, research suggests that the enormous costs of dam projects are such that countries simply cannot afford them. Close analysis of benefits and drawbacks shows that rarely do countries and contractors take a hard look at the “real” costs of large infrastructure projects like dams; if they did, they would be much more wary of engaging in these projects. This case concludes with some alternatives, such as the policy pursued in Norway of smaller, more eco-friendly dam projects that can produce needed energy but are affordable and environmentally sound.
Questions:
1) Given the history of large cost overruns associated with megadam construction, why do you believe they are so popular, especially in the developing world?
One obvious answer is the prestige they offer, especially in regard to presenting evidence of development and improvement to the national economy. Some developing countries pursue them as a sign of international legitimacy There is also the darker reason that large projects offer the opportunity for large-scale graft and corruption, as has been rumored with the Sochi Olympics construction projects.
2) Develop an argument in support of megadam construction. Develop an argument against these development projects.
This question works well for setting up an in-class debate between groups. The best approach is to first assign students to teams and have them research this question so they come prepared with actual evidence, rather than simple opinion. There are multiple arguments on both sides of the debate, and a thorough response should consider both the benefits and drawbacks of such massive construction projects, though the current longerterm evidence suggests that they are more a curse than a benefit.
The Boston “Big Dig” is a class case of a project that was a monumental failure in terms of cost and duration estimation, as well as a continued problem from a quality perspective. The project was initiated with very questionable estimates for the expected costs, became a “white elephant” in the Boston area, and finally staggered to completion after several years and billions of dollars over budget. This case analyzes the narrative of the development of the “Big Dig” and also looks at several of the chief culprits in its failure, including the general contractor, whose lack of oversight led to cost-cutting and poor quality, the local and state agencies, who routinely looked the other way and were of almost no help with oversight, and the contractors themselves, who used shoddy practices and fraudulent bookkeeping to keep costs down and profits high. The case has been updated to include the tragedy that occurred in 2006 when ceiling bolts gave way in a tunnel and killed a commuter passing underneath. This is a great case for general class discussion, to consider the role that each of the major stakeholders played in the project.
Questions:
1) Consider the following statement: “Government-funded projects intended to serve as ‘prestige projects,’ such as the ‘Big Dig,’ should not be judged on the basis of
cost.” Do you agree or disagree with this statement? Why?
This question asks us whether or not the standard rules of oversight apply to special projects, sometimes termed “prestige projects,” such as the “Big Dig,” the Channel Tunnel, and the Sydney Opera House. The issue is whether we willingly should ignore standard estimation and oversight procedures due to the special nature of these projects. As there is no obvious right or wrong answer, the question leads to good discussion of the benefits and drawbacks of these types of project.
2) Project success is defined as adherence to budget, schedule, functionality (performance), and client satisfaction. Under these criteria, cite evidence that suggests the “Big Dig” project was a success and/or failure.
Clearly, there is very little to recommend the “Big Dig” from any of the standard success criteria. If the tunnel system had performed adequately, perhaps a case may have been made that eventually it would be seen as a success in spite of terrible cost and schedule overruns. However, once the ceiling tiles starting falling and actually killed a passerby, the charge could be made that the project failed on all possible levels of project success.
3) What are the lessons to be learned from the “Big Dig” project? Was this a failure of project estimation or project control by the contractors and local government?
This question has no obvious answer and students should bring in evidence to support either position. Overall, based on the Project Management Research in Brief case in the chapter, Flyvbjerg’s research argues that large capital projects are rife with the potential for fraud and have to be evaluated carefully on that score. The Project Management Research in Brief vignette makes a nice supplement to answering this question.
8.1 Calculate the fully loaded cost of labor for a project team member using the following data:
Hourly rate: $35/hr.
Hours needed: 150
Overhead rate: 55%
Solution: The formula for calculating fully loaded cost of labor is:
8.2 Calculate the fully loaded cost of labor for your Project Engineer using the following data:
Hourly rate: $40/hr
Estimated hours of work: 120
Overhead rate: 65%
Personal time: 15%
Solution: The formula for calculating fully loaded labor costs is:
8.3 Calculate the direct cost of labor for the project team using the following data. What are the costs for the individual project team members? What is the fully loaded cost of labor?
Total Fully Loaded Labor Cost = $9,818
8.4 Assume that overhead is charged on a flat-rate basis. Each member of the project is assigned an overhead charge of $150/week. What would the fully loaded cost of labor be for an employee, given that she is assigned to the project for 200 hours at $10.50/hour?
Solution:
The hours that the employee works (200 hours) would equate to 5 weeks, thus the calculation would show:
=
8.5 Calculate the fully loaded labor costs for members of your project team using the following data. Who is the most expensive member of your team? What proportion of the overall fully loaded cost of labor is taken up by this individual?
Solution:
The fully loaded costs are embedded in the table in the right hand column. The most expensive resource for this project is Todd. His labor costs are approximately 44% of the total fully loaded labor cost for the project.
8.6 Using the following information about work package budgets, complete the overall time-phased budget for your project. (All cost figures are in $ 000’s.) Which are the weeks with the greatest budget expense?
Solution:
The plan and cumulative time-phased budget totals are shown in the bottom two rows of the table. The weeks with the biggest planned expense are Week 3 ($13,000) followed by Week 4 ($12,000). The total cumulative budget for the project is $53,000.
8.7 Given the following information, complete a time-phased budget for your project. (All cost figures are in $ 000’s.) What are weekly planned and cumulative costs for the project?
Solution:
The plan and cumulative time-phased budget totals are shown in the bottom two rows of the table. The total cumulative budget for the project is $49,000.
For the problems 8.8 through 8.10, refer to the chart of learning curve coefficients (unit and total time multipliers) shown below.
8.8 It took MegaTech, Inc. 100,000 labor-hours to produce the first of several oil-drilling rigs for Antarctic exploration. Your company, Natural Resources, Inc., has agreed to purchase the fifth (steady state) oil-drilling rig from MegaTech’s manufacturing yard. Assume that MegaTech experiences a learning rate of 80%. At a labor rate of $35 per hour, what should you, as the purchasing agent, expect to pay for the fifth unit?
TN = T1C
Where TN = Time needed to produce the Nth unit
T1 = Time needed to produce the first unit
C = Learning curve coefficient
Solution:
The table lists the fourth unit learning curve coefficient as .596, assuming a learning rate of 80%. Using the formula, to produce the fifth unit takes:
TN = T1C
Where TN = Time needed to produce the Nth unit
T1 = Time needed to produce the first unit
C = Learning curve coefficient
T5 = (100,000) (.596) = 59,600 hours
To find the cost, multiply the hours by the hourly rate: = (59,600) ($35 per hour) = $2,086,000
8.9 Problem 8 identified how long it should take to complete the fifth oil-drilling platform that Natural Resources plans to purchase. How long should all five oildrilling rigs take to complete?
Solution:
We can look at the total time column in the table associated with a learning rate of 80%. The multiplier is listed as 3.738. Using this value, the total time necessary to complete the five rigs is calculated as:
T5 = (100,000) (3.738) = 373,800 hours to complete all five oil-drilling rigs
8.10 Suppose that you are the assigning costs to a major project to be undertaken this year by your firm, DynoSoft Applications. One particular coding process involves many labor-hours, but highly redundant work. You anticipate a total of 200,000 labor-hours to complete the first iteration of the coding and a learning curve rate of 70%. You are attempting to estimate the cost of the twentieth (steady state) iteration of this coding sequence. Based on this information and a $60 per hour labor rate, what would you expect to budget as the cost of the twentieth iteration? The fortieth iteration?
Solution:
The costs for the 20th and 40th iterations are found as:
20th iteration: (42,800 hours) ($60 per hour) = $2,568,000
40th iteration: (30,000 hours) ($60 per hour) = $1,800,000
8.11 Assume you are a project cost engineer calculating the cost of a repetitive activity for your project. There are a total of 20 iterations of this activity required for the project. The project activity takes 2.5 hours at its steady state rate and the learning rate is 75%. Calculate the initial output time for the first unit produced, using the learning curve formula:
Yx = aXb where:
Yx = the time required for the steady state, x, unit of output
a = the time required for the initial unit of output
X = the number of units to be produced to reach the steady state
b = the slope of the learning curve, represented as: log decimal learning rate/log 2
Solution:
Use the formula to first determine the slope of the learning curve (log decimal learning rate/ log 2):
b = log 0.75/log 2 = -.2877/0.693 = -.415
2.5 hrs. = a (20) –0.415
a = 8.667 hours
8.12 As the manager of the IT group at your insurance firm, you have been asked to develop a cost estimate for upgrades to the computerized accident-reporting and claims adjustment system you have in place. Your system is basic, without many features, but it needs some general modifications, based on complaints from
customers and claims adjusters at your firm. You know that your programmer is capable of handling 3 function points in a person-month and your programmer makes $60,000, so her cost is $5,000 per month. The costs for the project are based on the following requirements:
The complexity weighting for these functions follows a standard formula:
a. Calculate the total estimated number of function points for this project.
b. What is the total expected cost of the project?
Solution:
a. Because we know the estimated complexity for each of the software functions that must be coded and the number of screens for each function, the calculation is relatively straightforward: multiplying, we find that the total function points for this project are estimated to be 220.
b. Your programmer can complete 3 function points per month, so the total number of person-months needed to complete the project is: 220/3 = 73.33. We multiply this value by the cost per programmer per month of $5,000 to estimate the total cost for this project as $366,667
8.13 You work at a regional health care center and have been asked to calculate the expected cost for a software project in your organization. You know that historically your programmers can handle 5 function points each person-month and that the cost per programmer in your company is $4,000 per month. The project whose costs you are estimating is based on the following requirements:
Further, you know that the complexity weighting for these functions follows a standard internal formula, shown as:
a. Calculate the total estimated number of function points for this project.
b. Calculate the total expected cost of the project. Solution:
a. Because we know the estimated complexity for each of the software functions that must be coded and the number of screens for each function, the calculation is relatively straightforward: multiplying, we find that the total function points for this project are estimated to be 414
b. Each resource can complete 5 function points per month, so the total number of person-months needed to complete the project is: 414/5 = 82.80. We multiply this value by the cost per programmer per month of $4,000 to estimate the total cost for this project as $331,200