Project Costing: Planned vs Actual

PROGRAMME

: EXECUTIVE

DIPLOMA in PROJECT MANAGEMENT

MODULE

: MODULE

FACILITATOR

: Mr.

MATRIX ID :

JX78946HP702

7: Project Construction Management

DATE OF SUBMISSION :

Chiang

Feb 23, 2009

Module 7: Project Construction Management

Table of Contents 1 Introduction Summary...................................................................................................4 2 Cost Variance..................................................................................................................5 3 Causes of Negative Cost Variances................................................................................7 4 Project planning and estimation..................................................................................10 4.1 Earned Value Reporting...........................................................................................11 5 Suggestions on avoiding variances between planned and actual costs....................15 5.1 Reference class forecasting......................................................................................16 5.2 Scope Management..................................................................................................17 5.3 Project baseline........................................................................................................18 6 Conclusion.....................................................................................................................19 7 Bibliography..................................................................................................................20 8 References .....................................................................................................................20

3

Module 7: Project Construction Management

1 Introduction Summary You have been given a project to manage. It is estimated to cost about $1M and should be completed within 12 months. Estimating the project budget is an essential part of project planning but for a number of reasons the actual expenditure during project implementation often exceeds the budget estimate. Explain what you consider are the major causes of the variances between planned and actual costs. Your explanation should include some suggestions as to how these problems might be avoided or overcome.

Project managers have the utmost task in organizations to complete projects based on cost, time, scope and quality. Based on these three points, the task of project management becomes a huge task because they have to manage the constraints related to cost, time, scope and quality of the project. A project is defined as having a finite starting and ending point (time), a budget (cost), a clearly defined scope or magnitude of work to be done, and specific performance requirements that must be met (Lewis 2007).

According to the Project Management Book of Knowledge, the art of project management is the application of knowledge, skills, tools and techniques to achieve the requirements of a project. Therefore, in order to accomplish a project, a project would consist of the application of processes in project management such as initiating, planning, executing, monitoring and controlling, and closing (PMBOK 1996). However, there are instances of project failure and most times project failures are attributed to poor fiscal management of a project. Poor fiscal management of the project can be traced to variances between planned and actual costs.

4

Module 7: Project Construction Management

According to the Standish group, it is found that average project cost overrun was 43 percent, 71 percent of projects were over budget, over time, and under scope, and total waste was estimated at US$55 billion per year in the US alone in 2003 (Standish Group 2004). In addition, cost overrun is common in projects such as in infrastructure, building, and technology projects. One of the most comprehensive studies of cost overrun that exists found that 9 out of 10 projects had overrun, overruns of 50 to 100 percent were common, overrun was found in each of 20 nations and five continents covered by the study, and overrun had been constant for the 70 years for which data were available (Flyvbjerg et al 2002)

Examples of cost overrun in actual live projects are as follows: •

Sydney Opera House in Sydney, Australia - 1,400%

•

Concorde supersonic airplane- 100%

•

City of Boston in Massachusetts, USA, Big Dig- 275% estimating at a cost of US$11 billion.

•

Channel tunnel between the UK and France- 80% construction costs and 140% financing costs.

2

Cost Variance There is a saying in Murphy’s Law that says that “whatever can go wrong

will go wrong.” This means that things will go accidently wrong in a project more than it being following according to plan. In a project,

5

Module 7: Project Construction Management

planning the budget during project planning is essential because the variance between actual and planned cost would determine the profitability of the project. However, there are instances where the project is overrun during the project implementation because the actual cost exceeds the planned cost. Therefore, a project manager’s main role in an organization is manage the profitability of a project.

An excess of actual cost over planned cost is known as a negative cost variance. When the project manager is planning for the project, the cost of the project is based on estimates and it is this estimates upon approval by management, that it becomes the budgeted cost. Cost overruns will happen when there is an additional amount of actual cost that goes above and beyond the budgeted cost. This is what we call cost overrun or budget overrun. Most studies have also shown that the greatest cause of cost growth was also due to a poorly defined scope during the establishment of the budget (Merrow et al 1981).

In organizations where they hope to seek a nett profit margin of 10 percent upon project completion, issues such as errors, sloppy work, incomplete requirements gathering, late deliverables, and faulty judgments will erode any profit made during the project. Instead what you have is a negative variance where the actual cost of the project exceeds the planned cost of the project. Most cases, the projects are deemed as a loss. In situations as such, project managers would often face the sack from the organization (Luckey and Phillips 2006).

6

Module 7: Project Construction Management

Cost overrun is typically calculated in one of two ways: •

As a percentage, namely actual cost minus budgeted cost, in percent of budgeted cost.

•

3

As a ratio, actual cost divided by budgeted cost.

Causes of Negative Cost Variances

Cost overrun is known as the extra amount of actual cost over a budgeted cost. By taking the optimistic view of projects without considering the known unknowns can be a folly. Often times, these known unknowns can be a potential problem to a project. Below is a list of possible problems during a project that can affect a negative variance between actual and planned cost of a project (Luckey and Phillips 2006): •

Errors and omissions in the project work scope that would take additional time as well as more effort needed for new unplanned tasks

•

Miscommunications of the project work and reporting which can cause work to be undone and require reworking.

•

Poor requirements gathering which mean necessary information not being relayed to the project team.

7

Module 7: Project Construction Management

•

Failure in user acceptance and quality control that can mean going back to the drawing board.

Poor risk analysis and contingency estimating practices account for many project cost overruns (Hackney 1997). In addition, project managers also face pressure from their project sponsors because they have to meet the project deadlines within the time and budget allocated as well as scope whilst achieving specific performance levels. This translates to the common problem of failure in project management where the main project constraints are dictated by the project sponsor. In addition, there are also other reasons why there are project cost overruns (Flyvbjerg et al 2002): •

Taking an optimistic view of projects without considering known unknowns

•

Poor risk analysis and contingency estimation

•

Lacking good project management skills and other tools and techniques required for cost estimations. It is a common rule in project management that the project

sponsor can assign values to three project constraints but the project manager must determine the remaining constraints. Figure 1 will explain the relationship of project constraints and the value indicator that can only be valued by the project manager.

The project constraints can be listed as such:

8

Module 7: Project Construction Management

C = f(P, T, S) C=Cost f= Function P=Performance T=Time S=Scope So basically, cost is a function of performance, time and scope. As shown in Figure 1 below, the relationship between these constraints.

Figure 1: Triangles showing the relationship between P, C, T, and S. Based on Figure 1, the constraints shown on a triangular relationship would be based on geometric explanation that if the value was known of the sides of a triangle, we can compute the area. Also, if we know the area and the value of the two sides, we are able to compute the length of the remaining side. This is the rule in project management: a value can be assigned to any three variables but the project manager must put on value the remaining constraint (Lewis 2007). 9

Module 7: Project Construction Management

4

Project planning and estimation In the past, project managers would only know the extent how much a project has

been overrun only when the project has been completed. The common belief that if a project was on time and within budget, the project manager would have completed the job as expected unless the schedule and budget were exceeded. As such, project managers would use methods of measuring the progress of a project to ensure that they meet the expectations of the project. Depending on problems such as technical issues, weather delays, labor strikes, contractual disputes between vendor and supplier, or design changes, the project manager would have to assume that the work being completed is at a lesser pace than originally planned.

According to PMBOK, a project is defined as an activity having a definite starting and ending points (time), a budget (cost), a clearly defined scope—or magnitude—of work to be done, and specific performance requirements that must be met (PMBOK 1996). When the project plan has been developed, the project manager would come up with a project baseline to balance the work objectives with schedule, resource, and cost considerations. The project baseline forms the comparison point between the actual and the planned performance of the project. The basic activities in the development of a project plan that forms the project baseline are: • Identification of the work. • Scheduling of the work.

10

Module 7: Project Construction Management

• Assigning resources. • Budgeting.

This is important because with the baseline indentified in the project, the project manager would be able to evaluate the progress on the project. This is based on a defined workscope, and schedule, resource, and cost issues as the baseline forms the basis of the project plan (Levine 2002). This gives the project manager an accepted cost-schedulequality equilibrium of the project. By changing the baseline, the equilibrium would be changed as well because matters such as missing the original cost and schedule goals would affect the outcome of the project. The new baseline should be close to real as possible that reflects the actual level of performance, which would give us a new costschedule-quality equilibrium of the project.

4.1

Earned Value Reporting However, in order to get a real measure of the cost performance, planned and

actual costs will be compared for a negative or positive variance. In getting the real comparison of the planned and actual costs, project managers use earned value reporting to get real cost data based on accurate cost and schedule reporting. In reference to Figure 2 below as an example, projects can be ahead of schedule which would be good but however can be over the budget, which is bad. However, the project can be ahead of schedule and also meets the budget which is good for the profitability of the project (Verzuh 2005). With earned value reporting, the project manager would have vital information visibility with the emphasis of the variance between actual and planned.

11

Module 7: Project Construction Management

Figure 2: Planned versus actual cost over time. During the first three months, the project spent money faster than forecasted, but that isn’t necessarily an indication the project will be over budget—it might be ahead of schedule. In addition, you can also add in additional points to ensure meeting the schedule and budget. However, a project manager needs to fully understand the situation of the project beyond looking at the cost and scheduling of the project. As per the diagram example of Figure 3 below, the project manager needs to look beyond the variance of just cost and schedule (Verzuh 2005).

12

Module 7: Project Construction Management

Figure 3: Cost and schedule performance chart. Graphing the cost and schedule variance of Projects A, B, C, and D quickly identifies which needs the most immediate attention. In measuring the variances between planned and actual cost, the Project Management Institute (PMI), based in the United States uses these terms in tracking cost. These terms are meant to aid the project manager to track cost using earner value reporting (PMBOK 1996). The terms are: Planned cost Budgeted cost of work performed (BCWP)

Actual cost of work performed (ACWP) Cost variance (CV): Cost variance percent (CV %)

The planned or budgeted cost of the project. The planned or budgeted cost of the tasks that has been completed. The value of this term represents the actual earned value of the project to date, because it is the value of the work that has been completed. The actual cost of tasks that have been completed. The variance of cost between planned and actual costs for completed work. CV = BCWP − ACWP. The cost variance divided by the planned cost. A positive cost variance percent is good; it means the work was performed

13

Module 7: Project Construction Management

Cost performance index (CPI)

Budget at completion (BAC) Estimate at completion (EAC)

Estimate to complete (ETC) Variance at Completion (VAC)

under budget. A negative cost variance percent would be bad, because it means that the project was over budget. CV% = CV/BCWP. Earned value (BCWP) divided by actual cost (CPI > 1.0, if the cost performance index is more than 1, then the project is under budget; CPI < 1.0, if the cost performance index is less than 1, then the project is over budget. The budget at the end of the project. This represents the approved budget for the project. This is a re-estimate of the total project budget. The original budget is multiplied by the ACWP and divided by BCWP. It’s a way of saying that if the current cost performance trends continue, the final cost can be predicted. The budget amount needed to finish the project, based on the current CPI. ETC = EAC − AC. The estimated difference, at the end of the project, between the budget and actual cost of the project. VAC = BAC − EAC.

Below at figure 4 is an example of how earned value reporting that assists the project manager in measuring cost performance to date and to recalculate the budget (Levine 2002).

14

Module 7: Project Construction Management

Figure 4: Sample calculation of measuring cost and schedule performance with earned value.

5

Suggestions on avoiding variances between planned and actual costs A negative variance between planned and actual costs occurs when the actual

project costs exceeds the budgeted costs. However, if the variance has been already included as part of project budget as part of a contingency plan then the project may not result in negative variances thereby creating a cost overrun. Unfortunately, variances do happen in a project and there are many ways that we can look to warrant against negative variances between planned and actual costs.

15

Module 7: Project Construction Management

There are methods that a project manager can use to warrant against negative variances or project cost overruns. Below is a summary of some of the methods that a project manager can follow (Kukreja 2008): 1. Reference class forecasting- a method with which the costs of a project are estimated by comparing it to similar projects in the past. 2. Ensuring the scope and details of the project prior and during the project. 3. Being clear on the decision making or the directing organizational structure in place to ensuring the project baseline. 5.1

Reference class forecasting Reference class forecasting is a method that predicts the outcome of a planned

activity by referencing historical project activities that are similar to the project being forecasted. This method was developed by economists, Daniel Kahneman and Amos Tversky, which won them the 2002 Nobel Prize in Economics.

According to Kahneman and Tversky, project managers get caught in negative variances because they focus too much on the project and they do not take into account historical information of other similar projects that can help avoid project cost overruns. They recommend that project managers or forecasters "should therefore make every effort to frame the forecasting problem so as to facilitate utilizing all the distributional information that is available" (Kahneman and Tversky 1979, p. 316). In using reference class forecasting for a project, these three steps should be followed: •

Identify the past and similar projects for reference use.

16

Module 7: Project Construction Management

•

Establish a probability distribution for the selected reference class for the parameter that is being forecast.

•

Compare the project being planned with reference to the other past and similar projects and thereby establishing a possible outcome for the project.

5.2

Scope Management The project manager needs to ensure that the project is properly scoped and defined

to safeguard against a project overrun, which would lead to cost overruns or negative cost variance. With the project scope in place as well as properly defined, this will match the contents of an approved contract or an approved work authorization, and spells out the work to be performed to meet the commitment of the project.

In monitoring the scope, the work items will have time and effort data associated with the project. This will include schedule dates, effort hours, and costs of the project. From here, the project manager would be able to track the progress against the project plan in the execution of the project (Levine 2002). Below are some recommended suggestions in maintaining control of the scope of the project: •

Ensuring that there is a standard practice for additions to the scope of work of the project.

•

Providing documentation forms, either in print or electronic format.

•

Identification of roles that are responsible scope changes.

•

In situations when a scope change is proposed, the work to be performed needs to be fully defined, preferably as a list of work items (tasks, activities, whatever) with work breakdown structure IDs, schedule, effort and costs. 17

Module 7: Project Construction Management

•

Indentifying the source of funding in providing for the additional work to be added to the scope. From here a decision is to be made from the project budget being increased or funds being used from a contingency fund.

•

The maintenance of records of all scope changes should be kept in accordance of the project scope to ensure information visibility as well as safeguarding of project information.

5.3

Project baseline It is assumed that once a project has been planned, a list of work items would have

been defined to support the project charter. The list of work items would contain time and effort data such as schedule dates, effort hours, and costs. From this information, we would have formed the project baseline and with its formation, the project manager would be able to track the progress of the project and also be able to measure any variances. Any adjustments can be made to project during the early phases of the project as long as it does not hugely affect the baseline and after valid authorization. With the project baseline being established the project manager would also be able to manage any scope creep of the project.

18

Module 7: Project Construction Management

6

Conclusion Projects that are big in scope and work tend to be challenging and difficult to

manage. This is because the project manager has to manage the cost variance as well as the schedule variance of the project. Managing the scope as well as the establishment of the project baseline helps the project manager in providing remedies against negative cost variance which is project cost overrun. Also by using reference class forecasting, project managers would be able to estimate planned costs better based on past and similar projects.

What is most important is that putting in place the project baseline, the project manager can use earned value reporting to monitor the actual progress of the project in terms of cost and schedule variances. What is needed in order for this is an approved detailed and defined project plan. From the progress, the project manager would be able to affect any changes needed from the data received via earned value in order to maintain the profitability as well as being on track for project completion. This requires the project manager to be disciplined and having systematic attention to details to be able to recognize any possible scope creep on the project.

“The most effective project managers are developed day-to-day, not year-to-year or project mistake-to-project mistake. Mistakes will happen, even with the best of mentoring, however, project managers with strong mentors should find their people effectiveness continually improving. The benefit is that the company and everyone connected to the project shares in those gains.” Neal Whitten (Whitten 1999)

19

Module 7: Project Construction Management

7

Bibliography

1. Kahneman, D. and Tversky, A., 1979b, Intuitive Prediction: Biases and Corrective Procedures. In S. Makridakis and S. C. Wheelwright, Eds., Studies in the Management Sciences: Forecasting, 12 (Amsterdam: North Holland).

2. Whitten, Neal PM Network Magazine, 1999

8

References 1. Flyvbjerg, Bent, Mette K. Skamris Holm, and Søren L. Buhl, 2002, "Underestimating Costs in Public Works Projects: Error or Lie?" Journal of the American Planning Association, vol. 68, no. 3, 279-295.

2. Hackney, John W. (Kenneth H. Humprhies, Editor), Control and Management of Capital Projects, 2nd Edition, AACE International, 1997

3. Kukreja, Krishan: Project Cost Overrun And Its Impact. 7 Sept. 2008

4. A. Levine, Harvey: Practical Project Management: Tips, Tactics, and Tools, Wiley, 2002

20

Module 7: Project Construction Management

5. Lewis, James P (2007): Fundamentals of project management New York: Amacom, 3rded.

6. Luckey, Teresa and Phillips, Joseph (2006): Software Project Management For Dummies, Indianapolis, Indiana, Wiley,

7. Merrow, Edward W., Kenneth E. Phillips, and Christopher W. Meyers, Understanding Cost Growth and Performance Shortfalls in Pioneer Process Plants, (R-2569-DOE), Rand Corporation, 1981

8. Project Management Institute (1996): A Guide to the Project Management Body of Knowledge Newtown Square, PA: PMI

9. Standish Group, 2004. CHAOS Report (West Yarmouth, MA: Author)

10. Verzuh, Eric, (2005): The fast foward MBA in project management New Jersey, Wiley, 2ed.

21