project costing: planned vs actual
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Major causes of the variances between planned and actual costs in a project. Discuss.TRANSCRIPT
PROGRAMME : EXECUTIVE DIPLOMA in PROJECT MANAGEMENT
MODULE : MODULE 7:Project Construction Management
FACILITATOR : Mr. Chiang
MATRIX ID : JX78946HP702
DATE OF SUBMISSION : Feb 23, 2009
Module 7: Project Construction Management
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Module 7: Project Construction Management
Table of Contents
1 Introduction Summary..............................................................................................42 Cost Variance.............................................................................................................53 Causes of Negative Cost Variances..........................................................................74 Project planning and estimation...............................................................................9
4.1 Earned Value Reporting....................................................................................115 Suggestions on avoiding variances between planned and actual costs...............15
5.1 Reference class forecasting................................................................................165.2 Scope Management............................................................................................175.3 Project baseline..................................................................................................18
6 Conclusion................................................................................................................197 Bibliography.............................................................................................................208 References..................................................................................................................20
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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.
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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,
planning the budget during project planning is essential because the
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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).
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Cost overrun is typically calculated in one of two ways:
As a percentage, namely actual cost minus budgeted cost, in percent of budgeted
cost.
As a ratio, actual cost divided by budgeted cost.
3 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.
Failure in user acceptance and quality control that can mean going back to the
drawing board.
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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:
C = f(P, T, S)
C=Cost
f= Function
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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).
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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.
• Assigning resources.
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• 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-schedule-
quality 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 cost-
schedule-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.
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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).
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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 The planned or budgeted cost of the project.
Budgeted cost of work performed (BCWP) 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.
Actual cost of work performed (ACWP) The actual cost of tasks that have been completed.
Cost variance (CV): The variance of cost between planned and actual costs for completed work. CV = BCWP − ACWP.
Cost variance percent (CV %) The cost variance divided by the planned cost. A positive cost variance percent is good; it means the work was performed
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under budget. A negative cost variance percent would be bad, because it means that the project was over budget. CV% = CV/BCWP.
Cost performance index (CPI) 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.
Budget at completion (BAC) The budget at the end of the project. This represents the approved budget for the project.
Estimate at completion (EAC) 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.
Estimate to complete (ETC) The budget amount needed to finish the project, based on the current CPI. ETC = EAC − AC.
Variance at Completion (VAC) 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).
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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.
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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.
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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.
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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.
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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)
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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
<http://project-and-program-management.com/?cat=4>
4. A. Levine, Harvey: Practical Project Management: Tips, Tactics, and Tools,
Wiley, 2002
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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.
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