By Allen C. Hamilton, PMP, CCE
Note: This series of articles is extracted from a paper presented at the AACE Int’l. Association for the Advancement of Cost Engineering meeting in Washington, DC in June 2004. The full text can be obtained at www.AACEI.org.
Cost management has increasingly become an important part of business. With the impact of globalization, companies had to recognize that a key part of business was efficiency. In this regard all types of projects can benefit from the appropriate application of cost management techniques, and not just in the biggest companies.
If the key steps of management are planning, implementing, and controlling, then the key steps of cost management are estimating, cost control, data collection, and analysis. Each is a parallel of the other in first establishing a plan or an estimate, then implementing that plan, controlling the activity, collecting data and analyzing the endeavor, and then making adjustments to the activity or adjustments to the information for the next cycle. The cost management cycle is illustrated below.
Cost estimating is the determination of quantities, and the prediction within a defined scope, the cost required for the equipment and construction of a facility (Ref. AACE International). People who are in project management understand that cost estimates are predictions of costs at a future date and are always subject to variability. Not understanding this variability is frequently why some projects fail to meet their stakeholder’s objectives. Some key characteristics of a cost estimate are that it has an equal chance of under running or overrunning. In addition, the cost estimate should be objective in reflecting the scope of work and the estimate basis.
The estimate basis is one of the critical elements in determining the quality and accuracy of a cost estimate. The three parts of the estimate basis are the design basis, the planning basis, and the cost basis.
Estimate classification systems are used to identify the criteria that a given estimate must have in order to be classified in a certain group. Characteristics include standard references such as ANSI, project descriptions, level of project definition, end use of the estimate, estimating methods used, and level of effort to produce the estimate. The use of the classification system is usually linked to expected estimate accuracy. Greater use of resources and more detailed basis documents will usually produce more accurate estimates. In assessing estimate classification and accuracy, it is important to differentiate quantity, quality, and accurate estimate basis information.
Two important organizational elements are required to have an effective cost estimating system: work breakdown structures and code of accounts. The Work Breakdown Structure (WBS) is a grouping of project elements that organize and define the total work scope of the project (Ref. Project Management Institute). The WBS organizes the many project cost elements into controllable parts such as work packages. The WBS should be established prior to starting the estimate and be used through project closeout. The WBS is a hierarchal breakdown and should be in sufficient detail to define the scope but not burden the project team with excessive detail.
Codes of Accounts (COA) are systematic methods of identifying categories of costs incurred in the progress of a job for accounting purposes (Ref. AACE International). COA are important to cost management as the framework for cost control, cost accounting, and cost history. Project COA are most useful when they are derived from and related to the owner’s accounting system. They should be flexible to specific project needs and be in enough detail to be manageable.
Of the many subjects in cost management, one that attracts a lot of discussion and attention is contingency. The success of many projects has depended on the assessment of how much contingency is added to a project estimate at a certain point in time. Many of these efforts have been unsuccessful as evidenced by the number of cost estimates that have overrun.
Contingency reflects a judgment by management to make an allowance to avoid project cost overruns within the parameters of risks assumed (Ref. AACE International’s Certification Study Guide, 1996).
The assessment and decision on contingency should reflect the previous subjects related to the cost estimate such as the estimate basis and estimate classification. A particular point of misjudgment and confusion is the specific inclusions and exclusions of contingency. One generally accepted definition of contingency defines it as including the original scope of work, the original estimate basis, and the original schedule. Generally it excludes major scope changes, increases/decreases in the facility capacity, weather extremes, facility location, and extraordinary events. Contingency can include any events that the stakeholders wish to include and have made appropriate allowances for.
This article introduced the subject of cost management on capital projects, identified its key steps, and discussed cost estimating. The next article in this series will discuss cost control.