Cost Control

Cost control is the process of controlling the project cost and taking corrective action when the control indicates that corrective action is necessary. It is important that our cost control system be thoroughly understood by those who are measuring with it as well as by those who are being measured. Inappropriate responses to cost and schedule variances can result in serious quality problems and higher than acceptable risk levels.

Earned Value Reporting

The earned value reporting system is now the most commonly used method of performance measurement and project control. The reason for the popularity of this reporting system in project management is that it reports performance to cost and performance to schedule in one report. Schedule and cost are both measured in dollars. Where earned value reporting is not used, reports favor measuring performance to schedule or performance to budget.

In any reporting system, the principle is to set some standard, measure the actual performance to that standard, and then report on the observed differences. In the earned value reporting system we use the planned budget and schedule and then measure the actual progress in the budget and schedule.

Frequently, a Gantt chart is used to show progress and performance to schedule, but this does not state the case clearly. If a scheduled activity is shown to be three days behind schedule, it is important to know whether there is one person involved in this activity or whether there are twenty.

In reporting cost, actual cost is frequently compared to budget cost to date. This does not show the full picture either. If a project is behind schedule, the actual cost could be tracking nicely to the expected budgeted expenditures, and the project could still be in a great deal of trouble.

Using the earned value reporting system the progress of the project in terms of cost is measured in dollars. The progress of the project in terms of schedule is also measured in dollars. This may sound confusing to people who are used to thinking of schedules in terms of days ahead or days behind. In fact, it is a more informational description of the condition of the project schedule. If a project activity is reported as being five days behind schedule, and there is one person working on the activity part time, it is very different from an activity that is behind five days and has twenty people working on it.

Obviously, what is needed is a reporting system that combines performance, schedule, and budget. This is the purpose of the earned value reporting system.

Cumulative Reporting

Earned value reports are cumulative reports. The values collected for the current reporting period are added to the values from the last reporting period, and the total is plotted.

Cumulative values will never go down unless a value is reversed. As can be seen in Figure 3-1, cumulative cost curves have a characteristic "S" shape. This is because projects typically start out spending money slowly and gradually increase their spending rate until a peak is reached, and then they gradually decrease their rate of spending until the project is finally completed.

Figure 3-1. Cumulative work hours.

Hours

Plan

Plan

One difficulty in showing the cumulative cost curve for a large project is that the scale required in order to show the entire cost of the project may be so compact that relatively large variations are not visible. A $400 million project plotted on an 8.5-by-11-inch page would show a million-dollar variation in only one-fiftieth of an inch of space.

Where large numbers are used, a plot of the variance can be used. The scale of this type of chart can be much less compact and still show the needed information. It is made by simply drawing a line as a zero base and then plotting the difference between actual and expected values (Figure 3-2).

Earned Value Parameters

The earned value reporting system depends on the tracking of three measurements of the project. In this book I am showing the old and new designations for the earned value reports. In the 2000 edition of the Guide to the PMBOK, PMI chose to change the names of these parameters. In reviewing the 2004 edition of the Guide to the PMBOK, I found that PMI is still listing both designations in their index. In this book I will at least show the relationship between the two designations for each of the earned value parameters.

1. Budgeted cost of work scheduled (BCWS), or planned value (PV). When we established the three project baselines, we definitively set the cost and schedule baselines. Each of the activities in the project had its own estimated cost and schedule. The PV is the cumulative budget plotted on a time axis showing when the expenditure is supposed to be made according to the project plan.

2. Actual cost of work performed (ACWP), or actual cost (AC). As the project progresses, actual cost is accumulated. This cumulative actual cost is plotted along the same time axis. The actual cost is plotted for every reporting time period.

3. Budgeted cost of work performed (BCWP), or earned value (EV). This is the cumulative plot of the value of the work actually completed. The value of the work is equal to the budget that was estimated for the work. The cumulative earned value is

Figure 3-2. Cumulative variance report.

Over 0

Under

Actuals

Actuals plotted on the same time axis. The earned value is plotted every time period based on the actual work that was accomplished.

If the project follows the project plan, each of these three parameters will be exactly the same. Significant deviations between the values of the three parameters—PV, AC, and EV—are cause for concern (Figure 3-3) (see the section ''Calculated Values for Earned Value'' below for definitions of EAC and BAC).

Difficulties in Data Collection

Plotting the PV is rather straightforward. Care must be taken that the timing and amounts that are plotted as PV are the same and that the timing is the same as when they are reported as actual expenditures.

In the area of material cost, the timing of the budget and the reporting of the actual expenditures are important. An expenditure may be recognized when the commitment is made to purchase the material, when the material is delivered, when the material is accepted, when it is invoiced, or when it is paid for. All of these dates may be quite different points in time. Care must be taken so that the timing of the PV matches the timing of the AC.

In the area of labor cost, difficulties frequently arise in the development of these estimates as well. Companies often do not like to have their estimators know the salary cost of individual employees. People are generally grouped together by similar skills. Within the group there can be a wide range of salaries. Since it is usually not possible to

Figure 3-3. Earned value reports.

Dollars Contracted Budget

Dollars Contracted Budget

determine exactly who will be working on a project when the work is actually done, the average cost of a person in the group is used for estimating purposes. When the project is actually done, the average cost of a person in the group is still used.

It may seem that this is the right thing to do, but look at the effect on the project manager. The project manager is going to be charged the same amount per hour regardless of which person in the group is used to do the work. The project manager will naturally try to get the best person of the highest skill and experience regardless of the real needs of the project. This situation creates demand for the more senior people, while the junior people are underutilized.

A better situation would be to budget to the average cost for a person in the skill group and then collect the actual cost according to the person's actual salary. This would allow the project manager to select the less skilled person if possible and trade time and rework for lower salary cost.

Reporting Work Complete

There is frequently difficulty in reporting work complete on the project. Many people tend to report that the percent that is complete on an activity is the same as the percent of the time that has elapsed. Thus, if 50 percent of the time to do an activity in the project has passed but only 25 percent of the work is actually done, misleading reports could result.

There are several approaches to solving this problem. The 50-50 rule is one such approach. In this approach to earned value data collection, 50 percent of the earned value is credited as earned value when the activity begins. The remaining 50 percent of the earned value is not credited until all of the work is completed.

The 50-50 rule encourages the project team to begin working on activities in the project, since they get 50 percent of the earned value for just starting an activity. As time goes by, the actual cost of work performed accumulates, and the project team is motivated to complete the work on the activity so that the additional 50 percent of the earned value can be credited. This creates an incentive to start work and another incentive to finish work that has been started. This solves the problem of reporting percent complete, and there should be few arguments about whether work has actually begun or has been completed on a project activity.

There are many variations of the 50-50 rule. Popular variations include the 20-80 rule and the 0-100 rule. These allow differing percentages of the earned value of the work to be claimed at the start and completion of the work.

Examples

In Figure 3-4, the EV is higher than the PV. This means that the project is ahead of schedule. More activities have been completed than were planned to be completed at this time. This can be good. The AC is higher than the PV as well. It is also higher than

Figure 3-4. Earned value example A.

Cost Today

Cost Today

Time

the EV. This means that we are spending more money to accomplish the work than we had planned, and we are spending more money to accomplish work than the EV for that work.

This could mean that the manager of this part of the project is working people overtime in anticipation of a problem that may come to pass in the near future. There could be many explanations for these irregularities. The report tells us that we should investigate to find out the cause for this.

In Figure 3-5, the EV is above the PV. Again, this means that the project is ahead of schedule. More activities are being completed, and their earned value is being credited faster than planned. The AC is lower than the EV. This means that we are spending less money than the earned value of the work that is being completed.

While this looks like a good situation—ahead of schedule and under budget—it is still not following the project plan. It is possible that things are just going well. It is also possible that some of the work is not being done as planned and that the quality of the work performed is suffering.

In Figure 3-6, the EV is less than the PV. This means that the project is behind schedule. The AC is less than the EV. This means that work is being accomplished with less cost than planned. A possible explanation for this situation is that the project is

Figure 3-5. Earned value example B.

Time

understaffed, but the people working on the tasks that are being done are doing a better-than-average job.

Calculated Values for Earned Value Reports

• Budget at Completion (BAC). The BAC is a point representing the total budget of the project. On a cumulative plot it will be the last point on the PV curve. The PV cannot be greater than the BAC.

This is the difference between the work that is actually completed and the cost expended to accomplish the work. A positive variance is good, and a negative variance is bad.

Figure 3-6. Earned value example C.

Cost Today

Cost Today

This is the difference between the work that was actually completed and the work that was expected to be completed at this time. A positive variance is good, and a negative variance is bad.

• Cost Performance Index (CPI)

• Schedule Performance Index (SPI)

Indexes are used when consistent numbers are required. Cost and schedule variance is measured in dollars. In a large project, say $100 million, a $100,000 cost or schedule variance might not be too significant, but in a small project, say $300,000, a $100,000 cost or schedule variance might be significant.

Cost and schedule variances also vary depending on what phase the project is in. Early in the project small variances may be significant, and later in the project these same size variances may not be terribly significant.

For this reason we use indexes. The values of indexes are the same for the same significance. The cost performance index is the EV divided by the AC. This is the amount of work accomplished per dollar of actual cost spent. The schedule performance index is the EV divided by the PV. This is the amount of work accomplished per dollar of budgeted cost expected to be spent.

• Estimate at Completion (EAC)

The EAC is an estimate of the project cost at the completion of the project. This is the BAC adjusted for current performance to date, cost wise. It says that if the project continues along at its present level of performance to cost, the EAC will be the final project cost. This is a pessimistic value since it says that the mistakes that have been made in the project are expected to continue for the remainder of the project.

This is often used for calculating the EAC. There are several other forms of the EAC that can be used that yield different results. One form is identical to the one above:

EAC = AC + Remaining PV/CPI

Since the remaining PV in the project is simply the difference between the total work that must be done to complete the project (the BAC) and the work that has been completed to date (the EV):

And the AC could be stated as:

Substituting, we get:

The above method for calculating the EAC is the one that is required for any questions on the PMP® examination. This method has been shown to represent the true EAC for most projects. Much research has been done to support the use of this calculation for EAC. The trouble with this calculation, while statistically supportable, is that your boss may not like it very much.

A more optimistic approach would be to assume that the mistakes on the project that have occurred so far are not going to continue and that the project from now on will go according to plan. It is the sum of the AC, which is what has been spent to date and cannot be improved on now, plus the amount of work remaining to be done.

Of course, the most optimistic view is that not only will the project improve its performance from now until the end of the project but also the expenditures over the budget to date will be recovered by the end of the project. This is a mistake often made by project managers. Generally speaking, if a project is over budget when 25 percent of the project is complete, the project will be completed with an over-budget condition greater than 25 percent, not less than 25 percent.

• Estimate to Complete (ETC)

The ETC is the remaining budget required to complete the project if work continues at the present performance rate.

There are many other calculations used in the earned value reporting system, but these are the calculations that are accepted by most people (Table 3-2).

Financial Measures

The business risks of a project can be best understood by looking at some of the financial measurements that are commonly applied to business decisions. It is important to recognize that many of the costs associated with a project do not stop once the project has been delivered and each of the stakeholders has accepted the project.

The simplest way to think of project desirability is to consider the benefit cost ratio: all of the benefits of doing something divided by all of the costs to accomplish it. Any sort of business consideration can be evaluated with this simple measure. If the benefit cost ratio is 1.0 or greater, the project is desirable. If it is less than 1.0, the project is not desirable.

Life cycle costing is the cost and benefits of a project that begin when the first effort is made on behalf of the project and continue through the conceptual phase, the planning phase, the execution phase, the closeout phase, the warranty period, and on until the project is disposed of. When projects are delivered to the customer, there are many costs that will continue through the life of the project. Maintenance, service, additions, and modifications are items that will continue after delivery. Some of these will result in additional cost, such as warranty repairs, and others will result in additional benefits, such as additions and modifications.

''Sunk cost'' is a term used to indicate the amount of money that has already been spent on a project. This is money that we no longer have any control over. Although it seems that if a project is currently very much over budget it would make sense to complete the project and collect the benefits, most financial managers hold that sunk costs should not be considered in making decisions as to whether to continue a project.

Table 3-2. Earned value example.

Week

PV

AC

EV

CV

SV

CPI

SPI

EAC

ETC

1

1,000

1,000

1,000

0

0

1.00

1.00

16,000.00

15,000.00

2

2,000

2,000

2,000

0

0

1.00

1.00

16,000.00

14,000.00

3

4,000

5,000

4,000

-1,000

0

0.80

1.00

20,000.00

15,000.00

4

7,000

8,000

6,000

-2,000

-1,000

0.75

0.86

21,333.33

13,333.33

5

10,000

12,000

9,000

-3,000

-1,000

0.75

0.90

21,333.33

9,333.33

6

12,000

13,000

11,000

-2,000

-1,000

0.85

0.92

18,909.09

5,909.09

7

13,000

14,000

11,500

-2,500

-1,500

0.82

0.88

19,478.26

5,478.26

8

14,000

14,500

13,000

-1,500

-1,000

0.90

0.93

17,846.15

3,346.15

9

15,000

15,000

14,500

-500

-500

0.97

0.97

16,551.72

1,551.72

10

16,000

16,000

15,500

-500

-500

0.97

0.97

16,516.13

516.13

11

16,000

17,000

16,000

-1,000

0

0.94

1.00

17,000.00

0.00

BAC

16,000

For example, a $300,000 project is 50 percent complete but is over budget by 30 percent. Revenue from the project is estimated to be $350,000. Based on this information it is estimated that the project, when complete, will cost $400,000. Should the project be continued? If the project stops today, $200,000 is sunk cost, and no revenue is made. If the project is completed, a loss of $50,000 will occur. From the point of view of many managers, all other things being equal, it would be better to stop the project and invest the remaining $250,000 that it would have taken to complete the project in another project that is more profitable. Of course, customer commitments and future revenue based on the completion of this project may influence this decision.

Financial measures are rooted in the accounting and financial worlds. The first thing that must be understood is that the fundamental reports in accounting—the income statement and the balance sheet—are of particular interest to the project manager, since the project manager's decisions directly influence these reports. The current trend in project management is to make project managers responsible for the revenue cost and expenses of the project. These are the basic reports of accounting for any business. In these statements, the words profit and income are frequently interchanged. The reason that project managers must be aware of these financial measures is that if the financial measures applied to the project are favorable and the company can keep all of its projects favorable, then the company's financial measures will also be favorable. The fundamental accounting equation is:

Assets = Liabilities + Owner's Equity

Assets are the things that a company owns, like cash, buildings, materials, and so on. Liabilities are what a company owes, such as unpaid bills, long- and short-term debt, and so on. The owner's equity is the value of the assets after the liabilities have been subtracted. In the successful operation of a company, the company takes on liabilities in order to produce goods and services that are then sold. When the goods and services are sold there is, hopefully, a positive difference in revenue generated versus costs and expenses incurred to allow the goods and services to be sold. At the end of a project the assets that are increased should be greater than the liabilities incurred. To balance the accounting equation, this difference increases the owner's equity.

The income statement (Figure 3-7) shows where the cash flowing into and out of the company came from, and the net profit after taxes is the sum of all the money flowing into the company and all of the money flowing out of the company.

The balance sheet (Figure 3-8) is the statement that shows a breakdown of the items in the fundamental accounting equation. The assets must balance the liabilities and owner's equity.

Project managers have an influence on the numbers on the company's financial reports. But the company's reports are just the summation of the different projects and other activities of the company. It is therefore sensible to consider these financial measures

Figure 3-7. Income statement.

Gross sales

Less cost of goods sold = Gross profit

Less operating expenses

Salaries and commissions Rent expenses Depreciation Selling expenses Other operating expenses = Net operating income Plus other income

Interest revenue Less other expenses Interest expense = Net income before taxes

Less income tax = Net income after taxes as they apply to the individual projects as well. If all projects being done by the company are individually profitable, then the company itself must be profitable. These measures are frequently called financial ratios.

Return on Sales

Return on sales, or ROS, equals the net profit after taxes divided by the gross sales. This is another way of saying how much profit is generated for each dollar of sales. The higher the value of ROS the better. Typically, for American business this ratio is usually nearly 5 percent. Note that the net profit after taxes is what is left of the revenue after all costs, expenses, and taxes have been deducted. Net profit is sometimes called the net operating profit after taxes, or NOPAT.

For example, a project generates revenue of $400,000. After deducting the project's share of all the costs, expenses, and taxes, the net profit after taxes is $23,000.

ROS = NOPAT/Gross Revenue ROS = $23,000 / $400,000 ROS = 5.75%

Return on Assets

Return on assets, or ROA, equals the net profit after taxes divided by total assets. This is another way of saying how much profit was generated for each dollar of invest-

Figure 3-8. Balance sheet.

Assets:

Current assets Cash

Accounts receivable Inventory Prepaid expenses Fixed assets

Plants and equipment Furniture and fixtures Less accumulated depreciation Total assets

Liabilities:

Current liabilities

Accounts payable Unpaid salaries Long-term liabilities Long-term debt

Owner's equity:

Common stock Preferred stock Retained earnings ment in the company. The higher the value of ROA the better. Typically, for American business, this value is nearly 9 percent. Since the assets of a company represent the money that is invested in the company, it is important to know how much profit is being made per dollar of investment.

For example, a project uses a share of the company's assets equal to $240,000. After deducting the project's share of all of the costs, expenses, and taxes, the net profit after taxes is $23,000.

ROA = NOPAT/ Total Assets ROA = $23,000/$240,000 ROA = 9.6%

Economic Value Added

The economic value added is also called the EVA. In this financial measurement we are interested in finding whether a project's NOPAT is sufficient to cover the cost of maintaining the assets that it uses. In other words, if a project uses a share of the company's assets, those assets have certain expenses associated with them. These expenses are the cost of interest on borrowed funds and the compensation paid to shareholders in the company. The rationale here is that the only way a company can acquire assets is by borrowing the money to purchase them, having investors purchase stock in the company, or generating profits. Organizations that lend money to companies are compensated in the form of interest payments. Stockholders are compensated in the form of dividends on their share of the company. The revenue generated by the project must be enough to meet all of the project's costs and expenses as well as offset the interest expense and dividends to the stockholders.

The first thing we will have to calculate is the cost of capital. This is the weighted average cost of the money paid to the stockholders in the form of dividends and the money paid to the lenders in the form of interest payments.

Suppose a company's assets are financed by 70 percent in stock sold to investors and 30 percent in funds borrowed from banks and other financial institutions in the form of loans. The average interest that is paid on the loans is 7 percent, and the company dividends are 17 percent. What is the cost of capital for this company?

Seventy dollars out of every $100 of the company's assets are financed by stockholders at 17 percent, or $11.90 per year. Thirty dollars of every $100 of the company's assets are financed by lenders at 7 percent, or $2.10 per year. The total cost of capital per $100 is $14, or 14 percent of the company's assets.

If we take the capital or the assets that are used for this project and multiply by the cost of capital, we will get the weighted average cost of capital (WACC).

Let's say that the capital that the project uses is $500,000 and the cost of capital is 14 percent:

If the net operating profit after taxes is $116,000:

Project economic value added, or EVA, would be $46,000. Depreciation

Depreciation is a necessary function in financial management, because without depreciation the irregularities in the fundamental financial reports of a company would vary considerably and make it difficult to compare one year or one quarter to the next. This is because large investments in assets do not occur on a regular basis. If the total cost of an investment were reflected in the financial time period in which it occurred, the effect on net profits would be considerable in this period, and then the net profit would rise significantly in the next period.

What is done with depreciation? The cost of the new asset is spread out over the life of the asset. This allows the company to claim some of the cost each year rather than the total cost of the asset all at one time.

Straight Line Depreciation

Straight line depreciation is the depreciation method that allows an equal amount of depreciation to be taken each year. The amount of depreciation is determined by subtracting the salvage value of the asset at the end of its useful life from the purchase price of the asset. The remaining value is called the book value. The book value is divided by the number of years, and this amount is expensed from the asset each year.

For example, a company buys a large machine for $1 million. The purchase is made with cash. In the accounts for this transaction, the cash account is reduced by $1 million, and the machine account is increased by the amount of $1 million. There is no effect on the liabilities or the owner's equity side of the accounting equation, and it remains balanced. The cost of this machine must eventually be recognized.

The machine has a useful life of ten years and is worth $100,000 at the end of its useful life in terms of scrap value or the ability to sell the machine to someone else. This means that the value of the machine that must be depreciated is $900,000. Since the life of the machine is ten years, the value depreciated each year is $90,000. This is known as straight line depreciation (Table 3-3).

Accelerated Depreciation

Accelerated depreciation methods are used to allow the expenses that are depreciated from the assets to be applied earlier in the useful life of the asset. The reason for this is to

Table 3-3. Straight line depreciation.

Purchase

Salvage

Current

Year

Price

Value

Depreciation

Book Value

0

1,000,000

100,000

0

900,000

1

90,000

810,000

2

90,000

720,000

3

90,000

630,000

4

90,000

540,000

S

90,000

450,000

6

90,000

360,000

l

90,000

270,000

B

90,000

180,000

9

90,000

90,000

10

90,000 Total 900,000

0

reduce the net profit after taxes (NOPAT). If NOPAT is reduced in a given year, the amount of tax that a company pays is less by this amount.

In accelerated depreciation methods the total amount of depreciation is the same as in straight line depreciation, but the time that it is taken is much earlier in the useful life of the asset. This means that more equipment expense is recognized and lower taxes are paid in the early part of the useful life of the asset purchased. In later years the taxes will be higher than in straight line depreciation. Because of the present value of the money, taxes that are deferred to later years allow us to use that money in the present years.

Two types of accelerated depreciation are commonly used: sum of the years' digits and double declining balances.

Sum of the Years' Digits. There is no scientific basis for the sum of the years' digits method. There is no financial reason for using this calculation except that it has become a standard accounting practice.

The calculation is made by totaling the digits representing the years of the useful life of the equipment. Thus, as can be seen in Table 3-4, for a ten-year useful life, the total is 55 (10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 = 55).

The amount of depreciation in the first year is determined by taking the highest digit year and dividing this by the sum of the years' digits. In the first year, the last year's digit is used, making the calculation 10 divided by 55. This number is then multiplied by the book value.

In the remaining years, the next lower year's digit is used. In the second year, the depreciation is calculated by dividing 9 by 55. Each year the numerator declines by one year.

Table 3-4. Sum of the years' digits.

Purchase

Salvage

Sum of

Current

Year

Price

Value

Year Digits

Depreciation

Book Value

0

1,000,000

100,000

0

900,000

1

10/55

163,636

736,364

2

9/55

147,273

589,091

3

8/55

130,909

458,182

4

7/55

114,S4S

343,636

S

6/55

9B,1B2

245,455

6

5/55

B1,B1B

163,636

7

4/55

6S,4SS

98,182

B

3/55

49,091

49,091

9

2/55

32,727

16,364

10

1/55

16,364 Total 900,000

0

Double Declining Balances. Like the sum of the years' digits depreciation, there is no scientific basis for the double declining balance calculation either. It is, however, a consistent method for accelerating the depreciation of equipment and has become a standard accounting practice.

The percent of depreciation is taken on the depreciable value of the item. The next year's depreciation is taken on the remaining depreciable value of the item, and so on until the salvage value is reached. With this method the amount taken as depreciation in the early years is much higher than in the later years (Table 3-5).

Project Management Made Easy

Project Management Made Easy

What you need to know about… Project Management Made Easy! Project management consists of more than just a large building project and can encompass small projects as well. No matter what the size of your project, you need to have some sort of project management. How you manage your project has everything to do with its outcome.

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