How to Calculate Project Costs
In the field of project management, the ability to accurately calculate costs stands as a cornerstone for successful execution and delivery. As organisations navigate through small- and large-scale projects, the importance of cost estimations cannot be overlooked. Calculating project costs helps with guiding decision makers, project teams and stakeholders, when making informed choices, allocating resources, mitigating risks and monitoring project success.
Within this article, we will talk about cost savings and how it differs from cost avoidance, calculating indirect costs, and how to determine and estimate cost for a project.
How to calculate cost savings of a project
Cost saving is a strategy used in project management to reduce expenses. Another strategy that is often used to reduce expenses is cost avoidance. It is important to understand that there is a clear difference between the two. Where cost avoidance is a proactive action that can be taken to either reduce or eliminate future expenses, ultimately impacting future financial cycles, cost savings is when you take action to reduce spend. This is also known as a ‘hard’ saving and impacts the budget and financial statements of the current year. The result? Saving money and spending it somewhere else.
The foundational equation to calculate cost savings is to subtract the final contracted cost from the pre-negotiated cost, or the market rate.
Project Cost Savings Equation
Initial proposed cost – final contracted cost = cost savings amount
Alternatively, if it is preferred that cost savings are reported as a percentage, then the equation would be as follows:
Project Cost Savings Calculation as a Percentage
Initial proposed cost – final contracted cost = difference
Difference/initial proposed cost = cost savings percentage
Indirect Project costs in project management
Indirect costs in projects are expenditures that are not a direct result of the projects activities. They are often costs that relate to maintaining and operating a business or project. Regarding a business, these are often costs such as utilities, office supplies and marketing campaigns. Whereas in projects, these costs may be related to personnel and security costs. Calculating indirect costs correctly is important for ensuring the success of the project and staying within budget.
The four key stages of calculating indirect costs are as follows:
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Identification of indirect project costs
Begin by identifying all potential indirect costs associated with the project. Indirect costs are not directly tied to a specific project task but are essential for its execution. Examples include overhead expenses, administrative costs, utilities, and shared resources. Collaborate with relevant departments and stakeholders to compile a comprehensive list.
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Calculate the percentage of project indirect costs
This is done by dividing the total indirect costs by the total costs. This will be the percentage of indirect costs that can be accounted for within the budget.
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Allocate the indirect project costs
The third step is to allocate the indirect costs. Once the percentage has been calculated, these indirect costs can then be distributed to various project tasks and activities. This will help to ensure that indirect costs are accounted for within the project budget.
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Monitor and adjust
The final step is to monitor and adjust the indirect costs as the project progresses. Keeping a close eye on the indirect costs will help to ensure the project stays within budget and completed within the allocated timeframe.
How to determine the project costs of capital
Capital budgeting can be defined as a process that a business will use to evaluate potential major projects. Cost of capital, therefore, is a calculation of the minimum return that would be necessary to justify undertaking a capital budgeting project. An example of this would be purchasing a new ERP system. The most important consideration to understand cost of capital is how much of a return the project would have to generate to offset the cost of implementing it, and then continue to generate profits for the company.
Cost of capital is typically calculated using the Weighted Average Cost of Capital (WACC) formula. This formula calculates the average price of a company’s capital sources, weighted by the proportion of each type of funding used. The formula is as follows:
WACC = (Weigh of debt X Cost of debt) + (Weight of equity X Cost of equity) + (Weight of preferred stock X Cost of preferred stock)
How to do a project cost estimation
Estimating the costs for a project is the process of estimating any and all costs that are associated with completing the project within its scope and timeframe allocated. The Association of Project Management(1) cite three ways to approach cost estimation:
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The top-down method
Estimating project costs begins with a swift, high-level assessment leveraging historical data. This approach minimises risks by providing broad estimates, suitable for early-stage scoping and validation.
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The bottom-up approach
In contrast, the bottom-up method involves meticulous task breakdowns, offering detailed, stakeholder-friendly estimates. While valuable for gaining buy-in, there’s a risk of overlooking emergent work, and estimates may exhibit an optimistic bias at the lower level.
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Ethereal approach
The ‘ethereal’ approach incorporates external estimates, a last-resort option for specialised elements. Though lacking auditability, it proves necessary in time-constrained scenarios. Project managers often blend these approaches for a balanced and accurate estimation process.
So, to summarise… Mastering the art of calculating project costs is paramount for successful project management. Cost savings and cost avoidance strategies play pivotal roles in reducing expenses, with clear distinctions between them. Understanding indirect costs and their proper allocation ensures project success within budget constraints. Determining the cost of capital is vital for evaluating project feasibility, often achieved through the Weighted Average Cost of Capital formula. Cost estimation methods vary from top-down assessments to meticulous bottom-up breakdowns, each offering unique insights to guide project planning and execution. By integrating these practices, project managers can navigate complexities, mitigate risks, and ensure the efficient delivery of projects within scope and budgetary constraints.
Project costs are easy to lose sight of but play a crucial role in delivering projects successfully and in budget. Perhaps you can reflect on some projects you’ve been involved with that have gone over budget… why do you think this was? Well, if you’re still pondering and want a helping hand in getting your projects in budget and delivered on time then it might be worth us having a chat. Get in touch today.
