Project Management

BSB20315-7

Lecture 8
Cost and Benefit Planning
 Learning Outcomes

• Basics of a cost planning process

• Business case development
• Challenges for the perceived wisdom

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 Cost and Benefit Planning
- An Introduction
Costing processes are rarely objective
• Stakeholders determine what is politically acceptable

Is there a perfect estimate?

• The estimate is an attempt to predict the state of spend at some
point in the future and is subject to uncertainty

Organisations need to decide which projects to pursue

• Portfolio management (Lecture 3), filtering (Lecture 5)
• The business case states predicted costs, benefits (not always
financial), risks
• Provides an input to selection and base line

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 Basics of a cost planning process

The cost planning process resembles the iterative

steps of the time planning process
– Likely changes in resource prices adds additional
uncertainty
– Currency fluctuations, inflation and base materials
costs
– Relationship of costs, price and profit
The role of costing
• Price = cost + profit
– Price can be fixed through legislation, target
costing, market analysis)
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 The role of costing
(Basics of a cost planning process)(Continued)

• Cost = price – profit

– Cost can be fixed through purchase contract; price
and profit can vary
• Profit = price – cost
– Profit might be fixed through cost-plus or
reimbursable pricing contracts
• Cost planning is interactive
– Planned costs become baselines
– Budgets are turned into activities and outcomes
– But requirements change as the project progresses
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 Approaches to costing
(Basics of a cost planning process)(Continued)

• Ground-up costing
– Estimates of each level in the work breakdown structure are
added together progressing up the hierarchy
– Estimates are likely to be prepared by people who will carry
out work resulting in commitment to achieve the figures
– But proposals may be cut; if anticipated, activity costing may
be artificially inflated
• Top-down costing
– A certain amount of money is allocated to the project which is
then split between the sub-projects by way of estimations or
target costing
– Creates a degree of competition between supervisors, which
may be beneficial
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 Approaches to costing
(Basics of a cost planning process)(Continued)

Figure 8.1 Top-down and ground-up approaches to costing

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 Elements of cost
(Basics of a cost planning process)(Continued)

• Time
– Direct input of labour
• Materials
– Consumables and other items
– At cost or cost + margin
• Capital equipment
– The means of providing the conversion process plus
maintenance, running, depreciation
– Entire cost when purchased specifically
– Possible residual value
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 Elements of cost
(Basics of a cost planning process)(Continued)

• Indirect expenses
– Transport, training, etc., not directly related to value-
adding activities but considered necessary
• Overheads
– Office, financial and legal support, managers and
non-direct staff
• Contingency
– Margin or allowance, e.g. 10 percent

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 Estimating techniques
(Basics of a cost planning process)(Continued)

Estimating techniques (1)

• Parametric estimating
– Projects are rarely totally unique, often repetition of
activities at lower levels of WBS
– Break down project into units that can be readily
estimated based on considerable experience of a
particular type of project
– Can be used at different levels of the product breakdown
• As…but…s
– Experience of similar projects
– Use previous cost as base line (assuming validity) and
proportion up or down
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 Estimating techniques
(Basics of a cost planning process)(Continued)

Estimating techniques (2)

• Forecasts
– A ‘best guess’ when uncertainty (e.g. exchange rates)
– Use parametrics or proxies
– Differentiate between fixed (firm/known) and variable
costs (fluctuate, estimate)
– Provide series of estimates to see impact on budget
– Factor in element for risk
• Synthetic estimation
– Based on practices of work measurement
– If large number of repetitive actions, work rate can be
analysed to provide generic actions, timings and costs
– Deconstruct new activities into similar actions and add
timings
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 Estimating techniques
(Basics of a cost planning process)(Continued)

Estimating techniques (3)

• Using learning curve effects
– Often repetitive elements at lowest level of WBS
– Time taken for a task if repeated will decrease as the
person becomes familiar with the method
– Subsequent improvement is speed becomes smaller
over time
– Yx = Kxn
• Yx = time taken to carry out task for the xth time
• K = time taken to carry out task for the first time
• x = the number of times the task has been carried out
• n = log b/log 2 where b = learning rate
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 Estimating techniques
(Basics of a cost planning process)(Continued)

Figure 8.2 Learning curve effects on time taken

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 Estimating techniques
(Basics of a cost planning process)(Continued)

Table 8.1 Improvement over time

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 Estimating techniques
(Basics of a cost planning process)(Continued)

Estimating techniques (4)

Wishful thinking
– Optimism bias – over-optimistic on how much can be
achieved and how little it will cost
– Politics – large figures likely to be unacceptable, the
objective is placed above costs
– Improper use of estimates – ball park figures become
official without checking or further development
– Failure to be systematic about planning – through
complacency/certainty (the person) will not have to do
work - vagueness, unqualified estimate to ‘get the
request off the desk’
• The best techniques are still only estimates
• Errors at this stage can be multiplied many times
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 Basics of a cost planning process
(Continued)

Figure 8.3 Elements of cost

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 Cost build-up
(Basics of a cost planning process)(Continued)

• Small pieces of work can look expensive if fully calculated

• Allocating overheads can damage profitability
• If revenue includes overhead allocation
– little incentive to improve methods or reduce time as this
would reduce apparent income
Use of cost estimates
• Reiteration is consistent theme through planning
• At outset
– initial costing will provide a idea if project is viable and the
return will justify the investment
• Progression into detail planning
– revised estimates as consideration increases
– these form the budgets and the basis for control
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 Business case development

The business case:

• ‘The justification for undertaking a project, in terms of
evaluating the benefits, cost and risk of alternative
options and the rationale for the preferred solution. Its
purpose is to obtain management commitment and
approval for investment in the project. The business
case is owned by the sponsor’ (APM)
This assumes
• The benefits, costs and risks can be assessed
• There is a well-understood problem that needs a
solution
• There is a defined sponsor
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 Financial appraisal
(Business case development)(Continued)

Financial appraisal (1) : Payback

• Compare the income that will be generated with the
initial investment to determine the payback period
• Example
– An initial investment of £30 million
– Generated revenue £6 million/year
– Payback = 30/6 = 5 years
• Companies may set time period
• Method is simple but
– Ignores total life-cycle costs
– Only considers costs within the payback period
– Time value of money ignored
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 Financial appraisal
(Business case development)(Continued)

Financial appraisal (2) : Discounted cash flow

• Considers time value of money by ‘discounting’
• Comparison of the value of the return to the value of the
sum invested had it been deposited in the bank at a given
rate of interest (the opportunity cost)
• Example
– Project aims to spend £100K on IT and £20K/year to maintain it for
4 years
– The return is £50K in terms of labour savings and extra profit
generated = £20K
– If the money was deposited in the bank instead at 2 percent interest
pa, at the end of year 4 the account would have £194 837
– Better to carry out project than to leave money in bank
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 Financial appraisal
(Business case development)(Continued)

Financial appraisal (2): Discounted cash flow (contd.)

• Compound interest on money in bank
– interest paid on (original sum plus previous interest)
• Discounting
– all monies considered in today’s terms, the present value (PV)
• Calculate the value of the sum that would have to be deposited
at a given rate of interest for a certain period to yield a stated
end value
• Benefits offset against costs – the net present value (NPV)
• NPV = PV of benefits – PV of costs
• Minimum criteria for project selection is NPV equal to or greater
than 0 at a given discounting rate
• Following examples explain...
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 Financial appraisal
(Business case development)(Continued)

Financial appraisal (2): Discounted cash flow (contd.)

Example 1
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 Financial appraisal
(Business case development)(Continued)

Financial appraisal (2): Discounted cash flow (contd.)

Example 2
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 Financial appraisal
(Business case development)(Continued)

Financial appraisal (2): Discounted cash flow (contd.)

• Discounting rate can be the interest rate earned in the bank

• More usual to consider project type and cost of borrowing
• Usual for revenues and costs to occur over period of years
– Future value (FV) – the value of the money C if deposited for
n years at an interest rate of i
– FV = C(1+i)n
– Rule of 72: if you invest a percent for b, where a x b = 72, your
money will double
– Example: £1000 will double if
• 6 percent pa over 12 years : 6 x 12 = 72 (£2012)
• 18 percent pa over 4 years : 18 x 4 = 72 (£1938)
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 Financial appraisal
(Business case development)(Continued)

Financial appraisal (2): Discounted cash flow (contd.)

Example 3
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 Financial appraisal
(Business case development)(Continued)

Financial appraisal (3) : Internal rate of return (IRR)

• The IRR is the discount rate for which the NPV
(Net Present Value) is zero
• By calculation, through a number of iterations
– Calculate the NPV with a variety of discount rates
gradually getting to NPV = 0
• By graph

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 Financial appraisal
(Business case development)(Continued)

Figure 8.5 NPV profile

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 Financial appraisal
(Business case development)(Continued)

Figure 8.6 NPV profile: large discount rate range

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 Financial appraisal
(Business case development)(Continued)

Figure 8.7 Multiple benefit and payment points

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 Financial appraisal
(Business case development)(Continued)
Using IRR
• No need to identify a discount rate
• Two projects may have the same IRR but different NPVs
– The project with the higher NPV is preferable
• But IRR cannot cope with changes in discount rate over time

Using discounted cash flow

• Built into most financial appraisal systems and spread sheets
• PMs can now build time and financial models which can be
interpreted by non-financial experts
• Limitations
– What interest rate should be used?
– Forecasting involves high degree of uncertainty
– ‘Cash flows’ are different from data presented in the balance
sheet (e.g. write-off values)
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 Financial appraisal
(Business case development)(Continued)

Determining cash flow figures for DCR and IRR

calculations
• Use cash flow figures, not profit figures
• Ignore sunk costs (costs already incurred)
• Only use variable costs (arising directly from
project)
• Exclude fixed costs (incurred whether project does
or does not go ahead)
• Take into account opportunity costs (developing
one area to the detriment of another)
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 Financial appraisal
(Business case development)(Continued)

Determining the discount rate

• Usually organisation’s policy
• Consider charge for use of capital, inflation, the
risk for the investor

Cash flow considerations

• Project sponsor will balance cost–benefit trade-
offs for a number of proposals
• In large projects timing of (stage) payments may
be critical
• Ditto financial risks despite credit checks
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 Challenges for the perceived wisdom
It is rare to have
• A well-defined benefit for a well-defined
investment
• Appraisal based solely on objective criteria

Conventional approaches are problematic when

• The return is not guaranteed
• Benefits are in terms of labour reduction
• The project is strategic (e.g. organisational
change)
• The organisation is in the ‘not-for-profit’ sector
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 Challenges for the perceived wisdom
(Continued)

Judgement on benefits will have to be qualitative –

sometimes a leap of faith is needed. For example
• Increased flexibility or capability
• Increased effective information transfer
• Improving quality of life
• Using a more expensive supplier because of an
ethical or environment stance

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 Factoring for optimism bias
(Challenges for the perceived wisdom) (Continued)

Comments on business case analysis…

• Experience shows that projects are usually
conservatively estimated
• Results will depend on the level of risk the
organisation is prepared to take
• Similar critical approach should be used on
benefits

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 Factoring for optimism bias
(Challenges for the perceived wisdom) (Continued)

Table 8.2 Recommended cost uplift for different project types

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 Benefits realisation analysis
(Challenges for the perceived wisdom) (Continued)

KPMG survey suggests

• 75 percent projects had no business case and
• 75 percent of the 25 percent that failed to meet the targets
included in the business case
Simply adding together the benefits of all projects in a
programme will not give the best overall picture
• Projects rarely act in isolation and
• Projects are frequently subject to overstated benefits
Despite optimism bias in costs and benefits, business cases
should not be ignored but should be critically analysed
using prior experience.

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 Summary

• Cost planning is important

– Likely costs can be determined through an iterative
process
– Similarly price and profit
– This establishes project viability
• There are many cost estimation techniques
– Although wishful thinking element to some
estimates
• Cost build-up integrates all elements
– This may become the budget against which project
will be assessed
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 Summary (Continued)

• The business case is developed through cost and

benefit analysis
– A rational process
– Founded on qualitative and quantitative analysis
– Behaviour interventions (e.g. optimism bias)
• Provide added complications
• May have a significant negative impact

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