Cost estimation is the process of predicting the costs of all resources needed to complete a project within a determined time frame.
When completed correctly, cost estimations determine project budgets, and help set schedules and manage business resources. They also determine the rates for which businesses invoice clients for goods and services. This makes them vital to functioning business operations and project management.
Inaccurate estimates lead to lost profitability, inaccurate distribution of resources, and poor decision-making. Ultimately, they may result in project failure. In fact, 28% of projects fail due to cost estimates that inaccurately overestimated or underestimated project scope.
In this article, we take a look at the different types of cost estimation techniques and how mind maps can be used for cost estimations to facilitate project cost visualizations.
The Basics of Cost Estimation
When calculating all resources required for a project, some of these resources may be more obvious than others. For example, materials, equipment, labor, vendors, and facilities are commonly considered resources. Yet other resources––such as risk mitigation plans and policies––may be less obvious (but no less vital) factors in a project’s cost.
Each resource is considered a direct or an indirect cost:
- Direct costs are costs related to a specific area (such as a department). Labor, materials, and equipment are all examples of direct costs that can easily be tied to a department or a project.
- Indirect costs are costs related to the entire organization. Rent, utilities, and supplies are all examples of indirect costs that cannot be tied to a specific project or department (but are necessary for the business to function).
The cost estimation process includes considering both direct costs and indirect costs for a project.
Direct costs are paid from the project’s budget. They are connected to cost objects, which include services, products, or organizational departments. Most direct costs are variable, which means their costs will fluctuate based on what is required to complete the project.
Indirect costs are more difficult to calculate since they are not directly associated with a particular project. They are allocated over multiple projects instead of being paid for directly from a specific project budget.
Most companies group indirect costs into pools and apply them to project objectives as an indirect cost rate. Each indirect cost pool is allocated to an indirect allocation base:
- Fringe costs relate to your staff, such as payroll taxes, health insurance, and worker’s compensation expenses. Indirect fringe expenses are usually allocated over total labor dollars.
- Overhead costs are not directly tied to your company’s products or services but are required to run the business. Accounting, office, and IT expenses are all examples of indirect overhead costs, which are allocated based on machine hours or labor costs.
- General and administrative (G&A) expenses are the day-to-day costs your organization must pay to remain in operation, such as rent, utilities, and business insurance. Allocation bases for G&A expenses include total cost input (applies G&A expenses to all organizational costs not included in the G&A expense pool) and value-added (G&A expenses are allocated only to organizational costs and are excluded from expenses related to subcontracts or supply purchasing).
Understanding and classifying your direct and indirect project costs will help improve cost estimates. Both variables are key to calculating the final project cost, and costs may be underestimated if you do not account for both direct and indirect costs.
To accurately estimate a project’s cost, you first need to consider the scope of the work. The scope helps project teams identify the tasks required to deliver the project and estimate the required costs.
4 Common Cost Estimation Methods
There are many ways to estimate costs, and organizations may apply multiple techniques and tools in their cost estimation process. The technique that’s right for you will largely depend on your business size and industry. These are the four most common estimating techniques:
1. Top-Down Method
The top-down method is a common estimation technique used by managers, investors, and other executive-level individuals who need the cost estimate of a large project but do not know the particulars of each department or entity.
This method breaks a large project into smaller pieces; managers then pass this plan on to experts within these departments in order to gather specific cost-related details.
An example of the need for the top-down approach is the construction of a new building. A business leader may have the competency to select the business location, but lack the skills required to determine specifics related to the project, e.g., costs of building amenities such as elevators.
The manager would therefore pass these budget-related duties onto subject matter experts, then use their reports to develop a project cost estimate.
2. Bottom-Up/Analytic Method
The bottom-up/analytic method estimates all the individual parts of the project (e.g., specific tasks) and then adds them together to get the total project costs. This is the opposite of the top-down estimation method, which identifies the costs of each task or job in relation to the overall project budget.
Cost estimations using the bottom-up technique are highly accurate because this granular approach achieves the following:
- Defines the roles and responsibilities of team members and other stakeholders, with individuals estimating the specific tasks they are responsible for.
- Allows for error mitigation across project components, such as offsetting underestimation of one work component by overestimating another component.
- Integrates with other cost estimation methods to enhance overall accuracy, such as using the parametric technique to identify the needed resources for a specific work activity.
- Reduces risk in each phase of the project by helping project managers anticipate challenges and empowering team members to assume control as needed to respond to potential problems.
An example of the bottom-up methodology can be applied to an IT department that needs to move an on-premises application to the cloud. Using the bottom-up approach, project team members will identify the tasks involved in the project.
One part of the estimation process will include finding out how much cloud storage space is required to host the application. With the space requirements known, you can then determine the cost to the organization to store the application in the cloud.
Moving mission-critical applications to the cloud can be a lengthy, multi-step process depending on the type of solution moved, how many people use it, level of cloud integration, and more. By looking at the individual tasks associated with the migration project, you can accurately estimate costs and choose the best migration strategy for your needs and budget.
3. Parametric Method
Parametric cost estimation applies historical and statistical data to determine the project cost. It uses cost variables and data points from previous projects to produce accurate estimation. Examples of variables used in the parametric method include unit costs, the duration of resource use, and the number of resource units required.
Because parametric estimations can be reused for similar projects, the data quality improves with each new project. However, the accuracy of parametric estimation can be impacted if factors differ between current and past projects. These factors include:
- Personnel and experience. If the project team includes staff who do not have experience or skillsets relevant to similar projects, historical data based on expert project teams will not be fully reflective of the current project.
- Intangible outputs. Creative projects and tasks that require different amounts of thought and creativity will lead to inaccurate parametric cost estimations because it is more difficult to compare and repeat intangible outputs.
The equation for the parametric method is as follows: Estimated project cost = cost per parameter X parameter value
- The parameter is the measured unit, such as square footage or the number of product lines.
- The cost per parameter unit represents the cost to complete the task using averages collected from historical, market, and industry data.
- The parameter value is the number of parameter units used to estimate the project cost, such as 3,500 square feet or 15 product lines.
4. Three-Point Method
The three-point method helps project managers increase cost estimation accuracy by looking at projects under three difference scenarios:
- Optimistic estimate. This considers the best-case scenario, in which the project goes smoothly with no challenges or disruptions.
- Pessimistic estimate. This represents the worst-case scenario for completing project tasks, such as delays, resource shortages, or inefficient work processes.
- Realistic estimate. This is the most-likely scenario and estimates both pessimistic and optimistic conditions to arrive at a middle ground between the two.
To calculate the three-point estimate, you take the average of the three scenarios: Expected estimate = (optimistic estimate + pessimistic estimate + realistic estimate) ÷ 3
Predicting the future is nearly impossible, but by considering these three scenarios, the three-point equation helps management identify potential future risks, then budget appropriately.
Three-point estimations are of particular use when businesses need to calculate the risks of a project (such as the cost and the duration) but do not have accurate initial estimates to begin calculations.
For example, if this is the first time a company will venture into a new project, and they lacks concrete data regarding labor required to complete a task.
By factoring in the worst- and best-case scenarios into its estimate, the three-point estimate helps avoid over or underestimating the project’s scope.
Using MindManager to Create Cost Estimations
Cost estimations often require collaboration between numerous parties. To ensure effective communication between all individuals, consider using a tool like MindManager®.
MindManager is a visual diagramming tool that enables users to create mind maps, which are illustrations that highlight connections between certain elements, such as the tasks required to complete a project. Mind maps help users visualize complex ideas and can be powerful (and creative) communication and learning tools.
With built-in calculation tools, MindManager brings finance into the world of mind mapping. Here’s how to create a cost estimate for your next project using MindManager:
- Make a detailed list of all project tasks and the resources needed to complete them.
- Create a new map in MindManager, then label a node or bubble at the center or left side of your project map to identify each resource needed and the task associated with it.
- Build a project schedule timeline by estimating the time required to complete each task.
- Calculate the project based on your chosen cost estimation method. You can even create custom formulas to process cost estimation equations.
Cost estimates can be developed using a number of MindManager diagrams. For example, you can use a spider diagram to organize project data in a mapped, visual interface. This can help capture complex information related to project planning by linking specific, granular details back to a broad concept.
Download a free 30-day trial to see how MindManager can help you create cost estimates for your next project.