How to Estimate Project Costs?
10 Reliable Methods

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Estimation is one of the 4 core components of project cost management and an integral part of the budgeting process. The importance of cost estimation is hard to overrate – without adequate estimates, it’s impossible to allocate and utilize funds properly and ensure that the team won’t experience cost overruns at some point throughout the course of project realization. Overall, estimation is a significant prerequisite of a project’s long-term financial health, and it is essential to invest enough effort in performing this practice the right way.

But what’s the best approach to cost estimation? Unfortunately, there’s no single answer to that question. The purposes of different estimation techniques are not necessarily the same, and one must choose a method while considering how mature their project plan is.

This article will help you get a more in-depth insight into the matter of cost estimation and select the optimal means for cost calculation. Here, we’ve reviewed 10 estimation techniques and described their strengths and weaknesses. Besides, on this page, you will learn about the levels of estimates’ accuracy and the factors of their credibility.

With all this knowledge, you’ll get one step closer to your project’s success.

Estimate Credibility Factors

To fulfill its function and be of any value, a cost estimate should be reasonable and trustworthy. Yet how to guarantee that your calculation results are sufficiently credible? The U.S. Department of Energy recommends managers to abide by these 8 rules:

  1. Form a clear picture of the project’s constraints, characteristics, conditions and tasks to have a realistic view of its financial requirements;
  2. Involve employees from different organizational levels into the estimation process to ensure information applied during decision making is complete and reliable;
  3. Utilize relevant and high-quality data when estimating costs;
  4. Implement a standardized and structured approach to estimation;
  5. Take into account risks, uncertainties and possible environmental changes, including cost escalation;
  6. Recognize excluded costs and make sure you have a good reason for not including them in your project budget;
  7. Conduct an independent review of final estimates to verify their accuracy;
  8. Always update forecasts in case your project plan and design have been subject to any modifications.

If you succeed in sticking to these recommendations, your chance for creating sound and reliable estimates will increase multifold.

Just numbers + a notepad

Classes of Cost Estimates

Cost estimates may be characterized by varying levels of accuracy, depending on calculation techniques used and phases of the project’s life cycle when the estimation process took place.

Today, one can find many systems for categorizing cost estimates in terms of their accuracy. Below, you will find the one created by the U.S. Department of Energy:

  • Class 5 Estimate (lowest accuracy level) can be received during the initial phase of project planning.  Its only aim is to screen and evaluate different project and cost concepts. Methods: Analogies, judgment and parametric models.
  • Class 4 Estimate (low accuracy level) can be obtained when the project plan is defined by 1-15%. Its primary function is to analyze performance feasibility. Methods: Equipment-factored or parametric models.
  • Class 3 Estimate (medium accuracy level) can be developed when the project is defined by 10-40%. It serves to authorize and control budgets. Methods: Semi-detailed unit cost analysis.
  • Class 2 Estimate (high accuracy level) can be obtained when the project is defined by 30-70%. It supports cost control activities and bidding. Methods: Detailed unit cost analysis.
  • Class 1 Estimate (highest accuracy level) can be received when the project plan is mature by 65-100%. It helps verify cost estimates or design compelling bids. Methods: Detailed unit cost analysis.

As you can already see from the above classification, some types of estimation methods are best to utilize when the project is still in the early phase of its development. At the same time, others require extensive knowledge of project details.

To better comprehend which approach is appropriate for your situation, let’s take a closer look at 10 cost estimation techniques.

Cost Estimation Techniques

1.    Expert Judgment (Class 5)

Expert judgment implies consulting with experienced cost estimators or specialists in the field of your company’s performance. When predicting costs by using this technique, you rely on experts’ knowledge of the project’s contents and the general business environment. In return, you get meaningful, evidence-based assumptions and explanations of relational patterns between relevant cost variables.

Pro: While computerized cost estimation is widely considered to be the most accurate, results obtained with the help of digital analytics tools are still not always correct. To eliminate estimation errors and make common sense of the generated numbers, human insight is often required. Therefore, expert judgment is indispensable when you need to identify intricate correlations among different cost variables and project-related factors and verify the accuracy of computer-supported calculations.

Con: Regardless of how knowledgeable and skilled humans may be, they are prone to make mistakes, whereas their judgment is frequently influenced by emotion and prejudices. For this reason, cost estimates obtained through expert review can be subject to bias.

2.    Delphi Method (Class 5-3)

The Delphi method is an interactive forecasting technique carried out by a group of experts. During a series of meetings, each member of the expert panel provides their cost forecasts in the questionnaire format. The answers are then analyzed and anonymously announced to others by a facilitator. This activity is repeated for two or more rounds to provide experts with an opportunity to adjust their forecasts each time until the ultimate goal of the Delphi method – consensus on a final cost estimate – is attained.

Pro: Since the Delphi technique is performed by a collective of experts, it overcomes the disadvantage of expert judgment by reducing the risk of bias. Also, this estimation method is highly structured and implies the use of statistical analysis. Thus, it can be characterized by a relatively high level of result accuracy.

Con: Implementation of the Delphi method is a resource-intensive endeavor. It usually takes a lot of time to analyze individual answers gathered during panel meetings and reach consensus in case experts have highly varied opinions at the beginning. In some situations, the agreement may never be reached without some significant trade-offs. Besides, there’s also always a chance to attain consensus on a wrong estimate.

3.    Estimation by Analogy (Class 5)

Analogous estimation is the calculation of a new project’s costs by contrasting the knowledge of its contents and features with data obtained when administering a similar project in the past. This technique involves 3 key steps:

  • Determine a new project’s attributes,
  • Locate any previous project with similar characteristics and retrieve all the information about its costs and financial performance,
  • Develop original cost estimates based on the acquired historical data.

Pro: Estimation by analogy is relatively easy to carry out if you have experience in managing comparable projects and have kept their performance records. Moreover, since the results of your previous business endeavors are already known, you may adjust new cost estimates in a way that eliminates all the errors encountered before and leads to greater project success.

Con: Though analogous estimation may produce highly accurate forecasts, it is important to remember that data concerning past events does not always apply to the present-day business situation. Thus, to verify historical estimates and minimize the risk of errors, one needs to carry out an up-to-date environmental analysis as well.

4.    Vendor Bid Analysis (Class 5-3)

If services and products required for project realization are going to be provided by vendors, it is possible to determine the cost of the entire project or its components by comparing suppliers’ pricing bids or proposals. They can be collected in a structured way by using the request for proposal (RFP) document outlining project details, including service or product to be delivered by a vendor, as well as its quality requirements. After qualified suppliers return the filled RFPs, managers should analyze them to identify a possible project cost range and decide on final estimates.

Piggy bank + bidding hammer

Pro: Vendor bid analysis implies the utilization of data provided by competent specialists. Due to this, the technique is beneficial in situations when managers lack experience in running similar projects. A side advantage of the method is that it helps make more informed procurement and vendor selection decisions, considering both the cost and quality issues.

Con: This estimation method is not exhaustive, especially if only a portion of project realization activities relies on suppliers’ contributions. Besides, it doesn’t take into account administrative expenses and other indirect costs that still play an essential role in work on the project.

5.    Top-down Estimation (Class 5)

Top-down cost estimation starts with the identification of the overall scope of the project and its total cost. After that, the general cost is broken down into smaller components, depending on the project’s contents and attributes.

Pro: The top-down approach is perfect for preliminary cost estimation performed at the early stages in the project’s life cycle when managers still don’t have a detailed understanding of project features and activities involved. Since this technique doesn’t consider any nuances, it is very easy and fast to implement.

Con: Results of top-down estimation are usually generalized in nature and lack accuracy. Therefore, it is recommended to combine this method with more advanced techniques throughout the course of budgeting and project planning.

6.    Bottom-up Estimation (Class 3-1)

In contrast to top-down estimation, the bottom-up approach starts the cost calculation process with the identification and evaluation of separate project components. The expenditures for every individual project task or a series of tasks are then summed up to arrive at the total project cost.

Pro: The bottom-up estimation technique can be very accurate in case a thorough and complete work breakdown structure is applied.

Con: The development of a work breakdown structure is usually time-consuming and requires much effort, especially if the project under consideration is a complex one.

7.    Parametric Estimation (Class 5-3)

By using parametric estimation, the total project cost is calculated based on the number and price of the project’s sub-components, also known as work units. The estimation process includes just 3 core steps:

  • Identify relevant project units (i.e., number of peanut butter jars to be produced, square feet of pavement to be laid, lecture hours to be delivered, etc.);
  • Estimate the cost of every unit by summing up the price of materials, labor, etc.;
  • Use the following equation to form the overall picture of project expenses:

Number of Work Units × Cost of a Single Unit

To define the cost of a single unit before administering the project, you may refer to historical data taken from previous projects or industry examples.

Pro: Parametric estimation allows obtaining very accurate cost forecasts in case the calculated single unit costs are correct and realistic.

Con: The method is suitable only for projects characterized by a high degree of task repeatability and cannot be applied to creative ones.

8.    3-point Estimation (Class 3-1)

To calculate a probable project cost with the 3-point estimating technique, one needs to create 3 types of estimates:

  • An optimistic estimate – the amount of money your team hopes to spend on project activities,
  • A pessimistic estimate – the project’s cost in the worst-case scenario when many things go not as expected,
  • The best-guess estimate – a realistic figure, the amount of money the team will most likely spend on project activities.

The final project cost value is then calculated by using the following equation, also known as the PERT formula:

[Optimistic Estimate + Pessimistic Estimate + (4 × Best-guess Estimate)] / 6

Just 3

Pro: 3-point estimation is more detailed than the majority of single-point estimation techniques and can be very accurate if a thorough work unit analysis is carried out. One of its major benefits is that it takes into account project risks and, thus, provides managers with the information necessary to prevent cost overruns. In this way, it not only increases forecast accuracy but also contributes to a better quality of cost management in general.

Con: 3-point estimation is a time-consuming technique. Besides, it requires know-how and expertise to produce accurate results. It should be carried out by specialists who are perfectly aware of all project attributes and parameters, as well as the situation in the business world and potential environmental changes.

9.    Reserve Analysis (Class 5-4)

As an estimation technique, reserve analysis focuses on factors of cost uncertainty and is primarily concerned with avoiding risks that may lead to cost overruns. The purpose of this method is to determine the size of two types of backup sums:

  • Contingency reserve – the amount of money allocated for mitigation of various expected project risks (e.g., delays in supply, increased staff turnover, technological holdbacks, etc.).
  • Management reserve – the amount of money that could be utilized to tackle the outcomes of unidentified risks.

Pro: Reserve analysis can be viewed as part of both the risk mitigation and the budgeting processes. It enhances the quality of project cost management by preventing cost overruns and, in this way, maximizes opportunities for the overall success of the planned endeavor.

Con: Reserve analysis doesn’t help calculate types of project costs other than costs of risk (i.e., direct, operating and administrative expenditures, etc.). Therefore, reserve analysis can be applied only as an auxiliary tool and should always be combined with other cost estimation methods to develop accurate project budgets.

10.    Cost of Quality Analysis (Class 5-4)

The purpose of the cost of quality (CoQ) analysis if to figure out how much money is needed to meet the preset project quality standards. The CoQ calculation process comprises the following phases:

  • Define project quality requirements and standards;
  • Identify the cost of good quality (CoGQ): cost of activities needed to prevent quality failures + costs of quality appraisal activities;
  • Identify the cost of poor quality (CoPQ): expenses the project may incur as a result of internal quality failures (e.g., product re-design, waste of time and material resources, etc.) + expenses the project may incur as a result of external quality failures (e.g., customer complaints, shipping errors and damages, etc.);
  • Calculate the total CoQ with this simple formula:

CoGQ + CoPQ

The received CoQ figure is then used to inform fund allocation decisions in a way that minimizes the risk of financial loss and helps sustain the optimal level of product and service quality.

Pro: Like reserve analysis, CoQ estimation is part of the risk management process and plays a vital role in the prevention of cost overruns.

Con: The technique has a unilateral focus. It doesn’t assist in creating estimates for many essential types of project costs and isn’t enough to develop a comprehensive project budget.

Conclusion

As you can see, 10 techniques reviewed in this article produce cost estimates of different accuracy levels. However, if an estimation method is associated with only vague and imprecise calculations, it doesn’t mean it should be discarded right away.

Even inaccurate cost estimates are useful when you’re still planning your project. Besides, approaches used for their creation are usually easy to implement. Thus, lower-class estimation techniques will readily support you in the evaluation of multiple cost variants and scenarios. With their help, you can generate and assess new ideas, perfecting the overall strategic and tactical picture of your future project and gathering all the information needed to arrive at more accurate forecasts at later stages in the project development process.

Do you have any comments and questions regarding this article? Please share them with us at productivity@actitime.com.

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