Project Cost Management: Basic Principles of Cost Management

Many information technology projects are never initiated because information technology professionals do not understand the importance of knowing basic accounting and finance principles. Important concepts such as net present value analysis, return on investment, and payback analysis are discussed as Project Scope Management. Likewise, many projects that are started never finish because of cost management problems. Most members of an executive board understand and are more interested in financial terms than information technology terms. Therefore information-technology project management professionals need to be able to present project information in financial ten as well as in technical terms. In addition to net present value analysis, return on investment, and payback analysis, project managers must understand several other Cost management principles, concepts, and terms. This section describes general topics such as profits, life cycle costing, cash-flow analysis, internal rate of return, tangible and intangible costs and benefits, direct costs, sunk costs, learning curve theory, and reserves. Another important topic and one of the key tools and techniques for controlling project costs, earned value management, is described in detail in the section on cost control.

Profits are revenues minus expenses. To increase profits, a company can increase revenues, decrease expenses, or try to do both. Most executives are more concerned with profits than with other issues. When justifying investments in new information systems and technology, it is important to focus on the impact on profits, not just revenues or expenses. Consider an electronic commerce application that you estimate will increase revenues for a $100 million company by ten percent. You cannot measure the potential benefits of the system without knowing the profit margin. Profit margin is the ratio between revenues and profits. If revenues of $100 generate $2 in profits, there is a 2 percent profit margin. If the company loses $2 for every $100 in revenue, there is a -2 percent profit margin.

Life cycle costing allows one to take a picture view of the cost of a project over its entire life. This helps you to develop a more accurate projection a benefits. Life cycle costing considers the total cost of owner or development plus support costs, for a project. For example, a company might complete a project to develop and implement a new customer service system in one or two years, but the new system could be in place for ten years. Project managers should create estimates of the costs and benefits of the project for its entire life, or ten years in the preceding example. Recall that the n present value analysis for the project would include the entire ten-year period of costs and benefits. Senior management and project managers need to consider the life cycle costs of projects when they make financial decisions.

Corporations have a history of not spending enough money in the early phases of information technology projects. This history has an impact cost of ownership. For example, it is much more cost-effective to spend money on defining user requirements and doing early testing on information technology projects than to wait for problems to appear after imp1ementation The Table below summarizes the typical costs of correcting software defects during different stages of the system development life cycle. If you identified and corrected a software defect during the user requirements phase of a project, you would need to add $100 to $1,000 to the project’s total cost of ownership. In contrast, if you waited until after implementation to correct the same software defect, you would need to add possibly millions of dollars to the project’s total cost of ownership.

Table of Costs of Software Defects (5)

Cash flow analysis is a n for determining the estimated annual costs and benefits for a project and the resulting annual cash flow. It must be done to determine set net present value (Google “Project Scope Management” for more on this topic). Most con sumers understand the basic concept of cash flow. If they do not have enough money in their wallets or checking accounts, they cannot purchase something. Managers must take cash flow concerns into account when selecting projects in which to invest. If managers select too many projects having high cash flow needs in the same year, the company will not be able to support all of the projects and maintain its profitability. It is important to define clearly the year on which the dollar amounts are based. For example, if you based all Costs on 2002 estimates, you would need to account for inflation and other factors when projecting costs and benefits in future-year dollars.

Internal rate of return (IRR) is the rate that makes net present value equal to zero. It is also called the time-adjusted rate of return. Some companies prefer to estimate the internal rate of return instead of, or in addition to, net p value and set minimum values that must be achieved for projects to be selected or continued. For example, assume a three-year project had projected costs in year one of $100 and projected benefits in years two and three of $100 each year. Assume there were no benefits in year one and no costs in years two and three. Using a 10 percent discount rate, you could compute the net present value to be about $67 (Google for details on “performing net present value calculations”.) The internal rate of return for this project is the discount rate that makes the net present value equal to zero. In this example, the internal rate of return is 62 percents

Tangible and intangible costs and benefits are categories for determining how definable the estimated costs and benefits are project. Tangible costs or benefits are those costs or benefits that can be easily measured in dollars. For example, suppose that the surveyor’s assistant project described in the opening case included a preliminary feasibility study. If a firm completed this study for $100,000, the tangible cost of study is $100,000. If Juan’s government estimated that it would have cost them $150,000 to do the study themselves, the tangible benefits of the study would be $50,000. In contrast, intangible costs or benefits are costs or benefits that are difficult to measure in monetary terms. Suppose Juan and a few other people, out of personal interest, spent some time using government-owned computers, books, and other resources to research areas related to the study. Although their hours and the government-owned materials were not billed to the project, they could be considered to he intangible costs. In benefits of the study might be the perceived potential benefit of having a system that could help the government lay water lines or fiber-optic cable faster or for less money. Because intangible costs and benefits are difficult to quantify, they are often harder to justify.

Direct costs are costs related to a project that can be traced back in a cost-effective way. You can attribute direct costs directly to a certain project. For example, the salaries of people working full-time on the project and the cost of hardware and software purchased specifically for the project are direct costs. Project managers should focus on direct costs, since they can control them.

Indirect costs are costs related to a project that cannot be traced back in a cost-effective way. For example, the cost of electricity, paper towels, etc. in a large building housing a thousand employees who work on many projects would be indirect costs. Indirect costs are allocated to projects, and project managers have very little control over them.

Sunk cost is money that has been spent in the past. Consider it gone like a sunken ship that can never be returned. When deciding what projects to invest in or continue, you should not include sunk costs. For example, in the opening case, suppose Juan’s office had spent $1 million on a project over the past three years to create a geographic information system, hut nothing valuable was ever produced. If his government was evaluating what projects to fund next year and someone suggested that they keep funding the geographic information system project because they had already spent $1 million on it, he or she would he incorrectly making sunk cost a key factor in the project selection decision. Many people fall into the trap of considering how much money has been spent on a failing project and, therefore, hate to stop spending money on it. This trap is similar to gamblers not wanting to stop gambling because they have already lost money. Sunk costs should be forgotten.

Learning curve theory states that when many items are produced repetitively, the unit cost of those items decreases in a regular pattern as more units are produced. For example, suppose the surveyor’s assistant project would potentially produce 1,000 hand-held devices that could run the new software and access information via satellite. The cost of the first hand-held device or unit would be much higher than the cost of the 1,000 unit. Learning curve theory should be used to estimate costs on projects involving the production of large quantities of items. Learning curve theory also applies to the amount of time it takes to complete some tasks. For example, the first time a new employee performs a specific task, it will probably take longer than the tenth time that employee performs a very similar task.

Reserves are dollars included in a cost estimate to mitigate cost risk by allow for future situations that are difficult to predict. Contingency reserves allow for future situations that may be partially planned for (sometimes called known unknowns) and are included in the project cost For example, if an organization knows it has a 20 percent rate of turnover for information technology personnel, it should include contingency reserves to pay for recruiting and training costs for project personnel. Management reserves allow for future situations that are unpredictable (sometimes called unknown unknowns). For example, if a project manager gets sick for two weeks or an important supplier goes out of business, management reserve could be set aside to cover the resulting costs.

5. Collard, Ross, Software Testing and Quality Assurance, working paper (1997).