Chapter 4: Cost Management

What is the cost baseline?

The cost baseline is the basis for the earned value reporting system. It is the budget for the estimated cost of the project spread over the time periods of the project. As we noted in Chapter 1, in managing a project we are concerned about three baselines: the schedule baseline, the cost baseline, and the scope baseline. These three baselines comprise the goals of any project and deliver to the stakeholders what was asked for, in the time predicted, and for the money that was estimated.

The cost baseline is the part of the project concerned with the amount of money that the project is predicted to cost and when that money will be used. The three baselines are closely related, and changes to one of them will result in changes to the others. If a change is made in the project scope baseline, either by adding or removing some of the work that is required, the schedule baseline and the cost baseline will probably have to be changed as well. It is foolish for managers to change the project scope without considering the effect on budgets or schedules, yet it is done to project managers all the time.

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In order to develop the cost of the project and complete our project plans, it is necessary to do a bottom-up, definitive, detailed cost estimate for all the activities of the project. The cost of all of the planned activities spread over time is the operational budget, sometimes called the performance budget.

Some care must be exercised when planning the cost baseline. Since this is the basis for our performance measurement system, we must be careful that the budget is shown on the cost baseline at the same point in time where we expect the actual cost to occur. This can be quite a problem. Suppose we show the budgeted expenditure for an item we are purchasing to be on a particular date, say April 15. To the project management planners this is the date that the project team completes the work that will make the purchase take place. In other words, the project team decides what it needs to purchase and issues a purchase requisition to the purchasing department to actually buy it. The actual expenditure, the time when the money is actually spent, the time when the company actually issues a check to the company supplying the parts to the project team, might be several months later. Because of the time delay, the actual cost will be below the budgeted cost for several months. This will, of course, have the effect of making the performance reports look better than they are. If there are many delays in the reporting of actual cost in the project, the entire project may look much better than it really is. Of course, sooner or later the actual costs are shown. Then the project performance suddenly falls.

The cost baseline is not enough money to get the project done. In addition to all the work that has been identified, we will have some other work to do that was not planned. This unplanned work is the result of risks we took. Some of the risks in the project were identified and planned for while others come as a complete surprise. We will discuss risk management in Chapter 8. Risks are just project work activities that have a probability associated with them. The probability is a measure of the likelihood that they will or will not have to be done in the course of the project. The risks that have been identified must have an estimated cost associated with them as well as a probability. Multiplied together, the result is the expected value of the risk. For example, suppose that there is a risk of 5 percent that the paint on our project will not adhere properly and we will have to strip it off and repaint. If the cost of the repair is $1,000, it would not make much sense to budget $1,000 into the project for this risk. If we did this, all of our projects would be greatly overbudgeted. While it will indeed cost $1,000 to make the repair, it is only necessary to budget the expected value, 5 percent of $1,000 or $100. If the project is painted acceptably the first time, we will have an extra $100 in our project risk budget; if it is not, we will spend the $100 and $900 more.

Since any project will have many risks, some of them will result in extra cost and work, and others will not. If our estimates for probability and impact were correct, at the end of the project the budget for these risks should end up to be equal to the total expected value of all of the risks that actually took place in the project.

This takes care of the identified risks, but what about the risks that came as a surprise and were not anticipated? These risks, the unidentified risks of the project, must be budgeted as well. Unfortunately, the budget for these risks is going to be a bit of a guess. We can only rely on our past experience with other similar projects to come up with this estimate. These budgets for unknown and unidentified risks are generally estimated very roughly as some percentage of the total project. The percentage should be quite small, however.

Where the budget for unknown risks is higher than a very small percentage of the project cost, there is a chance that the risk identification process was poorly done and that many of the risks that could have been identified were not. In this case the budget for the unknown risks is frequently inflated as a way of compensating for this lack of identification. A much better solution would be to spend more time identifying the risks that can be identified, evaluating them properly, and setting aside a small amount of budget for the unknown risks.