What is the difference between estimated cost and price?

Estimating cost means developing the approximate cost of completing the entire project or part of it. It is the expected quantitative result. When we estimate the cost of doing a project, we are estimating the amount of money that it will take to complete the entire project.

In addition to the project completion cost, we may frequently include the life cycle cost as well. Normally the cost of the project includes only the amount of money that will be spent by the project team up until the time the completed project is turned over to the client and the stakeholders. Life cycle cost includes the cost of the project that continues after delivery of the project throughout the useful life of the project. Although the project team will be concerned with the cost of the project up until the time of delivery, many of the decisions it makes will affect life cycle cost and should be discussed with management and the stakeholders and shown in the project justification.

The selling price minus the cost of the project is equal to the profit of the project.

Selling price is the amount of money the organization will charge to deliver the project. This may be more or less than the cost of the project. The price of a project should be equal to the perceived value to the customer. The value to the customer is generally what money the project will generate for the customer and has little to do with what it costs to produce the project.

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Many companies undersell their projects. For example, a client comes to the company and asks that the company do a project for them. The description of the requirements of the project produces a cost estimate for the amount of money that must be spent to deliver the project. Many times the company has a history of making a certain percentage of profit on its projects. It uses this percentage to factor up the estimated cost of the project to develop the selling price. It may be that the customer is willing to pay much more to have the project completed. The reason the customer is willing to pay more is that the customer is going to use the project in a way that will generate revenue for the company. This anticipated revenue justifies the higher price for the project. This is the perceived value to the customer. In other words, if we can deliver a project for a cost of $25,000 that has a value to our customer of $100,000, should we charge them $100,000 or something slightly more or less than that?

What we should do is sell the customer the project at $100,000 and use the $75,000 profit to improve our business so that we will continue to be competitive when our competition offers our customer similar projects at lower prices in the future. In a free market economy this is what will surely happen. Competitors will see that we can make large profits in this type of business and will enter the market to compete with us at ever lowering prices.

Where a company can get into trouble is in not realizing this. Let us say that in the above example, we mistakenly estimated the cost of doing this same project at $50,000 and we sold it to our customer at a price of $100,000, making a nice profit of $50,000. If the estimate to complete the project were $50,000, it is likely that the actual project cost will be close to $50,000. In most companies there will be little for management to complain about if the project is completed for the budget that was set for it. The project team will usually not take corrective action if project tasks are being completed within the expected budget. Most companies work this way because they have other, more serious problems to worry about. They follow the adage, "If it ain't broke, don't fix it".

Remember that the correct cost for this project was $25,000 and our company is making the project for $50,000. Of course the company does not know that the project should really cost close to $25,000. It thinks that the estimate is correct at $50,000. Since the company is making a $50,000 profit, it will be very satisfied. Eventually the competition will start quoting similar projects to our customer at lower prices and the customer will accept them. This means that we will have to reduce our prices as well. If we think that we are operating at the least cost of $50,000, this price reduction will reduce our profits. This may still be acceptable until our point of minimum profit is reached. If competition forces us to reduce our price below $50,000, we will be losing money on this business.

Many times companies leave the business rather than find out that their cost has been $25,000 higher than it should have been for years. They tend to be resistant to change. They frequently cannot convince themselves that they can reduce the cost of what they have been doing so successfully for years. They will claim instead that the competition is "buying" the business and is doing the work for less than their actual cost. They will claim that their long-time customer is being lost for any reason other than the correct one. That reason is that they have been wasting money all these years and doing projects like this at far above what their true cost should be.

It is important then to have accurate cost estimates for what we are to produce because without good cost estimates, we will never know what the true cost should be. Having made good and realistic estimates we must then sell our projects for the perceived value that they have to the customer and the stakeholders.