The key to any successful project is designing an accurate cost estimate. Cost projections allow you to forecast the resources you need to execute a project, which ensures you complete the project on time and on budget, thus preserving your profit. Cost estimating is a mature discipline and some industries like construction have whole teams dedicated to the process. You can borrow their techniques to get you started with your own projections.
In essence, a cost projection is the summation of all the costs involved in finishing the project – both direct and indirect costs. Direct costs are costs that relate specifically to the project – without the project, these costs would not exist. Examples include the materials you need to buy and contractors' wages.
Indirect costs are the costs you need to keep the business running – you would incur these even if you did not perform the project. This category includes a proportion of the costs you share across a number of projects such as utilities or security costs.
Beyond these broad classifications, you can design specific categories of expenses that are applicable to your projected budget. Common examples include:
- Hardware and software.
- Facilities (renting specialized equipment or locations).
- Contingency costs: a financial buffer for additional expenses that you cannot yet foresee.
The next step is to assign a cash value to each of your heads of expense. The two most common methods of valuing the project are top down and bottom up. With a top-down estimate, you rely on past project data to create an estimate for current projects. If you repeatedly perform similar projects, it's easy to look at prior deliverables and their associated costs, and adjust those for the scale and complexity of the new project.
For example, if a previous project cost $20,000, and the current project is 20 percent bigger, then you would estimate costs of $24,000.
Bottom-up estimating breaks the project into a series of distinct milestones or work packages, then calculates the costs for that work breakdown. It's more accurate than top-down estimating because of the lower level of each component in each package. If you had a big construction project, for example, then one of the components may be to build a fence. This would be simple enough to estimate by adding the material cost of the fence posts and panels to the labor charge (daily labor rate multiplied by the number of days it will take to install the fence).
Add all the components together, and you have the final cost projection.
Rather than simply list the costs, you need to explain how you've arrived at the figure in the projection. Explaining your assumptions allows the project team to understand where the costs are coming from, and why actual costs may differ from projected costs. For instance, if you projected $10,000 for contractors, and the contractors' bill comes to $15,000, then the project team needs to see why you underestimated this cost. Where appropriate, include your cost data sources.
If the project has a long duration, then it's likely that work scheduled for the near future will have a more accurate cost estimate than work scheduled further away in time. Therefore, you may need to start with a rough estimate of future costs and firm this up as the project moves forward. There's no prescribed method for doing this, but the American Society of Professional Estimators classifies the accuracy of cost estimates on a five-point scale:
An order of magnitude estimate is an extremely rough cost estimate for when the scope of the project has not been defined, which may be the case for work taking place in the future. This is a high-level view of costs, which is often used to determine whether a project is financially feasible.
An intermediate estimate is useful when the project has been defined to some extent. It's also used for determining the viability of a project.
A preliminary estimate is created when the project is about halfway through, usually by adjusting an order of magnitude or intermediate estimate based on what you've learned during the first half of the project.
Substantive estimates are accurate cost projections, used for when the scope of the work is known and the time frames are not too far in the future. You can use this estimate to control project expenditure.
A definitive estimate is a fully-defined, final estimate prepared using bottom-up techniques. This is the most reliable estimate, useful when you know your base assumptions are not going to change and there's not much risk of project overruns or price fluctuations from your suppliers.