B-BDS311 PROJECT APPRAISAL AND IMPLEMENTATION

UNIT 1 PROJECT MANAGEMENT IN CONTEXT

1. DEFINITION OF A PROJECT
There are many written definitions of a project. For those looking for a formal definition of a
project, the Project Management Institute (PMI) defines a project as a temporary endeavor
undertaken to create a unique product, service, or result. The temporary nature of projects
indicates a definite beginning and end. The end is reached when the project’s objectives
have been achieved or when the project is terminated because its objectives will not or
cannot be met, or when the need for the project no longer exists.

2. WHAT IS PROJECT MANAGEMENT?

An official definition of project management, courtesy of the Project Management Institute,
defines the term as the application of knowledge, skills, tools, and techniques to project
activities to achieve project requirements.

A more tangible (but less interesting) description is that project management is everything
you need to make a project happen on time and within budget to deliver the needed scope
and quality.

In order to really get our heads around these definitions, we need to discuss some of the
terms. A project is distinguished from regular work in that it’s a one-time effort to change
things in some way. So the creation of a new web site would be a project; ongoing
maintenance and minor updates would not.

Time and budget are familiar terms—perhaps the project is intended to take six weeks and
have a budget of $20,000. Scope refers to the list of deliverables or features that have been
agreed—this is where the scale of the required solution is identified. For instance, creating a
new web site for the company may realistically be possible in six weeks, but rewriting all the
accounting software isn’t. Quality is exactly what it says on the tin, but in project-speak,
quality may include not only the quality of the finished product, but also the approach.
Some industries require that particular quality management approaches be used—for
instance, factories producing automotive parts have to meet particular international
standards.

These four aspects (time, budget, scope, and quality) make up what’s known as the balance
quadrant. The balance quadrant demonstrates the interrelationship between the four
aspects and how a change to one aspect will unbalance the quadrant. For instance, an
increase in the project’s scope will have an impact on the time, the cost, and the quality of
the project.

3. CHARACTERISTICS OF A PROJECT
• A project contains a well-defined objective. The project objective is defined in terms of
scope (or requirements), schedule, and cost

• A project is carried out via a set of interdependent tasks.

• A project uses various resources to carry out these tasks.

• A project has a definite start date and an expected completion date. The actual
completion date may not always be the same as the expected date.

• A project is a one time or unique endeavor.

• A project has a customer.

4. LIFE CYCLE OF A PROJECT

The life cycle of a project consists of all activities from the very beginning of formulating the
idea of the project until to the formal completion of the project, normally divided into four
groups. These groups of activities are to a great extent linearly ordered and are called
stages:

2 Life cycle of a project

Sometimes project monitoring is considered the fifth stage. This stage then has a special
status because it runs in parallel to the other stages.

The activities within a stage depend on the type and volume of the project. We list activities
that are present in most projects (the main aim of the stage is indicated in brackets).
There are always some project-related activities that are performed after project completion.

The division of the life cycle of the project into stages gives an opportunity to break off the
project after the initiation and planning stages if it will be unreasonable to proceed with the
project. It would cause huge losses if the project would be cancelled in a later phase. A
project can have two or even more planning phases. If, for example, a project proposal was
rejected, then based on additional information (explanations, reports, etc) the project plan
should be changed accordingly. Sometimes a successful project can be repeated in another
context by making only a few necessary modifications.

We will discuss the stages and activities in more detail in subsequent sections; here we point
out the most important aspects only.

Identification of needs is extremely important as it determines to a great extent the

success of the project. The probability of being financed is larger if:

• The project corresponds to the priorities of the donor/financing institution;

• The outcome of the project causes a significant advancement in relation to the

solutions used before;

• The target group benefiting from the outcome of the project is big

In the identification of the needs it is important to understand the interests of the decision
makers.
Needs analysis should reveal the most important factor(s) the project should deal with.

The determination of the main objective and resource analysis is usually performed in
parallel. The main objective should be formulated very clearly and in measurable terms. The
objective cannot be “to analyse” or “to investigate” something. Analysis and investigations
can only be tools for achieving the project objective. Ambitious objectives can be reached
by two or more projects.

Resource analysis and especially deciding on partners should act as an assurance that
the project will not have big problems and that in case the project faces difficulties the
partners will support each other.

The project charter serves primarily to create the project team and obtain acceptance to
start project planning. The charter is a short (usually 1-2 pages) document that states the
main objective, lists the main activities and outcomes, necessary resources, etc.

The composition of a project plan is a good success indicator of the project’s success
potential. If the partners complete the tasks correctly and in a timely manner in the
preparation process, then it can be expected that the project will be successful as well. A
perfect project plan is another success indicator while a poor project plan can be rejected
even if the objective of the project is great.

PR activities are necessary for

• Forming a public opinion of the importance of the project,

• Convincing potential donors that you are able to successfully run the project.

5. SO WHY DO PROJECTS FAIL?

i. Poor project and program management discipline

ii. Lack of executive-level support

iii. Wrong team members

iv. Poor communication

v. No measures for evaluating the success of the project

vi. No risk management

vii. Inability to manage change

6. PROJECT CLASSIFICATION
There is no standard classification of the projects. However considering project goals, these
can be classified into two broad groups, industrial and developmental. Each of these groups
can be further classified considering nature of work (repetitive, non-repetitive), completion
time (long term, shot term etc), cost (large, small, etc.), level of risk (high, low, no-risk), mode
of operation ( build, build-operate-transfer etc).

Industrial projects also referred as commercial projects, which are undertaken to provide
goods or services for meeting the growing needs of the customers and providing attractive
returns to the investors/stake holders. Following the background, these projects are further
grouped into two categories i.e., demand based and resource / supply based. The demand
based projects are designed to satisfy the customers’ felt as well the latent needs such as
complex fertilizers, agro-processing infrastructure etc. The resource/ supply based projects
are those which take advantage of the available resources like land, water, agricultural
produce, raw material, minerals and even human resource. Projects triggered by successful
R&D are also considered as supply based. Examples of resource based projects include food
product units, metallurgical industries, oil refineries etc. Examples of projects based on
human resource (skilled) availability include projects in IT sector, Clinical Research projects
in bio services and others.

Development projects are undertaken to facilitate the promotion and acceleration of overall
economic development. These projects act as catalysts for economic development
providing a cascading effect. Development projects cover sectors like irrigation, agriculture,
infrastructure health and education.

The essential differences between Industrial projects and Developmental project are
summarized in the table below:

ension Industrial Project Developmental Project

Scale of Project Limited Large
Promoters Entrepreneurs or corporates Government, Public Sectors, NGOs
Investment …………. High
Gestation Period …………. High
Profitability High, Considered on IRR Modest, Considered on ERR
( Internal Rate of Return) (Economic Rate of Return)
Finance Stringent debt equity norms Operates on higher debtequity norms
Source of fund National stock markets and International organizations like World
from domestic financial Bank, IMF,ADB,DFID and others mostly
institutions as loan ,yet times providing for some
grants.
7. PROJECT MANAGEMENT ACTIVITIES
Project management activities are activities that are the responsibility of the project
manager and that usually are performed (or delegated) by the project manager. There is no
fixed list or taxonomy of project management activities, however, some activities are listed
below:

1. Planning, organizing and coordinating the work of the project team.

2. Acquiring and allocating human and other resources.

3. Controlling project execution, tracking and reporting progress.

4. Solving problems/conflicts both inside the project team as well with other parties.

5. Assessing and controlling the risks.

6. Informing the project team and other parties involved about the state of the art of the
project, as well as about success and problems.

7. Creating the necessary work environment.

8. Encouraging devotion, excitement and creativity inside the project team.

8. MEASURING PROJECT SUCCESS

We measure the success of a project using 4 major project constraints, specifically:

• Scope.

• Cost.

• Schedule (Time).

• Customer satisfaction (quality and performance).

9. COMMON PROJECT TERMS

• Deliverables: Tangible ‘things’ that the project produces

• Milestones: Dates by which major activities are performed.

• Tasks: Also called Actions. Activities undertaken during the project

• Risks: Potential problems that may arise

• Issues: Risks that have happened

• Gantt Chart: A specific type of chart showing time and tasks. Usually created by a
Project Management program like MS Project.

• Stakeholder: Any person or group of people who may be affected by your project

• Need: refers to the gap or discrepancy between a present state (what is) and a desired
state (what should be). The need is neither the present nor the future state; it is the gap
between them.

• A Needs Assessment: is a systematic approach that progresses through a defined

series of phases.
UNIT 2 PROJECT APPRAISAL
1. RATIONALE FOR ORGANIZATIONAL PERFORMANCE
Organizations are formed for varied purposes that include attaining the set objectives of
stakeholders who form them, an association of persons or a segment of the market. They
could also be formed to interact or utilize collective capabilities. For profits organizations
are formed to engage in activities which maximize profits while community-based
organizations are formed to deliver empowerment to its members and the society as well
(Bedanand et al., 2014). Organizations such as faith-based organizations could be formed to
offer spiritual nourishment to the community while organizations such as human rights
activist groups may exist to defend the rights of the public. Bedanand et al., (2014) notes
that all these organizations have one thing in common: they are formed to achieve a
particular mission. They also have a long term vision where they see themselves in future
but most importantly they have goals and objectives that they set to get there.

It is therefore very important for organizations to perform and attain their aspirations of
why they began. Progressively more, organizations are becoming concerned in finding out
how best they are meeting the customers’ needs, acclimatising to changes in the
organization’s external and internal environments, identify the organization’s added-value
or position in the competitive global environment and identify as well as address the risks
and challenges which may potentially affect the organization’s future efficacy, sustainability,
and relevance (Winston, Stevens, Sherwood, & Dunn, 2013). These are the core pillars of
performance that any organization must aim at achieving. Missoni & Alesani (2013), states
that organizational performance can be achieved through its strategies, adaptive leadership,
evidence-based practices and resource capacity. They further observed that strategies shape
the optimal methods to achieving the organization's long-term impact while adaptive
leadership encourages innovation. Evidence based practice helps an organization to make
decisions based on data and not intuition and the resource capacity enables it to function
effectively and efficiently. The evidence based practice is a central link in project appraisal
and therefore cannot be ignored by organizations in its pursuit of performance. It is this link
that the study attempted to examine and how it enables an organization to perform highly.

Organizational performance entails increased growth and productivity, satisfied customers

who are retained by the organization, a vibrant financial performance and most importantly
the sustainability of performance in the long run. Bedanand et al., (2014), pointed out that
customer satisfaction causes an organization to retain its customers whilst increasing
growth and productivity which results in financial gains for the organization. Ultimately, an
organization that maintains this model was able to have a sustainable performance.
2. CONCEPT OF PROJECT APPRAISAL IN PROJECT
MANAGEMENT
Project management has been hailed as one of the most monumental and auspicious skills
in recent and current times because of how organizations and management can use it to
help in controlling costs, reducing the probable risks and improving set outcomes (Aubry et
al., 2014). Project management has been defined as the activities involving the planning,
organizing, and executing of a pre-established set of steps in order to maximize the use of
resources and achieve specific objectives (PMI, 2013). The Project Management Institute
(PMI), an organization created in 1969 to promote the discipline of project management,
acclaims the process with helping businesses to save time and money, improve their Return
on Investment (ROI) and reduce risk. It also highlights many benefits to an organization’s
staff members including improved collaboration and decreased stress as a result of
teamwork.

When deciding which projects an organization intends to implement, an organization must

institute an appraisal of the potential project to make sure the project was actually effective
and that it supports the right solution and solves the problem that hampers the
organization’s performance. In this context, project appraisal management serves as the
major process of analysing and approving the project. According to Harris (2012), projects
to be implemented must undergo screening to determine their viability before being
implemented. He further noted that by using the more common financial appraisal and
ignoring non-financial criteria, organizations were bound to implement projects that are not
aligned to their mission, vision and objectives. The organizations was also bound to
experience market and competition risks, socio-economic risks as well as technical risks that
may affect its performance, specifically in growth aspects, customer satisfaction and
sustainable competitive advantage (Almeida & Duarte, 2011).

3. DEVELOPMENT OF A TYPICAL PROJECT

A project usually passes through three developmental phases:

• Pre-investment phase – A phase in which the project idea is generated and conceived.
This includes the identification of relevant investment opportunities, preliminary filtrations,
project formulation and trial evaluation decision.

• Investment phase – The second phase comprises the formulation of detailed design and
implementation. This involves several inter-disciplinary tasks comprising negotiation and
contracting, preparation of detailed project design and its implementation.
• Operations phase – This is the third and final phase in which the actual operation
commences. This involves the day to day operation of the completed project resulting in
anticipated benefits and attainment of desired objectives.

4. TECHNICAL APPRAISAL
You may well appreciate that a project can be considered for implementation once it is
technically fit for implementation. We should also consider the different alternative
technology options that are more cost effective and environmental friendly. A technology is
considered appropriate only if it is assessed to be satisfactory and relevant, vis-à-vis the
following aspects in the specific situation to the project.

• Specification of the task/ product

• Developmental imperatives (growth of employment, maximum use of local resources,

reduction in parities of income level etc)

• Required gestation period versus the time available for the project.

• Indigenous availability of comparable technology.

• Dependence as non-renewable resources of energy

• Capacity of the organisations to absorb/ adopt the technology

• Timely availability of man power with required skills

• Safe characteristics

• Environmental and socio-cultural sensitivities

5. MARKET APPRAISAL
It is imperative that you should consider the requirements of your customers before
finalizing any project idea. To survive in the market you have to be forward looking, carry
out market/ demand analysis and develop strategic business policies. In this session we will
discuss the various aspects that should be considered in market appraisal.

5.1. Demand Forecasting

You are aware that all business planning starts with forecasting. High volume, high
technology, mass production systems have further underlined the importance, of accurate
demand analysis. Any mismatch between actual production and demand will lead to higher
capital tied up in the finished products which are slow in selling. The demand forecasting
can be any of the following levels

i) Firm Level: Forecast demand at the national, state or regional levels

ii) Industry Level: Forecast demand for the industry on a whole at the national, state or
regional levels (may be undertaken jointly by group of companies)

iii) National Level: Forecast demand to facilitate the government to take policy decisions
on import, export etc.

iv) International Level: Forecasting demand for companies operating at the multinational
level.

5.2. Criteria for a Good Forecasting Method

You may consider the following as good indicators while making your demand forecast.

i) Accuracy in forecast: The accuracy of your forecast depend on the basic assumptions
based on which you developed the prediction. It can be measured in terms of past forecast
against, current revenue and by the present as of deviation from actual demand.

ii) Plausibility of forecast: You may note that the forecasts of demand must be reasonable,
consistent and plausible

iii) Economy of forecasts: You may carry out your forecast exercise with minimum effort
and cost

iv) Quick results: The method you have selected should be capable of yielding quick and
useful results v) Flexibility: Flexibility of forecast is an added advantage. You may be able to
adjust co-efficient of variables from time to time the cope with the changing conditions.

You may now be curious to know how a systematic demand forecasting can be carried out.
Different qualitative and quantitative techniques are available for conducting a reasonably
accurate forecast of demand. We may now further discuss some of those techniques.

i) Collective opinion survey: The sales/field personnel attached to an area will collect the
opinion of the customers on the product/ services of a firm. These estimates are collated,
reviewed and revised to work out a realistic demand forecast.

ii) Survey of customer intention: Collection of customers intention through questionnaires

or through interviews.
iii) Delphi method of demand forecasting: Opinions of experts in the related field are
collected, collated, edited and summarised. The summarized report will again be subjected
to cross verification by experts in the panel.

You may note that quantitative techniques such as simple average method, moving average
method, exponential smoothing method, Regression analysis, Econometric models etc are
available for demand forecasting.

6. ECONOMIC AND FINANCIAL APPRAISAL

Economic appraisal can be defined as a judgmental technique that may be applied to a
project, program or policy by taking into account its costs and benefits that are
denominated in monetary terms or which a comparable monetary value can be estimated
(Sloan & Hsieh, 2012). A more technical explanation was given by Rima (2012), who
observed that economic appraisal as a logical process that examines alternative use of funds
and resources assessing the needs, the objectives, the options, the costs, the benefits, the
risks, the funding, the affordability and other factors relevant for decision making. Economic
analysis aims to assess the desirability of a project from the societal perspective. The
rationale behind economic appraisal was to analytically explore the justification for a
project, its objectives, costs and benefits so as to find out if the project in was affordable
and represented good value for money, given the risks involved (Lorna & Virginia, 2011).
This type of appraisal differed from financial appraisal since financial appraisal is generally
done from the perspective of a particular stakeholder such as an investor, a lender or a
government agency (Burg, 2012). There are three methods employed in economic appraisal
approach. These methods are; costbenefit analysis (CBA), cost-effectiveness analysis (CEA)
and cost-utility analysis (CUA) (Rima, 2012).

In this section we will discuss the economic and financial appraisal for the final selection or
rejection of a project.

6.1. Average rate of return on investment

This is an accounting method taking book profit after taxes and depreciation as revenue for
appraisal. There is also disagreement on the definition and a number of alternative methods
of calculating the rate of return are available. The most commonly used equation is given
below. Please refer equation 2.1 Equation 2.1
6.2. Pay Back Period (PB)
You may note that pay back period is a conventional or traditional method which is simple
and perhaps most widely used for project appraisal. It is a measure, in terms of time, it will
take to recover from proposed operations, the initial investment which normally disregards
the salvage value of the equipment at the end of its useful life. You can calculate the
payback period as mentioned below. The revenue to be considered here will be cash flow
after taxes but before depreciations.

• When the cash flows are constant throughout the life of the project

6.3. Discounted Cash Flow Techniques

As you have already noted, traditional methods of project evaluation do not take into
account the total benefit from the entire life cycle of a project. They also do not consider the
time value of money which should be an important criterion for project appraisal. Now let
us acquint with the following discounted cash flow technique.

Net Present Value (NPV)

The objective any business organisation, in the modern context will be to maximize the net
present value or net present worth of an organisation. The NPV technique, therefore, is in
perfect agreement with the wealth maximization objective of the firm duly considering the
time value of money, which are absent in the conventional techniques.

Let us now understand what is NPV and how it is calculated. NPV is the difference between
Gross Present Value of expected future benefits and initial investment the Gross Present
Value of expected future benefit is calculated by multiplying the cash flow after taxes of
each years with an appropriate discounting factor.

Discounting factor, which is otherwise known as cost of capital or cut off rate is the
minimum rate of return expected by an invests to keep the market value of his share
unchanged.

Symbolically, the calculation of NPV can be expressed as follows:

6.4. Internal Rate of Return (IRR)

Now let us discuss another method of time adjusted technique to evaluate an investment
proposal. You may understand that this method is known by many other names also – yield
on investment method marginal efficiency or capital method, marginal productivity of
capital method, rate of return method, time adjusted rate of return method etc. This method
is best described as the rate of return the project earn for itself because, it is that
discounting factor which equates the present value of cash flow with the aggregate present
value of cash outflows of the project i.e. this rate of discounting which gives zero NPV.

You may note that the calculations of IRR is a difficult task. IRR is a powerful financial tool to
assess the financial viability of the project. It can be accomplished through trial and error
method. However, there is an easy method to calculate IRR if we follow the steps in the
sequence given below.

Step 1: Determine a fake - pay back factor (FPBF)

Step 2: Refer Present value an annuity of Rs. 1 table and find out the factor which is almost
near to the fake pay back factor (Table given in appendix 2) look horizontal to the last years
cash flow. e.g. if cash flow is upto 10 years, look horizontal to 10th year.

Step 3: Find out NPV based on that factor (look vertically at the top and find out
percentage). If NPV so calculated is negative, try at a lower rate and continue the process till
you arrive at a positive NPV. You may reverse the process if the originally calculated NPV is
positive.

Step 4: Now you have positive and negative NPV. The exact value of NPV now can be
calculated by applying the formula of interpolation as given below:

You can start with highest rate also. If you follows highest rate, NPV will be as per the
following equation.
7. SOCIAL COST BENEFIT ANALYSIS
Social cost benefit analysis is done from the view point of society or economy as a whole.
The evaluation is done on a wider angle not merely on financial terms. Social appraisal of
projects should cover the following whether.

• It fits into natural priorities

• It contributes to the development of that sector or economy

• Benefits justify the consumption of scare resource of the nations.

The concept of social cost benefit analysis, as you are aware, is fairly simple and well known.
The application of cost benefit analysis on a limited scale, started in India in the sixties. The
SCBA has not widely been used except in case of some irrigation project. It is only in the last
few years that the planning commission has been insisting upon CB analysis as a criterion
for ‘passing’ a project for public investment. SCBA thus reflects the opportunity cost of the
project.

7.1. Methodology for SCBA

A systematic application of SCBA would generally involve the following.

• Estimating economic, social and environmental inputs and outputs of the project.

• Assigning prices (values) for the estimated inputs and outputs.

• Determination of an appropriate discounting factor

• Assessment of social acceptability of the project

7.2. Estimation of Benefits and Cost

You can broadly classify the economic, social and environmental benefit and cost of a
project in to three categories. The first category comprises those benefits and costs which
can be quantified and can also be translated in to money terms. For instance, benefits from
a hydro-electricity project arising in the shape of supply of electricity can be quantified in
terms of units of electricity generated and distributed. You can also translate this into
monetary terms by using the rate per unit of electricity to be charged by the project
authority.
The second type of benefits and costs are those which could be quantified but cannot be
translated in to monetary terms. For example, if as part of the hydro-electricity project, a
dam is constructed for storing water to bring it through penstocks for throwing the water
on the generators to run them, the storing of water in the dam may yield benefits in the
second category. If it can be traced that the dam would be put up in an area which has been
flood prone and because of recurrence of floods in the area ten lives used to be lost every
year, the dam by holding flood waters would save the area from recurrence of floods, and
thus would save ten lives which used to be lost every year. The benefits in such a case would
be ten lives saved per annum, which has been quantified but cannot be translate into
money terms. You know that it is fairly difficult to assign a socially acceptable money value
to a life saved.

The third category of benefits and costs which can neither be quantified nor translated in to
money terms. Continuing our example of the dam to be constructed as part of the hydro-
electricity project, it would also render benefits to the environment of its existence
beautifies the area and improves the landscape because of he availability of water. However,
these benefits rendered to the society by the creation of the dam would be of an intangible
nature which can neither be quantified nor translated into money terms.

7.3. Shadow prices

You will agree that the cost and benefits of a project can be estimated only if the inputs are
translated in to cost by the use of price mechanism. The output of the project which is
measurable and convertible in to money terms is translated in to monetary benefits with the
help of prices. What prices are used for converting inputs in to cost and output in to
monetary benefits determine the complexion of social cost benefit analysis. These prices
which are relevant for use in social cost benefit analysis are called shadow prices or social
prices or planning prices, or accounting prices.

You may be aware that the prevailing market prices need not reflect the true scarcity value.
In SCBA you may go what is behind market prices. The shadow prices express prices in
terms of opportunity cost. If for example, the real resources used for producing a ton of
fertilizer cost Rs.2000/-, its shadow price should be Rs.2000/- per ton even it may be
supplied to the farmer at a subsidized rate of Rs.1500/- per ton. Hawala rate will be a fair
reflection. You may look at another example. If the prevailing rate of foreign exchange is
higher than the officially fixed rate, then the price of imports in to country is understated. In
such a case, the shadow price of foreign exchange used in social cost benefit analysis would
be higher than the official exchange rate. Also, while determining shadow price of a
commodity, taxes are renewed from the market price, as these are considered to be transfer
payments and therefore not a cost to the society.

8. CONTROLLING COSTS
Controlling project costs includes monitoring cost performance, ensuring that only
appropriate project changes are included in a revised cost baseline, and informing project
stakeholders of authorized changes to the project that will affect costs. The project
management plan, project funding requirements, work performance data, and
organizational process assets are inputs for controlling costs. Outputs of this process are
work performance measurements, budget forecasts, organizational process asset updates,
change requests, project management plan updates, and product document updates.

8.1. Earned Value Management

Earned value management (EVM) is a project performance measurement technique that
integrates scope, time, and cost data. Given a cost performance baseline, project managers
and their teams can determine how well the project is meeting scope, time, and cost goals
by entering actual information and then comparing it to the baseline. A baseline is the
original project plan plus approved changes. Actual information includes whether or not a
WBS item was completed or approximately how much of the work was completed, when the
work actually started and ended, and how much it actually cost to do the completed work.

Earned value management involves calculating three values for each activity or summary
activity from a project’s WBS.

1. The planned value (PV), also called the budget, is that portion of the approved total cost
estimate planned to be spent on an activity during a given period.

2. The actual cost (AC) is the total direct and indirect costs incurred in accomplishing work
on an activity during a given period.

3. The earned value (EV) is an estimate of the value of the physical work actually
completed. It is based on the original planned costs for the project or activity and the rate at
which the team is completing work on the project or activity to date. The rate of
performance (RP) is the ratio of actual work completed to the percentage of work planned
to have been completed at any given time during the life of the project or activity.

The cost performance index can be used to calculate the estimate at completion (EAC) an
estimate of what it will cost to complete the project based on performance to date.
Similarly, the schedule performance index can be used to calculate an estimated time to
complete the project.

8.2. Project Portfolio Management

Many organizations now collect and control an entire suite of projects or investments as
one set of interrelated activities in one place a portfolio. Project managers need to
understand how their projects fit into the bigger picture, and they need to help their
organizations make wise investment decisions. Many project managers also want to move
on to manage larger projects, become program managers, then vice presidents, and
eventually CEOs. Understanding project portfolio management, therefore, is important for
project and organizational success.

There can be a portfolio for information technology projects, for example, and portfolios for
other types of projects. An organization can view project portfolio management as having
five levels, from simplest to most complex, as follows:

1. Put all your projects in one database.

2. Prioritize the projects in your database.

3. Divide your projects into two or three budgets based on type of investment, such as
utilities or required systems to keep things running, incremental upgrades, and strategic
investments.

4. Automate the repository.

5. Apply modern portfolio theory, including risk-return tools that map project risk on a
curve.
UNIT 3 A STRATEGY FOR THE APPRAISAL OF INVESTMENT PROJECTS

1. STAGES IN PROJECT APPRAISAL AND APPROVAL

Every project has certain phases in its development and implementation. The appraisal stage
of the project cycle should provide information and analysis on a range of issues associated
with the decision making of the project. First, the administrative feasibility of project
implementation must be fairly assessed and the marketing and technical appraisals of the
project must be provided to evaluate its feasibility. Second, the financial capability of the
project to survive the planned duration of its life must be appraised. Third, the expected
economic contribution to the growth of the economy must be measured based on the
principles of applied welfare economics and a series of assumptions used to undertake this
appraisal. Finally, an assessment must also be made to determine if, and how, this project
assists in attaining the socio-economic objectives set out for the country, along with an
analysis to determine if this project is cost-effective in meeting these objectives.

These stages can be shown diagrammatically as in Figure 2.1.

2. IDEA AND PROJECT DEFINITION
The first and most important task of every procedure for project evaluation is to ensure that
the prospective benefits of a project exceed its prospective costs. This is by no means a
simple and straightforward task. In practice, it typically takes place in a sequence of stages
(see Figure 2.1), each involving more time and resources than its predecessor, and as a
consequence (one hopes) developing a more accurate picture of the project’s likely costs
and benefits. To be approved, a project should surmount each of the successive hurdles. A
rejection, on the other hand, can take place at any stage. Some projects are so bad that their
gross inadequacies are shown up even by the very roughest initial screening. Other, less bad
projects, tends to be screened out in the pre-feasibility phases. The later stages of feasibility
and detailed design may give rise to the rejection of some projects, but are more likely to
be concentrated on such elements as the precise tuning and scale of the project, the specific
design and determination of its components, etc.

It should be clear from the above that in cases where stakeholder interests play a significant
role, and/or where the viability or success of a project in vulnerable to avoidable financial
contingencies, these elements should be taken into account at each successive stage of the
appraisal process. It is not prudent to leave them to be dealt with, almost as an
afterthought, only at or near the final stage. This is why we, in this book, have tried to
present an appraisal that permits the analyst to focus on economic, financial, and
stakeholder considerations within a substantially integrated framework.

3. PRE-FEASIBILITY STUDY
The pre-feasibility study is the first attempt to examine the overall potential of a project. In
undertaking this appraisal, it is important to realize that its purpose is to obtain estimates
that reflect the right “order of magnitude” of the variables in order to roughly indicate
whether the project is attractive enough to warrant more detailed design work.

Throughout the appraisal phase and, in particular, at the pre-feasibility stage, estimates
which are clearly biased in one direction are often more valuable than mean estimates of
the variables, especially when these latter are only known with significant uncertainty. In
order to avoid acceptance of projects based on overly optimistic estimates of benefits and
costs, the pre-feasibility analysis should use estimates with a downward bias for benefits
and an upward bias for costs. If the project still looks attractive even in the presence of
these biases, then it stands a good chance of passing a more accurate evaluation.

The pre-feasibility study of any project will normally cover six different areas. These can be
summarized as follows:
a) Demand module in which the demand for the goods and services, and prices, or the
relative needs of social services are estimated, quantified, and justified.

b) Technical or Engineering module in which the input parameters of the projects are
specified in detail and cost estimates developed.

c) Manpower and administrative support module in which manpower requirements are

specified for the implementation as well as for the operation of the project and sources of
manpower identified and quantified.

d) Financial/Budget module in which the financial expenditures and revenues are

evaluated along with an assessment of the alternative methods of financing.

e) Economic module in which the project’s economic costs and benefits as a whole are
appraised from the viewpoint of the economy.

f) Environmental Assessment module in which the various environmental impacts of the

project are identified, evaluated and proposals developed for their mitigation.

g) Stakeholder module in which the project is appraised from the point of view of who
receives the benefits and who pays the costs of a project. Where possible, quantification
should be made to determine by how much each of these groups benefits or pays.

Whenever possible, the pre-feasibility study should utilize secondary research. Secondary
research examines previous studies on the issues in question and reviews the specialized
trade and technical journals for any important data that may be relevant to the appraisal of
the project. Utilization of the research on commodities and technical aspects of projects
from institutions or associations disseminating pertinent information is essential. Most
technical and marketing problems have been faced and solved before by others. Therefore,
a great deal of information can be obtained quickly and cheaply if the existing sources are
utilized efficiently.

3.1. Demand Module

The demand module should be thought of as a first attempt at serious quantification of the
benefits of the project. If the output of the project is directly marketed (like telephone
services), the module may consist of projecting the likely time path of its economic price (in
real terms), and estimating the quantity demanded along that price path at each point in
time. If the project provides a service (like highway services), that might but need not be
subject to a user charge, the appropriate procedure is to go directly to an economic
evaluation of benefits and costs in real terms, and then consider whether user charges are
appropriate, how high they should be, and how they should be administered. In such cases,
the willingness to pay of the beneficiaries is a key element in the estimation of benefits,
even though total benefits may differ significantly from estimated toll collections. At the
other extreme, there are projects in which the estimated user-demand plays little or no role.
Typically in these cases, the value of the product of the project is established in other ways.
Sometimes the value of the “output” of the project is seen by all substantially exceed its
cost. In these cases resort is made to a fundamental economic principle: one should not
attribute to any project a benefit that is greater than the cost of the least-cost alternative
way of achieving the same result. Often in such cases a “standard” alternative exists (for
example, thermal electricity generation in the case of electricity), whose costs are easily
determined. Then the benefit of “our” project would be considered to be the saving of costs
that it provides, as against the costs of the “standard” alternative.

For the demand analysis of tradable goods, the key variables are the prospective levels and
likely trends of their prices, relative to the domestic price level (and to that of tradable
goods generally). Here one can often find market analyses by the relevant producer
associations and professional experts with projections of prices and world output.

For the demand analysis of a product to be sold in the domestic market, it will be more
important to begin primary research at the pre-feasibility stage of the project appraisal. The
analysis will need to assess the overall marketing plan of the organization undertaking the
project. The potential users of that product will often have to be surveyed before an
accurate picture of its potential demand can be determined. If the product is to be sold in a
competitive environment, then a judgment should be made to as to how the competitors in
the market are likely to react. Such a judgment can be based on reviews of past actions, as
well as the institutional strengths and weaknesses of the competitors. Ultimately, the
demand for the project’s output will depend on the nature of the product, the competitive
advantages of the project in supplying the product and the resources spent to market the
output.

In the case of public monopolies such as public utilities, government policies themselves
may be important in determining the demand for the output. Extension of electricity supply
to new rural areas and the development of new industrial complexes can have an important
bearing on the future demand. The growth in the demand for the output of a public utility
can often be projected accurately by studying the relationship over time of demand with
respect to variables such as disposable income, industrial output, household formation and
relative prices. The study of growth in demand experienced by utilities in other countries
with similar circumstances can also help to provide a good basis for projecting future
trends.

The output of this module, if it is to be a commercial project, should be a set of forecasts of

the following variables for the duration of the project:
1) Quantities of expected “output” of the project as well as the time path of associated real
benefits.

2) Quantities of expected sales and prices for goods to be sold domestically and not in
competition with internationally traded goods.

3) Sales taxes and export taxes that are expected to be paid on the project’s output of the
traded goods.

4) Sales taxes to be paid on goods not traded internationally.

5) Subsidies to be received on the basis of production, sales, exports, etc.

6) Government regulations (such as price ceilings and floors, or quotas), affecting the sales
or price of the output.

7) Product trends in terms of technological developments and the expected product cycle.

8) All trade restrictions that are not created by government regulation must be identified
and their impact should be quantified.

3.2. Technical or Engineering Module

In this module, secondary research can be used very effectively. Engineering firms and
technical experts in a field usually have considerable experience in other projects that have
used either identical technology or similar techniques. Often there are many consulting
firms or government agencies that have technical expertise in a specific area. The most
important rule to follow when using outside expertise in assisting with feasibility studies, is
that the consulting group being employed to provide this information must be informed
that it will not be considered for the design or management of the facility in the design and
implementation phase. It is critical to avoid placing the consultants used in the appraisal of
a project in a position where they have a conflict of interest.

The output from the technical module of a pre-feasibility study should obtain the following
information:

1) The quantities of inputs by type which will be required for the construction of the project.

2) The likely time paths of the real prices of these inputs and their probable sources of

supply.
3) The time paths of the labor requirements of the projects, for each occupation and each
category.

4) The physical input requirements for the operation of the project by year and by volume
of output.

5) The likely sources of supply for these inputs and the assumptions on which the time paths
of their future real prices are based.

6) Information on the technological life of the project.

7) The nature and extent of the impacts that the project is expected to have on the
environment.

3.3. Manpower and Management Module

Project appraisal, to be effective, must not confine itself to examining the financial and
economic costs and benefits under the assumption that the project can be built and
delivered operationally and on time. This assumes a degree of management capacity that
simply does not exist in many situations. Many projects have failed because they were
undertaken without making sure the management and administrative expertise was
available to be able to deliver the project as specified.

This module must reconcile the technical and management requirements of the project with
the supply constraints on manpower available to this project. If they cannot be reconciled,
then the project should not be undertaken. A careful study of the labor markets should be
made in order to ensure that the estimates of expected real wage rates to be paid are
soundly based and that the planned sources of manpower are reasonable in the light of
labor market conditions.

In general, manpower requirements should be broken down by occupational and skill

category and these needs should be evaluated in terms of the possible sources from which
they might be met. Where difficulties are foreseen, this information should be passed to the
technical module so that possible revisions of the timing of the project can be considered.

3.4. Financial/Budget Module

The financial/budget module provides the first integration of the financial and technical
variables that have been estimated by the previous modules. A cash flow profile of the
project will be constructed which will identify all the receipts and expenditures that are
expected to occur during the lifetime of a project. Even in the pre-feasibility stage, an
attempt should be made to provide a description of the financial flows of the project that
identifies the key variables to be used as input data in the economic and stakeholder
appraisal.

Initially, the financial cash flows will be expressed in terms of nominal prices overtime
because certain key variables such as taxes and debt repayments are calculated in terms of
their nominal values. These nominal values are then converted into their real value
equivalents by dividing by a numeraire price index. It is usually necessary to examine a
project financed performance over time in terms of the real values of the financial variables
in order to determine its financial robustness over time and, hence, its financial
sustainability.

Because of the need for estimates of particular variables (e.g., foreign exchange
requirements) for the purpose of making economic and stakeholder project appraisals, the
level of financial detail required is considerably greater than what is usually found in the
financial appraisal of a private sector project. The financial module should answer a series of
basic questions concerning the financial prospects and viability of the project. Four of the
most important of these questions are outlined below:

1) What relative degrees of certainty do we place on each of the revenue and cost items in
the financial analysis? What factors are expected to affect these variables directly and in
what way?

2) What sources of financing will be used to cover the cost of the project? Does this
financing have special features, such as subsidized interest rates, grants, foreign equity or
loans?

3) What is the minimum net cash flow required by this investment to be able to continue
operations without unplanned requests being made to the government treasury for
supplementary financing?

4) Does the project have a large enough net cash flow or financial rate of return for it to be
financially viable? If not, what sources of additional funds are available and can be
committed to assist the project if it is economically and socially justified?

If any one of these questions points to future difficulties then adjustments should be made
in either the design or financing of the project to avoid failure.

3.5. Economic Module

This module attempts to cover the full benefits and costs of a project in society or the
economy, as flows through time, expressed in real terms.
The distinction is made between the benefits and costs of the project as seen by the
“project owner” and those perceived by “the economy as a whole”. Here one is concerned
with such items as taxes, subsidies and other distortions flowing between the government
and the project, with benefits that accrue to the project’s users (in the form, say, of
consumer surplus), and with externalities like pollution and congestion, where costs are
borne by people other than their specific perpetrators. Typically, a financial analysis will
incorporate only the financial flows accruing to or paid by the project.

3.6. Environmental Impact Assessment Module

The environmental impact assessment module brings together the information from both
the demand module and the technical module to assess the likely environmental impact of
the project and to determine the most cost-effective ways of mitigating the negative
impacts. The analysis undertaken in this module in many instances should quantify the
physical impacts of the project on the environment and attempt to measure the economic
costs and benefits of these impacts. In the assessment of the negative impacts there is a
need to consider the trade-offs that might exist between the benefits arising from the
project and the environmental damage that is likely to occur. The alternatives and their
economic cost for controlling the environmental damage should be compared to the
economic cost of the damage that will be incurred. When the environmental costs are
uncertain but have the potential of inflicting significant damage, other alternative ways of
supplying the good or service that do not have the same potential for inflecting the
environmental costs must to be evaluated as alternatives to the project under consideration.

In the cases where the benefits or costs (and damages) cannot be quantified but the
impacts are considered significant, they should be listed, substantiated and properly
documented in the analysis. For those intangible or qualitative items, they may have
significant impacts on decision-making.

3.7. Stakeholder Module

The stakeholder analysis is concerned with the identification and wherever possible, the
quantification of the impacts of the project on the various stakeholders. These include the
impact of this project on the well-being of particular groups in society, since seldom does a
project benefit everyone in a country proportionally. Political factors should be identified as
well as long-run impacts of the project on the community, which are not reflected by the
changes in income. While this aspect of the appraisal may be less precise than the financial
or economic analysis of a project, the stakeholder evaluation should be tied to the same
project factors that are expected to reduce poverty or address the basic needs of poorer
members of the community.

4. FEASIBILITY STUDY
After completing all the modules of the pre-feasibility study, the project must be examined
to see if it now shows promise of meeting the financial, economic, and social criteria that
the government has set for investment expenditures. A sensitivity analysis must be made on
the project to identify the key variables which determine its outcome.

The function of the feasibility stage of an appraisal is to improve the accuracy of the
measures of key variables if this particular project indicates it has a potential for success. In
order to improve the accuracy, more primary research will have to be undertaken and
perhaps a second opinion sought on other variables.

The important risk variables that affect the project’s performance need to be identified. The
methods of risk reduction, allocation and management need to be developed and applied
to the identified risk variables as part of the feasibility study.

It is at the end of this stage that the most important decision has to be made as to whether
the project is financially attractive to all interested parties in activity and if it should be
approved. It is much more difficult to stop a bad project after the detailed (and expensive)
design work has been carried out at the next stage of appraisal. Once sizable resources have
been committed to prepare the detailed technical and financial design of a project, it takes
very courageous public servants and politicians to admit that it was a bad idea.

5. DETAILED DESIGN
After the feasibility study, if the decision-makers give their approval to the project, then the
next task being is to develop a detailed project design and make detailed arrangements for
financing the project. Preliminary design criteria must be established when the project is
identified and appraised but usually expenditures on detailed technical specifications are
not warranted at this time. Once it has been determined that the project will continue, the
design task should be completed in more detail. It involves setting down the basic
programs, allocating tasks, determining resources and setting down in operational form the
functions to be carried out and their priorities. Technical requirements, such as manpower
needs by skill type should be determined at this stage. Upon completion of the blueprints
and specifications for construction of the facilities and equipment, then the operating plans
and schedules along with contingency plans must be prepared and brought together in the
development of a formal implementation plan.

In summary, the detailed design stage of a project appraisal is the point where the accuracy
of the data for all the previous modules is improved to the point where an operational plan
of action can be developed. Not only is the physical design of the project completed at this
stage, but so is the program for administration, operating, and marketing.
When this process is completed, the project is again reviewed to see whether it still meets
the criteria for approval and implementation. If it does not, then this result must be passed
on to the appropriate authorities for rejection.

6. PROJECT IMPLEMENTATION
If the appraisal and design have been properly executed then the selection of the project for
implementation should only entail the completion of negotiations to finalize the conditions
for financing and the formal approval of the project. The formal approval will require the
acceptance of funding proposals and agreement on contract documents, including tenders
and other contracts requiring the commitment of resources.

The implementation of a project involves the coordination and allocation of resources to

make the project operational. The project manager will have to bring together a project
team including professionals and technicians. This team will in turn have to coordinate the
various consultants, contractors, suppliers and other interested agencies involved in putting
the project in place. Responsibility and authority for executing the project must be assigned.
This will include the granting of authority to make decisions in areas related to personnel,
legal and financial matters, organization and administration. Proper planning at this stage is
essential to ensure that undue delays do not occur and that proper administrative
procedures are designed for the smooth coordination of the activities required for the
implementation of the project.

The appointment of a project manager means that responsibility for implementation will fall
within his or her jurisdiction. This will involve decisions regarding the allocation of tasks to
groups within the organization and decisions regarding the procurement of equipment,
resources and manpower. Schedules and time frames need to be established. Control and
reporting procedures must be activated to provide feedback to policy makers and the
project manager.

When the project nears completion preparation must be made for phasing out of the
construction activities and hand over to the new operational management. The project
completion will necessitate a scaling down and dismantling of the project organization. A
transfer of project personnel and equipment to other areas of the operation will be
required. These activities may occur over a considerable period of time. However, as the
project becomes operational it is essential that the skills, plans and controlling organization
be available to carry on with the function of the project in order to avoid excessive start up
costs which can easily undermine the overall success or failure of the project.

7. EX-POST EVALUATION
In the short history of formal cost benefit analysis or project appraisal considerably more
effort has gone into the pre-evaluation of projects than into the review of the projects
actually implemented. For the development of operational techniques of project appraisal it
is essential to compare the predicted with the actual performance of projects. In order that
this review of the strengths and weaknesses of implemented projects be of the maximum
value to both policy makers and project analysts it is important that some degree of
continuity of personnel be maintained within the organization’s project evaluation teams
through time.

In carrying out this evaluation a review of the administrative aspects of the project
development should be made immediately after the project becomes operational. The
managers of the operational phase of the project must be made aware of the fact that an
indepth evaluation of the project’s performance is to be carried out through time. In this
way the necessary data can be developed through the normal financial and control activities
of the operation to enable an evaluation to be carried out at minimum cost.

The ex-post evaluation helps not only to assess the performance of a project and to give an
ultimate verdict on its contribution to the country’s development but also to identify the
critical variables in the design and implementation of a project that have contributed to its
success or failure. The ex-post evaluation helps an organization to repeat the successful
experiences and to eliminate the failures.
UNIT 4 ESTIMATING PROJECT COSTS AND BENEFITS
1. WHAT IS COST?
Webster’s dictionary defines cost as something given up in exchange. Costs are often
measured in monetary amounts, such as dollars, that must be paid to acquire goods and
services. (For convenience, the examples in this unit use dollars for monetary amounts, but
monetary amounts could be in any currency.) Because projects cost money and consume
resources that could be used elsewhere, it is very important for project managers to
understand project cost management. Estimating costs involves developing an
approximation or estimate of the costs of the resources needed to complete a project. The
main outputs of the cost estimating process are activity cost estimates, basis of estimates,
and project document updates. A cost management plan is created as part of integration
management when creating the project management plan. It should include information
related to the level of accuracy for estimates, variance thresholds for monitoring cost
performance, reporting formats, and other related information

2. COST ESTIMATION FOR PROJECTS

Good cost estimation is essential for keeping a project under budget. Many costs can
appear over the life cycle of a project, and an accurate estimation method can be the
difference between a successful plan and a failed one. Estimation, however, is easier said
than done. Projects bring risks, and risks bring unexpected costs. Cost estimation is the
process that takes those factors into account, and calculates a budget that meets the
financial commitment necessary for a successful project. Project cost estimation applies to
everything from building a bridge to developing that new killer app. It all costs money, so
the clearer you are on the amount required, the more likely you’ll achieve your objective.

3. PROJECT COST ESTIMATION TECHNIQUES

These entire factors impact project cost estimation, making it difficult to come up with
precise estimates. Luckily, there are techniques that can help with developing a more
accurate cost estimation.

3.1. Analogous Estimating

Seek the help of experts who have experience in similar projects, or use your own historical
data. If you have access to relevant historical data, try analogous estimating, which can show
precedents that help define what your future costs will be in the early stages of the project.

.2. Statistical Modeling

There is statistical modeling, or parametric estimating, which also uses historical data of key
cost drivers and then calculates what those cost would be if the duration or another aspect
of the project is changed.

3.3. Bottom-Up Estimating

A more granular approach is bottom-up estimating, which uses estimates of individual tasks
and then adds those up to determine the overall cost of the project.

3.4. Three-point Estimate

Another approach is the three-point estimate, which comes up with three scenarios: most
likely, optimistic and pessimistic ranges. These are then put into an equation to develop
estimation.

3.5. Reserve Analysis

Reserve analysis determines how much contingency reserve must be allocated. This
approach tries to uncertainty.

3.6. Cost of Quality

Cost of quality uses money spent during the project to avoid failures and money applied
after the project to address failures. This can help fine-tune your overall project cost
estimation. And comparing bids from vendors can also help figure out costs.

3.7. Dynamic Tools

Whenever you’re estimating costs, it helps to use an online software to collect all of your
project information. Project management software that can be used in congress with many
of these techniques to help facilitate the process.

4. ESTIMATING COSTS
Project managers must take cost estimates seriously if they want to complete projects within
budget constraints. After developing a good resource requirements list, project managers
and their project teams must develop several estimates of the costs for these resources. For
example, if an activity on a project is to perform a particular type of test, the list of activity
resource requirements would describe the skill level of the people needed to perform the
test, the number of people and hours suggested to perform the test, the need for special
software or equipment, and so on. All of this information is required to develop a good cost
estimate. This section describes various types of cost estimates, tools and techniques for
estimating costs, typical problems associated with information technology cost estimates,
and a detailed example of a cost estimate for an information technology project.

4.1. Types of Cost Estimates

One of the main outputs of project cost management is a cost estimate. Project managers
normally prepare several types of cost estimates for most projects. Three basic types of
estimates include the following:

1. A rough order of magnitude (ROM) estimate provides an estimate of what a

project will cost. ROM estimates can also be referred to as a ballpark estimate, a
guesstimate, a swag, or a broad gauge. This type of estimate is done very early in a project
or even before a project is officially started. Project managers and top management use this
estimate to help make project selection decisions. The timeframe for this type of estimate is
often three or more years prior to project completion. A ROM estimate s accuracy is
typically 50 percent to 100 percent, meaning the project s actual costs could be 50 percent
below the ROM estimate or 100 percent above. For example, the actual cost for a project
with a ROM estimate of $100,000 could range between $50,000 to $200,000. For
information technology project estimates, this accuracy range is often much wider. Many
information technology professionals automatically double estimates for software
development because of the history of cost overruns on information technology projects.

· A budgetary estimate is used to allocate money into an organization s budget. Many

organizations develop budgets at least two years into the future. Budgetary estimates are
made one to two years prior to project completion. The accuracy of budgetary estimates is
typically 10 percent to 25 percent, meaning the actual costs could be 10 percent less or 25
percent more than the budgetary estimate. For example, the actual cost for a project with a
budgetary estimate of $100,000 could range between $90,000 to $125,000.

· A definitive estimate provides an accurate estimate of project costs. Definitive

estimates are used for making many purchasing decisions for which accurate estimates are
required and for estimating final project costs. For example, if a project involves purchasing
1,000 personal computers from an outside supplier in the next three months, a definitive
estimate would be required to aid in evaluating supplier proposals and allocating the funds
to pay the chosen supplier. Definitive estimates are made one year or less prior to project
completion. A definitive estimate should be the most accurate of the three types of
estimates. The accuracy of this type of estimate is normally 5 percent to 10 percent,
meaning the actual costs could be 5 percent less or 10 percent more than the definitive
estimate. For example, the actual cost for a project with a definitive estimate of $100,000
could range between $95,000 to $110,000.
The number and type of cost estimates vary by application area. For example, the
Association for the Advancement of Cost Engineering (AACE) International identifies five
types of cost estimates for construction projects: order of magnitude, conceptual,
preliminary, definitive, and control. The main point is that estimates are usually done at
various stages of a project and should become more accurate as time progresses.

In addition to creating cost estimates, it is also important to provide supporting details for
the estimates. The supporting details include the ground rules and assumptions used in
creating the estimate, a description of the project (scope statement, WBS, and so on) used
as a basis for the estimate, and details on the cost estimation tools and techniques used to
create the estimate. These supporting details should make it easier to prepare an updated
estimate or similar estimate as needed.

A cost management plan is a document that describes how the organization will manage
cost variances on the project. For example, if a definitive cost estimate provides the basis for
evaluating supplier cost proposals for all or part of a project, the cost management plan
describes how to respond to proposals that are higher or lower than the estimates. Some
organizations assume that a cost proposal within 10 percent of the estimate is acceptable
and only negotiate items that are more than 10 percent higher or 20 percent lower than the
estimated costs.

Another important consideration in preparing cost estimates is labor costs, because a large
percentage of total project costs are often labor costs. Many organizations estimate the
number of people or hours they need by department or skill over the life cycle of a project.

5. BASIC PRINCIPLES OF COST MANAGEMENT

This section describes general topics such as profits, life cycle costing, cash flow analysis,
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.

5.1. Profits
Profits are revenues minus expenditures. 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 e-commerce application that you estimate will increase revenues for a $100
million company by 10 percent. You cannot measure the potential benefits of the e-
commerce application without knowing the profit margin. Profit margin is the ratio of
revenues to 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

5.2. Life cycle costing

Life cycle costing allows you to see a big-picture view of the cost of a project throughout
its life cycle. This helps you develop an accurate projection of a project s financial costs and
benefits. Life cycle costing considers the total cost of ownership, 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, with assistance from financial experts in
their organizations, should create estimates of the costs and benefits of the project for its
entire life cycle, or ten years in the preceding example. Recall that the net present value
analysis for the project would include the entire ten-year period of costs and benefits. Top
management and project managers need to consider the life cycle costs of projects when
they make financial decisions.

.3. Cash flow analysis

Cash flow analysis is a method for determining the estimated annual costs and benefits for
a project and the resulting annual cash flow. Project managers must conduct cash flow
analysis to determine net present value. Most consumers understand the basic concept of
cash flow. If they do not have enough money in their wallets or checking/credit accounts,
they cannot purchase something. Top management must consider cash flow concerns when
selecting projects in which to invest. If top management selects too many projects that have
high cash flow needs in the same year, the company will not be able to support all of its
projects and maintain its profitability. It is also important to define clearly the year on which
the company bases the dollar amounts. For example, if a company bases all costs on 2008
estimates, it would need to account for inflation and other factors when projecting costs
and benefits in future-year dollars

5.4. Tangible and intangible costs and benefits

Tangible and intangible costs and benefits are categories for determining how definable
the estimated costs and benefits are for a project. Tangible costs or benefits are those
costs or benefits that an organization can easily measure in dollars. For example, suppose
the Surveyor Pro project described in the opening case included a preliminary feasibility
study. If a company completed this study for $100,000, the tangible cost of the study is
$100,000. If Juan s government estimated that it would have cost $150,000 to do the study
itself, the tangible benefits of the study would be $50,000 if it assigned the people who
would have done the study to other projects. Conversely, 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 intangible costs. Intangible benefits for projects often include items like
goodwill, prestige, and general statements of improved productivity that an organization
cannot easily translate into dollar amounts. Because intangible costs and benefits are
difficult to quantify, they are often harder to justify.

5.5. Direct costs

Direct costs are costs that can be directly related to producing the products and services of
the project. 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.

5.6. Indirect costs

Indirect costs are costs that are not directly related to the products or services of the
project, but are indirectly related to performing the project. For example, the cost of
electricity, paper towels, and so on 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.

5.7. Sunk cost

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, but they never produced anything valuable. If his government were 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
be 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.

5.8. Learning curve

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 Pro project would potentially produce 1,000 handheld devices that
could run the new software and access information via satellite. The cost of the first
handheld device or unit would be much higher than the cost of the thousandth unit.
Learning curve theory should help 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.

5.9. Reserves
Reserves are dollars included in a cost estimate to mitigate cost risk by allowing 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 baseline. 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 information technology 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.