Understanding Project Costs and Why They Went Up or Down
By Preben Ormen
When we try to understand project costs and why they went up or down we invariably have to puzzle out the simultaneous effects of several variables. This can get quite complex, but at the heart of the matter is a very simple concept for project variance analysis.
Conceptually, costs are a function of quantities and rates (or prices). Pretty basic, yet still valid after all these years. When we analyse costs, we typically take something calculated now and compare that to some baseline. The baseline is usually the budget or plan numbers. Again, no surprise there.
It’s when we try to decide whether changes were more due to one factor than the other that things can get a little confusing. But cost accountants figured this out a good while back, so we don’t have to. As a matter of fact, they figured it out in so much detail that even that becomes a bit daunting, so let me pare this down to the bare essentials.
Stating the Problem
Stated concisely, we want to know the individual effects on costs from a) the changes in quantities (how much or how little we used of something) and b) the changes in the rates we paid (how low or how high the prices or unit costs were).
If we think about it, costs can tend lower if we use less (lower quantity), ut still get a boost upwards if the rates turn out higher than expected. Thus it is possible for these changes to balance out, reinforce each other on one way or the other or confound each other by moving in different directions. Not so easy to grasp just by eyeballing some numbers. We need a better method and here it is.
Defining the Terms
Let me start by defining three key terms for the numbers we have to calculate so that we can separate out quantity effects from rate effects. (This will work for all types of projects including revenue generating ones.)
- Budget Cost for Work Scheduled (BCWS)
- Budget Cost for Work Performed (BCWP)
- Actual Cost for Work Performed (ACWP)
Budget Cost for Work Scheduled (BCWS)
Budget Cost for Work Scheduled or BCWS for short, means the budget quantity times the budget cost. This is the starting point and the baseline for comparison in subsequent cost analyses.
Obviously, BCWS is usually an aggregate of many different budget items each with its own quantity and rate. However, the core concept is budget quantity times budget rate.
Budget Cost for Work Performed (BCWP)
Budget Cost for Work Performed or BCWP for short, means that we compute the project costs of actual quantity used times the budget rate.
This is just a way of asking what the budget would have looked at if we had budgeted exactly the same quantity as what we actually used. By comparing BCWP to BCWS we can now separate out the effect of the quantity variance itself.
Actual Cost for Work Performed (ACWP)
Actual cost for work performed or ACWP for short, means calculating the project costs with actual quantities and actual rates. This is typically the figure that shows up on the project cost report and which is then compared to the budget (i.e., BCWS) to compute a variance.
It is precisely this overall variance that we want to explain in more detail and we saw how BCWP less BCWS gives us the quantity variance. If we take ACWS less BCWP, we now separate out the rate variance, i.e., the effect of the actual rates being different from the budget rates.
Putting the Pieces Together
We can now create a scorecard as follows (the numbers are for illustration purposes only).
|BCWP||BCWS||Quantity Variance (BCWS – BCWP)||ACWP||Rate Variance (ACWP – BCWP)||Total Variance (ACWP – BCWS)|
In this case we can see how we might miss the insight that despite project costs being lower, we are facing increasing rates. This will likely give us undesirable variances as soon as we catch up with the work.
Of course, an analysis like this also needs to take into account how much of the work as measured by the quantities used brought us closer to completing the associated deliverables.
For all the criticism of the % complete estimate, we can use it beneficially if we estimate it as a gauge of how much closer we are to completing the work rather than as an estimate of how much budget was consumed this far.
We need both, but be aware that at any given time in a project, the most important thing to be clear on is how much more effort is required to complete the work.
We have to be able to make running updates to the Estimated Cost At Completion (ECAC) because this is the number that tells us if we need to go to the sponsor for a change order or not.
As a final note, let me just add that the above analysis is what cost accountant s call standard cost analysis. Full blown standard cost analysis is a little more involved, but even a simple analysis can bring us new insights. Those who are familiar with Earned Value Analysis (EVA) will have recognized that the above is consistent with EVA.
Preben Ormen has over 35 years experience with a wide range of businesses, teams and cultures from around the world. He has experience in SAP, IT Governance, procurement, system selection and integration, and performance and process improvements. You can read more from Preben on his blog, you can follow him on Twitter, and you can contact him via LinkedIn.