What is a cost overrun and what can cause it?
According to statistics, over 45% of IT projects go over budget before they end. Such a cost overrun is not only a burden for a project manager, but also for the entire company. Here’s how you can solve and prevent the problem from happening in the first place!
What is a cost overrun?
Cost overrun (or budget overrun) is a situation where the actual costs of a given operation exceed the planned budget. Such an occurrence is particularly common in construction projects, as well as software development.
How to define project cost overruns?
Cost overrun can be defined:
- As a percentage of the total expenditure
- As a total percentage including and above the original budget
- As a percentage of the cost overruns to the original budget.
Cost overrun - examples
There are a few typical examples of cost overrun in a project budget that are particularly common for the IT industry. They include:
- a fixed price projects running out of money because of too much work being done,
- a retainer project underestimating monthly workload and, therefore, spending too much money,
- a time & material project that goes over the budget limit for a given period of time.
What is the difference between cost overrun and cost escalation?
In general, cost overrun is a surprise for those who experience it - it simply appears out of nowhere at one point, as it was not included even in the most distant plans.
Cost escalation, on the other hand, is taken into account long before the project starts. In other words, it is anticipated that some costs in the project (usually a long-term one), are going to grow with time, and that change is included in the cost estimation for the project.
What are the main causes of cost overrun?
The main causes of cost overrun include:
Fluctuations in costs and project scopes
Changes in wages, time offs, project scope, and numerous little tasks we tend to overlook on a daily basis may have a significant impact on the cost overrun. Of course, short holidays of one of the employee’s probably won’t ruin your project; however, when combined with additional tasks suddenly ordered by the customer, it can really take a toll on its financial results and leaving a project manager with little to be done.
How to keep track of cost fluctuations?
The key to keeping the cost fluctuations at bay is to monitor them on a regular basis and calculate their cost, even when the change seems quite small. Then, you should include all these changes in your budgets and update them, too, while remembering to including all the additional project costs. Thanks to that, you will be able to accurately measure the profitability of your operations.
It is often thought that the costs in a project management are limited to technology and wages. Unfortunately, that is a wrongful assumption. That is because the profits from the project should also cover:
- project overheads, both one-time and recurring, such as subscriptions, additional devices, delegations and more,
- company overheads, including the cost of support departments (marketing, sales, etc.), costs of rent, utilities, costs of project management itself, etc.,
- additional operations that were initially not included in the project scope,
- the length of the project. The longer the project, the bigger the chances its profitability will drop with time. Therefore, you should take into consideration the changes in its scope to make sure that project remains profitable.
Of course, these projects are inevitable. However, they should not be ignored and left to chance; otherwise the project may not be profitable in the end!
How to keep track of hidden costs and avoid cost overruns?
Still, solving the problem of hidden and unexpected costs in projects is fairly easy. It usually starts with a simple time tracking that compares project's scope with actual data. Timesheets based on the tracked hours will show you exactly how much time was spent on different tasks, and, when combined with information on wages, how much they cost.
However, to monitor the real profit margin in every project and prevent cost overruns, project managers also need to gather all the information about finances in a single project management tool. To do so, they should:
- use the cost allocation key to assign spendings to the projects that should cover them (or a part of them),
- keep track of both billable and non-billable hours in the project team,
- choose the profitability rate they want to achieve and react to any changes in the profitability that threaten it,
- use the project management software that allows them to do all of that.
The project management software should also be able to distinguish between project costs and company overheads, to show the managers exactly what their profits are, and what they can improve about their project management
Every project budget starts as a cost estimation based on the basic deliverables, and it is a backbone of project's success. Of course, to predict the budget, managers need a resource forecasting process that can help them assess the costs of work to come. Then, they have to take other critical costs into account.
Sounds simple? It may, but it doesn’t change the fact that inaccurate project estimates are one of the main causes of cost overrun, as they may ruin the project plan and put an entire project management team in a difficult position.
There are a few reasons why estimates do not reflect the reality of work. In general, they include:
- an assumption that every part of the project will go as planned,
- unexpected costs that weren't included in the risk management plan by a project manager,
- lack of knowledge of similar past projects leading to incorrect estimates,
- unclear deliverables that include unnecessary actions or omit the ones that are crucial for the project,
- unrealistic project deadlines or unexpected project changes causing a difference between actual cost and planned cost of a task,
- lack of fixed wages depending on the specialization and seniority of the employee. With the information on their costs and average incomes per hour, estimates are much more accurate.
How to fix incorrect estimates and prevent cost overruns?
Creating correct estimates largely depends on the skills and experience of a person who makes them in the first place. Their knowledge of project life cycle, as well as dependencies in the company, can make the forecasts much more accurate. Therefore, choosing the right manager for the job is the key to preventing cost overruns.
However, a valuable input from an experienced project manager is not the only thing that can help you improve the financial estimates in your project. You can also:
- consult the most experienced specialists that have worked on similar projects before to improve the accuracy of estimates,
- cooperate with all the stakeholders to cover all the deliverables in a project at an estimation phase,
- determine what to do in case some estimates turn out to be incorrect,
- leave some room for error in the budget,
- estimate the workload for parts of the project instead of the entire project using average hourly incomes or average costs of similar phases in other projects. If in the last 5 projects a Backend phase took you 500 hours, there’s a good chance that the value will be similar for the new project, too, provided it has a similar scope.
By improving the estimates, you can improve the condition of the entire company and prevent cost overruns - just like Capco did by creating the estimates with 90% accuracy.
Project scope creep
Of course, even the best project scope may start to change as the work in the project progresses. Such a situation is called a scope creep and it may take a huge toll on the project budget - especially when the workload is growing exponentially. As a result, the sum of wages is also on the rise, and so are all the other expenses, causing an inevitable cost overrun in the projects, putting a project success at risk.
What causes the scope creep in the first place?
Scope creep is generally caused by a series of errors made in the planning phase. The most common ones are:
- underestimating the complexity of a project or omitting its parts,
- problems with communication with stakeholders,
- incorrect estimates for time and costs of different operations in the project.
Naturally, all of these problems may become a cause of a cost overrun. Then what can we do about them?
How to solve the problems with scope creep?
Let’s start with the basics. Just like in any other work, in the IT industry communication is also the key (even though it can sometimes be underestimated). Therefore, you should spare no effort to ensure that the customer knows what he wants and is able to present you with all the information you need to create a project scope in the first place in order to avoid cost overrun. We recommend suggesting the customers to choose a single product champion capable of gathering such data and converting it into valuable insights for your team.
Having done that, make sure that you understand the requirements of the project correctly and that your team can ensure the project's progress, as well as positive project outcomes. Discuss the operation with your team and customer to outline the work as accurately as possible, and summarize each key point along with its costs to prevent cost overrun. Then, present the results of your analysis to your customer before moving on!
Last but not least, monitor the project as it progresses, as project cost overrun may happen at any stage of work. Keep track of the time specialists spend on different phases, their costs, check the budget for unexpected overheads and ensure that wages stay within the budget.
Let’s be honest - anything can happen when a project is launched. Sometimes an important specialist has to take a few sick days; other times, a mundane task takes longer than expected. There are, however, thousands of different situations that may have a negative impact on a project's performance and cause a huge cost overrun.
What is the main cause of performance problems?
Depending on the type of the project, performance problems affecting the original project budget may originate from different sources. In the IT industry, they usually include:
- unrealistic project timeline,
- problems with resource management, including scheduling conflicts,
- absence or lack of specialists with crucial skills for a given phase of the project,
- incorrect or interwoven dependencies,
- lack of project milestones or other metrics that can be used to measure the progress.
Of course, any of these scenarios may result in delays or additional work being required, contributing to a cost overrun.
How to react to performance failures?
Unfortunately, performance failures sometimes cannot be avoided - often they are a matter of sheer bad luck, not premeditated mistakes. We can, however, prepare for them by calculating the project risks and leaving some room for error both in the budget, and in the resource plan. By doing so, project managers can be sure that they will stay in the budget even when things go south and avoid cost overrun altogether.
Of course, risk management is also of the utmost importance in that case. Before the project starts, try to establish dependencies between the task and pay particular attention to those who are likely to cause trouble later on. Then, adjust the schedules of project teams accordingly to give your team some room for error.
Last but not least, project managers should always stay on top of their project to react to unexpected occurrences and calculate cost overrun on regular basis. Quick reaction may save you from a project failure!
How to prevent cost overrun?
Luckily, cost overrun may be prevented before it wrecks havoc on your project. Here are some things you can do to avoid being trampled by growing costs and deliver a successful project.
Use cost allocation key formula
The profitability of your project depends not only on the work and equipment involved, but also on the costs of other endeavors your commercial operations need to cover. To determine the real amount of costs associated with a given project, you need to assign a portion of the general expenses to it using a cost allocation key formula.
Of course, the fraction of the additional cost depends on the size of the project in question or its expected profits. This formula allows to assign cost proportionally without forcing smaller projects to cover enormous costs.
Track both billable and non-billable hours
Internal work may sometimes be essential, but in some cases it may just be the source of additional costs. To make things worse, it can sometimes escape the attention of managers, as it is often considered to be free - and wrongfully so! Non-billable hours still require money for wages and equipment; that is why you should track the time spent on the internal work, too.
Standardize the calculations for utilization and profitability
Depending on the knowledge, experience and background, each and every manager may have a different way of calculating utilization and profitability, and they may take different factors into account while doing so. That may lead to confusion and wrong decisions being made.
Fortunately, there is a simple solution to that problem. Before you start measuring different indicators, whether they are profitability or utilization, make sure that all managers are using the same formula for their calculations. By using it, you ensure that you can easily compare all the data and create a reliable base for all the future decisions.
Use your experience to create estimates
As we have proven in this article time and time again, accurate estimates and plans are the key to accurate budgeting, as they specify the amount and cost of work in the first place. Therefore, you should pay maximum attention to how they are created.
To improve your estimates, you should:
- treat estimates just like Lego bricks. Use similar tasks and processes to forecast the time and the cost of the new ones to increase the chances of success.
- work closely with both stakeholders and experienced specialists in your company,
- not be overly enthusiastic while making estimations; leave some room for error and unexpected situations, such as absences or delays,
- keep track of the wages and salaries while completing a resource planning process,
- include overheads and other costs in your forecasts.
Monitor the project progress
Project managers should not lose their focus once the project is planned, as changes to the scope of work are almost inevitable - especially in the long-term operations. Therefore, they need to monitor the work on a daily basis to ensure that there are no unexpected obstacles that may interfere with the project and cause a cost overrun.
To keep track of the project progress, managers should regularly check:
- the amount of hours worked on the project (paying particular attention to overtimes, delays or absences),
- the cost of work done in the project in a given time period,
- whether any additional tasks or resources are required for the project to progress,
- general budget of the project, including project and organizational overheads,
- settlements and payments.
Using this information, project managers will be able to react to any arising issues, preventing the project from going over budget and becoming unprofitable.
In addition, some tools offer bespoke tools that can combine all of the information above. For example, in Primetric you can use a project progress report to see the amount of work done in a given operation, as well as its costs and other spendings.
Leave Excel behind you!
Of course, all of these things cannot be done on a simple piece of paper. The right tool can help you not only spot the cost overrun, but also prevent it - but Excel is not one of these tools, either!
With Excel, all of this information will spread over hundreds and thousands of rows you will need to update manually every time something changes. In addition, to create graphs, reports or other valuable visualizations, you will need to spend a few hours on your precious time. And, after all that effort, you still can’t be sure that your calculations are correct, as manual calculations are prone to mistakes!
However, there are some tools that are not only capable of gathering all the information, but also turning them into more valuable insights - all in a fully automated way, and with no chance of making mistakes.
If you are not sure where to find such a tool, we have good news for you - Primetric is here to help you. Test it now or book a demo with one of our advisors to learn more!
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Visit our blog to learn more about managing an IT company, or simply go right to our articles about:
- solving problems with schedule conflicts in projects,
- cost allocation in IT companies,
- budget tracking in Jira,
- project milestones and their meaning for project management.