How to do cost estimation in project portfolio management

Accepting a new project without proper estimation is like a dive into the unknown. Sure, you get an adrenaline rush because the client is big and the project is a perfect fit.

Arkadiusz Terpiłowski

Co-Founder

Finance Management

12/10/2021

Table of contents

But sooner or later, reality catches up with you, and - in the worst-case scenario - your project stops being profitable.

Many IT service companies avoid putting real effort into estimating because they think their estimations aren’t going to be accurate enough.

But don’t shy away from estimating, even when you have minimal historical data to back it up.

If you don’t start estimating project costs, you’ll never get better at it. And once you get better at it, you’ll take your business to the next level by making sure that all your projects have a healthy profit margin.

So where do you get started with cost estimation? Keep on reading this article to find out the best practices to follow and challenges to prepare for on the way.

What happens if you fail to estimate project costs accurately?

Why is estimating project costs worth the trouble? Here are a few things that are bound to go wrong when you start realizing a client project without knowing how much bringing it to life will cost you.

Your profit margin will become unpredictable

If you don’t add your direct and indirect project costs, you’ll have no idea how much you need to cover to realize the project and still get the project margin your business needs.

It’s not only about coming up with the number of hours needed to build a few features and multiplying this number by the hourly rate of your employees. You also need to add indirect costs like your project or company overheads (calculating the overhead per employee is the best approach here). 

Check out this article to learn how to include overhead in the price of billable hours.

You will struggle in decision-making 

It’s hard to make the right decision about a project without knowing whether it’s going to bring you the profit margin you need or only cause loss and frustration.

Estimation helps to understand how that project will play out in the future and what kind of engagement it will require from you over the long term. You will know whether it’s worth involving your employees in it in the first place. 

It’s only going to get worse in the future 

If you’re running a smaller company and keeping up with everything is still possible, it’s not going to stay that way for long. As your business grows, the complexity will catch up with you. 

Comparing a new project to one’s you’ve already realized to come up with an estimation isn’t going to be enough. Especially if you start hiring more employees and contractors with varied hourly rates. 

Your employees will suffer too

Software developers are sought-after on practically every job market around the world. You need to keep an eye on their utilization rate, or else you risk that they become overworked, burn and crash.

You need to reach a good utilization rate for your business without overwhelming your employees. How can you possibly get started without tracking employee performance and estimating the number of hours the project needs from them?

Lack of historical data will only make estimation harder

In an ideal scenario, you should be able to develop a long-term estimation and accurate cost forecasting for any project that lands on your doorstep.

But I get it, estimation is hard. It’s only going to become harder if you don’t have any historical data about past projects to back up your estimates.

What you need to do isn’t only estimate a project, launch it hoping that all goes according to plan and then move on to estimating another one. You need to find a way to compare your plans to reality as the project is developed. Luckily, solutions like Primetric help you do that and gain heaps of valuable data to inform your future estimations.

What is good cost estimation

Every project cost estimation includes two types of costs:

  • Direct costs - the salaries of employees directly involved in the project
  • Indirect costs - other costs that you need to bear to make the project a reality called project and business overheads.

Why is counting overhead costs so important?

Every software company has ongoing expenses of operating the business. They need to be paid regardless of whether all your employees are working or half of them are sitting on the bench. 

Here are a few examples of overhead costs for a service-based business:

  • Office rent, utilities, equipment, and insurance costs
  • Support staff costs (administrative and marketing costs)
  • Material costs (materials you use to provide services like hardware and software)
  • Management board expenses
  • Car leasing costs

You can differentiate between business overhead and project overhead costs. Buying a software license required to deliver a project is a project overhead because this cost doesn’t apply to the entire company. Administrative and marketing costs are business overheads because they do.

Here’s an article that explains overhead costs in detail: How do you calculate overhead cost per employee?

What is the Estimate to Complete?

Another concept you should know when estimating project costs is Estimate to Complete (ETC).

Estimate To Complete refers to the remaining cost you will have to pay in order to complete a project. It’s not the final overall expected project budget - this is called Estimate at Completion (EAC). Estimate to Complete looks at the costs from the present moment until the end of the project; it never includes the project expenditures prior to that moment. 

This metric plays a critical role in comparing your plans to reality. You can use it to check the project’s burn rate and act immediately if you discover that you’ve already burned 70% of your project budget when you’re only 40% through planned work.

Take a look here to learn more about this helpful metric: How to Calculate the Estimate to Complete (ETC)

6 cost estimation techniques

Here are some of the most popular cost estimation techniques used by PPMs across every sector. Bottom-up estimation is a good match for the IT industry where teams ten to split projects into smaller chunks and tasks, for example when following an Agile methodology of software development like Scrum.

Note: For any of these techniques to work, you need up-to-date data about your previous projects and the requirements of the project at hand. Using project management software like Primetric to bring all of this data together is a smart move.

Bottom-up estimating

If a comprehensive work breakdown structure is an option, you can easily use this approach. It’s the most accurate estimating technique out there. 

How does it work? You start by dividing the project deliverables into work packages using a work breakdown framework (each work package includes a number of tasks). The project team calculates the cost of finishing each task, and then adds up the prices of all the project's tasks and work packages to arrive at a cost estimate for the entire project.

Bottom-up estimates become better with time because experienced project teams get better at estimating the costs of tasks and work packages.

Top down estimation

Like expert judgment, analogous estimating — also called top-down estimating or historical costing — relies on historical project data to form estimates for new projects.

Analogous estimating draws from a purpose-built archive of historical project data, often specific to the company. If a business repeatedly realizes similar projects, it becomes easier to draw parallels between their deliverables and associated costs - and then adjust these in line with the scale and complexity of a project.

Parametric estimation

The parametric approach to estimating uses unit prices for projects with comparable operations. The key here is the high degree of repetition. 

To use this technique, start by breaking down a project into work units. Then calculate the cost per unit, multiply the number of units by the cost per unit, and - finally - multiply the total cost by the cost per unit to get an estimate of the overall cost. 

As long as you get the cost per unit right, your estimations will be accurate.

Three-point estimation

This technique originates from the Program Analysis and Review Technique (PERT), a statistical approach for project costs by coming up with optimistic, pessimistic, and most likely estimates for each activity. 

Three-point estimating calculates the predicted costs from optimistic, pessimistic, and most probable approaches using various weighted formulas like this:

Expected value = [Optimistic estimate + Pessimistic estimate + (4 x Most likely estimate)] ÷  6

Empirical estimation

Empirical approaches use software tools to draw on past project experiences. They’re effective for projects that are similar and occur regularly - like building an MVP.

A project manager looking to develop an empirical cost estimate needs to fill out a form with the project's features and attributes, and the system calculates the cost depending on the type of project at hand.

Delphi cost estimation

This type of estimation is also an empirical estimating approach based on expert consensus that can help in resolving differences between different estimates. 

Here’s how it works:

Experts develop anonymous cost estimates with rationales and send them to a coordinator, who then compiles and distributes a summary of the replies. Then experts develop a fresh set of anonymous estimates. This is done several times. 

After each round, the coordinator might let the experts debate their estimations. The idea is for their estimations to converge as the experiment proceeds, indicating growing consensus.

Challenges of cost estimation

Nobody said it would be easy. Here are the most common challenges to prepare for on your path to cost estimation:

  • Lack of experience with similar projects - the easiest way to estimate a task or work package is to draw on your previous experience. But what if your team has never developed a desktop or mobile app before?
  • Length of the planning horizon - long-term planning is tough if you don’t hany any software tools supporting you throughout the process. But developing a long-term calculation of your project and business costs is key for keeping your company afloat. You can do that with Primetric, here’s how.
  • Human resources challenges - sourcing, attracting, recruiting, and onboarding IT experts is a tough nut to crack. It might take more time than you planned too.
  • Expecting that employees will work at maximum productivity - 100% utilization of your experts might work for a week or two, but not longer. People need time to have lunch, attend conferences and meetups, and improve their skills. This would lead them straight down the burnout road.
  • Failing to identify risks - every project carries its specific risks, and it’s your job to prepare contingency plans and reserves in case anything happens.
  • Not updating cost estimates after the project scope changes - cost estimation isn’t a one-off job, it’s a process. You need to have up-to-date data for your estimations. It will usually take a few estimations for you to start seeing where you tend to underestimate or overestimate. But only if you update your data regularly.

How project management software helps in estimating project costs

Precise resource allocation

A software solution like Primetric stores all the hourly rates of your employees. Whenever your estimate changes, all the outcomes like project margin are updated based on the number of hours worked and your overhead costs.

Smart resource allocation also means selecting the best resource for the job rather than the first one that comes to mind. With insights from Primetric get to choose an employee that fits the project's projected financial performance while maintaining the required profit margin. This is usually 30% for software development businesses.

Checking project profitability

Primetric lets you change values and simulate different scenarios to become more accurate at predicting your project profitability. You can try out different combinations of employees to find a winning mix that gets you the profit margin you need and takes individual professional development goals of your experts into account.

Another advantage is the ability to anticipate who you'll need to recruit ahead of time. This is especially useful for IT firms who are experiencing a shortage of professionals - pretty much all of them!

Overhead calculation is easier

How do you figure out the correct hourly rate for a long-term project where both overhead costs and direct labor fluctuate from month to month?

This is when automation helps. Primetric connects the dots and automatically calculates your overhead rate to help you reach the profit margin you need at every stage of project planning and allocation.

Ability to see project financial performance over long-term, check how that affects your cash flow, settlement per project segment

Smarter billing

When your company is small, you make all sorts of compromises to secure a project. But as your business grows, these models might not be the best. 

A tool like Primetric helps to move to more advantageous settlement methods by combining people allocation, finance, and time tracking in one system. Thanks to this, when allocating people, you immediately have budget forecasts at hand - and as people log working time, the real budget is filled in real time.

From the perspective of a Finance Manager or Project Manager, this is a revolution compared to how they carried this process out before - starting from exporting data from the time tracking tool to multiplying the working hours by hourly rates located in several other spreadsheets used by other PMs. Now all data is completed automatically, and the PM just needs to approve it or check for discrepancies (this is made even easier with advanced reports).

Try Primetric to see how easy estimating your project costs can be.

Sign up for a demo and get started.

If you don’t start estimating project costs, you’ll never get better at it. And once you get better at it, you’ll take your business to the next level by making sure that all your projects have a healthy profit margin.

Arkadiusz Terpiłowski

Co-Founder

Arkadiusz is Head of Growth and Co-founder at Primetric. Prior to that, Arkadiusz was at the helm of his own software development company where he oversaw operations. A great enthusiast of process improvements, his personal mission is to make software companies more profitable and efficient on their path to growth.

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