Cost management

What is cost management?

In the context of projects, cost management involves the overall planning, co-ordination, control and reporting of all cost-related aspects from project initiation to operation and maintenance. It is the process of identifying all the costs associated with the investment, making informed choices about the options that will deliver best value for money and managing those costs throughout the life of the project. Techniques such as value management help to improve value and reduce costs.

Why is it important?

Cost management is an essential part of effective programme/project management, but is a persistent barrier to successful delivery and consequent failure to achieve value for money. Cost over-runs are often caused by the client; the main reasons for cost increases are:

objectives that are unclear and changed during the course of the project
unrealistic estimates (usually too optimistic)
a project brief that is incomplete, unclear and/or inconsistent
risk allocation that is ambiguous
inadequate management control.

In construction projects, additional problems are frequently caused by:

design that does not meet planning or statutory requirements
design that lacks co-ordination and is difficult to build and maintain.

In e-business projects, there may be significant costs if the department has to offer parallel means of providing a service (to ensure that nobody is disadvantaged, for example, or where there is a long period of transition from conventional service delivery to e-business). There is also the risk that costs will be incurred without benefit if citizens do not want to use an e-business service.

Key issues

Decisions about costs must be based on an understanding of the whole supply chain involved in the project or service (including customers/citizens as end-users) and where costs are expected to fall. This is especially important in cross-cutting projects, where efficiency gains for one organisation may result in increased costs for another or where there is no direct benefit to the organisation that contributes to funding.

Cost estimates should include consideration of:

displacement costs - the net saving or cost after the initial investment in IT or new facilities of transferring to new ways of working
minimum and maximum assumptions on productivity improvements that should be achievable
assumptions about the length it should take before efficiency gains could begin to be realised
the cost of transition periods, when conventional and new ways of delivering services may need to be offered in parallel - or a period of transition when old and new facilities have to operate together.

Whole life costing is aimed at answering the question: 'What is the cost of achieving this objective in this way?' It is always considered in relation to quality in meeting the business need, in order to determine value for money. Different solutions to meeting the business need could result in significantly different cost profiles and contract duration; appraisal of options needs to be flexible enough to compare very different approaches. Sensitivity analysis is also important, to challenge assumptions about uncertain future events and hence variations in costs.

'Optimism bias' needs to be assessed with care, because experience has shown that undue optimism about benefits that can be achieved in relation to risk will have a significant impact on costs. A recommended approach is to consider best and worst case scenarios, where optimism and pessimism can be balanced out. The probability of these scenarios actually happening is assessed and the expected expenditure adjusted accordingly.

Who is involved

The investment decision maker (typically the management board) is accountable for any decisions relating to the cost of a project or programme.

The SRO is responsible for ensuring that estimates are based on whole life costs and is assisted by the project sponsor or project manager, as appropriate, together with additional professional expertise as required.

The process

Estimating

The process begins with initial estimates of whole life costs - that is, the acquisition costs, the operating costs and disposal costs. The total costs include risk allowances and internal departmental costs as well as the prices charged by suppliers. Estimates are refined as assumptions are validated and confirmed during the procurement process. Budgets are approved and allocated against these estimates, where they demonstrate that value for money will be obtained. As costs are incurred during the development/design and operational stages, they are tracked against estimates on a continuous basis. There are formal reviews of costs at key decision points, together with value management reviews to identify opportunities for adding value and driving down cost.

The initial budget estimate and all subsequent estimates should allow for all the costs relating to the project (including costs for parallel ways of delivering a service, where e-business is a major component) . These include in house costs, fees for consultancy, legal advice and other specialist expertise, design/development and construction costs (where applicable), operation and maintenance costs, environmental and disposal costs.

Cost estimates are made up of the base estimate (the estimated cost without any risk allowance built in) and a risk allowance (the estimated consequential cost if the key risks materialise. The risk allowance should be steadily reduced over time as the risks or their consequences are minimised through good risk management.

The wider, consequential effects of different options must be considered and included. These may be cost increases or decreases borne by others - for example:

journey times to a hospital (an opportunity cost for patients and visitors and an actual cost to ambulance services)
infrastructure improvements (such as the cost of building new or improved roads
environmental impact.

Common principles of cost estimating

Actual categories of costs will be very different from project to project. They may include capital costs as well as running costs; depending on the procurement route these costs may fall to the department, partners/suppliers, customers/end-users or others affected by the changes that will occur as a result of the investment decision. Note that initial costs of construction represent a small proportion of the whole life costs - typically 10%. Similarly, the costs of the IT aspects of business change are relatively small - in the region of 20% of the total cost; 80% relates to the 'soft' aspects such as cultural change

Cost estimates (wherever possible, based on actual historical data) progressively become more reliable and detailed as the level of information improves. At each review stage (such as Gateways - see below) the estimates are used as the basis of control for the next stage. Each signed-off cost estimate becomes the original cost plan in the following stage which is maintained, accurate and up to date as the current control cost plan for continuous comparison against the anticipated final cost.

The cost plan is presented as a work breakdown structure (WBS) which reflects the level of control required. It becomes progressively more detailed as the project proceeds, reflecting:

key areas of the project during feasibility
detailed requirements
design/development (where applicable)
construction/system development (where applicable)
implementation/transition costs (which may include major costs associated with changes in business process and/or organisational change; training; operating parallel services)
operational costs (including ongoing maintenance and changes if appropriate)
disposal

At each stage there will be risk allowances in addition to the base estimates; the risk allowances should progressively reduce in relation to planned expenditure. (For construction projects, see Achieving Excellence briefing 7: Cost management: whole life costs and financial control)

The profile of costs may vary from project to project over time, depending on the contract strategy. A conventional profile would involve high costs up front for start-up of a new service or delivery of a facility, followed by a relatively flat line that gradually rises as maintenance costs become higher over the life of the asset. But a different profile would be achieved where there were incentives to improve performance/value for money over the contract term.

Controls

There must be formal controls for authorising planned expenditure and any required changes. For a programme, the initial estimates of costs and expenditure outlined in the programme brief are developed into a detailed Financial Plan. This provides details of the overall financial management of the programme (including budget information) and how the financial spend on the programme will be managed and controlled, together with a profile of the expected costs and when they will be incurred. For a project, similar information is maintained in the project plan (or Project Execution Plan for construction projects); the project manager reports at regular intervals on costs and expenditure.

During the life of the project and/or operational services, there may be agreed changes that involve cost. These must be authorised through a formal change control process.

The business case contains details of costs and agreed variations, which are subjected to scrutiny at the key decision points in the project/programme lifecycle.

Review stages

There should be a financial review at each Gateway or equivalent major decision point. It should ensure that:

the latest estimate is compared with the previously approved budget and does not exceed it without fully reasoned justification
the latest estimate is made up of the base estimate and the risk allowance
the risk allowance is for identified risks only (not an assumed contingency provision)
the project is still affordable
funds are available for planned expenditure.

The financial review should normally be carried out by the departmental finance team. They should report to the investment decision maker.

Further information

See the Programme Management workbook and the Project Management workbook for details of cost management relating to the programme and project environment.

OGC supports, co-ordinates and monitors the public sector in delivering the Government's target of achieving £21.5 billion efficiency gains a year by 2007/08, see the main OGC website for further details.