What is Cost Estimate?
Cost Estimate is the preliminary stage for any project, operation or program wherein a reasonable calculation of all the project costs is done and therefore, involves precise judgement, experience and accuracy.
Explanation
- Cost Estimation is often done by separate individuals, trained to estimate cost accurately. It is a challenge considering the ever-changing economic environment. If a project is significant, then companies need to pass Tender. Once the Tender is accepted, then the particular company gets the project and starts working.
- So to pass the Tender, the company will have to estimate all the costs related to the project. If the project is going to take long to complete, then the company will have to determine the inflation and other changes that may occur. So the estimation of cost for big projects is complicated and needs to be performed accurately.
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Characteristics
- The most important characteristic is the preparation of cost estimates. There are several ways by which cost estimates can be prepared. Companies often use models to precisely estimate the cost.
- Quality is directly proportional to cost, so options are being set up regarding different deliveries, which involve different costs. So the project manager has to choose what kind of quality he wants, considering the cost.
- The budget for the overall project or operation is set. Since the scariest thing is the capital, acceptance of a project depends on the budget set for the project.
- Another essential characteristic is that keeping the whole operation within the budget mentioned.
Types of Cost Estimate
The three most important types of cost estimate are:
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#1 – Historical Estimating
It doesn’t involve lots of judgment. So it is quick and not so accurate. Under this similar past, projects are being searched, and then costs are adjusted considering the inflation and other economic changes. So when a method is being set up using historical cost, it is not so accurate, but can be used during the initial stage of a project.
#2 – Parametric Estimating
Parametric estimation is an estimation done based on parameters. So recent ongoing projects are taken, and it is used as a parameter. Say a similar project is being constructed somewhere, and the cost per square feet of the project is known. So multiplying the total space that you are going to create in your project can help you to get the total cost. This process helps to get cost more accurately as it is recent, and all current economic factorsEconomic FactorsEconomic factors are external, environmental factors that influence business performance, such as interest rates, inflation, unemployment, and economic growth, among others.read more are already incorporated.
#3 – Bottom-Up Estimating
It involves a thorough analysis of all the labors, raw materials included in the project. So granular cost estimation is done first, and then after adding up everything, you get the total cost. This process is hugely time-consuming but most accurate.
Methods of Cost Estimate
#1 – Least Square Regression
Least Square regressionLeast Square RegressionVBA square root is an excel math/trig function that returns the entered number's square root. The terminology used for this square root function is SQRT. For instance, the user can determine the square root of 70 as 8.366602 using this VBA function.read more of statistics is used to find the best fit line for variable and fixed cost using historical data. So this method helps to build a model which shows that for a particular level of production, this much should be the variable cost and this much should be the Fixed CostFixed CostFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more. So once a model is set, this method becomes easy as new data can be incorporated easily.
#2 – High-Low Method
High Low methodHigh Low MethodThe high-low method is used to separate fixed and variable cost elements from the historical cost mixture of fixed and variable costs. Fixed cost = highest activity cost – (variable cost per unit * highest activity units)read more shows you the highest and lowest level of cost that you may incur. So it doesn’t throw the possibility of the cost that lies in the middle. This method is generally easy to compute and helps to have a preliminary idea regarding the cost.
#3 – Statistical Modelling
This method is the most sophisticated. It involves all the estimation of several economic factors that may lead to a change in cost estimation. Statistical models are extremely accurate as several factors are considered to set up the cost. These models are costly to set up, so it gets difficult for small businesses to build statistical models.
Process
This process can involve the determination of the total cost that is required to accomplish a project in a given time. It is not an accurate measure; it is an approximation. Correct estimation of labor and raw material cost is also required. Optimally how much productivity can be obtained given a certain amount of cost is the main objective of Cost Estimation.
Importance
Cost Estimation is the most critical step for project management. Without proper estimation, it will be complicated to make a budget for the project. Incorrect estimation may lead to losses. A project’s IRR and profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more are decided based on the cost that is estimated. So inaccurate estimation of the cost may lead to acceptance of a wrong project or rejection of a profitable project.
Cost Estimate vs. Budget
Cost Estimation is the preliminary stage, so at first, the cost is projected then the budget is fixed accordingly. So the budget is the total money allocated for a particular project. The budget is decided based on the cost that is estimated. The budget can be set more than the cost to be safe in case of an incorrect projection of cost.
Advantages
- It helps in deciding how much funds and resources are needed to carry out a particular project. Without cost estimation, it will be challenging to decide on a budget.
- It helps to inculcate discipline in project handling. Once a project manager knows the cost estimation, so he will not spend unnecessarily and will try to finish the project within the estimate.
- Cost estimation breakup helps stakeholders to challenge in case of discrepancies. So if they feel that the estimation is wrong or manipulated, then they may not provide funds.
Disadvantages
- Inaccurate estimates may lead to acceptance of wrong projects which will lead to capital erosion for the firm
- Projections are always risky as they involve events that have not occurred yet. So depending too much on the estimation and not keeping a hair-cut may lead to failure of projects
Conclusion
This step is the most crucial step for any project or operation of a businessOperation Of A BusinessBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation.read more. Proper estimation helps a firm to accept positive NPVNPVNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not.read more projects, which in turn adds value to the firm. A trained person must be appointed to carry out the cost estimation of a project. Several third parties sell data for accurate cost estimation. So different resources must be used to make projections accurate.
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