Cost Estimate

Updated on April 17, 2024
Article bySourav Sinha
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

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 judgment, experience and accuracy.

Cost Estimate

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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 adds value to the firm. A trained person must be appointed to carry out the cost estimation. Several third parties sell data for accurate cost estimation. So different resources must be used to make projections accurate.

Cost Estimate Explained

Cost estimate is a concept which explains the methods adopted, the reasons and end result of evaluation of the cost of a project or program, in order to take decision regarding its feasibility and future potential. There are various method used for this purpose. This concept is not limited to only big corporations but also small startups, individuals and even the government of a country.

The figures obtained after the estimation may be in the form of a single value or cost breakup of multiple components of a project. But overall, it gives a clear idea about the probable cash outflow behind the program and how much effort, time and resources may be invested to cover that cost, so that there is benefit in the form of profit or growth.  

A proper project cost estimate may help the company avoid cost overrun, which is detrimental to the financial health of the company in the long run. For this reason, it is necessary that the management always prepares this analysis on time and takes the help of professionals who are experts in this field.

Cost Estimation is often done by separate individuals trained to estimate costs accurately. It is a challenge considering the ever-changing economic environment. If a project is significant, then companies need to pass the Tender. Once the Tender is accepted, 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 a long time, then the company will have to determine the inflation and other changes that may occur. So, the cost estimation for big projects is complicated and needs to be performed accurately.

Characteristics

Some important characteristics of the concept cost estimate in construction or any other form of project are mentioned below:

  • The main characteristic of this concept is that it uses various cost elements involved in the project and authentic data and historical information is required to calculate the same.
  • There are several ways by which cost estimates can be prepared. The most important characteristic is the preparation of cost estimates. Companies often use models to precisely estimate the cost.
  • Quality is directly proportional to cost, so options for different deliveries involving different costs are set up. So the project manager has to choose the 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 keeping the whole operation within the budget mentioned.
  • This process must be handled by professionals who are well-informed about the various methods that can be used based on the type and information. They should be qualified enough to understand various nitty-gritty of the process along with legal issues so that the results obtained can be used without any problem.
  • The financial data used must be accurate and without any discrepancy. Otherwise, the cost figure obtained will not prove helpful and will lead to misguidance and mismanagement.
  • Every organization tries so that there is profitability.

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Types

The three most important types of cost estimate are:

Types of Cost Estimate

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#1 – Historical Estimating

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. It doesn’t involve lots of judgment. So it is quick and not so accurate. Under this similar past, projects are being searched, and costs are adjusted considering inflation and other economic changes.

#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 foot of the project is known. So multiplying the total space you will create in your project can help you get the total cost. This process helps to get costs more accurately as it is recent, and all current Economic factors are external, environmental factors that influence business performance, such as interest rates, inflation, unemployment, and economic growth, among others.read moreeconomic 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

This process is hugely time-consuming but accurate. It involves a thorough analysis of all the labor and raw materials included in the project. So granular cost estimation is done first, and then after adding everything, you get the total cost.

Apart from the above there are also some other types of costs that has to be estimated and are very common in the market. They are maintenance and repair cost, manufacturing cost, cost of exploitation of resources, renewal and rehabilitation cost, cost estimation of supply chain management, cost of purchasing and implementing new softwares for upgradation and betterment of work environment, etc.

Each of them will follow different methods of cost estimate techniques, depending on their components, timing or purpose.

Methods

Some standard methods of the same are given below.

Methods of Cost Estimate

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#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 costs. So this method helps to build a model which shows that for a particular production level, this much should be the variable cost, and this much should be theFixed 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 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 estimating 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 costs. These models are costly to set up, making it difficult for small businesses to build statistical models.

The above are widely used in the market to find cost of different situations and ideas. However, they will greatly depend on the type of idea, the information available, the time period for which the project may be undertaken, the size of the project, etc. If the cost evaluation shows that it is more than the amount of return that the organization is expecting to get from it if future, then there is every possibility that the program or idea may be rejected or kept aside to be followed later.

Process

Optimally how much productivity can be obtained given a certain amount of cost is the main objective of Cost Estimation. This process can involve determining the total cost 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.

It supports the evaluation of the feasibility or funds needed to support the planning of the same. This concept is an essential requirement during budget proposal.

Example

Let us assume that a project is has been evaluated and the management has calculated that the possible cost should be not more than $1,500,000, as per its nature, size and resources required. But after completion of 80% of the work, it is noticed that the funds spent is already $ 1,620,000. In this case, there is a possibility of more funds being spent on it since it is not yet complete, resulting in a huge pressure of the financial resources of the company. From here we realise the correct cost estimation is extremely important.

Importance

Following are some of the important of benefits of the cost estimate techniques.

  • The cost estimate template helps the business make an accurate decision regarding whether they should go ahead with the program or idea or not.
  • It act, as a method to keep strict monitoring of the performance if any idea is already implemented in any department. The cost estimation will give an idea whether the implemented idea is actually giving any positive result, or it is just leading to wastage of resources.
  • This also helps in creating a provision for funding because based on cost along with various other factors, the business will arrange for capital for funding the investment or projects.

Thus, the above are some points of importance of this concept.

Advantages

Some advantages of the concept of cost estimate template are given below:

  • 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 teach discipline in project handling. Once a project manager knows the cost estimation, 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, they may not provide funds.

Disadvantages

Here are some noteworthy 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 haircut may lead to the failure of projects.

It is important to understand the advantages and disadvantages of the concept so that the concept can be utilised as and when required.

Cost Estimate Vs Budget

It is essential to understand that both the above aspects are crucial for any business and involves a lot of financial planning. But they are two different concepts. Let us study the differences.

  • Cost Estimation is the preliminary stage, so the cost is first projected, then the budget is fixed accordingly.
  • The budget is decided based on the cost that is estimated. So the budget is the total money allocated for a particular project.
  • The budget can be set more than the cost to be safe in case of an incorrect cost projection.
  • The former helps in proper management and planning for resources and acts as a guide to their optimum utilization. But the latter is the provision made of funds kept aside to do the former.
  • The latter can be used to keep a check on the expenditure made behind a particular process. The management can always refer to the budget to ensure that there is enough fund to carry out the task and not go overboard with operational procedures to achieve targets. In this way budget also ensures that the cost is kept under control to avoid cost overrun.
  • The former is the total expenditure that the company will have to incur on the project and which will lead to fund outflow. But the latter is the fund kept aside to meet that expenditure.
  • The former is what the business will plan to spend from its own resource behind the program but the latter is what the business is planning to charge its clients as a compensation for giving and product or service.
  • Companies initially start working on the cost estimates and later on move to their estimated budget to check where they stand in terms of expenditure and available funds.

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