Increase Profit With a Best Practice Cost Analysis Capability

Joe Hamaker, PhD, Galorath Federal Inc.

Your Organization Can Improve By Refining Business Case Assumptions

Any organization that is involved in projects can benefit their bottom line by possessing the capability to perform best practice cost analysis on their projects both before projects commitments are made and throughout the project life cycle.  Based on our experiences at Galorath, most projects suffer significant cost and schedule growth from poor assumptions in the original business case analysis.  Cost overruns come right out of the projected profits and drag down the Internal Rate of Return.  I will show you that sensitivity later in this article.

Notice I used the words “cost analysis” and not the words “cost estimate” in the above paragraph.

What’s the difference and why is it important?  A cost estimate is generally the most probable expected cost.  A cost analysis, on the other hand, is a more extensive piece of work and includes things like testing the sensitivity of the cost numbers to varying assumptions.  Cost analysis is not an exact science—behind all the calculations there are always numerous assumptions--assumptions which probably seem realistic but in fact are not guaranteed to be true.  Stuff happens.  A vendor may not deliver materials or parts as promised.  Equipment may not work as designed.  Off the shelf hardware or software may have to be unexpectedly reworked. A test can fail (that’s why we test)—but the cost estimate probably assumed the test would pass. Weather and labor problems could delay things.  At Galorath we have a saying:  “There are always more things that can go wrong than there are things that can go right!”  We have learned this--our own version of “Murphy’s Law”--and our cost estimates now routinely test the potential impact and probability of these problems and our estimates carry a prudent reserve to work them off.

Stand up a professional independent best practice cost analysis organization

You need professionals to do this—people that are truly interested and excited to do cost analysis as their main job and people that have had the proper training and experience to do this work. Depending on the number and scope of your projects, this cost analysis “organization” can be one person or dozens of people.

Good cost analysts come from all backgrounds: accounting, engineering, science, the humanities--but regardless of academic background, they need to have great analytical skills, be comfortable with numbers, not be afraid of learning some statistics, be able to work with people and teams, be able to speak truth to power and probably most importantly of all —both their left brain (the analytical side) and their right brain (the intuitive side) must work.  Cost estimating requires both mindsets on about equal terms. At Galorath we have an acid test for interviewing a prospective cost analyst and it is simply this question: “Do you think you would enjoy using your skills and intuitions to puzzle out what a project might cost and how long it might take to accomplish it even if nothing like it has been done before?”  If their eyes light up, that’s a good sign.  If they say “Wow, I didn’t know there was such job!”, that is actually a great sign (if it has that “wow” or something like it somewhere)—the best matches between people and jobs are in cases where a person is presented a job they may not have even known existed but one to which they immediately feel drawn.  If the prospect says something like “you can’t estimate something that has never been done before” or “I don’t like puzzles” I can guarantee you that you need to place this person as far away from cost analysis as possible.

Your professional cost staff need to not be beholden to the people managing and advocating the project—in other words, the cost analysts need to be freely capable of giving independent opinions without fear of repercussions.  But these professionals need connective tissue with some kind of independent technical/engineering talent (which can be within the company but ideally also not reporting to the project management)—the costs analysts will need to depend on this technical arm to establish that the engineering requirements and processes are viable, and feasible and within acceptable technical risk.

Establish a corporate cost analysis policy

  It is crucial that top management’s fingerprints on are this document because, as we at Galorath have learned, the first requirement for a good cost analysis capability is a management culture that wants a good internal cost analysis capability—without that, all is for naught.  A written policy specifies the “who, why, when, what and how” of project cost analysis. It should delineate project cost analysis gate reviews tied to specific project milestones. It should be kept under configuration control with the revisions controlled by management and the cost analysis organization.

Develop a cost analysis guide

  Such a guidance document should flow down from the cost analysis policy.  While the policy covers what management’s “desirements” are for cost analysis, a good cost analysis guide doubles down and covers cost analysis approaches, techniques, tools, ground rules and assumptions, and other nitty gritty details.  The guide should include a standard corporate Work Breakdown Structure (WBS)—the WBS will be the common language for cost analysis and project management.

Best practice is to focus on life cycle cost as opposed to only the upfront cost of implementing a project because for a long lived project, sometimes most of the cost can be in the operational phase.  And don’t forget about hardware versus software—its’ sometimes easy to overlook the latter and software is increasingly becoming a larger piece of the “lifecycle cost pie.”  There are cost techniques that focus on software cost including the grandfather of all parametric software cost models, the Galorath SEER-Software Estimating Model or SEER-SEM.

Data is the life blood of cost analysis

Regardless of how you go about everything else here, in order to have a good cost analysis capability, you are eventually going to have to collect data on your own projects as they proceed.  (Galorath cost models can work “right out of the shrink wrap” without you having any corporate cost data—they do this by using what we call Knowledge Bases” which are default parameter settings that represent industry averages for cost drivers/cost predictors).  But if you collect your own data, cost models can then be calibrated to your own corporate efficiency.  Maybe your company is a little more or a little less efficient than the industry average and you can use your data to tune cost models to your performance standard.

Galorath heartedly recommends a hard-nosed cost analysis data requirement that requires all projects to collect and report their cost in a standard way.  This is the best practice for capturing cost and technical data as projects proceed and warehousing that data for future cost analysis needs.  Projects have little incentive to collect cost data, normalize it and warehouse it.  We at Galorath have observed that without a required and centralized effort the data collection will likely be ad hoc, have no common standards for collection and normalization, not be centrally accessible through the organization--data will be kept in Joe’s file cabinet which he keeps locked.  This database will require constant and sustained attention.

Galorath recommends that data proprietary issues be explicitly dealt with up front.  You might be surprised how data restrictions that some of your subcontractors or vendors rather routinely and mindlessly stamp on any documents they provide to you as part of their products or services can hamstring you later in using this data or letting cost analysis support contractors you may wish to hire have unfettered access to this data.  I am reminded of my grandmother.  If my grandmother hired somebody to paint her barn and the painting contractor delivered her the specifications on how they were going to accomplish the work, how long it would take and how much it was going to cost and had the audacity to stamp that document as their proprietary property…well lets’ just say my grandmother would have used her broom to dust that contractor right off her property.  If you are buying products and services from others, make it clear that you are insisting on buying the data as well.  One way Galorath has observed that works well in this regard are Access and Release Clauses in all contracts.  The Release Clause notifies contractors that you, the buying  organization is buying not only a product but has the right to record its cost.  Access clause warns any support contractors that you may later hire (like Galorath) that they are obligated to protect the propriety of sensitive cost data and not let “painting contractor A” see “painting contractor B’s” cost data.

Consider parametric cost estimating

As best practice, consider more modern approaches to cost estimating such as parametric cost estimating as compared to the more common and staid approach of a detailed engineering estimating approach which requires the enumeration of each and every requirement and the labor, materials, parts and subcontracts that go with each requirement.  As we have learned at Galorath, it is really not necessary to count every tree in the forest to estimate the number of trees—there are much more efficient methods. The parametric approach utilizes statistical cost estimating relationships (CERs) to estimate cost with mathematical relationships—an organization can develop the models from internal data, or employ a cost analysis firm such as Galorath Inc. to develop or adapt or calibrate existing models to their corporate history.

Parametric cost estimating is best practice because it is quicker, cheaper, more automatically includes “I forgets”, is more repeatable and lends itself much more readily to sensitivity analysis and cost risk analysis. And the parametric approach will usually be different from the approach taken by the project (which almost certainly will be the labor-material buildup approach).  Parametrics will thus offers a look “through a different lens” that can highlight issues with the estimates and lead to valuable reconciliations. Standing up a parametric estimating approach can require data collection and cost model development or an easier way is to use commercial parametric models like the Galorath SEER suite which, as previously mentioned, can be used right out of the box to estimate the cost of most any type of project based on the project’s technical characteristics, acquisition plans, degree of new design and technology readiness.  The SEER models can readily be calibrated to your organization’s past projects.

And while we have been discussing cost analysis, the scope of the analysis should ideally also take an independent look at the overall project schedule—not necessarily down to the Integrated Master Schedule (IMS) level with hundreds or thousands of tasks but rather from the 40,000 foot level to give the project advocated schedule a sanity check in terms of how viable the overall schedule is  when compared to projects of similar scope, complexity and risk.

There is a lot of support out there for a best practice cost analysis organization—here’s where to find it

There are a number of excellent professional societies that cater to the cost analysis profession.  The leading ones are the International Society of Cost Estimating and Analysis (ICEAA), the American Association of Cost Estimators (AACE) but there are others.  These organizations offer certifications which are rigorous courses of study followed by testing to assure that your cost analysts “know their stuff”.  Galorath Inc. also maintains an extensive website including SEER University and other help.  Just use your Internet search engine to reach these sites.

How good cost analysis can affect your bottom line

I mentioned at the outset of this article that good cost analysis can increase your profitability.  Here is an example:  Assume you are contemplating a new project that is expected to require 100 units of money expended over 2 years before the project begins to generate revenues and that the operations and maintenance cost of your project is expected to be 10 units of money per year beginning in year 3.  Your projection is that once revenues start, also in year 3, they will be 40 units of money and the project’s operational life is expected to be 10 years.  Let’s keep this simple and assume no decommissioning cost and no salvage value.  Thus, your project’s cash flow will be as shown in the Table 1.  Table 1 depicts a pretty decent profitability.  There is a payback in year 5, profit as defined by revenues minus cost are $700 in total over the project life cycle and the Internal Rate of Return (IRR) is 32%.  Not bad.

 

year 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 9 year 10 year 11 year 12 total
Planned Investment -$50 -50 0 0 0 0 0 0 0 0 0 0 -100
Planned Annual Operations $0 0 -10 -10 -10 -10 -10 -10 -10 -10 -10 -10 -100
Planned Revenues $0 0 50 50 50 50 50 50 50 50 50 50 500
Net Cash Flow -$50 -50 40 40 40 40 40 40 40 40 40 40 300
Net Cumultive Cash Flow -$50 -100 -60 -20 20 60 100 140 180 220 260 300 700
Profit $700
IRR on net Cash Flow 32.3%

Table 1: Cash Flow with Projected Cost and Schedule

However, let’s hypothesize that your organization didn’t have the benefits of the best practice cost analysis capability that I have been describing.  Let’s further conjecture that the anticipated cost of your project and its schedule both suffer a 50% growth: instead of costing $100 units of money and taking 2 years it actually costs $150 units of money and takes 3 years before it is up and running and generating revenues.  And let’s say that the forecasted operations and maintenance cost of $10 per year also grew by 50% to $15 per year. Now your cash flow will be shown in Table 2.  Table 2 depicts a much degraded profitability—all because cost and schedule grew by 50%.  The payback in now delayed to year 8, profit is reduced from $700 to $480 and the IRR is down to 14%.  What was a really good business plan didn’t turn out so well due to that nasty cost and schedule growth.  While possessing a best practice cost analysis might not change the business performance of this investment, it would have given management the chance to consider if it was worth it before undertaking the project.

 

year 1 year 2 year 3 year 4 year 5 year 6 year 7 year 8 year 9 year 10 year 11 year 12 total
Planned Investment -$50 -50 -50 0 0 0 0 0 0 0 0 0 -$150
Planned Annual Operations $0 0 0 -15 -15 -15 -15 -15 -15 -15 -15 -15 -$135
Planned Revenues $0 0 0 50 50 50 50 50 50 50 50 50 $450
Net Cash Flow -$50 -50 -50 35 35 35 35 35 35 35 35 35 $165
Net Cumultive Cash Flow -$50 -100 -150 -115 -80 -45 -10 25 60 95 130 165 $480
Profit $735
IRR on net Cash Flow 14.1%

Table 2: Cash Flow with Cost and Schedule Overruns

There are other elements of a best practice cost analysis capability.  Space here does not allow us to discuss other best practice cost analysis capabilities (such as cost sensitivity analysis, cost and schedule risk analysis and budgeting to some minimum statistical confidence level) but contact us at Galorath if you’d like to know more.

Galorath Support

We at Galorath would be proud to help you with any or all the steps required to set up a truly professional cost analysis capability inside your organization.