Every Expense Counted, Explained with Examples

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Every Expense Counted

Quantitative Analysis · Chapter 8: Project Timelines and the Critical PathSection 8.4 · lesson 38 of 5511 min · free with a free account

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In this lesson

Distinguishing direct and indirect costs in project budgeting.

  • Separate direct costs from indirect costs
  • Predict how each reacts when the schedule moves
  • Locate the duration that minimizes total cost
  • Compute SV, CV, SPI, CPI and EAC

Transcript

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Project Timelines and the Critical Path · Section 8.4

Every Expense Counted

A project's budget is more than a single number. It is a structured statement of how money will be spent. Against what activities, and over what period of time. To manage that statement, you first have to classify the costs inside it. Some costs attach to a deliverable. Others attach to the calendar. Those two families behave in completely different ways when the schedule moves. Get the classification wrong, and the budget stops telling you the truth. You get poor budget management, and inaccurate profitability assessment. Decisions that look right on a spreadsheet, and then fail in practice. This section separates direct costs from indirect costs, and shows how each reacts. Then it introduces earned value management, the standard way to ask whether a project is on track.

Why It Matters

A Budget Is a Structure, Not a Number

Start with the shape of the section, because the three moves build on each other. First, classification. Every cost is either direct, traced to one activity, or indirect, spread across the project. Second, the trade-off. Crashing a project pushes direct costs up, and pulls indirect costs down. That opposition is exactly what creates a minimum total cost. Third, control. Earned value management watches schedule and cost together, while the work is still running. Now notice what classification is not. It is not bookkeeping neatness. A misclassified cost quietly corrupts your profitability figure, your variance analysis, and your crash decision. All of them inherit the error, and not one of them announces it.

Category One

Direct Costs: Traced to a Deliverable

A direct cost is one you can trace to a specific activity or deliverable. Here is the test. Point at a line item and say, this dollar was spent producing that deliverable. If the sentence is true, the cost is direct. Labor hours for a specific task are the clearest case. The wages of the developer writing the module, or the engineer building the prototype. Materials purchased for a particular activity count as well. So does equipment for one phase, like a testing rig leased only for the quality assurance stage. And subcontractor fees, paid to a third party for a defined work package. Now the behaviour that matters for scheduling. Direct costs typically increase when a project is crashed, through overtime and premium prices. The faster you push, the more direct cost you incur per unit of work.

Category Two

Indirect Costs: Allocated Across the Whole

An indirect cost supports the project as a whole. It cannot reasonably be traced to any single activity. So it is allocated across the project, usually as a daily, weekly or monthly charge. The project manager's salary is the standard example. The manager supports every activity, so the cost belongs to none of them. Office space is another. Rent and utilities exist regardless of which task is running. Shared equipment counts too. Servers, software licenses, vehicles, tools used across many activities. So does a share of corporate overhead, for human resources, legal and accounting. And general insurance, the liability and property cover wrapping the whole project. Here is the crucial property. Indirect costs are time dependent. Every extra week the project stays alive adds another week of rent, salary and premium. So shortening the project cuts total indirect cost, even when direct cost goes up.

The Trade-Off

Two Costs, Opposite Directions

Now put the two behaviours side by side. They move in opposite directions when the schedule changes. Compress the duration by crashing, and direct costs rise while indirect costs fall. Extend the duration, and direct costs fall while indirect costs rise. That opposition has a consequence which is easy to miss. Total cost is a function of duration, and that function has a clear minimum. Push the schedule too hard, and overtime eats the savings on overhead. Let it drift, and overhead eats the savings on labour. Somewhere between the extremes sits the duration that minimizes the sum of the two. You can find it graphically, by plotting the direct, indirect and total curves. Or algebraically, by differentiating the total cost function and setting it to zero.

Measuring In Flight

Earned Value Management

Classifying costs and building a budget is only the start. Once execution begins, the manager needs to answer one question at any moment. Are we on track? Earned value management is the standard answer to that question. It rests on three numbers, and every metric that follows is built from them. Planned value is the budgeted cost of the work scheduled by the status date. It is sometimes called the budgeted cost of work scheduled. Planned value reflects the plan. Earned value is the budgeted cost of the work actually completed by that date. Also called the budgeted cost of work performed, it reflects achievement. Notice that earned value is measured in the original budget's currency, not in what you paid. Actual cost is the money actually spent to produce that completed work. One gap reveals schedule performance. The other reveals cost performance.

Four Metrics

Variances and Indices

Four metrics come out of those three numbers. Two are variances measured in dollars. Two are indices, which are pure ratios. Schedule variance is earned value minus planned value. Positive means ahead of schedule. Negative means behind. Cost variance is earned value minus actual cost. Positive means under budget. Negative means over. The schedule performance index is earned value divided by planned value. Above one, the team is working faster than planned. Below one, slower. The cost performance index is earned value divided by actual cost. Above one, you are earning more value than you are spending on it. Read the indices as cents in the dollar, and they become intuitive at once.

Worked Example

A Project at the Status Date

Time to run the numbers on a real status report. A project is reported to be forty per cent complete at the status date. Planned value is two hundred thousand dollars. Earned value is one hundred and sixty thousand dollars. Actual cost is one hundred and eighty thousand dollars. And the total budget at completion is five hundred thousand dollars. Read those numbers before you touch a formula. The team has done less work than planned, and paid more than the work was worth. One thing is worth noticing about that reported completion figure. It plays no part in the five calculations that follow. Every metric comes from planned value, earned value, actual cost and the budget.

Steps 1 And 2

The Two Variances

Step one. Schedule variance. Earned value minus planned value gives minus forty thousand dollars. It is negative, so the project is behind schedule. The team has earned forty thousand dollars less value than the plan called for by this date. Step two. Cost variance. Earned value minus actual cost gives minus twenty thousand dollars. It is negative, so the project is over budget. The team has spent twenty thousand more than the budgeted value of the work it completed. Now notice what a variance is, and what it is not. It is an absolute amount of money, and it is easy to explain to a sponsor. But it says nothing about scale, and for that you need a ratio.

Steps 3 And 4

The Two Indices

Step three. The schedule performance index. Earned value divided by planned value gives zero point eight zero. The team is completing work at only eighty per cent of the planned rate. Every scheduled dollar of value is arriving with twenty per cent slippage. Step four. The cost performance index. Earned value divided by actual cost gives approximately zero point eight nine. Read that one as cents in the dollar. The project is getting only eighty-nine cents of budgeted value for every dollar spent. So the team is overspending by roughly eleven per cent on the work it has produced. Indices travel in a way that variances simply cannot. A cost index of zero point eight nine means the same thing on a project of any size.

Step 5

Forecasting the Final Cost

Step five turns today's performance into a forecast. The estimate at completion is the budget at completion divided by the cost performance index. Five hundred thousand dollars, divided by the cost index, gives five hundred and sixty-two thousand five hundred. Read the assumption carefully, because the whole forecast rests on it. This assumes current cost performance continues for the rest of the project. If the team fixes the problem, the forecast is pessimistic. If things worsen, it is optimistic. One arithmetic warning. Divide by the exact index, not by the rounded one. Rounding first shifts the answer by about seventy dollars here, and by far more on bigger budgets. So what does management actually hear? The project is behind schedule and over budget at the same time. Left alone, the overrun is forecast at sixty-two thousand five hundred dollars, or twelve and a half per cent. Earned value does not solve that problem. It surfaces it early enough to act.

Key Takeaways

What to Carry Forward

Pull the whole section together. Direct costs trace to a specific activity, and they rise when a project is crashed. Indirect costs support the whole project and are allocated across activities. They are time dependent, so every additional week adds overhead. Because the two move in opposite directions, total cost is a U shaped function of duration. The minimum total cost point is the optimal trade-off between those two behaviours. Earned value management compares planned value, earned value and actual cost. Schedule and cost variance measure the gap in dollars. The two indices express performance as a ratio, easy to read and to compare. And the estimate at completion turns mid project data into a credible final cost projection. Ask both questions at every status date. Am I doing the work? And am I paying the planned price?

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Quantitative Analysis carries a NCCRS credit recommendation. These universities work with NCCRS; some are UPI Study's signed partners. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.

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FAQ

Questions students ask us

About Every Expense Counted

What is the difference between direct and indirect project costs?
A direct cost can be traced to a specific activity or deliverable, such as labor on a task, materials for an activity or a subcontractor's fee. An indirect cost supports the project as a whole, such as the project manager's salary, office rent, shared equipment or insurance, and is allocated over time. Crashing raises direct costs, while indirect costs fall as the project gets shorter, so total cost has a minimum at some duration.
What are planned value, earned value and actual cost?
They are the three inputs of earned value management. Planned value is the budgeted cost of the work scheduled by the status date. Earned value is the budgeted cost of the work actually completed by that date, measured in the original budget's terms. Actual cost is the money really spent on that completed work. Comparing earned value with planned value shows schedule performance; comparing it with actual cost shows cost performance.
How do you calculate SV, CV, SPI and CPI in earned value management?
Schedule variance is SV = EV - PV and cost variance is CV = EV - AC; negative values mean behind schedule or over budget. The indices are SPI = EV/PV and CPI = EV/AC, where values below 1 signal trouble. With PV of $200,000, EV of $160,000 and AC of $180,000, SV is negative $40,000, CV is negative $20,000, SPI is 0.80 and CPI is about 0.89.
How do you calculate estimate at completion (EAC)?
A common formula is EAC = BAC / CPI, the budget at completion divided by the cost performance index. With a $500,000 budget, EV of $160,000 and AC of $180,000, CPI is 160/180 \approx 0.889 and EAC is $562,500, a forecast overrun of $62,500, or 12.5%. It assumes current cost performance continues, and the exact CPI should be used, since rounding it first shifts the result.

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