PM-Foundations – Using Earned Value to Identify Budget Variances

Within the world of IT projects, labor generally represents the largest and most complex component of the overall project budget. As a result, the development of the project schedule is a major driver in creating the project budget. Deliverables and activities are identified and sequenced, resources are estimated, and the project timeline is established. The project staffing plan is created from the resources loaded in the project schedule, and this staffing plan generally represents the largest component of the overall project budget. Ironically, after the project budget is created using the project schedule as a primary source of information, project managers often disconnect the linkage between the schedule and the budget when analyzing these two critical project artifacts during project execution. Many project managers identify and report on budget variances by comparing actual costs to planned costs (by reporting period), without taking into consideration planned vs. actual progress on the project. In this post I use an example from an actual project to help articulate the value of using earned value techniques to perform budget analysis.

Traditional Budget Analysis

The picture below depicts the labor related budget and actual costs from a project. This is the information created / captured during the planning (project budget information) and monthly budget update (actual cost information) processes.

If you are strictly comparing actuals to planned amounts, the budget performance looks fairly positive, and you would draw the following conclusions:

  • Tracking $6,153 under budget (Planned Costs to-date: $292,680 – Actual Costs to-date: $286,527)
  • $71,555 is the forecasted remaining costs to complete the project (Total Budget: $364,235 – Planned Costs to-date: $292,680)
  • $ 358,082 is the forecasted Estimate at completion of the project (Actual Costs to-date: $286,527 + Estimated to Complete: $71,555)

Even without completing the earned value calculation, you get an early indication of a potential schedule and/or cost related issue when you compare the total progress to-date from the project schedule (72%) to the total costs spent to-date (78.6%).

  • 78.6% of budget spent to-date (Actual Costs to-date: $286,527 / Total Project Budget: $364,235)
  • 80.3% is the planned completion % (Planned Value: $292,680 / Total Project Budget: $364,235)

Using Earned Value Techniques

If you progress the schedule on a regular basis, using a tool such as MS Project, you have all the information required to calculate earned value metrics. Start by organizing the information you need to calculate the key earned value metrics:

  • Planned value (PV) is the total amount budgeted through this time period (November 2010)
  • Earned value (EV) is calculated as the total budget * % Work Complete (from the project schedule)
  • Actual costs (AC) through November 2010
  • Cost Performance Index (CPI) = Earned Value / Actual Costs
  • SPI = Earned Value / Planned Value

In this case both the SPI and CPI are less than 1, which indicates that the project has a negative variance, both from a schedule and a cost perspective.

Upon completion of these calculations you are ready to calculate the key earned value metrics (estimated to complete, estimated at completion, and variance at completion):

  • Estimated to Complete (ETC) is $111,427 vs. $71,555 computed based upon planned vs. actual
  • Estimated At Completion (EAC) is $397,954 vs. $358,082 computed based upon planned vs. actual
  • Variance At Completion (VAC) is over budget ($33,719) vs. $6,153 under budget based upon planned vs. actual

Using the earned value technique for budget analysis, it becomes evident that the project is both over budget and behind schedule, and corrective action is most likely warranted. Integrating the work and time dimension in with the traditional budget and schedule analysis provides a whole different perspective on the project performance.

When to Use Earned Value

The example demonstrates the value associated with the earned value technique. The following points highlight a few considerations when determining the appropriate use of the earned value technique to measure project performance:

  • Good use of this technique requires that reliable schedule and cost data are available in a timely manner throughout the project life cycle:
    • Actual hours and costs are reported in an accurate and timely manner
    • Schedule progress (% complete) is updated regularly and is reasonably accurate
    • Planned % complete is available (either based upon budgeted hours or based upon the baseline established in the schedule)
  • Obviously budget control / management must be part of your role as the project manager to fully utilize the earned value technique. However, the same metrics can be derived by replacing costs with hours. The only thing that the earned value technique using hours will not highlight are rate related variances (since you are only using effort hours to drive the cost and schedule variances).
  • The earned value technique is most effective when there is a strong correlation between cost and the schedule. This is not an effective technique for example if 80% of the project cost is associated with a single purchase, and 80% of the project timing is associated with the implementation effort (which is only 20% of the cost).
  • The best metrics to utilize to track the cost and schedule performance trends are the CPI and SPI. These are fact based data points that are valuable to report to the project sponsors on a regular basis (as support of the rating of the overall health of the project).
  • The majority of this section (including the example) focuses on providing the analysis through the end of the project. However, if the cost and schedule information are organized properly, this analysis can be performed based upon major milestones (e.g., project phase). This practice would be best utilized for very large and complex projects involving several different large work efforts.
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PM-Foundations – Is my project funded?

When I worked as a project manager on the client side of the fence, on a regular basis I would have a discussion with my project sponsor that went something like this:

Sponsor: We are going to need to slow down our spending on the project until the end of the quarter.

Project Manager: How can this be? Our budget is already approved by the Steering Committee.

Sponsor: I understand, but the company is struggling to hit it quarterly financial goals, and I have been asked to contribute to the cost saving required to achieve these goals by delaying spending on our project.

Project Manager: You realize that continuing to stop and start activities on our project has an adverse effect on the overall timeline and effort / budget? In addition, it makes it difficult to maintain continuity from a resource perspective when we continue to implement actions of this nature.

Project Sponsor: I understand, but this decision is out of my hands. Help me understand the impact on the project, and I will communicate it when I present the proposed spending delays to my manager.

This is a disheartening experience for project managers because the project team is working hard to meet deadlines, and then due to situations outside of their control, the project is delayed (or in a worst case, put on hold). Project managers that are unaware of the difference between the project budget and project funding are often shocked when this situation occurs. Many project managers believe that once their project budget is approved they are “free and clear” to spend the approved amount. The reality is that as the project progresses, events can occur at the project, portfolio or organization level that cause the project budget and funding to be reevaluated and adjusted. Examples of these events include:

  • The project is taking longer and/or costing more than originally expected
  • The project benefits are less than originally anticipated
  • Other projects are now more important than this project (shifts in emphasis at the portfolio level)
  • The organization needs to cut costs (the discussion described above)

This post describes certain aspects of the project budgeting process that help the project manager work through project funding related events.

The Project Budgeting Process

The development of a project budget represents a “build up” costs from the lowest level activities planned in the project schedule to the point that a project is fully funded within the organization’s cost budgeting processes. The diagram below provides a depiction of the cost build up process.

The following explains each of the components of the process of building up to the overall cost budget:

  • Activity Costs: Represents the cost associated with specific activities in the project schedule. For labor related activities the activity cost is derived from the activity hours times the labor rate for resources assigned to the activity. For material related activities the activity cost represents the material cost assigned to the activity (e.g., purchase of software, infrastructure).
  • Work Package Costs: Costs associated with a work package represents the roll-up of the activity costs for a specific deliverable. Generally this cost can be viewed in the project schedule in the form of a summary task for the deliverable (work package).
  • Control Account: A control account is another name for cost categories that are reported on in the project budget. Control accounts are generally either types of costs (internal labor, external labor, software, infrastructure), or costs associated with major work efforts (project phases or work streams). Control accounts are also where the breakdown between capital and expense amounts are captured. Control account amounts are reflected in the project budget summary, and are derived from the sources for labor and non-labor costs (see previous slides).
  • Project Estimate: Represents the sum of the Control Account amounts (without the project contingency, unless the contingency is included in a control account).
  • Contingency Reserve: Represents the project budget reserve required to mitigate known project risks. Generally the contingency is derived as a percent (%) of specific control accounts or work packages with the associated risk. The best practice is to report contingency as an explicit number either separated on the budget summary, or as a separate control account.
  • Cost Baseline: Represents the total project budget, including the project contingency reserve. This is the amount that the project manager reports against throughout the project life cycle.
  • Management Reserve: Represents the amount that is included in the project funding to account for unknown risks. The management reserve is reflected in capital plans and/or departmental budgets.
  • Cost Budget (Project Funding): Represents the total amount funded for the project, including management reserves. This is the amount that the departmental budget managers are reporting against throughout the financial reporting lifecycle (with input from the project manager). This is also the amount that is reduced when the organization needs to impact the amount spent on a project during a specific time period.

Capital vs. Expense Project Costs

The concept of capital vs. expense related costs is another important area that has a direct impact on project budgets and funding. Under American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 98-1 companies are able to capitalize the costs associated with developing or purchasing software designated for internal use. Capitalization allows organizations to defer certain costs related to the software development effort to be amortized over future periods. Expense related costs must be reported in the period in which the costs are incurred. Only certain cost types may be capitalized, and only during particular stages of the internal software project. Expense related project costs are scrutinized much more frequently and closely than capital costs because they impact the current financial reporting period (vs. future periods).

As a project manager, it is important to understand the organization’s specific policies and procedures associated with SOP 98-1. These policies define how costs are categorized as capital vs. expense within the project budget. These policies also outline how the project manager must capture and report capital vs. expense project costs throughout the project life cycle.

The chart below depicts the breakdown of capital vs. expense costs within the project budget.

Project Funding

Although as the project manager, you will likely have limited responsibility for project funding, it is important to reconcile the funding model (cost budget) to the cost baseline for the project. This process starts by understanding when your project is approved by the sponsor team whether or not it is fully funded. Fully funded refers to the fact that the project is accounted for in Departmental Budgets (Expense budget) and/or Capital Plans (Capital budget).

Another important aspect of the funding model is not only comparing the total project budget to the total amount funded, but also understanding the timing of the project funding vs. the cost baseline. Differences between the cost baseline and the cost budget represent the Management Reserve or Deficit. Underfunding situations (deficit) at any point in time requires some action prior to executing on the project as planned:

  • Does the underfunding situation require specific activities to be delayed?
  • Can funds be pulled forward (spent in an earlier time period) to resolve the underfunding?

The chart above provides a depiction of the comparison of project funding (cost budget) to the cost baseline.

 

 

PM Foundations – Creating a Meaningful Project Budget

As a person who had both project and cost center budgeting responsibilities for many years, I must admit this was an effort that I did not necessarily enjoy and usually procrastinated (much like those of us that procrastinate filing our taxes). Ironically, now that I am on the other side of the fence as a consultant, I work very hard to establish the credibility and trust of my client that is required to be assigned responsibility for the project budget.

Best practices associated with the project budget are focused on efficiently leveraging the planning assets created to that point in the process, and performing the appropriate level of analysis to develop a project budget that will be understood and approved by the client, and just as importantly can be managed throughout the project life cycle. Therefore, the best practices shared in this column represent areas that should be considered during the project budgeting process, not a step by step instruction on creating and maintaining a project budget.

The following represent the best practice topics discussed in this column:

  • Efficiently creating the labor budget for your project
  • Other cost considerations
  • Project budget vs. funding

The Labor Budget:

Within the world of IT projects, labor generally represents the largest and most complex component of the overall project budget. The important concept associated with the labor budget is to ensure that other planning artifacts are utilized to efficiently create the labor budget. This approach significantly streamlines the development of the labor budget, and most importantly it ensures that the project budget is defensible when compared to the project schedule and resource / staffing plan.

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The resource usage view of the project schedule is utilized to create the staffing plan. The staffing plan depicts the full-time equivalent resources (or resource hours) per planning period. The resource quantities are imported into the labor budget and translated into dollars per planning period. The following represent the key elements of the labor budget:

  • Grouping of resources – Understanding of costs by type of resource helps articulate the key cost drivers within the labor budget.
  • Breakdown between internal and external costs – Clients generally place more emphasis on external costs, because these costs are incremental to their business (these costs would not be incurred if the project was not completed).
  • Timing of costs – It is important to summarize the costs by time period, because timing of project costs will be required for financial budgeting and reporting purposes.

Other Project Budgeting Considerations:

The following represent the other areas to consider when completing the development of the project budget. These areas are discussed with your client to understand the appropriate approach, based upon the client’s environment and organizational assets (e.g. financial reporting policies, procedures and tools).

  • Non-labor costs – Non-labor costs generally relate to planned purchases required to support the project. There are capabilities to capture these costs within the project schedule, but it usually adds limited value to reflect them in the project schedule. It is a best to plan and track these costs directly within the Project Budget Tracking tool.
  • Capitalized costs – Companies capitalize certain costs associated with developing or purchasing software designated for internal use. It is important to understand your clients business rules associated with capitalization, and ensure that the project budget supports both planning and tracking capital versus expense project costs.
  • Operational Costs – Although it is not part of the project budget, it is important to provide visibility of the impact of the project on the cost of the on-going operations. The costs included in the project budget can be utilized to derive many of the cost impacts on the on-going operations, such as: depreciation, customer support, infrastructure maintenance and software maintenance.

Project Budget versus Project Funding:

The project manager normally has limited responsibility for project funding decisions, however he/she must reconcile the funding model to the project budget. It is important to understand that when the project budget is approved by the project sponsor, the project cannot be launched until it is fully funded. Fully funded refers to the fact that the project is accounted for in both department cost center budgets (expense) and the capital plans (capital). Another critical aspect of the funding model is not only comparing the total project budget to the total amount funded, but also understanding the timing of the project funding vs. the budget. Under funded situations at any point in time require action prior to executing on the project as planned (e.g., may require delays in launching specific project activities / phases).

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The following provides an illustration of the components of the project budget, from the lowest level activity estimates in the project schedule up to the project funding model for the project.

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In conclusion, the project budget can be considered a strong component of the overall project plan when following have been fulfilled during the planning process:

  • The project budget is fully supported by other project artifacts
  • The project budget process connects to the client’s financial policies, procedures and tools
  • The project budget can be reconciled to the approved cost center budgets and capital plans