What are the cost estimation methods?

Cost estimating is a valuable tool that is used in each of the acquisition phases. There are a number of cost estimating techniques that can be used in estimating the costs of a future and current weapon system. The use of a specific approach will depend on how much information is available and where the weapon system is in its development and lifecycle. Most programs will use multiple techniques to get a good cross-reference of the accuracy of their estimates.

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Cost Estimating Techniques
AcqNotes Tutorials
AcqLinks and References:
What is project cost estimation?
Why is cost estimation important?
What are the types of cost estimates in project management?
What costs need to be estimated?
How to estimate costs
Best project cost estimation techniques
Project management estimating software
Want to improve your cost estimation skills?
What are the methods of cost estimation in accounting?
What are the types of cost estimates?
What are 4 techniques of estimation?
What are the 3 main types of estimates?

Cost Estimating Techniques

A few of the most common cost estimating techniques are :

Parametric: The parametric technique uses regression or other statistical methods to develop Cost Estimating Relationships (CERs). A CER is an equation used to estimate a given cost element using an established relationship with one or more independent variables. The relationship may be mathematically simple or it may involve a complex equation (often derived from regression analysis of historical systems or subsystems). CERs should be current, applicable to the system or subsystem in question, and appropriate for the range of data being considered. [1]

Analogy:An analogy is a technique used to estimate a cost based on historical data for an analogous system or subsystem. In this technique, a currently fielded system, similar in design and operation to the proposed system, is used as a basis for the analogy. The cost of the proposed system is then estimated by adjusting the historical cost of the current system to account for differences (between the proposed and current systems). Such adjustments can be made through the use of factors (sometimes called scaling parameters) that represent differences in size, performance, technology, and/or complexity. Adjustment factors based on quantitative data are usually preferable to adjustment factors based on judgments from subject-matter experts. [1]

Engineering Estimate: With this technique (Also called Bottoms Up), the system being costed is broken down into lower-level components (such as parts or assemblies), each of which is costed separately for direct labor, direct material, and other costs. Engineering estimates for direct labor hours may be based on analyses of engineering drawings and contractor or industry-wide standards. Engineering estimates for direct material may be based on discrete raw material and purchase part requirements. The remaining elements of cost (such as quality control or various overhead charges) may be factored in from the direct labor and material costs. The various discrete cost estimates are aggregated by simple algebraic equations (hence the common name “bottoms-up” estimate). The use of engineering estimates requires extensive knowledge of a system’s (and its components’) characteristics and lots of detailed data. [1]

Actual Costs:With this technique, actual cost experience or trends (from prototypes, engineering development models, and/or early production items) are used to project estimates of future costs for the same system. These projections may be made at various levels of detail, depending on the availability of data. Cost estimates that support a full-rate production milestone decision should be based on actual cost data to the greatest extent possible. A common mistake is to use contract prices as a substitute for actual cost experience. Contract prices should not be used to project future costs (even when firm-fixed-price) unless it is known that the contract prices are associated with profitable ventures and that it is reasonable to assume that a similar price experience will be obtained for subsequent contracts. [1]

Three-Point Estimate: This Program Analysis and Review Technique (PERT) style cost estimate has the project manager identifying three separate estimates. One estimate is “optimistic”, the other is “pessimistic” and the last is “most likely”. This scenario has the estimate typically fall somewhere in the middle.

AcqNotes Tutorials

AcqLinks and References:

[1] Defense Acquisition Guidebook (DAG) – Chapter 3
Guide: Operating and Support Cost Estimating Guide – Sept 2020

Updated: 2/24/2022

Rank: G5

Accurate cost estimation is one of the trickiest project management skills to master, as there are always so many unknowns in projects.

In your eagerness to get a project over the line, you’ve probably underestimated costs at some stage, but as you will be held accountable for your cost estimates, it can be stressful when your budgets are reached too soon.

Fortunately, there are plenty of resources to help you hone your cost estimating skills. Let’s explore cost estimation in detail, including a range of estimating methods to help you get better at delivering your projects on budget.

What is project cost estimation?

Cost estimation in project management is forecasting the total cost of resources needed to deliver a project’s scope of work.

Project managers are responsible for making the most accurate cost estimates possible. Using a work breakdown structure (WBS) and cost estimation techniques, project managers shape the project scope and assign costs to each project task.

A cost estimate is more than just a long list of projected expenses. It’s usually accompanied by a detailed report called the Basis of Estimate which runs through all the inclusions, exclusions, assumptions and other aspects to explain and justify the cost estimates presented.

Why is cost estimation important?

It’s widely acknowledged that inaccurate cost estimates cause project failure. Cost estimation is critical throughout the project lifecycle because it:

aids planning
helps secure funding
assists decision-makers to make investment and scope decisions
sets stakeholder expectations
establishes essential metrics for tracking and assessing budget and project performance during the project lifecycle.

What are the types of cost estimates in project management?

There are two main types of project cost estimates.

Rough order of magnitude: has lower accuracy and a broader range of possible outcomes. It’s typically used in the earlier stages of a project where ballpark figures suffice to get a project started.
Definitive estimates: are more accurate because they are more grounded in known data. This might be because more accurate information is available upfront (like a repeat project) or more accurate inputs become available during the project.

What costs need to be estimated?

Projects typically have direct and indirect costs that need estimating.

Direct costs including fixed labour, supplies, materials, and equipment.
Indirect costs including facilities, utilities, hardware, and software.

How to estimate costs

Project managers estimate costs by first breaking the project scope into manageable parts. Then they use all available information to forecast the total expected cost for the project. Here’s an overview of what you need to do.

Build a list of project tasks and the resources you’ll need to deliver them. A work breakdown structure is an excellent tool for this.
Estimate how long you’ll need and create a project schedule.
Allocate resources and assign a cost for each project element.
Assign contingency reserves to account for uncertainty.
Calculate the project budget based on your chosen estimation method.
Track your budget throughout the project and adjust as needed.

“Markets are currently highly volatile with world events, changing government policies, and stimulus packages all affecting the supply of materials and resources. Consider adding a contingency allowance for unforeseen costs, and an allowance for cost escalation to your estimates, bringing an added robustness to your cost estimate.”
Tracy Mackay, Project Director at Bridge42 Pty Ltd

Best project cost estimation techniques

There are a range of cost estimation techniques. The best technique depends on many variables, like what stage of the project you’re at, what effort you want to invest in it and how much is riding on its accuracy.

1. Expert judgement

If the project team is experienced in delivering the type of work in the scope, they can use their specialised knowledge to estimate costs. The accuracy of this method relies on the skill of the project team and a tightly defined project scope.

2. Analogous estimate

This technique uses historical data from similar projects or business as usual tasks to create cost estimates. Adjustments are made for known differences between the old and new projects or tasks. This method is usually used in the early phases of a project.

3. 3-point estimate

This concept calculates a project’s costs based on the weighted average of the most likely (a realistic estimate), optimistic (best case estimate) and pessimistic (worst case estimate) cost projections. For example, let’s say you usually outsource web development for $10,000 (realistic estimate). A friend told you they used a contractor who charged $7,500 (optimistic estimate), but you’re concerned labour shortages might inflate costs to $15,000 (pessimistic estimate). You get your 3-point estimate by adding them together and dividing by 3, giving you a cost estimate for your web development of $10,833.

4. Parametric estimate

Parametric estimating uses statistical modelling to derive cost estimates. It uses historical data of key cost drivers to calculate an estimate the cost for different projects. For example, if it takes one person an hour to build 20 components, then parametric estimating suggests 100 components will take one person five hours to build, or five people one hour, and so on.

5. Bottom-up estimate

Bottom-up estimating uses the estimates from individual work packages to calculate the overall cost estimate for the project. It’s generally more accurate because it analyses costs at a granular level. It’s a good idea to get the team members or vendors responsible for the task to make the estimate as they’ll have a better idea of how long it will take. The downside to this method is it can be time-consuming and resource-intensive, especially in large, complex projects.

The federal government has published detailed cost estimation advice and guidance. It includes theory and practical examples on a range of project cost estimation techniques.

Project management estimating software

When you’re estimating costs, it helps to use software to collect and organise your project information. There’s software available to facilitate all the techniques we’ve covered.

Cost estimating software includes apps, spreadsheets, simulators and statistical software tools. They can help you with work breakdown structures, resource allocation and cost tracking. Online tools often have free trials, so do your research to find the tool that best suits your needs and then give it a go. If you’re part of a professional network, you’ll be able to ask for recommendations and advice.

Want to improve your cost estimation skills?

Professional bodies like the Australian Institute of Project Management (AIPM) exist to help project professionals develop essential project management skills like cost estimation through every stage in their career.

If you want to boost your cost estimation skills or any other project management skills, joining the AIPM is a great place to start. Your membership connects you with a network of project professionals, professional development courses, events and on-demand webinars to fill skills gaps and advance your capability and career prospects.