Intro to Project Management: Project Cost Management - Types of Costs, Direct Indirect Fixed Variable Opportunity Sunk

What This Is

Understanding the different types of costs is crucial for project managers to make informed decisions and allocate resources effectively. Let's consider a real-world example: building a new highway. The project involves constructing a 10-mile stretch of road, which requires excavating, laying down asphalt, and installing safety features. The project manager needs to estimate the costs involved, including the costs of labor, materials, equipment, and other expenses. By categorizing these costs into direct, indirect, fixed, variable, opportunity, and sunk costs, the project manager can create a comprehensive budget and make informed decisions about resource allocation.

Key Terms & Formulas

• Direct Cost (DC): A cost that can be directly attributed to a specific activity or task, such as labor costs for excavating or materials for asphalt.
• Indirect Cost (IC): A cost that cannot be directly attributed to a specific activity or task, such as administrative salaries or office expenses.
• Fixed Cost (FC): A cost that remains the same even if the level of activity changes, such as rent or salaries for permanent employees.
• Variable Cost (VC): A cost that varies with the level of activity, such as labor costs for overtime or materials for additional features.
• Opportunity Cost (OC): The cost of choosing one option over another, such as the cost of not pursuing an alternative project or investment.
• Sunk Cost (SC): A cost that has already been incurred and cannot be changed, such as the cost of purchasing equipment that is no longer needed.
• Cost of Quality (COQ): The cost of ensuring quality, including costs of inspection, testing, and rework.
• *Cost Performance Index (CPI):* CPI = EV / AC (Earned Value / Actual Cost), which measures the project's cost efficiency.
• *Schedule Performance Index (SPI):* SPI = EV / PV (Earned Value / Planned Value), which measures the project's schedule efficiency.
• *Earned Value (EV):* EV = % complete × BAC (Earned Value = percent complete times Budget at Completion), which measures the project's progress.
• Budget at Completion (BAC): The total budget for the project, including all costs and expenses.

Step-by-Step / Process Flow

1. Identify costs: Break down the project into its various activities and tasks, and identify the costs associated with each.
2. Categorize costs: Classify the costs into direct, indirect, fixed, variable, opportunity, and sunk costs.
3. Estimate costs: Use historical data, industry benchmarks, and other sources to estimate the costs of each category.
4. Create a budget: Use the estimated costs to create a comprehensive budget for the project.
5. Monitor and control costs: Regularly track and review the project's costs to ensure they are within budget and make adjustments as needed.

Common Mistakes

• Mistake: Failing to distinguish between direct and indirect costs.
• Correction: Direct costs are those that can be directly attributed to a specific activity or task, while indirect costs are those that cannot be directly attributed.
• Mistake: Ignoring opportunity costs.
• Correction: Opportunity costs are the costs of choosing one option over another, and should be considered when making decisions about resource allocation.
• Mistake: Failing to account for sunk costs.
• Correction: Sunk costs are costs that have already been incurred and cannot be changed, and should not be considered when making decisions about resource allocation.

Exam Tips

• Tip: Be able to distinguish between direct and indirect costs, and provide examples of each.
• Tip: Understand the concept of opportunity cost and how it applies to project decision-making.
• Tip: Be able to calculate the cost performance index (CPI) and schedule performance index (SPI).

Quick Practice Questions

1. If the CPI is 0.8, is the project under or over budget? Answer: Under budget. Explanation: A CPI of 0.8 indicates that the project is earning value at a rate that is 20% higher than the actual cost incurred.
2. What is the difference between a fixed cost and a variable cost? Answer: A fixed cost remains the same even if the level of activity changes, while a variable cost varies with the level of activity.
3. If a project has a budget of $100,000 and has earned $80,000 in value, what is the percentage of completion? Answer: 80%. Explanation: The percentage of completion is calculated by dividing the earned value by the budget at completion.

Last-Minute Cram Sheet

• Direct Cost (DC): A cost that can be directly attributed to a specific activity or task.
• Indirect Cost (IC): A cost that cannot be directly attributed to a specific activity or task.
• Fixed Cost (FC): A cost that remains the same even if the level of activity changes.
• Variable Cost (VC): A cost that varies with the level of activity.
• Opportunity Cost (OC): The cost of choosing one option over another.
• Sunk Cost (SC): A cost that has already been incurred and cannot be changed.
• Cost of Quality (COQ): The cost of ensuring quality.
• Cost Performance Index (CPI): CPI = EV / AC (Earned Value / Actual Cost).
• Schedule Performance Index (SPI): SPI = EV / PV (Earned Value / Planned Value).
• Earned Value (EV): EV = % complete × BAC (Earned Value = percent complete times Budget at Completion).
• Budget at Completion (BAC): The total budget for the project, including all costs and expenses.
  Decomposition breaks down work, not activities – it creates the WBS, not the activity list.
  Scope creep occurs when changes to the project scope are not properly managed.
  Earned Value is a measure of project progress, not a measure of project success.