Topic 3.6: Business case: financial estimates
Project (output) costs
Ownership (outcome) costs
Project costs are arrived at by asking the question, ‘How much will it cost to deliver this project?’
In other words, it estimates all the costs associated with delivering the project’s output(s).
Ownership costs estimate the ongoing, operational expense to the client organisation of maintaining these outputs once the project is finished.
Another way to look at them is as the price of realising project outcomes.
Even though these costs are often off-set by a revenue stream, it should be accepted that public or not-for-profit projects will usually run at a financial loss.
Opportunity costs are a theoretical acknowledgement that by investing in a project, we are foregoing the potential to re-invest in business-as-usual (the default next best option) and enjoying the ordinary profit this re-investment might bring.
Let’s look at each of these costs – and their relationship to each other – in the next few lessons.
In the business case – where we are only comparing the relative merit of each option – it is sufficient to estimate these costs at the project level to within ±20%.
This is called top-down estimating.
To ensure you broadly capture all the likely project costs in your estimate, you might like to use the following high-level cost classifications.
Note that the project costs for the ‘do nothing’ option always equal zero, because when we do nothing, no project is being delivered!
Being cost-free, ‘do nothing’ also has a default advantage over the ‘do something’ project options – it means the value returned by the preferred project must offset this!
They are also known as outcome costs.
For project outputs that are delivered or sold on to an external client, ownership costs are usually limited to service agreements and warranty claims.
For project outputs that are retained by the performing organisation, such as new machinery, networks or infrastructure, operating TCOs might include:
Infrastructure (such as rent, power, telecommunications and water)
Interfaces (such as network connections or ongoing policy alignment)
Insurance and compliance costs
These are often annual costs that are multiplied by the number of years the project solution will remain in place (the project output’s useful life).
Strategic TCOs that could also be reasonably (if less reliably) forecast include:
New user training
Major repairs and upgrades, and
Strategic TCOs are sometimes called ‘lumpy’, in that their occasional, ad hoc occurrence means they cannot be smoothly apportioned over the life of a project.
It is also important to note that operating and strategic TCOs may increase over time as the solution deteriorates.
Strategic TCOs are added to operating TCOs to estimate the total cost of ownership.
In the business case, analysis of the total costs of ownership also allows us to compare options with different useful lives (for example: five versus ten years), and options with different operating costs (for example: two versus five users to do the same task).
For example, in the scenario that follows, Option A has a useful life of two (2) years and Option B has a useful life of four (4) years.
In this example, Option A and Option B have the same ownership costs of $500 per year.
If we only need our project outputs to last for 2 years, then Option A is going to be cheaper; however, if we need our outputs to last for 4 years, then Option B should be preferred.
Note too that whereas the ‘do nothing’ option has no project costs (because there is no project output), its TCOs may be quite prohibitive!
In commercial terms, it is the profit or loss an organisation makes on its investment in a project.
The net financial impact of a project can be calculated as follows:
Project revenue – (project + ownership costs)
Continuing our example from the previous lesson, let’s suppose our two Options (A and B) each return $1,500 in annual income once the project is delivered.
However, because the project takes six months to deliver, we can only receive half the income ($750) in any project delivery year.
Our projected cash flow now looks like this:
You can see that Option A is still a better two-year solution; however, over a four-year cycle, Option B would be much more preferable (by financial criteria alone).
Another important post-project milestone is the break-even point.
This is the point at which the project and its operations fully recover their costs of investment and proceed into profitable territory.
You can see in our example that even though Option A breaks-even sooner (Year 2), the need to rebuild this Option every two years significantly reduces its long-term profitability versus Option B.
Real-world examples will be much more complex, but these are essential financial principles that any business analyst / project manager should know.
You might also use the following formula when evaluating net financial impact:
Project (outcome) revenue – ownership (outcome) costs
You would use this when you want to consider project outputs and outcomes as separate criteria for business case decision-making. We apply this method later in this Unit.
Opportunity costing asks, “What would we make if we re-invested all this project money in business-as-usual activities?”
For example, a city has $1 billion in the bank and decides to construct a new football stadium – these are the project costs.
It might then cost the city $10 million per year over 40 years to own and operate the stadium – ownership costs of another $400 million.
They also expect to make $2 billion leasing the stadium to professional sports teams and major events over that time, for a net financial impact of +$600 million ($2 billion – ($1 billion + $400 million)).
Assuming our estimates are reliable, this sounds like a good deal!
However, by investing $1 billion in the football stadium, we also lose the opportunity to leave the money in the bank and make 2% per year compounding interest over 40 years, or a net financial profit of $2.2 billion.
In our example, the opportunity cost of building a stadium (+$2.2 billion) is greater than its projected net financial impact (+$600 million).
On this basis, we should leave the money in the bank.
We know that a stadium project will bring much more value to its community than the direct revenue it generates through leasing.
Sophisticated economic modelling can forecast the additional financial impacts of the downstream increase in tourism numbers, jobs created, tax revenue and related city benefits.
This is important, as outcomes such as these align to the strategic objectives of our city planners.
Because the application of these methodologies is beyond what is expected of most project managers, you should involve relevant experts where appropriate in this regard.
And beyond that are a range of impacts that cannot be quantified in monetary terms.
After all, what price do you put on the civic pride that people get from having a professional sports team to cheer for?
For that reason, non-financial impacts may also be critical inputs into business case decision-making, and we will look at these in the next topic.