Project cost estimation: What it is, why it’s important and how to do it

No matter the project or job, having a precise cost estimate is key. It helps businesses allocate resources wisely, stick to their budgets, and stay profitable in today's competitive environment. According to the QuickBooks Business Solution Survey, 95% report that the rising costs of inflation have been a challenge, putting immense pressure on margins and budgets. 

This makes accurate project costing a vital part of protecting profitability and ensuring viability. It allows businesses to anticipate potential cost fluctuations, secure adequate funding, divide resources, and safeguard profitability.

This guide will explain the core aspects of project cost estimation, covering the fundamental steps and various techniques you can employ. Learn which tools are available to help and why mastering this skill is key for your company's resilience and success.

Jump to:

• What is cost estimation in project management?
• How to estimate project costs in 7 steps
• 11 project cost estimation techniques
• How to choose the right project cost estimate technique
• Why project cost estimation is important
• Project cost estimate tools
• Boost productivity and enhance profitability

What is cost estimation in project management?

Project cost estimation is the process of forecasting the total financial resources necessary to complete a project according to its defined scope, objectives, and timeline. This forecast includes all anticipated expenses, such as labor, materials, equipment, services, and indirect costs.

What are the levels of cost estimation?

Project cost estimates have different levels of accuracy depending on when you make them and how much detail you can provide. 

Early in a project, you'll have a very rough "order of magnitude" estimate. With detailed planning, you can later create a much more precise "definitive" estimate used for final budgets or bids. 

Estimates get more accurate as time goes on and the project needs become more clear.

How to estimate project costs in 8 steps

Creating a reliable project cost estimate requires an organized approach. Following these steps helps ensure you account for all necessary components, leading to a more accurate financial forecast for your project.

1. Define the project’s scope

Before you can estimate costs, you need a crystal-clear understanding of what the project involves. A poorly defined scope is a primary cause of budget overruns. 

To define it effectively, document the following:

• Objectives: What specific, measurable, achievable, relevant, and time-bound goals will the project accomplish? Clearly stating the intended outcomes helps focus all subsequent planning.
• Deliverables: What tangible results or outputs will the project produce? This could include products, reports, software features, completed installations, or specific services.
• Requirements: What criteria must the deliverables meet? Detail the necessary functions, performance levels, technical specifications, and any compliance or quality standards.

Gathering this information often involves having discussions with stakeholders, reviewing business cases, and documenting everything in a formal scope statement. 

This document serves as the baseline agreement on what the project will deliver. It provides the boundaries for effective cost allocation, particularly when using methods like job order costing to track expenses against specific projects.

2. Create a work breakdown structure

A work breakdown structure (WBS) is a fundamental project management tool that organizes the team's work into manageable sections. Think of it as a hierarchical outline or map of the entire project scope.

It starts with the overall project objective at the top level and then systematically breaks that down into major phases or deliverables. These further separate into smaller work packages and then finally into specific tasks and sub-tasks required to complete each package. Each level provides progressively more detail.

To create it, start with the major deliverables identified in the scope statement and break them down until you reach individual tasks that can be assigned, managed, and estimated. Identifying all necessary tasks and sub-tasks ensures neither party overlooks anything critical during estimation.

3. Estimate the resources needed to complete the project 

With a detailed WBS, you can now identify the resources required for each specific task. This involves determining the type and quantity of everything your company needs to get the job done. 

Consider categories such as:

• Labor: Identify the necessary roles, skill levels, and estimated amount of time each role will spend on each task.
• Materials: List all consumable supplies or raw materials needed to produce the deliverables. Specify quantities accurately.
• Equipment: Determine the necessary tools, machinery, or technology. Note whether your company will need to purchase or rent any equipment.
• Facilities: Consider any necessary physical spaces like offices, labs, workshops, or storage areas.
• Technology and software: Account for specific software licenses, cloud service subscriptions, or specialized applications needed for the project.

Consult team members and subject matter experts, plus review historical data from similar projects to ensure your resource list is comprehensive.

4. Calculate costs for each element of the project

Once you know the resources needed, assign a cost to each one. This step translates your resource plan into a preliminary financial estimate. 

Here are the individual costs you’ll need to calculate:

• Labor rates: The company's finance and human capital management (HCM) systems—specifically payroll—will typically manage these rates. For external contractors or consultants, use their quoted rates. Multiply the rate by the estimated time required for each task.
• Material costs: Get quotes from suppliers for required materials. If quotes aren't feasible immediately, use current market prices or reliable historical data. Then, factor in quantities necessary for each task.
• Equipment costs: Determine costs based on rental agreements (cost per day/week/month) or purchase prices. Include associated costs like maintenance, fuel, or operation.
• Other costs: Calculate costs for rent, utilities, software licenses, travel, training, etc.

Apply these costs to the corresponding resources identified for each task in the WBS. Summing these provides the estimated cost for each individual task.

5. Consider any additional costs

Identifying the direct project costs associated with specific tasks is crucial, but don't overlook indirect costs. These are expenses that aren't tied to a single work package but are necessary for the project's execution, like:

• Administrative overhead: General support from functions like HR, finance, legal, or executive management. This is often calculated as a percentage of direct costs.
• Utilities: Costs for electricity, water, internet, etc., for the facilities used by the project team.
• General project expenses: Items like office supplies, communication costs, or team-related expenses.
• Insurance and permits: Costs related to project-specific insurance policies or required regulatory permits.
• Training costs: Expenses for training team members on specific tools or methodologies needed for the project.

Failing to account for these indirect costs can lead to an underestimation of the total project funding required.

6. Conduct a risk analysis

Every project faces uncertainties that could impact its cost. A risk analysis involves identifying potential threats, assessing their likelihood and potential financial impact, and planning responses.

Start by brainstorming potential risks related to scope, schedule, resources, technology, vendors, and external factors. 

Common risks include:

• Scope creep 
• Schedule delays requiring overtime or extended resource allocation
• Unexpected increases in material prices
• Resource unavailability 
• Technical challenges requiring additional R&D or different solutions
• Supplier delays or failures
• Changes in regulatory requirements

Once identified, assess each risk's probability and potential cost impact. This analysis helps determine where to allocate contingency funds and informs how risks are addressed in project agreements, which is especially valuable in detailed construction contracts.

7. Create a reserve fund

Even the best plans encounter unexpected issues. A reserve fund provides a financial buffer to handle these situations without derailing the project. There are typically two types of reserves:

• Contingency reserve: Funds allocated to cover the costs associated with specific, identified risks. The amount is often based on the expected monetary value of those risks. 
• Management reserve: An additional fund for unforeseen risks – the "unknown unknowns" that the risk analysis didn’t uncover. This amount is often a percentage of the total estimated project cost based on project complexity, uncertainty, and organizational policy. 

Including reserves is great for creating a realistic budget that accounts for uncertainty.

8. Review the estimate with stakeholders

Before finalizing the cost estimate, present it to key stakeholders. This typically includes the project sponsor, clients, key team members, and finance representatives.

Explain your methodology, assumptions, the WBS, resource allocations, cost calculations, identified risks, and proposed reserves. This review serves several purposes:

• Validation: Stakeholders can verify assumptions and check for omissions or errors
• Alignment: Ensures everyone understands the financial scope and commitment required
• Buy-in: Gains support and approval for the proposed budget
• Refinement: Incorporates feedback and adjustments based on stakeholder expertise or concerns

Be prepared to answer questions and revise the estimate based on feedback before seeking final approval. This collaborative step increases confidence in the estimate and sets clear expectations.

11 project cost estimation techniques

Various techniques exist for estimating project costs, each offering different levels of detail, accuracy, and effort. Often, combining multiple techniques yields the most reliable result, especially for complex projects.

Understanding these methods helps you choose the best approach for your specific situation.

Top-down estimate

The top-down estimate approach involves first developing a high-level estimate for the entire project, often based on historical information or high-level parameters. It's typically useful when detailed information is scarce, providing a quick approximation or order-of-magnitude cost. The overall estimate might then be allocated to lower-level components. 

While top-down estimates generally lack the precision needed for detailed cost control later on, they are useful for initial feasibility studies and securing initial budget approval. 

Key top-down methods include:

• Analogous estimating: This method uses the actual costs of previous, similar projects as the basis for estimating the current project. 

For instance, if a similar marketing campaign last year cost $50,000, an initial analogous estimate for a new, slightly larger campaign might start at $60,000, adjusting for known differences. Its accuracy depends heavily on how comparable the past project truly is to the current one and the quality of the historical data available.

• Parametric estimating: This technique calculates an estimate by using a statistical relationship between historical data and other variables (parameters). 

For example, if similar construction projects cost $200 per square foot and the current project involves 5,000 square feet, the parametric estimate would be $1,000,000 (5,000 sq ft x $200/sq ft). 

Similarly, estimating software development based on cost per function point relies on established cost metrics per unit of functionality. It requires accurate data and scalable parameters.

Bottom-up estimate 

When done correctly, bottom-up estimating is considered one of the most accurate methods. It involves forecasting costs for individual tasks or work packages at the lowest level of the work breakdown structure (WBS). These detailed estimates are then rolled up or aggregated to determine the total project cost. 

For instance, if Task A is estimated at $500, Task B at $1,200, and Task C at $800, the bottom-up estimate for this part of the project would be $2,500 ($500 + $1,200 + $800).

This method is highly granular and detailed because it relies on estimating every component of the project. It requires a well-defined scope and WBS and can be time-consuming, but it provides a strong basis for budgeting and cost control throughout the project lifecycle.

Expert-driven estimate

The expert-drive estimate technique relies on the experience and judgment of subject matter experts to determine the cost estimate. These experts could be internal team members, external consultants, or individuals with deep knowledge of specific project components or the industry.

This method is particularly valuable when historical data is limited, the project involves new technology, or there are unique factors that statistical models can't easily capture. 

A common structured approach within this category is the Delphi Method. 

This method uses an anonymous panel of experts who provide estimates. A facilitator collects the estimates, summarizes them (often providing rationale without names), and sends the summary back to the experts for another round of estimation. 

Three-point estimate

The three-point estimate technique addresses estimation uncertainty by considering a range of possible costs for each activity or work package rather than a single value. It involves determining three distinct estimates:

• Optimistic (O): The lowest possible cost, assuming everything goes perfectly according to plan (best-case scenario)
• Most Likely (M): The most realistic cost, based on typical effort and normal conditions
• Pessimistic (P): The highest possible cost, assuming significant issues or challenges arise (worst-case scenario)

These estimates are often used in formulas to calculate a weighted average cost that accounts for this uncertainty, providing a single expected value for planning. 

For example, if a task's Optimistic cost (O) is $800, Most Likely (M) is $1,000, and Pessimistic (P) is $1,500, a simple triangular average estimate would be $1,100 (($800 + $1,000 + $1,500) / 3). Other formulas might give more weight to the Most Likely estimate.

These ranges can also be used as inputs for Monte Carlo simulation, a more sophisticated technique using software to model the probability distribution of the total project cost based on the uncertainty in individual tasks. This approach provides a probabilistic forecast rather than a single deterministic number.

Vendor bid analysis

Vendor bid analysis becomes a key estimation technique when a company outsources significant portions of the project work to external suppliers or contractors. 

This method involves obtaining bids or proposals from multiple qualified vendors for a specific scope of work defined in a request for proposal (RFP) or similar document.

The process includes analyzing the received bids, comparing pricing structures, assessing vendor capabilities, and potentially negotiating terms. 

The selected bid or an average of competitive bids can then be used as the cost estimate for that portion of the project work. Its accuracy depends on the clarity of the requirements provided to vendors and the competitiveness of the bidding process.

For example, a construction company outsourcing electrical work might receive bids ranging from $120,000 to $150,000. After reviewing qualifications and negotiating details, the company may select a mid-range bid of $135,000 to use in its project cost estimate.

Reserve analysis

The reserve analysis technique focuses specifically on determining the appropriate amount of funding needed for the contingency and management reserves within the project budget. It's directly linked to risk management.

Reserve analysis involves evaluating the cost impact of identified risks (from the risk analysis step) to quantify the contingency reserve needed to address known unknowns. 

For example, if a specific risk (like a key supplier delay) has a 20% probability of occurring and would cost an estimated $10,000 in expedited shipping if it happens, the expected monetary value (EMV) for that risk is $2,000 (20% x $10,000). 

Adding together the EMV of several key risks might form the basis of the contingency reserve. It also considers the overall level of project uncertainty and organizational risk tolerance to establish the management reserve needed for unknowns. This ensures the project budget includes buffers to handle potential cost overruns due to risks and unforeseen events.

Cost of quality (COQ)

The cost of quality (COQ) technique estimates the total costs associated with achieving quality on a project. It helps in making informed decisions about investing in quality activities by weighing the cost of prevention against the cost of potential failures. 

COQ includes costs related to:

• Prevention: Costs incurred to prevent defects from occurring in the first place
• Appraisal: Costs associated with evaluating, measuring, auditing, and testing products or services to ensure they meet quality standards
• Internal failure: Costs incurred when defects are detected before the product or service is delivered to the customer  
• External failure: Costs incurred when defects are found after delivery to the customer

With COQ estimates in hand, organizations can better understand the financial impact of quality (or lack thereof) and justify investments in prevention and appraisal activities to reduce overall failure costs.

Other techniques

Beyond the main methods, several other specialized techniques or inputs contribute to project cost estimation:

• Learning curve theory: This suggests that as individuals or teams repeat a task, their efficiency increases, leading to a predictable reduction in the time and cost per unit produced.
• Value engineering: This is a systematic analysis focused on improving the project's value by examining the functions of its components and finding ways to achieve those functions at the lowest possible cost without sacrificing quality or performance.
• Historical data analysis: This involves systematically reviewing and analyzing detailed cost and performance data from previous projects to identify trends and inform current estimates, often forming the basis for analogous and parametric techniques.
• Resource cost rates: This refers to using pre-determined, standardized costs for specific types of labor, materials, and equipment, often maintained by the finance or procurement departments, to ensure consistency in estimates.

Applying these specialized techniques where appropriate can further refine cost predictions and enhance the overall accuracy of your project estimates.

How to choose the right project cost estimate technique

With several estimation techniques available, selecting the most appropriate one (or combination) for your project is key to achieving a reliable forecast. The choice isn't arbitrary; it depends on various factors related to the project and the context in which the estimate is being prepared. Carefully considering the following aspects will help you select the most effective approach.

Identify the project stage

Where you are in the project lifecycle significantly influences the best estimation technique. Early phases, like initiation or feasibility studies, often have limited detail available. In this situation, top-down methods such as analogous or parametric estimating are suitable for quickly creating rough order of magnitude (ROM) estimates. 

As you progress into detailed planning, where the scope and work breakdown structure are well-defined, bottom-up estimation becomes more feasible. It provides the higher accuracy needed for establishing baseline budgets and exercising cost control.

Consider the project size and complexity

The scale and intricacy of your project are important considerations. Smaller, relatively straightforward projects might be adequately estimated using simpler methods like analogous techniques or basic expert judgment. 

Large, complex undertakings, however, typically demand the detail and rigor offered by bottom-up estimation. For such projects, supplement this with parametric modeling for repetitive components and expert review for particularly unique or high-risk areas to ensure comprehensive coverage.

Review available data

The quality and quantity of information you can access will guide your technique selection. Analogous or parametric estimation can be efficient and effective if your organization has robust historical data from similar past projects. 

Conversely, if reliable data is scarce and inconsistent, or the project involves novel elements, you may need to rely more heavily on expert judgment initially. Or, you could wait until task details are available to build estimates from the ground up using the bottom-up approach.

Assess the time and resources available

Be realistic about the effort you can dedicate to the estimation process itself. Techniques vary significantly in the time and resources they demand. 

Bottom-up estimation, while thorough, is inherently time-consuming and resource-intensive. 

If project deadlines are tight or the team available for estimation is limited, quicker methods like top-down or analogous estimating might be necessary as a starting point. However, you must acknowledge the potentially lower level of initial accuracy associated with them.

Determine the required accuracy

Finally, determine the level of precision needed for the estimate's specific purpose. Higher accuracy techniques are essential if the cost estimate will form the basis for a critical business decision. Examples of this include submitting a fixed-price bid, securing major external funding, or choosing between competing strategic options. 

In these cases, the effort should be invested in detailed bottom-up estimation, possibly refined with three-point estimates or Monte Carlo simulation. For internal planning, preliminary assessments, or feasibility checks, a less precise estimate derived from a top-down approach might initially be sufficient.

Why project cost estimation is important

Effective project cost estimation goes far beyond simply predicting expenses; it's a critical process that underpins project success and overall business financial health. 

Accurate cost estimates are the foundation for creating realistic budgets. They ensure your company has sufficient funds to cover all necessary project activities, preventing financial shortfalls that could jeopardize completion. A well-founded budget provides financial stability and clear spending guidelines for the project team.

Furthermore, reliable estimates enable informed decisions at critical junctures. Stakeholders rely on cost projections to:

• Determine project feasibility
• Prioritize initiatives based on potential ROI
• Choose between different approaches
• Secure necessary funding or approvals

When evaluated alongside the project's expected benefits and the potential opportunity cost, sound estimates lead to truly strategic choices about which projects deliver the most overall value.  

Integrated platforms like Intuit Enterprise Suite enhance this decision-making by providing reliable data for estimates and powerful reporting to analyze potential outcomes before commitments are made.

The approved estimate also serves as the baseline for managing project costs effectively during execution. By comparing actual spending against the estimated costs, project managers can monitor financial performance, identify variances early, and implement corrective actions quickly. 

Regularly tracking the costs incurred against the total estimated cost is vital for budget control. It’s also helpful in accounting practices, like the percentage of completion method—used to recognize revenue on long-term contracts.

Finally, the process of developing a detailed estimate inherently helps companies mitigate risk. It forces a thorough examination of the project scope, required resources, and potential challenges, bringing potential financial risks to light early on. 

As a result, teams can plan mitigation strategies and incorporate appropriate contingency funds, reducing the likelihood of costly surprises.

Project cost estimate tools

While the right techniques provide the framework for estimation, various software tools can significantly aid the process, improve accuracy, and streamline tracking. 

The best tool depends on your company size, project complexity, and integration needs, ranging from basic spreadsheets to comprehensive enterprise systems.

Spreadsheet software

Spreadsheets like Microsoft Excel or Google Sheets are still commonly used for cost estimation, particularly in smaller businesses or for quick, ad-hoc analysis. They offer flexibility in setting up calculations and are familiar to many users. 

They do come with significant drawbacks, however. 

Spreadsheets are highly susceptible to formula errors, rely heavily on manual data entry, offer limited real-time collaboration capabilities, make version control difficult, and lack the scalability needed for complex projects or robust historical data analysis.

Project management software

Project management software helps teams organize, track, and manage project work, often including features useful for cost estimation inputs. A key benefit of PM software is that it typically allows you to break down projects into tasks (like a WBS), assign resources (people, equipment), estimate time, and easily track progress. 

Common platforms include:

• Asana
• Trello
• Monday.com
• Jira

These platforms centralize project information, improving visibility and collaboration, which can indirectly support estimation by clarifying scope and effort. 

However, their cost estimation capabilities are often secondary. They might lack direct links to real-time financial data (like payroll for actual labor costs) and may offer limited financial reporting beyond basic budget tracking.

Business intelligence tools 

Business intelligence (BI) tools work by connecting to various data sources (like accounting software, project management tools, or even spreadsheets), extracting relevant data, and transforming it for analysis and visualization. 

Core features include creating interactive dashboards, generating custom reports, analyzing trends over time, and allowing users to drill down into data details. 

Examples of popular BI tools include:

• Tableau
• Power BI
• Google Looker Studio

These tools analyze estimate accuracy against actual costs, visualize project financial performance, and identify cost drivers from past projects. 

While powerful for analysis and monitoring after the fact, they aren't typically used for creating the initial estimate itself and depend heavily on the quality and structure of the underlying data sources.

Artificial intelligence (AI) and machine learning (ML)

Artificial intelligence (AI) and machine learning (ML) are rapidly gaining importance across the business landscape. Underscoring this trend, the QuickBooks Business Solutions Survey found that 9 out of 10 respondents agree that AI is key for business success in today’s economic climate. 

When applied to project cost estimation, AI and ML capabilities are typically advanced features within other sophisticated software platforms rather than being standalone estimation platforms that most businesses would adopt directly.

AI and ML features leverage algorithms to analyze vast amounts of historical project data, identify complex patterns, and generate more accurate predictive cost forecasts than traditional methods, especially for large-scale or repetitive projects. 

Enterprise resource planning (ERP) systems

Enterprise resource planning (ERP) systems are integrated software suites that help businesses manage core processes within a unified platform. This includes finance, HR, inventory, and project management. The integration of ERP eliminates data silos and creates a single source of truth, which is invaluable for accurate business planning and reliable project cost estimation.

Intuit Enterprise Suite offers powerful ERP capabilities tailored for businesses that need strong financial control over their projects. This means your company can build project cost estimates using real-time data, such as current material costs from inventory management, leading to significantly higher accuracy.

Beyond estimation, Intuit Enterprise Suite allows you to track actual project costs against your detailed estimates in real time. With robust job costing features and customizable reporting, you gain immediate visibility into project profitability and budget variances. 

Boost productivity and enhance profitability

Accurate project estimation paired with integrated financial tools doesn't just prevent budget overruns; it actively boosts productivity and enhances profitability by providing clear financial control. 

Leveraging a connected system ensures your estimates are grounded in reality and allows for efficient tracking and informed decision-making throughout the project lifecycle. 

Explore how Intuit Enterprise Suite can help you achieve this level of financial command, ultimately contributing to increased enterprise value.