Module 7: Innovation Finance & Metrics
Cost Estimation Basics
Why should you use this method?
- Estimate the costs of an innovation project
- To plan the expenditures with little error
- To formulate a rough budget for an innovation project
What are the different ways to perform a basic cost estimation?
Analogy method: Take one single terminated project and compare this single terminated project with yours. You can adapt that old project to yours to make the estimation more precise, to make a one-on-one comparison.
The analogy method is helpful to compare work packages, but less for large projects, as innovation projects usually differ a lot.
Relation method: Use a structured comparison with already terminated projects. You look at five, ten, 15, or how many projects you have and compare them. This allows you to look at, for example, how much time you spend on experimentation. The outcome is either an average value or a range of how much time/money was spent on past projects. Repeat the same with other activities you go through in your project. The benefit of this method is that you compare many projects to come to a more accurate estimate.
Multiplication method: This method uses its expenditure per unit to develop total expenditures based on old projects. The unit could be anything. For example, if you build a building, it's the cost per square meter. But it could also be something like cost per user interview, cost per prototype, or cost per testing day. So additionally to the time spend on each unit, by comparison with the old project, you determine what costs are connected to it.
Parametric estimation: Similar to the multiplication method, but parameters are used instead. The parameters are specific to the project and are used to relate the costs or other characteristics of two or more projects. E.g., it could be the size of the project that delivers the parameter. If the new project is twice the size of that last project (e.g., by being a two-month instead of a one-month project), we must add a factor to the original cost. Be aware that this factor might not be proportional and is developed by comparing many previous projects!
How do you develop a budget estimate for your project?
There are two possible ways for project estimation that work for both classical and agile innovation projects: The bottom-up approach or the top-down approach. Usually, the bottom-up approach creates a much better estimate, which is why we recommend you using it preferably.
Also, consider the development of your estimate over time! The budget you estimate before starting the project will be much less accurate than in the middle of the project. Therefore, you should revise your estimates regularly.
1. Calculate human resource cost
Add up the human resource costs of developer, engineer, product manager, etc. Consider the cost based per hour.
2. Calculate material costs
The material costs include all prototyping costs, software, etc. Consider the cost based per unit.
3. Calculate cost of acquired services
Add the costs for acquired services, such as consultancies, legal fees, etc.
4. Calculate indirect costs
Add the overhead costs to the direct costs mentioned from Steps 1 to 3. These are the costs related to infrastructure, management, office equipment, etc.
5. Profit/ Risk margin
Add a profit margin and a risk margin. Usually, this is around 30 to 50 percent on top of the direct and indirect costs.
Your team, Data from previous project(s)