Budget Metrics as Part of Earned Value Management
When it comes to allocating resources toward an investment to derive value from it (you can’t just buy a machine without allocating resources to the operation, maintenance, and financing of that machine), the corporation must develop a budget for that investment.
Because so much money and so many resources are being spent to generate a return on investment, ensuring that the investment is adhering to its budget is a big part of how successful executive management will consider the investment to be.
Of course, the performance of an investment will also come through in the updated calculations of the MIRR over time, but some additional calculations are frequently performed in EVM that are concerned specifically with budgetary issues, in order to identify why deviations in the MIRR over time might occur.
The amount of value that a corporation can derive from an investment at a given cost is a large concern for a corporation. No one likes to continuously throw funds down a money pit. So reaching the anticipated 100 percent value from your investment on-budget is preferred. If some variation exists, it’s calculated like this:
CV = EV – AC
where the cost variance (CV) is equal to the earned value (EV) less the actual cost (AC). Spending more money to generate value at given milestones throughout a project is a bad thing. You may have to reevaluate whether continuing to pursue the investment’s value is worth the additional costs.
If the actual cost is lower for a given point in earned value, you should start planning how to use the surplus budgetary funding.
As with time schedule metrics, another way to look at cost measurements is through a ratio. This time it’s called the cost performance (CP) ratio, and it’s measured like this:
CP = EV/AC
This ratio measures the earned value at a given point to the actual cost (AC) at that point.
Estimate at completion
The total cost of the capital investment at its completion is measured using a simple equation called estimate at completion (EAC):
EAC = BAC/CP
BAC = Budget at completion
CP = Cost performance
So, the planned budget for the entire project is divided by the cost performance of the investment when the calculation is being done (in order to use the most recent data available). By doing this, you get a dollar value answer that tells you how much the investment actually cost compared to how much you planned on it costing. Here’s a quick example:
EAC = $10,000/1.2 = $12,000; you’re $2,000 over budget.
That $2,000 is actually called the estimate to complete (ETC). As with everything else, there’s a formal calculation for this:
ETC = EAC – AC
Just like you did in the preceding example, you subtract the actual costs from the estimated cost at completion to see how much cost you have left to finish the project.
Whether or not the investment is worth pursuing after it has already begun going over budget depends on whether the ETC is lower than the potential present value of future cash flows, calculated as such:
Efficacy of investment = NPV – ETC
If the ETC surpasses the net present value (NPV) of future cash flows, you’re just throwing money away by continuing the project.
Whether or not a corporation can improve the financial efficiency of an investment to make that investment worth pursuing is calculated using the to-complete performance (TCP):
TCP = (BAC – EV)/(BAC – AC)
You subtract the earned value (EV) from the budget at completion (BAC) and divide the result by the BAC less the actual cost (AC). This ratio tells the corporation by what percentage it needs to increase its performance efficiency.
So, for example, if the TCP on a corporation’s project is 1.10, it needs to improve efficiency by 10 percent in order to get the project back on track to be completed on budget.