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Project Management: A Project Management: A Managerial ApproachManagerial Approach

Chapter 7 – Budgeting and Cost Chapter 7 – Budgeting and Cost EstimationEstimation

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OverviewOverview

• Estimating Project BudgetsEstimating Project Budgets– Top-downTop-down– Bottom-upBottom-up

• Work Element CostingWork Element Costing

• Budget IterationBudget Iteration

• Activity BudgetsActivity Budgets

• Continuous Budget ImprovementContinuous Budget Improvement

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Budgeting and Cost Budgeting and Cost EstimationEstimation• The budget serves as a The budget serves as a standardstandard for for

comparisoncomparison• It is a baseline from which to It is a baseline from which to measuremeasure the the

difference difference between the between the actual and actual and plannedplanned use of resources use of resources

• Budgeting procedures must associate Budgeting procedures must associate resource useresource use with the with the achievementachievement of of organizational organizational goalsgoals or the or the planning/control process becomes uselessplanning/control process becomes useless

• The budget is simply the project plan in The budget is simply the project plan in another formanother form

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Estimating Project BudgetsEstimating Project Budgets

• In order to develop a budget, we must:In order to develop a budget, we must:– Forecast Forecast what resourceswhat resources the project will require the project will require– Determine the Determine the required quantityrequired quantity of each of each– Decide Decide whenwhen they will be they will be neededneeded– Understand how much they will cost - including the Understand how much they will cost - including the

effects of potential price inflationeffects of potential price inflation

• There are two fundamentally different There are two fundamentally different strategies for data gathering:strategies for data gathering:– Top-downTop-down– Bottom-upBottom-up

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Activity-Oriented BudgetsActivity-Oriented Budgets

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Top-Down BudgetingTop-Down Budgeting

• This strategy is based on collecting the This strategy is based on collecting the judgment and experiences of judgment and experiences of top and top and middle managersmiddle managers

• These cost estimates are then given to These cost estimates are then given to lowerlower level managers, who are expected level managers, who are expected to continue the breakdown into to continue the breakdown into budget budget estimatesestimates

• This process continues to the lowest levelThis process continues to the lowest level– Aka: BBS – Budget Breakdown StructureAka: BBS – Budget Breakdown Structure

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Top-Down BudgetingTop-Down Budgeting

• Advantages:Advantages:– AggregateAggregate budgets can often be developed quite budgets can often be developed quite

accuratelyaccurately

– Budgets are Budgets are stablestable as a percent of total allocation as a percent of total allocation

– The statistical distribution is also stable, making for The statistical distribution is also stable, making for high predictabilityhigh predictability

– Small yet costly tasks do not need to be individually Small yet costly tasks do not need to be individually identified (???)identified (???)

– The experience and judgment of the executive The experience and judgment of the executive accounts for small but important tasks to be accounts for small but important tasks to be factored into the overall estimatefactored into the overall estimate

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Bottom-Up BudgetingBottom-Up Budgeting

• In this method, elemental tasks, their In this method, elemental tasks, their schedules, and their individual schedules, and their individual budgets are budgets are constructed following the WBSconstructed following the WBS or project or project action planaction plan

• The The people doing the workpeople doing the work are consulted are consulted regarding times and budgets for the tasks to regarding times and budgets for the tasks to ensure the best level of accuracyensure the best level of accuracy

• Initially, Initially, estimates estimates are made in terms of are made in terms of resourcesresources, such as labor hours and materials, such as labor hours and materials

• Bottom-up budgets should be and usually are, Bottom-up budgets should be and usually are, more accuratemore accurate in the in the detailed tasksdetailed tasks, but it , but it is critical that all elements be includedis critical that all elements be included

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Bottom-Up BudgetingBottom-Up Budgeting

• Advantages:Advantages:– Individuals closer to the work are apt to Individuals closer to the work are apt to

have a have a more accurate ideamore accurate idea of resource of resource requirementsrequirements

– The The direct involvementdirect involvement of low-level of low-level managers in budget preparation increases managers in budget preparation increases the likelihood that they will accept the the likelihood that they will accept the result with a minimum of aversionresult with a minimum of aversion

– Involvement is a good Involvement is a good managerial managerial training techniquetraining technique, giving junior , giving junior managers valuable experience managers valuable experience (??)(??)

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BudgetingBudgeting

• Top-down budgeting is very commonTop-down budgeting is very common

• True bottom-up budgets are rareTrue bottom-up budgets are rare– Senior managers see the bottom-up Senior managers see the bottom-up

process as riskyprocess as risky– They tend not to be particularly trusting of They tend not to be particularly trusting of

ambitious subordinates who they fear may ambitious subordinates who they fear may overstate resource requirementsoverstate resource requirements

– They are reluctant to hand over control to They are reluctant to hand over control to subordinates whose experience and subordinates whose experience and motives are questionablemotives are questionable

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Work Element CostingWork Element Costing

• The actual process of building a budget - either top-The actual process of building a budget - either top-down or bottom-up - tends to be a straightforward down or bottom-up - tends to be a straightforward but tedious processbut tedious process

• Each work element in the action plan or WBS is Each work element in the action plan or WBS is evaluated for its resource requirements, and then the evaluated for its resource requirements, and then the cost cost

• Direct costs for resources and machinery are charged Direct costs for resources and machinery are charged directly to the project. Labor is usually subject to directly to the project. Labor is usually subject to overhead charges. Material resources and machinery overhead charges. Material resources and machinery may or may not be subject to overhead.may or may not be subject to overhead.

• There is also the General and Administrative (G&A) There is also the General and Administrative (G&A) chargecharge

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An Iterative Budgeting An Iterative Budgeting ProcessProcess

• Resource estimates and actual requirements Resource estimates and actual requirements are rarely the same for several reasons:are rarely the same for several reasons:– The farther one moves up the organizational chart, The farther one moves up the organizational chart,

the easier, faster and cheaper the job looksthe easier, faster and cheaper the job looks

– Wishful thinking leads the superior to Wishful thinking leads the superior to underestimate costunderestimate cost (and time) because the (and time) because the superior has a stake in representing the project as superior has a stake in representing the project as a profitable venturea profitable venture

– The subordinates are led to build-in some level of The subordinates are led to build-in some level of protection against failure by protection against failure by adding an adding an allowance for “Murphy’s Law”allowance for “Murphy’s Law”

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An Iterative Budgeting ProcessAn Iterative Budgeting Process

• IN AN IDEAL WORLD!!!IN AN IDEAL WORLD!!!– Usually the initial step toward reducing the Usually the initial step toward reducing the

difference between the superior’s and the difference between the superior’s and the subordinate’s estimates is made by the superiorsubordinate’s estimates is made by the superior

– The superior agrees to be “educated” by the The superior agrees to be “educated” by the subordinate in the realities of the jobsubordinate in the realities of the job

– The subordinate is encouraged by the superior’s The subordinate is encouraged by the superior’s positive response and then surrenders some of the positive response and then surrenders some of the protection of the budgetary “slop”protection of the budgetary “slop”

– This is a time consuming process, especially when This is a time consuming process, especially when the project manager is negotiating with several the project manager is negotiating with several subordinatessubordinates

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Category/Activity Budgeting vs. Program Category/Activity Budgeting vs. Program BudgetingBudgeting

• The traditional organization budget is either The traditional organization budget is either category oriented or activity orientedcategory oriented or activity oriented

• Often based upon historical data Often based upon historical data accumulated through an accounting systemaccumulated through an accounting system

• With the advent of project organizations, it With the advent of project organizations, it became necessary to organize the budget in became necessary to organize the budget in ways that conformed more closely to the ways that conformed more closely to the actual pattern of fiscal responsibilityactual pattern of fiscal responsibility

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Category/Activity Budgeting vs. Program Category/Activity Budgeting vs. Program BudgetingBudgeting

• Under traditional budgeting methods, the Under traditional budgeting methods, the budget could be split up among many budget could be split up among many different organizational unitsdifferent organizational units

• This diffused control so widely that it was This diffused control so widely that it was almost nonexistentalmost nonexistent

• This problem gave rise to This problem gave rise to program budgetingprogram budgeting which alters the budgeting process so that which alters the budgeting process so that budget can be associated with the projects budget can be associated with the projects that use themthat use them

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Program BudgetingProgram Budgeting

• Program budgeting aggregates income and Program budgeting aggregates income and expenditures across programs (projects)expenditures across programs (projects)

• Aggregation by program is in addition to, not Aggregation by program is in addition to, not instead of, aggregation by organizational unitinstead of, aggregation by organizational unit

• These budgets usually take the form of a These budgets usually take the form of a spreadsheet with standard categories spreadsheet with standard categories disaggregated into “regular operations” and disaggregated into “regular operations” and charges to the various projectscharges to the various projects

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Program BudgetingProgram Budgeting• Project Budget by Task and MonthProject Budget by Task and Month

Task I J Estimate 1 2 3 4 5 6 7 8

Monthly Budget (£)

A 1 2 7000 5600 1400

B 2 3 9000 3857 5143

C 2 4 10000 3750 5000 1250

D 2 5 6000 3600 2400

E 3 7 12000 4800 4800 2400

F 4 7 3000 3000

G 5 6 9000 2571 5143 1286

H 6 7 5000 3750 1250

I 7 8 8000 2667 5333

J 8 9 6000 6000

75000 5600 12607 15114 14192 9836 6317 5333 6000

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Improving the Process of Cost Improving the Process of Cost EstimationEstimation

• There are two fundamentally different There are two fundamentally different ways to manage the risks associated ways to manage the risks associated with the chance events that occur on with the chance events that occur on every project:every project:– The most common is to make an The most common is to make an

allowance for contingencies - usually 5 or allowance for contingencies - usually 5 or 10 percent10 percent

– Another is when the forecaster selects Another is when the forecaster selects “most likely, optimistic, and pessimistic” “most likely, optimistic, and pessimistic” estimatesestimates

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Funding Non profitable Funding Non profitable ProjectsProjects

• There are several reasons that firms would There are several reasons that firms would choose to fund a project that is not profitable:choose to fund a project that is not profitable:– To develop knowledge of a technologyTo develop knowledge of a technology– To get the organization’s “foot in the door”To get the organization’s “foot in the door”– To obtain the parts or service portion of the workTo obtain the parts or service portion of the work– To be in a good position for a follow-on contractTo be in a good position for a follow-on contract– To improve a competitive positionTo improve a competitive position– To broaden a product line or a line of businessTo broaden a product line or a line of business

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Learning CurvesLearning Curves

• Studies have shown that human performance usually Studies have shown that human performance usually improves when a task is repeatedimproves when a task is repeated

• In general, performance improves by a fixed percent In general, performance improves by a fixed percent each time production doubleseach time production doubles

• More specifically, each time the output doubles, the More specifically, each time the output doubles, the worker hours per unit decrease to a fixed percentage worker hours per unit decrease to a fixed percentage of their previous valueof their previous value

• That percentage is called the That percentage is called the learning ratelearning rate

• The project manager should take the learning curve The project manager should take the learning curve into account for any task where labor is significantinto account for any task where labor is significant

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Other FactorsOther Factors• Anywhere from about three-fifths to five-sixths Anywhere from about three-fifths to five-sixths

of projects fail to meet their time, cost, and/or of projects fail to meet their time, cost, and/or specification objectivesspecification objectives

• There are several common causes:There are several common causes:•Arbitrary and impossible goalsArbitrary and impossible goals

•Scope creepScope creep

•Wildly optimistic estimates in order to influence Wildly optimistic estimates in order to influence the project selection processthe project selection process

•Changes in resource pricesChanges in resource prices

•Failure to include an allowance for waste and Failure to include an allowance for waste and spoilagespoilage

•Bad luckBad luck

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Types of Estimation ErrorTypes of Estimation Error

• There are two generic types of There are two generic types of estimation error:estimation error:– Random errorRandom error - where overestimates and - where overestimates and

underestimates are likely to be equalunderestimates are likely to be equal

– BiasBias - a systematic error where the chance - a systematic error where the chance of overestimating and underestimating are of overestimating and underestimating are not likely to be equalnot likely to be equal