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Project Management: A Managerial Approach 4/e

By Jack R. Meredith and Samuel J. Mantel, Jr.

Published by John Wiley & Sons, Inc.

Presentation prepared by RTBM WebGroup

Project ManagementA Managerial Approach

Chapter 7

Budgeting and Cost Estimation


The budget serves as a standard for comparison

It is a baseline from which to measure the difference between the actual and planned use of resources

Budgeting procedures must associate resource use with the achievement of organizational goals or the planning/control process becomes useless

The budget is simply the project plan in another form

Chapter 7-1

Estimating Project Budgets

In order to develop a budget, we must: Forecast what resources the project will require Determine the required quantity of each Decide when they will be needed Understand how much they will cost - including the

effects of potential price inflation

There are two fundamentally different strategies for data gathering: Top-down Bottom-up

Chapter 7-2

Top-Down Budgeting

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

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

This process continues to the lowest level

Chapter 7-3

Top-Down BudgetingAdvantages:

Aggregate budgets can often be developed quite accurately

Budgets are stable as a percent of total allocation The statistical distribution is also stable, making for

high predictability Small yet costly tasks do not need to be individually

identified The experience and judgment of the executive

accounts for small but important tasks to be factored into the overall estimate Chapter 7-4

Bottom-Up Budgeting

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

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

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

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

Chapter 7-5

Bottom-Up BudgetingAdvantages:

Individuals closer to the work are apt to have a more accurate idea of resource requirements

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

Involvement is a good managerial training technique, giving junior managers valuable experience Chapter 7-6

BudgetingTop-down budgeting is very commonTrue bottom-up budgets are rare

Senior managers see the bottom-up process as risky

They tend not to be particularly trusting of ambitious subordinates who they fear may overstate resource requirements

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

Chapter 7-7

Work Element Costing

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

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

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

There is also the General and Administrative (G&A) charge Chapter 7-8

An Iterative Budgeting Process

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

the easier, faster and cheaper the job looks Wishful thinking leads the superior to

underestimate cost (and time) because the superior has a stake in representing the project as a profitable venture

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

Chapter 7-9

An Iterative Budgeting Process

Usually the initial step toward reducing the difference between the superior’s and the subordinate’s estimates is made by the superior

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

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

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

Chapter 7-10

Category/Activity Budgeting vs. Program Budgeting

The traditional organization budget is either category oriented or activity oriented

Often based upon historical data accumulated through an accounting system

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

Chapter 7-11

Category/Activity Budgeting vs. Program Budgeting

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

This diffused control so widely that it was almost nonexistent

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

Chapter 7-12

Program BudgetingProgram budgeting aggregates income and

expenditures across programs (projects)

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

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

Chapter 7-13

Program Budgeting Project Budget by Task and Month

Chapter 7-14

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

Improving the Process of Cost Estimation

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

allowance for contingencies - usually 5 or 10 percent

Another is when the forecaster selects “most likely, optimistic, and pessimistic” estimates Chapter 7-15

Funding Non profitable Projects

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

Chapter 7-16

Learning Curves

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

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

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

That percentage is called the learning rate The project manager should take the learning curve

into account for any task where labor is significant

Chapter 7-17

Other FactorsAnywhere from about three-fifths to five-sixths

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

There are several common causes:Arbitrary and impossible goalsScope creepWildly optimistic estimates in order to influence

the project selection processChanges in resource pricesFailure to include an allowance for waste and

spoilageBad luck Chapter 7-18

Types of Estimation Error

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

underestimates are likely to be equal Bias - a systematic error where the chance

of overestimating and underestimating are not likely to be equal

Chapter 7-19

Summary

The intent of a budget is to communicate organizational policy concerning the organization’s goals and priorities

There are a number of common budgeting methods: top-down, bottom-up, and the program budget

Firms will fund projects whose returns cover direct but not full costs in order to achieve long-run strategic goals of the organization

Chapter 7-20

Summary

If projects include repetitive tasks with significant human input, the learning phenomenon should be taken into consideration when preparing cost estimates

The learning curve is based on the observation that the amount of time required to produce one unit decreases a constant percentage every time the output doubles

Chapter 7-21

Summary

Other major factors, in addition to learning, that should be considered when making project cost estimates are inflation, differential changes in the cost factors, waste and spoilage, personnel replacement costs, and contingencies for unexpected difficulties

Chapter 7-22


Questions?

Chapter 7-23


Picture Files


Figure 7-1


Figure 7-2


Figure 7-4


Table Files

Copyright © 2000 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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