Project management a managerial approach chapter 07

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 • Bu

Project Management: A

Managerial Approach

Chapter 7 – Budgeting and Cost

Estimation

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

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

Activity-Oriented Budgets

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

– Aka: BBS – Budget Breakdown Structure

Top-Down Budgeting

• Advantages:

– 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

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

Bottom-Up Budgeting

• Advantages:

– 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 (??)

• Top-down budgeting is very common

• True 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

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

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”

An Iterative Budgeting Process

• IN AN IDEAL WORLD!!!

– 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

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

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

Program Budgeting

• Project Budget by Task and Month

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

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

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

• That percentage is called the learning rate

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

Other Factors

• Anywhere 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 goals

• Scope creep

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

• Changes in resource prices

• Failure to include an allowance for waste and spoilage

• Bad luck

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

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