Budgeting and Cost Estimation

16-07-2013

Cost Management Definition

Management of cost related activities achieved by collecting, analyzing, evaluating, and reporting cost information used for budgeting, estimating, forecasting, and monitoring costs.

Project Cost Management

Project cost management includes the processes required to ensure that the project is completed within an approved budget.

Cost Management Processes

Resource Planning The process of determining what physical resources and what quantities of each should be used to perform project activities. Cost Estimating The process of developing an estimate of the costs of the resources needed to complete project activities. Cost Budgeting The process of allocating the overall cost estimates to individual work items in order to establish a cost baseline for measuring project

Cost Management ProcessesContd

Cost control
The process of: Influencing the factors which create changes to the cost baseline to ensure that changes are beneficial Determining that the cost baseline has changed Managing the actual changes when and as they occur.

Cost Management Plan

A Cost Management Plan is a document that describes how the organization will manage cost variances on the project.

Cost Estimate Definition

Cost Estimate is defined as an approximation of the

probable cost of a project, product or program, computed on the basis of available information. Four common classifications of cost estimates are:
1.Planning Estimate: A rough approximation of cost within a reasonable range of values, prepared for information purposes only. Also called ball-park estimate. 2.Budget Estimate: An approximation based on well-defined (but preliminary) cost data and established ground rules. 3.Firm Estimate: A figure based on cost data sound enough for entering into a binding contract. 4.Not-to-exceed /Not-less-than Estimate: The maximum or minimum amount required to accomplish a given task, based on a firm cost estimate.

Budget Definition
Budget can be defined, generally, as a

particular sum of money that has been allocated for a particular item, purpose, or event over a specific or fixed period of time. The Project Management Institute (PMI) says that "aggregating the estimated costs of individual activities or work packages [establishing] an authorized cost baseline" is the definition of a project budget. Whether a project is millions of dollars/rupees or hundreds of dollars, working within a budget helps ensuring that it is completed for the cost expected.

Budgeting and Cost Estimation in Project Management

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 otherwise the planning/control process will become useless The budget is simply the project plan in

Estimating Project Budgets

In order to develop a budget, we must: Forecast what resources the project will require Determine the required quantity of each activity 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(private) Bottom-Up(public)

Top-Down Budgeting
TOP-DOWN BUDGETING is where budgets are created by starting from the highest level working towards the bottom using parametric relationships. A monetary value is placed on an individual unit (product, service, materials, and labor hour). An estimate of the number of units required is then converted to currency by multiplying the quantity of units by the unit price. 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

Top-Down Budgeting
Advantages: Aggregate budgets can often be developed quite accurately When upper management evaluates overall financial needs, it provides a clear picture of how much money it can reasonably allocate to different areas. Provides better financial accountability of project team. Small yet costly tasks do not need to be individually identified Top-down budgeting is much more time-efficient

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

Bottom-Up Budgeting
Advantages:
Individuals closer to the work are in better control to

have a more accurate idea of resource requirements Decentralized and participative 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 Greater employees motivation

Budgeting.Contd
Top-down budgeting is very common True bottom-up budgets are rare because: 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 topdown 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

Basic Principles of Cost Management

Tangible costs or benefits are those costs or

benefits that an organization can easily measure in dollars

Intangible costs or benefits are costs or benefits

that are difficult to measure in monetary terms

Direct costs are costs that can be directly related to

producing the products and services of the project

Indirect costs are costs that are not directly related

to the products or services of the project, but are indirectly related to performing the project
Sunk cost is money that has been spent in the past;

when deciding what projects to invest in or continue,

Basic Principles of Cost Management

Learning curve theory states that when many items

are produced repetitively, the unit cost of those items decreases in a regular pattern as more units are produced
Reserves are dollars included in a cost estimate to

mitigate cost risk by allowing for future situations that are difficult to predict Contingency reserves allow for future situations that may be partially planned for (sometimes called known unknowns) and are included in the project cost baseline Management reserves allow for future situations that are unpredictable (sometimes called unknown unknowns)

Budget Contingencies
The allocation of extra funds to cover uncertainties and improve the chances of finishing on time.
Contingencies are needed because Project scope may or does change Murphys Law is present Cost estimation must anticipate interaction costs

What Cost Estimates Include

A good cost estimate is unbiased. It should not be

made by someone who would over- or under-state the numbers. The cost estimate should clearly define the purpose of the project, what it will accomplish, what assumptions are made, how long the estimate is valid, and how much the project will cost. It should show all interested parties everything relevant, without holding back information. The estimate should be flexible, adaptable and provide a range of the costs involved. Cost estimates start out broad, and as various

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 3 to 10 percent maximum Another is when the forecaster selects most likely, optimistic, and pessimistic estimates

TYPES OF ESTIMATES
Rough Order of Magnitude (ROM) Estimates Made without detailed technicalities Accurate to within +50% or -30% of actual

costs Factor (Benchmark) Estimating Utilizes costs from similar projects Historical cost data is normalized and scaled to fit Budget (Planning) Estimates Based on preliminary or partial data Accurate to within +25% or -15% of actual costs Detailed (Definitive) Estimates

Accuracy .. A Requirement
Project Managers need to assess the

accuracy of cost estimates and budgets. Unanticipated expenses can result in the project being abandoned. Cost estimates that are overstated also have negative consequences. If they are too liberal, they can kill an otherwise viable project by making it look unaffordable. Good cost estimating requires access to a

Some Factors may affect cost estimates

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: Impossible or overambitious goals Scope creep Wildly optimistic estimates in order to influence the project selection process Changes in resource prices Failure to include an allowance for wastage Bad luck