UNIVERSITY OF HONG KONG

Faculty of Engineering

Cost Estimation
and Budgeting

This set of lecture material is adopted from ”Project Management – achieving

competitive advantage” by Jeffrey K. Pinto and “Project Management” by Dennis
Lock. MEBS6003
K.F. Chan (Mr.) 1

Project phase Five-year periods

1 Original concept
2 Feasibility study
3 Business plan
4 Risk assessment
5 Public enquiry
6 Authorization
7 Organization
8 Planning
9 Design
10 Procurement
11 Fulfilment
12 Test/commission
13 Handover
14 Economic life
15 Disposal

During the early project phases, cost estimates are

the basis for a business case budget.

MEBS6003
K.F. Chan (Mr.) 2

K.F. Chan (Mr.) 1

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Project phase Five-year periods

1 Original concept
2 Feasibility study
3 Business plan
4 Risk assessment
5 Public enquiry
6 Authorization
7 Organization
8 Planning
9 Design
10 Procurement
11 Fulfilment
12 Test/commission
13 Handover
14 Economic life
15 Disposal

From the perspectives of the client, in commercial

fixed price projects, estimates made during this time
are the main pricing factor.
MEBS6003
K.F. Chan (Mr.) 3

Project phase Five-year periods

1 Original concept
2 Feasibility study
3 Business plan
4 Risk assessment
5 Public enquiry
6 Authorization
7 Organization
8 Planning
9 Design
10 Procurement
11 Fulfilment
12 Test/commission
13 Handover
14 Economic life
15 Disposal

From the perspective of the client, when

the project is authorized, the cost
estimates convert to operating budgets
MEBS6003
K.F. Chan (Mr.) 4

K.F. Chan (Mr.) 2

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Project phase Five-year periods

1 Original concept
2 Feasibility study
3 Business plan
4 Risk assessment
5 Public enquiry
6 Authorization
7 Organization
8 Planning
9 Design
10 Procurement
11 Fulfilment
12 Test/commission
13 Handover
14 Economic life
15 Disposal

Best
guess Final known cost

Estimating accuracy will improve as

the project goes through its life cycle
MEBS6003
K.F. Chan (Mr.) 5

Project phase Five-year periods

1 Original concept
2 Feasibility study
3 Business plan
4 Risk assessment
5 Public enquiry
6 Authorization
7 Organization
8 Planning
9 Design
10 Procurement
11 Fulfilment
12 Test/commission
13 Handover
14 Economic life
15 Disposal

Best Final known cost

guess

Cost estimates will be replaced by actual costs over time

MEBS6003
K.F. Chan (Mr.) 6

K.F. Chan (Mr.) 3

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Cost Estimation
and Budgeting – Road Map
◼ Plan Cost Management – from Project Management
Plan and Project Charter to Cost Management Plan
◼ Estimate Costs – from the above + Human Resource
Management Plan, Scope baseline, Project Schedule,
Risk Register to Activity Cost Estimates and Basis of
Estimates
◼ Determine Budget – from the above to Cost
Baselines and Project Funding Requirements
◼ Control Cost
MEBS6003
K.F. Chan (Mr.) 7

Common Sources of Project

Cost
▪ Labor
▪ Materials
▪ Subcontractors
▪ Equipment &
facilities

▪ Travel
MEBS6003
K.F. Chan (Mr.) 8

K.F. Chan (Mr.) 4

 UNIVERSITY OF HONG KONG
Faculty of Engineering

MEBS6003
K.F. Chan (Mr.) 9

Another way to examine

project costs
◼ Type – direct vs indirect
◼ Frequency of occurrence –
recurring vs non-recurring
◼ Opportunity to be
adjusted – fixed vs variable
◼ Schedule – normal vs
expedited

MEBS6003
K.F. Chan (Mr.) 10

10

K.F. Chan (Mr.) 5

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Cost Classifications

MEBS6003
K.F. Chan (Mr.) 11

11

Cost Estimation

Estimating project costs is a challenging process

that can resemble an art form as much as a
science. 2 principles:
1) The more clearly you define the projects’ various
costs in the beginning, the less chance there is of
making estimating errors.
2) The more accurate your initial cost estimations,
the greater the likelihood of preparing a project
budget that accurately reflects reality for the
project and the greater your chance of completing
the project within budget estimates.
MEBS6003
K.F. Chan (Mr.) 12

12

K.F. Chan (Mr.) 6

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Which approach?
◼ Knowledge of the firm’s industry
◼ Ability to mange cost variables
◼ History of successful projects the firm
possesses
◼ Number of similar projects undertaken
◼ Knowledge and resourcefulness of
project managers
◼ Company’s budgeting requirements
MEBS6003
K.F. Chan (Mr.) 13

13

◼ The better the job we do in estimating

costs, the more likely we will be able to
maintain a reasonable profit margin in this
highly competitive world.
MEBS6003
K.F. Chan (Mr.) 14

14

K.F. Chan (Mr.) 7

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Creating a Project Budget

scope The budget is a plan
that identifies the
resources, goals and
Project
schedule that allows
Plan
a firm to achieve
Scheduling Budgeting those goals

MEBS6003
15

15

Order of Magnitude estimation

◼ Also called Ballpark estimation
◼ Used when time or information is scarce
◼ Used as a preliminary estimates for
resource requirements or to determine
if a competitive bid can be attempted.
◼ The unofficial rule is -25 to +75%

MEBS6003
K.F. Chan (Mr.) 16

16

K.F. Chan (Mr.) 8

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Estimating a Project Budget

◼Top-down, e.g. analogous estimate by
referring to similar projects (used when
details are not yet available)
◼Bottom-up, e.g. engineering estimate,
parametric estimate (when more details
are available)

MEBS6003
K.F. Chan (Mr.) 17

17

Estimation accuracy
◼ Order of Magnitude estimate -25 to
+75%
◼ Preliminary estimate -15 to +50%
◼ Budget estimate -10 to +25%
◼ Definitive estimate -5 to +10%

MEBS6003
K.F. Chan (Mr.) 18

18

K.F. Chan (Mr.) 9

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Top-down estimating

Considers
the The project
whole
project
first.
• Intuitive
Greater • Probably ball-park
detail • Useful when there is:
might - little time available
not be - little information
possible

19

Top-down estimating
☺ Brings in budgetary discipline and
control.
 Difficulty in translating long range
budgets into short range budgets.
 Competition among departments for
budget
 Analogous estimate is an example of
top down estimating
MEBS6003
K.F. Chan (Mr.) 20

20

K.F. Chan (Mr.) 10

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Project prime cost

Builds up
in detail
from the
bottom
of the
task list
or work
breakdown
structure

Bottom-up estimating

21

Bottom-up estimating
☺ Clear flow of information and the use of
detailed data such as cost, schedule,
resources information.
 Reduces top management’s control of
the budgetary process to one of
oversight.
 Fine tuning can be time consuming.

MEBS6003
K.F. Chan (Mr.) 22

22

K.F. Chan (Mr.) 11

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Parametric estimation

MEBS6003
K.F. Chan (Mr.) 23

23

Prime cost

The prime cost is the sum of all the direct

costs (labour, materials and expenses).

Direct costs are costs that can be measured

and charged directly to the project.

If this is a business change project, it is

probable that this prime cost will be used for
the business case and subsequent budgets.

K.F. Chan (Mr.)

24

K.F. Chan (Mr.) 12

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Prime cost

If this is a project that is to be sold to a

customer for a budget or fixed price, then
additions must be made to the prime cost
to get the selling price.

K.F. Chan (Mr.)

25

Prime cost

Overhead
Contingency (grey area)
Escalation
P C sums (if any)

Mark-up for profit

Selling price
K.F. Chan (Mr.)

26

K.F. Chan (Mr.) 13

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Prime cost

Overhead

A pro rata overhead amount is added to the

prime (direct) cost so that the company’s
indirect costs can be recovered in the selling
price.
Indirect costs include administration of the
business, such as accommodation expenses
and the salaries of managers and other workers
that cannot be specifically allocated to projects
or other work in progress.
K.F. Chan (Mr.)

27

Prime cost

Overhead

Prime costs and overhead costs are also

known as above-the-line costs

K.F. Chan (Mr.)

28

K.F. Chan (Mr.) 14

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Prime cost

Overhead
Contingency (grey area)
A contingency allowance is often added in an
attempt to offset all or some of the inevitable
errors in design and building during the project.

The size of the contingency allowance may be

as big as competitive pricing will allow.

K.F. Chan (Mr.)

29

Prime cost

Overhead
Contingency (grey area)
Escalation
AAn
Now escalation
P allowance
to consider
contingency C sums
two
sum may
often be added
(ifadded
any)
isbelow-the-line to
tocosts:
offset
offset future rises in labour and
the costs of possible design and buildmaterial
costs caused
mistakes duringbythe
cost inflation. life of the
forthcoming
Mark-up for profit
project. This
This is not is usuallywhen
necessary a lowthe
percentage of
annual cost
the above-the-line
inflation rate is verycosts, set
low or asprojects
for high as of
competitive Selling price
project pricing will allow.
short duration.
K.F. Chan (Mr.)

30

K.F. Chan (Mr.) 15

 UNIVERSITY OF HONG KONG
Faculty of Engineering

A provisional costPrime cost

(PC) sum is an advisory
note to the customer of an additional amount
that will be charged if a specified condition is
Overhead
revealed after work starts that could not
reasonably have been determined when the
Contingency (grey area)
original fixed price proposal was made.
Escalation
P C sums (if any)

K.F. Chan (Mr.)

31

Example of a PC sum.
Prime cost
A fixed price has been quoted for a flat roof
repair.
Overhead
But a PC sum has been added saying that an
additional cost of £60 per square
Contingency (grey metre
area)will be
charged if the underlying decking is found to be
rotted and needingEscalation
replacement.

P C sums (if any)

K.F. Chan (Mr.)

32

K.F. Chan (Mr.) 16

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Prime cost

Overhead
Contingency (grey area)
Escalation
P C sums (if any)
The last three items:
• Contingency
• Escalation
• PC sums
K.F. Chan (Mr.) are known as below-the-line costs.
33

Prime cost

Overhead
Contingency (grey area)
Escalation
P C sums (if any)

Mark-up for profit

Selling price
K.F. Chan (Mr.)

34

K.F. Chan (Mr.) 17

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Preparing departmental budgets

Prime cost estimate

Overhead
Contingency
Dept Dept Dept Dept
Escalation A B C D

K.F. Chan (Mr.)

35

Responsibility of higher
management – not dept
managers
(accountability without
corresponding power)

Overhead
Contingency Hold these budgets in
reserve and draw down
Escalation later, if needed

K.F. Chan (Mr.)

36

K.F. Chan (Mr.) 18

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Prime costs £
Direct labour cost 100 000
Labour burden 20 000
Direct materials cost 150 000
Materials burden 20 000
Direct expenses 10 000
Estimated prime cost 300 000
Overheads at 66.67% 200 000
Estimated cost of sales 500 000
Below-the-line items
Escalation allowance 2% 10 000
Contingency 5% 25 000
Adjusted cost of sales 535 000
40% mark-up for profit 214 000
Proposed selling price 749 000

Provisional items

Typical items in a commercial project cost estimate

MEBS6003
K.F. Chan (Mr.) 37

37

• The optimist
estimates usually too low

• The pessimist
estimates usually too high
People as estimators
• The waverer
totally unreliable - no set pattern

• The genius
always right but a very rare animal
MEBS6003
K.F. Chan (Mr.) 38

38

K.F. Chan (Mr.) 19

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Direct labour by
standard grades

Cost Item Materials Item

code description 1 2 6 Cost Wks cost

Estimating elements for an engineering or manufacturing project

K.F. Chan (Mr.)

39

Cost Item Item

code description cost

Columns here as required for:

• vendor (if known);
• basic price
• shipping tonnage
• freight, duty and insurance
cost
• foreign currency conversion
rate
• expected delivery time

Materials and equipment estimates for a capital project

K.F. Chan (Mr.)

40

K.F. Chan (Mr.) 20

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Add below
the line items

Estimates are
now budgets

Review / agree
the estimates

Make initial
estimates
Logical
List all the
cost items stages for
Define and
code the WBS a bottom-up
Define cost estimate
the project
MEBS6003
K.F. Chan (Mr.) 41

41

Time-phased budget
◼ The time-phased budget allocates costs
across both project activities and the
anticipated time in which the budget is
to be expended.

MEBS6003
K.F. Chan (Mr.) 42

42

K.F. Chan (Mr.) 21

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Learning curve
◼ The learning curve originated in the time of
Frederick Taylor (1856-1915), often called
the father of industrial engineering and time
study in industrial applications, and Henry
Ford (1863-1947), the father of the
assembly line. Taylor noticed that when
workers were given a piece of work to do,
the time that it took them to do the work
decreased each time they repeated the piece
of work.

K.F. Chan (Mr.)

43

Learning Curves
Each doubling of output results in a
reduction in time to perform the last
iteration.
Tx = T1 X b
where
Tx = time requiredfor the x unit of output
T1 = time requiredfor the first unit of output
X = the number of units to be produced (iterations)
log(learning % ) log LR
b = learning curve slope = =
log 2 log 2
MEBS6003
LR = learning curve % 44

44

K.F. Chan (Mr.) 22

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Adopted from “Project Management – achieving competitive advantage” 2nd

Ed by Jeffrey K. Pinto
MEBS6003
K.F. Chan (Mr.) 45

45

Learning curve
◼ Henry Ford made great use of this information in developing
the assembly line. If very short work operations are used, the
amount of time that it takes to double the number of times to
do the work becomes short as well. What this means is that if
we were to design work so that the time interval to do the
work is very short, people would come down the learning
curve very quickly and reach the flat part of the curve. At
this point they could be considered to be fully productive on
their work assignment.
◼ What Ford wanted was a way to incorporate new people into
his factory with a minimum of training and experience. By
making the work tasks very short, people would become
proficient at them very quickly. It was important for him to
be able to bring in a new person with very little experience or
training to learn the job and do the job proficiently as quickly
as possible so that he did not rely on the labour force
K.F. Chan (Mr.)

46

K.F. Chan (Mr.) 23

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Cost improvement curve

◼ In some contracts, generally large ones, the
client may require the vendor to reduce the
price of items supplied later in the project to
less than the delivery price of earlier items
of the project.
◼ Sometimes even though the deliverables of
the project are not the same, a certain
amount of improvement can be gained with
the delivery of each deliverable.

K.F. Chan (Mr.)

47

Cost improvement curve

◼ Rationale:
◼ Vendor will become familiar in dealing
with the customer’s requirements
◼ There will be certain amount of value
engineering
◼ Vendor’s vendors themselves will
improve too.

K.F. Chan (Mr.)

48

K.F. Chan (Mr.) 24

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Cost improvement curve

◼ While cost improvement curve looks

similar to learning curve, it should be
noted that cost improvement is not
necessarily based on learning effect,
alone.

K.F. Chan (Mr.)

49

Control Cost

◼ Earned Value Management

◼ Variance Analysis
◼ Trend Analysis
◼ Reserve Analysis

MEBS6003
K.F. Chan (Mr.) 50

50

K.F. Chan (Mr.) 25

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Problems with Overruns and

Cost Estimation

◼ Low initial estimates

◼ Unexpected
technical difficulties
◼ Lack of definitions
◼ Specification
changes
◼ External factors
MEBS6003
K.F. Chan (Mr.) 51

51

HONESTY
◼ PADDING - Exaggerates activity
duration and costs – padding allows
plenty of time and contingency for the
work to be completed
◼ As the Parkinson’s Law states, “Work expands so
as to fill the time available for its completion”, the
trouble with padding is that the task will magically
expand to require the exaggerated activity duration
and cost available.
MEBS6003
K.F. Chan (Mr.) 52

52

K.F. Chan (Mr.) 26

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Remarks on Budget
Contingencies
The allocation of extra funds to
cover uncertainties and improve
the chance of finishing on time.
Contingency reserve to cater
for known unknowns
Management reserve to cope
with unknown unknowns

MEBS6003
53

53

Total funding requirements

MEBS6003
K.F. Chan (Mr.) 54

54

K.F. Chan (Mr.) 27

 UNIVERSITY OF HONG KONG
Faculty of Engineering

Contingencies are needed

because
◼ Project scope may change
◼ Murphy’s Law is present
◼ Cost estimation must anticipate
interaction costs
◼ Normal conditions are rarely
encountered

MEBS6003
K.F. Chan (Mr.) 55

55

Appropriateness of applying
contingency funds in cost
estimation
◼ Recognizes that the future
is unknown
◼ Provision in the plan for
cost increase
◼ Application of contingency
fund gives an early
warning of potential
overdrawn budget
MEBS6003
K.F. Chan (Mr.) 56

56

K.F. Chan (Mr.) 28