PROJECT MANAGEMENT

MIDTERMS
(MODULE NO. 4)
A.
TOPIC LEARNING OBJECTIVES
Project Budgeting  Understand the budgeting in the
project planning
 Determined different methods is
budgeting


B. DISCUSSION

Budgeting

Having finished the planning for the technical aspects of the project, there is one more important element
of planning to finish that will then result in the final go‐ahead from top management to initiate the project. A
budget must be developed in order to obtain the resources needed to accomplish the project’s objectives. A
budget is simply a plan for allocating organizational resources to the project activities. But the budget also serves
another purpose: It ties the project to the organization’s aims and objectives through organizational policy.

Methods of budgeting
Budgeting is simply the process of forecasting what resources the project will require, what quantities of
each will be needed, when they will be needed, and how much they will cost. Budgeting a project such as the
development of a new mobile app, however, is often more difficult than budgeting more routine activities—and
even more difficult than regular departmental budgeting which can always be estimated as: “Same as last year
plus X percent.” But project budgeters do not usually have tradition to guide them. Projects are, after all, unique
activities. Of course, there may be somewhat similar past projects that can serve as a model, but these are rough
guides at best. Forecasting a budget for a multiyear project such as a large product line or service development
project is even more hazardous because the unknowns can escalate quickly with changes in technology,
materials, prices, and even the findings of the project up to that point.

In the process of gaining this familiarity, the PM will discover that cost may be viewed from three different
perspectives (Hamburger, 1986). The PM recognizes a cost once a commitment is made to pay someone for
resources or services, for example when a machine is ordered. The accountant recognizes an expense when
an invoice is received—not, as most people believe, when the invoice is paid. The controller perceives an
expense when the check for the invoice is mailed. The PM is concerned with commitments made against the
project budget. The accountant is concerned with costs when they are actually incurred. The controller is
concerned with managing the organization’s cash flows. Because the PM must manage the project, it is advisable
for the PM to set up a system that will allow him or her to track the project’s commitments.

1. Top‐Down Budgeting
The top‐down approach to budgeting is based on the collective judgments and experiences of top and
middle managers concerning similar past projects. These managers estimate the overall project cost by
estimating the costs of the major tasks, which estimates are then given to the next lower level of managers to
split up among the tasks under their control, and so on, until all the work is budgeted. The advantage of this

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approach is that overall budget costs can be estimated with fair accuracy; though individual elements may be in
substantial error. Another advantage is that errors in funding small tasks need not be individually identified
because the overall budget allows for such exceptions.

2. Bottom‐Up Budgeting
Bottom‐up budgets are usually more accurate in the detailed tasks, but risk the chance of overlooking
some small but costly tasks. Such an approach, however, is common in organizations with a participative
management philosophy and leads to better morale, greater acceptance of the resulting budget, and heightened
commitment by the project team. It is also a good managerial training technique for aspiring project and general
managers.
Unfortunately, true bottom‐up budgeting is rare. Upper level managers are reluctant to let the workers
develop the budget, fearing the natural tendency to overstate costs, and fearing complaints if the budget must
later be reduced to meet organizational resource limitations. Moreover, the budget is upper management’s
primary tool for control of the project, and they are reluctant to let others set the control limits. Again, we will see
that the budget is not a sufficient tool for controlling a project. Top‐down budgeting allows the budget to be
controlled by people who play little role in designing and doing the work required by the project. It should be
obvious that this will cause problems—and it does.

Project budgeting is a difficult task due to the lack of precedent and experience with unique project
undertakings. Yet, understanding the organization’s accounting system is mandatory for a PM. The two major
ways of generating a project budget are top‐down and bottom‐up. The former is usually accurate overall but
possibly includes significant error for low‐level tasks. The latter is usually accurate for low‐level tasks but risks
overlooking some small but potentially costly tasks. Most organizations use top‐down budgeting in spite of the
fact that bottom‐up results in better acceptance and commitment to the budget.

COST ESTIMATING
In this section, we look at the details of the process of estimating costs and some dangers of arbitrary
cuts in the project budget. We also describe and illustrate the difference between activity budgeting and program
budgeting.

Work Element Costing

The task of building a budget is relatively straightforward but tedious. Each work element is evaluated for
its resource requirements, and its costs are then determined. For example, suppose a certain task is expected
to require 16 hours of labor at $10 per hour, and the required materials cost $235. In addition, the organization
charges overhead for the use of utilities, indirect labor, and so forth at a rate of 50 percent of direct labor. Then,
the total task cost will be

In some organizations, the PM adds the overhead charges to the budget. In others,the labor time and
materials are just sent to the accounting department and they run the numbers, add the appropriate overhead,
and total the costs. Although overhead was charged here against direct labor, more recent accounting practices
such as activity‐based costing may charge portions of the overhead against other cost drivers such as machine
time, weight of raw materials, or total time to project completion.

Activity versus Program Budgeting

Traditional organizational budgets are typically activity oriented and based on historical data accumulated
through an activity‐based accounting system. Individual expenses are classified and assigned to basic budget

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lines such as phone, materials, fixed personnel types (salaried, exempt, etc.), or to production centers or
processes. These lines are then aggregated and reported by organizational units such as departments or
divisions.
Project budgets can also be presented as activity budgets, such as in Table 4-3 below where one page
of a six‐page monthly budget report for a real estate management project is illustrated. When multiple projects
draw resources from several different organizational units, the budget may be divided between these multiple
units in some arbitrary fashion, thereby losing the ability to control project resources as well as the reporting of
individual project expenditures against the budget.
This difficulty gave rise to program budgeting, illustrated in Table 4-4. Here the program oriented project
budget is divided by task and expected time of expenditure, thereby allowing aggregation across projects. Budget
reports are shown both aggregated and disaggregated by “regular operations,” and each of the projects has its
own budget.

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 Budget Uncertainty and Project Risk Management
In spite of the care and effort expended to create an accurate and fair budget, it is still only an
estimate made under conditions of uncertainty. Because projects are unique, risk pervades all elements of the
project, and particularly the project’s goals of performance,
schedule, and budget.

Budget Uncertainty
Perceptually, the PM sees the uncertainty of the budget like the shaded portion of Figure 4-3,
where the actual project costs may be either higher or lower than the estimates the PM has derived. As we will
describe later, however, it seems that more things can go wrong in a project and drive up the cost than can go
right to keep down the cost. As the project unfolds, the cost uncertainty decreases as the project moves toward
completion. Figures 4-4 (a), (b), and (c) illustrate this. An estimate at the beginning of the project as in Figure 4-
3 is shown as the t0 estimate in Figure 4‐4(a). As work on the project progresses, the uncertainty decreases as
the project moves toward completion. At time t1 the cost to date is known and another estimate is made of the
cost to complete the project, Figure 4‐4(b). This is repeated at t2, Figure 4‐4(c). Each estimate, of course, begins
at the actual cost to date and estimates only the remaining cost to completion. The further the project progresses,
the less the uncertainty in the final project cost. It is common in project management to make new forecasts
about project completion time and cost at fixed points in the project life cycle, or at special milestones.

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 The reasons for cost uncertainty in the project are many: prices may escalate, different resources may
be required, the project may take a different amount of time than we expected, thereby impacting overhead and
indirect costs, and on and on. Earlier, we discussed ways to improve cost estimates, to anticipate such
uncertainty, but change is a fact of life, including life on the project, and change invariably alters our previous
budget estimates.

Three Causes for Change. There are three basic causes for change in projects and their budgets and/or
schedules. Some changes are due to errors the cost estimator made about how to achieve the tasks identified
in the project plan. Such changes are due to technological uncertainty: a building’s foundation must be reinforced
due to a fault in the ground that wasn’t identified beforehand; a new innovation allows a project task to be
completed easier than was anticipated, and so on.
Other changes result because the project team or client learns more about the nature of the scope of the
project or the setting in which it is to be used. This derives from an increase in the team’s or client’s knowledge
or sophistication about the project deliverables. The medical team plans to use a device in the field as well as in
the hospital. The chemists find another application of the granulated bed process if it is altered to include
additional minerals.
The third source of change is the mandate: A new law is passed, a trade association sets a new standard,
a governmental regulatory agency adopts a new policy. These changes alter the previous “rules of conduct”
under which the project had been operating, usually to the detriment of the budget.

Handling Changes. There are different ways to handle such changes. The least preferred way is simply
to accept a negative change and take a loss on the project. The best approach is to prepare for change ahead
of time by including provisions in the original contract for such changes. The easiest change to handle is when
the change is the result of an increased specification by the client, yet even these kinds of changes are often
mishandled by the project organization. The best practice is to include in the contract a formal change control
procedure that allows for renegotiation of price and schedule for client‐ordered changes in performance.
More difficult changes are those resulting from misunderstood assumptions, technological uncertainty,
and mandates. Assumptions and some technological uncertainties are most easily handled by carefully listing
all the assumptions, including those regarding technology, in the contract and stating that if these assumptions
fail to hold, the project’s cost and schedule may have to be adjusted.

Project Budgeting in Practice

According to the Oxford Review of Economic Policy, a study of 258 projects in 20 countries showed that
nine out of ten projects experience cost overruns, and sometimes by over 100 percent! You might wonder how
this can possibly happen, but it turns out that it happens quite easily, primarily due to the dynamics of people
and groups making decisions in an organization over some period of time. Let’s go through what happens in a
typical project to see how this occurs.
To determine a project budget, the project manager (PM) starts with the project plan or WBS to determine
the various steps required in the project, the resource needs, labor hours, and associated costs. This cost
estimate, plus a “contingency” of up to 25 percent added to either the labor hours or total cost, is then used as
the project budget for both obtaining approval for the project and as a placeholder in the department’s budget so
the funds will be encumbered and unavailable for other purposes. (The addition of a contingency is standard
practice and expected.)
But the dynamics are still not over. At some point(s) in the future, the department’s budget may well be
cut further, so all the projects’ placeholder budgets are decremented even more, requiring additional
“adjustments” to the project plan (but again without allowing a reduction in scope). According to one expert in
project management (Swanson, 2011), due to natural optimism at project start most PMs underestimate their

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projects’ costs by 30 percent or more. Given that their expense contingency was less than 25 percent even
before these factors impacted the budget, it is no wonder that the great majority of projects have cost overruns.

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