Project Management: A

Managerial Approach

Chapter 7 – Budgeting and Cost

Estimation
© 2006 John Wiley and Sons, Inc.
 Overview
• Estimating Project Budgets
– Top-down
– Bottom-up
• Work Element Costing
• Budget Iteration
• Activity Budgets
• Continuous Budget Improvement

© 2006 John Wiley and Sons, Inc.

 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

© 2006 John Wiley and Sons, Inc. 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
© 2006 John Wiley and Sons, Inc. Chapter 7-2
Activity-Oriented Budgets

© 2006 John Wiley and Sons, Inc.

 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

© 2006 John Wiley and Sons, Inc. Chapter 7-3

 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
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

© 2006 John Wiley and Sons, Inc. 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
© 2006 John Wiley and Sons, Inc. Chapter 7-5
 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
(??)

© 2006 John Wiley and Sons, Inc. Chapter 7-6

 Budgeting
• 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
© 2006 John Wiley and Sons, Inc. 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

© 2006 John Wiley and Sons, Inc. 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”

© 2006 John Wiley and Sons, Inc. Chapter 7-9

 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
© 2006 John Wiley and Sons, Inc. 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

© 2006 John Wiley and Sons, Inc. 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

© 2006 John Wiley and Sons, Inc. Chapter 7-12

 Program Budgeting
• Program 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
© 2006 John Wiley and Sons, Inc. Chapter 7-13
 Program Budgeting
• Project Budget by Task and Month

Monthly Budget (£)

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

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
© 2006 John Wiley and Sons, Inc.
75000 5600 12607 15114 14192 9836 6317 5333 6000
Chapter 7-14
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

© 2006 John Wiley and Sons, Inc. 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
© 2006 John Wiley and Sons, Inc. 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

© 2006 John Wiley and Sons, Inc. Chapter 7-17

 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

© 2006 John Wiley and Sons, Inc. 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

© 2006 John Wiley and Sons, Inc. Chapter 7-19

Copyright 2006 John Wiley & Sons, Inc.
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© 2006 John Wiley and Sons, Inc.