Chapter 7

A Strategic Management Approach

Tenth Edition

Budgeting &
Risk
Management

Copyright 2012
Copyright 2018,John
JohnWiley
Wiley&&Sons,
Sons,Inc.
Inc.
The Musings of Dilbert……

7-2
 Budgeting

 A plan for the costs of project resources

 A budget implies constraints
 Consequently, it also implies managers
will not get everything they want or need

7-3
 Budgeting Continued

 A budget for an activity also mandates

management support for the project
 Higher the budget, relative to cost, the
higher the managerial support should be
 A budget is also a control mechanism
– Many organizations have controls in place
that prohibit exceeding the project budget
– Comparisons are made against the budget
 above, below, or on target
7-4
 Estimating Project Budgets

 On most projects
– Material + Labor + Equipment + Capital +
Overhead + Profits = Bid
 In other words
– Resources + Profits = Bid
 So we are left with the task of forecasting
resources

7-5
 Using a Range of Estimates in
Economic Analysis
 It is more realistic to describe parameters with a
range of possible values.
 A range could include an optimistic (O) estimate, the
most likely (M) estimate, and a pessimistic (P)
estimate.
 With Beta distribution, the approximate mean value of
a parameter can be calculated as:

O  4M  P
M e a n va lue 
6

7-6
 Duration Mean: Plan Concert

Immediate
Activity Description Predecessor t0 tm tp
s
A Find Site ---- 1 2 3

B Find Engineers A 1 2 3

C Hire Opening Act A 4 5 6

D Set Radio/TV Ads C 2 3 4

E Set up Ticket Agents A 1 3 5

F Prepare Electronics B 2 3 4

G Print Advertising C 3 5 7

H Set up Transportation C 1 2 3

I Rehearsals F, H 2 4 6

J Last-minute Details D, E, G, I 2 3 4

7-7
Expected Duration & Variation

E(t) = (to + 4tm + tp) / 6

σ2 = (tp - to)2 / 36
σ = (∑(critical path variances))1/2

7-8
Duration Mean & Variance: Plan Concert

Activity t0 tm tp E(t) σ2
A 1 2 3 2.0 4/36 = 1/9
B 1 2 3 2.0 4/36 = 1/9
C 4 5 6 5.0 4/36 = 1/9
D 2 3 4 3.0 4/36 = 1/9
E 1 3 5 3.0 16/36 = 4/9
F 2 3 4 3.0 4/36 = 1/9
G 3 5 7 5.0 16/36 = 4/9
H 1 2 3 2.0 4/36 = 1/9
I 2 4 6 4.0 16/36 = 4/9
J 2 3 4 3.0 4/36 = 1/9
 PERT Chart

2 3
B F 4
2 I
H
2 5 3
5
A C G J
D
3
E
3
 Variance for Critical Path
σ = (∑(path variances))1/2
σ = (4/36 + 4/36 + 4/36 + 16/36 + 4/36)1/2

= (16*2 / 36)1/2 = (2/3)(2)1/2 = 0.94

Projected Range for Completion @ 95% confidence:
0.05/2 = 0.025 or 2.5%; Z = 1.96
16 – 1.96(0.94) < Duration < 16+1.96(0.94)

14.2 < Duration < 17.8

Or, the duration of the project is 16 weeks + 1.8 weeks

 Estimating Project Budgets Continued

 Like any forecast, project budgets have

some associative uncertainty
 There is uncertainty regarding usage &
price
– Especially true for materials & labor
 The more standardized the project &
components, the lower the uncertainty
 The more experienced the cost estimator,
the lower the uncertainty
7-12
 Rules of Thumb

 Some estimates are prepared by rules of

thumb
– Construction cost by square feet ($150/sqft)
– Printing cost by number of pages
– Lawn care cost by square feet of lawn
 These rules of thumb can be adjusted for
special conditions (trim, floors, ceilings, etc.)
 However, this is far easier than starting an
estimate from scratch
7-13
 Estimating Budgets is Difficult

 There may not be as much historical

data or none at all
 Even with similar projects, there may be
significant differences
– Location, labor rates, supply sources
 Normally, several people can have input
to a budget

7-14
Estimating Budgets is Difficult Continued

 Multiple people have some control over

the budget
 There is more “flexibility” regarding the
estimates of inputs (material and labor)
 The accounting system may not be set
up to track project data (week to week)
 Usage of labor and material is very
lumpy (variable) over time (Burn Rate
Schedule)
7-15
 Types of Budgeting

 Top-down
 Bottom-up
 Negotiated

7-16
 Top-Down Budgeting

 Top (senior) managers estimate/decide on

the overall project budget
 Needs trickle down through the organization
where the estimates are broken down into
greater detail at each lower level
 The process continues to the bottom level

7-17
 Advantages

 Overall project budgets can be

set/controlled very accurately
– A few elements may have significant error
 Management has more control over budgets
 Small tasks need not be identified
individually
– Numerous small tasks add up – changes results
if not addressed

7-18
 Disadvantages

 More difficult to get buy in

– “Too many chiefs”
 Leads to low-level competition for larger
shares of budget

7-19
 Bottom-Up Budgeting

 Project is broken down into work packages

 Low level managers price out each work
package
 Overhead and profits are added to develop
the budget

7-20
 Advantages

 Greater buy in by the low-level managers

 Higher probability of catching unusual
expenses

7-21
 Disadvantages

 People tend to overstate their budget

requirements “Gold Plating” their part
 Senior Management has a tendency to
cut budgets
– Accountability to the various stakeholders

7-22
 Work Element Costing

 Labor rates include overhead & personal

time
 Direct costs usually do not include
overhead
 General and administrative (G&A) charge

7-23
 An Iterative Budgeting Process–
Negotiation-in-Action

 Most projects use some combination of

top-down and bottom-up budgeting
 Both are prepared and compared
 Any differences are negotiated

7-24
 Category Budgeting Versus
Program/Activity Budgeting

 Organizations are accustomed to budgeting

& collecting data by company activities
 These activities normally correspond to “line
items” in the budget
– Examples include phone, utilities, direct labor,
energy, raw materials,…etc.
 Projects need to accumulate data and
control expenses differently
– This resulted in program budgeting

7-25
 Typical Monthly Budget

Table 7-1 7-26

 Project Budget by Task & Month

(Planned Burn Schedule)

Table 7-2 7-27
 Improving The Process of Cost
Estimation

 Inputs from many areas are required to estimate

a project
– May have a professional cost estimator to do the job
 Project manager should work closely with cost
estimator when planning a project
 We are primarily interested in estimating direct
costs
 Indirect costs are not a major concern

7-28
 Problems

 Even with careful planning, estimates are

often wrong
 Most firms add 5-10 % for contingencies
– Account for unplanned change or errors in
budgeting

7-29
 Learning Curves

 Human performance usually improves

when a task is repeated
 This happens by a fixed percent each
time the production doubles
 Percentage is called the learning rate

7-30
 Example – Experienced Team

 Time Planned: 70 hours per unit

 Number of units: 25 units
 Labor Rate: $12 per hour
 Labor Benefits:28%

Estimated total labor cost:

= (1+0.28)($12)(25)(70) = $26,880

7-31
 Example (continued)…..

 The previous example likely underestimates

the real cost….. Why?
– At the outset of production, the costs is normally
much higher
 Slower product rates (100 hours per unit or more)
 Equipment related issues (working out the bugs)
 Employee education to speed up (best practices)
 Gaining experience in the best ways (learning)

– In general, as output doubles, worker hours per

unit decrease at some fixed percentage
7-32
 Learning Curve Calculations
Tn = Time for nth unit
r T1 = Time for first
Tn  T1n unit
lograte  n = Number of units
r r = log decimal
log 2 rate = L.C.rate/log
rate = %
2
N
Total time  T1  n r

n 1
7-33
 Example (continued) …..

 L.C. Rate: 85%

 Time Planned: 70 hours per unit
 Number of units: 25 units
 Labor Rate: $12 per hour
 Labor Benefits:28%
 After 20 units, time stabilizes at 70 hours
per unit
 What is actual labor cost for this project?
7-34
 Calculations

r = ln 0.85 / ln 2 = - 0.23447

Tn = T1 (20)-0.23447
T1 = (70) / (20 )-0.23447
T1 = 141.30

7-35
Final Calculations

Total Cost = 2,102.4 (1.28) (12)

= $32,293.63

7-36
 Other Factors

 Escalation of cost
– Examples: steel, lumber, union rates, etc.
 Waste or Spoilage
 Bad Luck
– Strikes
– Machinery failures

7-37
 Making Better Estimates
 Projects are known for being over budget
– Unlikely this is due to deliberate underestimating
 There are two types of errors
– Random Errors
– Errors of Bias
 There is nothing we can do about random
errors (error happens by chance)
– Have a tendency to cancel each other
 Eliminate systematic errors

7-38
 Risk Estimation

 Duration of project activities varies

 Amounts of various resources needed
varies
 Value of accomplishing a project varies
 Can reduce but not eliminate ambiguity
 Want to describe uncertainties in a way
that provides useful insight to their nature

7-39
 Applying Risk Analysis

 Must make assumptions about probability

distributions
– Key parameters
– Variables
 Estimate the risk profiles of the outcomes
of the decision
– Also known as probability distributions
 Simulation is often used
7-40
 General Simulation Analysis
 Simulation combined with sensitivity
analysis is useful for evaluating projects
 Would support project if NPV is positive
and is the best use of funds
 Should avoid full-cost philosophy
– Some overheads are not affected by
changes
 Analysis gives a picture in terms of costs
and times that will be affected
 Project is then reviewed using simulation

7-41
RISK MANAGEMENT

7-42
 F-15 E
Strike Eagle
McDonnell Douglas

F16XL
Fighting Falcon
General Dynamics

6-43
 Risk Management

 Projects are risky, uncertainty always present

 Project manager must manage this risk
– Not surprisingly, it’s called “risk management”
 Risks vary widely between projects
 Risks can also vary between organizations
 Risk management should be built on results
of prior projects
– Lessons learned, past experience, school of
“hard-knocks”
6-44
 Parts to Risk Management

 Risk management planning

 Risk identification
 Qualitative risk analysis
 Quantitative risk analysis
 Risk response planning
 Risk monitoring and control
 The risk management register (maintenance)
6-45
 Risk Management Planning

 Need to know the risk involved before selecting

a project
 Risk management plan must be carried out
before the project can be formally selected
 At first, focus is on externalities
– Track and estimate project’s survivalability
 Project risks take shape during planning
 Often handled by project office

6-46
 Risk Identification
 Risk is dependent on technology &
environmental factors
 Delphi method is useful for identifying
project risks
 Other methods include brainstorming,
nominal group techniques, checklists,
and attribute listing
 May also use cause-effect diagrams,
flow charts, influence charts, SWOT
analysis
6-47
 Organization of Causes ……

Lots of information on the subject and

difficult to organize and make sense of.
 Internal Feedback……

Nine internal resources from CIS

 3 Quality consultants
 2 Environmental and Quality
 3 Lean Manufacturing
 1 Center manager
 244 years of combined experience
 Internal Survey Results……

Condensed to easier format

 Top five (customer survey target)
 6-11 for later work
 Internal Results

 Poor Communications 48
 No / Poor Trending Metrics 43
 Managers & Leaders 31
 Poor Problem Solving 28
 Poor Manufacturing Skills 28
Totals 178

7-51
External Survey - Customers
 Qualitative Risk Analysis

 Purpose is to prioritize risks

 A sense of the impact is also needed
 Each objective should be scaled and
weighted
 Construct a risk matrix
 Same approach can be used for
opportunities

6-53
 Risk Matrix

Figure 7-6 6-54

 Quantitative Risk Analysis

1. List ways a project can fail

2. Evaluate severity
3. Estimate likelihood
4. Estimate the inability to detect
5. Find the risk priority number (RPN)
(RPN = S(severity)  L (likelihood)  D (detect))
6. Consider ways to reduce the S, L, and
D for each cause of failure
Severity is changed only thru re-design
6-55
 Failure Mode Effects Analysis Examples

Note: it is a multiplicative relationship!

Table 6-1 6-56

FMEA

6-57
FMEA

6-58
 Decision Tree Analysis – Right to Left

EMV2 = 12(0.5) + 6(0.3) + 3(0.2) = 6.0+1.8+ 0.6 = 8.4

EMV2 = 8.4

EMV3 = 8.0

EMV4 = 6.5

Figure 7-7 (modified) 6-59

 Risk Response Planning

Threats Opportunities
– Avoid – Exploit
– Transfer – Share
– Mitigate – Enhance
– Accept – Accept

6-60
 Risk Monitoring and Control

 Monitoring covered in detail in Chapter 10

 Control covered in Chapter 11

6-61
 The Risk Management Register

 Environments that may impact projects

 Assumptions made
 Risks identified
 List of categories and key words
 Estimates on risk, state of project’s
environment, or on project assumptions
 Minutes
 Actual outcomes

6-62
6-63
6-64
RMR Example

6-65