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Project Management

A Managerial Approach

Budgeting and Cost Estimation

What is a budget? A Plan for allocating resources. The act of budgeting is the process of allocating the scarce resources to the various endeavors of an organization.

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

The degree to which the different activities of a project are supported by an allocation of resources is one measure of the importance placed on the outcome of the activity.

budget serves as a control mechanism. Exception reports can be generated if resource expenditures are not consistent with accomplishments. The pattern of deviations can be examined to forecast significant departures from budget.

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 Approximation of projects cost
Last

years figures+x Estimated wt of product*specific factor

All

projects are unique All project budgets are based on forecasts of resource usage and associated costs Estimating the cost for any project involves risk Problems in multiyear usage (cost of materials) Degree of executive oversight and review.

Actual use of resources


Suppose

you have estimated that $5000 of a given resource will be used in accomplishing a task over 5 weeks. The actual use of the resource may be none in Week1, $3000 in Week2, none in Week3, $1500 in Week4, $500 in Week5 Unless time pattern of resource usage is explained in the plan, the accounting deptt. Which takes a linear view will spread this equally over the 5 week period.

There

are two fundamentally different strategies for data gathering:


Top-down Bottom-up

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.

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

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. Usual elements are labour, materials, consumables, capital expenditure, travel etc..

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

Budgeting
Top-down
Senior

budgeting is very common True bottom-up budgets are rare


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 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

Suppose a work element requires 25 hrs of labour by a technician. The technician assigned to the job is paid $17.5 per hr. Overhead charges to this project are 84% of direct labour charges. Cost appears to be 25 hr*$17.5*1.84=$805 Personal time of worker=12% of total work time. If Personal time was not included, in the 25 hr estimate made above, the cost calculation is 1.12*25 hr*$17.5*1.84=$901.6 Not including personal time would have resulted in underestimation.

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

The Iterative budgeting process


An

individual concocting the action plan at the highest level would estimate resource requirements and durations at the highest level action plan. Ri=Resource requirement for ith task. Ti=Time requirement for ith task A subordinate estimates ri and ti Ideally Ri=ri. However, Ri<ri

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 Murphys Law (contingency allowance)

An Iterative Budgeting Process

Usually the initial step toward reducing the difference between the superiors and the subordinates estimates is made by the superior The superior agrees to be educated by the subordinate in the realities of the job(Ri rises) The subordinate is encouraged by the superiors positive response and then surrenders some of the protection of the budgetary slop(ri decreases) This is a time consuming process, especially when the project manager is negotiating with several subordinates

Category/Activity Budgeting vs. Program Budgeting


The

traditional organization budget is either category oriented or activity oriented based upon historical data accumulated through an accounting system 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

Often With

Category/Activity Budgeting vs. Program Budgeting


Under

traditional budgeting methods, the budget could be split up among many different organizational units diffused control so widely that it was almost nonexistent problem gave rise to program budgeting which alters the budgeting process so that budget can be associated with the projects that use them

This This

Program Budgeting
Program

budgeting aggregates income and expenditures across programs (projects) by program is in addition to, not instead of, aggregation by organizational unit budgets usually take the form of a spreadsheet with standard categories disaggregated into regular operations and charges to the various projects

Aggregation

These

Program Budgeting

Project Budget by Task and Month


Monthly Budget () Task
A B C D E F G H I J 6000

I
1 2 2 2 3 4 5 6 7 8 2 3

Estimate
7000 9000 10000 6000 12000 3000 9000 5000 8000 6000 75000

1
5600

2
1400 3857 3750 3600 5143 5000 2400

4 5 7 7 6 7 8 9

1250 4800 3000 4800 1286 3750 1250 2667 5333 2400

2571

5143

5600

12607 15114 14192 9836

6317

5333

6000

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 is when the forecaster selects most likely, optimistic, and pessimistic estimates

Another

Funding Non profitable Projects


There
To

are several reasons that firms would choose to fund a project that is not profitable:
develop knowledge of a technology To get the organizations 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

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

Budgeting and Cost Estimation

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

Types of Estimation Error


There

are two generic types of estimation

error:
Random

error - where overestimates and underestimates are likely to be equal - a systematic error where the chance of overestimating and underestimating are not likely to be equal

Bias