1. Project Management A Managerial Approach
Chapter 7
Budgeting and Cost Estimation

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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”

11. An Iterative Budgeting Process
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

12. 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

13. 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

14. 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

15. Program Budgeting Project Budget by Task and Month Monthly Budget (£)
Task I J Estimate A B C D E F G H I J

16. 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

17. 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

18. 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

19. 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

20. 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

21. Summary
The intent of a budget is to communicate organizational policy concerning the organization’s goals and priorities
There are a number of common budgeting methods: top-down, bottom-up, and the program budget
Firms will fund projects whose returns cover direct but not full costs in order to achieve long-run strategic goals of the organization

22. Summary
If projects include repetitive tasks with significant human input, the learning phenomenon should be taken into consideration when preparing cost estimates
The learning curve is based on the observation that the amount of time required to produce one unit decreases a constant percentage every time the output doubles

23. Summary
Other major factors, in addition to learning, that should be considered when making project cost estimates are inflation, differential changes in the cost factors, waste and spoilage, personnel replacement costs, and contingencies for unexpected difficulties

24. Budgeting and Cost Estimation
Questions?

25. Budgeting and Cost Estimation
Picture Files

26. Budgeting and Cost Estimation
Figure 7-1

27. Budgeting and Cost Estimation
Figure 7-2

28. Budgeting and Cost Estimation
Figure 7-4

29. Budgeting and Cost Estimation
Table Files

30. Budgeting and Cost Estimation

31. Budgeting and Cost Estimation

32. Budgeting and Cost Estimation