Project Management: A Managerial Approach Chapter – Budgeting and Cost Estimation â 2006 John Wiley Overview Estimating Project Budgets – Top-down – Bottom-up • • • • Work Element Costing Budget Iteration Activity Budgets Continuous Budget Improvement © 2006 John Wiley 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 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 Chapter 7-2 Activity-Oriented Budgets â 2006 John Wiley 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 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 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 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 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 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 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 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 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 Chapter 7-10 © 2006 John Wiley 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 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 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 Chapter 7-13 Program Budgeting • Project Budget by Task and Month Monthly Budget (£) Task A I J Estimate 1 7000 5600 B 9000 C 10000 D 6000 E 12000 4800 F 3000 3000 G 9000 H 5000 I 8000 J 6000 6000 75000 6000 1400 3857 3750 3600 5143 5000 1250 2400 2571 4800 5143 2400 1286 3750 1250 2667 12607 Wiley 15114 14192 ©5600 2006 John 5333 9836 6317 5333 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 or 10 percent – Another is when the forecaster selects “most likely, optimistic, and pessimistic” estimates © 2006 John Wiley 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 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 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 â 2006 John Wiley 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 Chapter 7-19 Copyright 2006 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in section 117 of the 1976 United States Copyright Act without express permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein © 2006 John Wiley ... (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... 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... 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 Chapter 7-17 Other Factors