budgeting n cost estimation

7/31/2019 Budgeting n Cost Estimation

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Project ManagementA Managerial Approach

Budgeting and Cost Estimation


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What is a budget?

A Plan for allocating resources.

The act of budgeting is the process ofallocating the scarce resources to the

various endeavors of an organization.


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The budget serves as a standard forcomparison

It is a baseline from which to measure the

difference between the actual and planned useof resources

Budgeting procedures must associateresource use with the achievement of

organizational goals or the planning/controlprocess becomes useless

The budget is simply the project plan in anotherform


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The degree to which the differentactivities of a project are supported byan allocation of resources is onemeasure of the importance placed on

the outcome of the activity.


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A budget serves as a controlmechanism.

Exception reports can be generated ifresource expenditures are not consistentwith accomplishments.

The pattern of deviations can beexamined to forecast significantdepartures from budget.


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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 effectsof potential price inflation

Approximation of projects costLast years figures+x

Estimated wt of product*specific factor


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All projects are uniqueAll project budgets are based on forecasts

of resource usage and associated costs

Estimating the cost for any project involvesriskProblems in multiyear usage (cost of

materials)Degree of executive oversight and review.


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Actual use of resources

Suppose you have estimated that $5000 of agiven resource will be used in accomplishing atask over 5 weeks.

The actual use of the resource may be none inWeek1, $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 thisequally over the 5 week period.


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There are two fundamentally differentstrategies for data gathering:Top-down

Bottom-up


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Top-Down Budgeting

This strategy is based on collecting thejudgment and experiences of top and middlemanagers.

These cost estimates are then given to lowerlevel managers, who are expected tocontinue the breakdown into budgetestimates.

This process continues to the lowest level.


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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


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Bottom-Up Budgeting

In this method, elemental tasks, their schedules, and theirindividual budgets are constructed following the WBS orproject action plan

The people doing the work are consulted regarding times

and budgets for the tasks to ensure the best level ofaccuracy 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 allelements be included. Usual elements are labour, materials, consumables,

capital expenditure, travel etc..


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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 inbudget preparation increases the likelihood thatthey will accept the result with a minimum ofaversion

Involvement is a good managerial trainingtechnique, giving junior managers valuableexperience


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Budgeting

Top-down budgeting is very common

True bottom-up budgets are rareSenior managers see the bottom-up process as

risky

They tend not to be particularly trusting ofambitious subordinates who they fear may

overstate resource requirementsThey are reluctant to hand over control to

subordinates whose experience and motives arequestionable


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Work Element Costing

The actual process of building a budget -either top-down or bottom-up - tends to be a

straightforward but tedious processEach work element in the action plan or WBS

is evaluated for its resource requirements,

and then the cost


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Suppose a work element requires 25 hrs of labour by atechnician. 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=$901.6Not including personal time would have resulted in

underestimation.


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Direct costs for resources and machineryare charged directly to the project. Laboris usually subject to overhead charges.

Material resources and machinery mayor may not be subject to overhead.

There is also the General and

Administrative (G&A) charge


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The Iterative budgeting process

An individual concocting the action plan at thehighest level would estimate resourcerequirements and durations at the highest levelaction plan.

Ri=Resource requirement for ith task.

Ti=Time requirement for ith taskA subordinate estimates ri and ti

Ideally Ri=ri. However,Ri


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An Iterative Budgeting Process

Resource estimates and actual requirements arerarely the same for several reasons: The farther one moves up the organizational chart, the

easier, faster and cheaper the job looksWishful 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)


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An Iterative Budgeting Process

Usually the initial step toward reducing the difference betweenthe superiors and the subordinates estimates is made by thesuperior

The superior agrees to be educated by the subordinate in therealities of the job(Ri rises)

The subordinate is encouraged by the superiors positiveresponse 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


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Category/Activity Budgeting vs.Program Budgeting

The traditional organization budget is either

category oriented or activity oriented

Often based upon historical data accumulatedthrough 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


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Category/Activity Budgeting vs.Program Budgeting

Under traditional budgeting methods, the budget

could be split up among many different

organizational unitsThis diffused control so widely that it was almost

nonexistent

This problem gave rise toprogram budgetingwhichalters the budgeting process so that budget can be

associated with the projects that use them


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Program Budgeting

Project Budget by Task and Month

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

75000 5600 12607 15114 14192 9836 6317 5333 6000

I i h P f C


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Improving the Process of CostEstimation

There are two fundamentally different waysto manage the risks associated with thechance 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


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Funding Non profitable Projects

There are several reasons that firms wouldchoose to fund a project that is not profitable:

To develop knowledge of a technologyTo 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


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Learning Curves

Studies have shown that human performance usuallyimproves 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 intoaccount for any task where labor is significant


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Other Factors

Anywhere from about three-fifths to five-sixths ofprojects fail to meet their time, cost, and/orspecification objectives

There are several common causes:Arbitrary and impossible goalsScope creepWildly optimistic estimates in order to influence the

project selection processChanges in resource pricesFailure to include an allowance for waste and spoilageBad luck


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Types of Estimation Error

There are two generic types of estimationerror:

Random error- where overestimates andunderestimates are likely to be equal

Bias - a systematic error where the chance of

overestimating and underestimating are not likely

to be equal

budgeting n cost estimation

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