intro to project management - 07 - budgeting and cost estimation

8/13/2019 Intro to Project Management - 07 - Budgeting and Cost Estimation

http://slidepdf.com/reader/full/intro-to-project-management-07-budgeting-and-cost-estimation 1/41

MGT 550: Introduction to Project Management

March 31, 2002 1For academic use only.

MGT 550

Introduction to

Project Management

Chapter 7:

Budgeting and

Cost Estimation

Wesley J. Howe School of Technology Management

Course Development Team Members:Michael Poli

Celia Desmond, PMPDavid Keeney, PMP, CQM, CPDT





Copyright Information

The slides in this file are provided to faculty instructing MGT 500 on behalf of the

Stevens Institute of Technology. Use is restricted to academic endeavorsassociated with the delivery of MGT 550 to students properly enrolled at theStevens Institute of Technology. All other rights are reserved by the original ownersof materials contained in this program.

The slides contain copyrighted material that has been reproduced and/or adapted tothe course syllabus under the doctrine of “fair use for academic purposes”. Allslides in this course are copyrighted by the original source. Requests to reproducematerials for other purposes should be directed to the copyright owner identified inthe bibliography that will be made available to faculty.





Budgeting and Cost Estimation

M&M Text, Chpt. 7





Module 7:

Cost Estimating and Budgeting

Purpose: prepare students to understandthe elements of a project budget and thetechniques commonly used to estimate

costs in a project plan.





Module 7 Objectives

• Review Financial Statements

– Describe the balance sheet, income statement, andcashflow statement

– Explain the basic relationships between each financial

statement – Link the financial statements to measures of project

profitability discussed during project selection

– Explain the differences between the capital budget, theoperating budget, and imputed costs





WBS, OBS, RBS, and CBS

DirectCosts IndirectCosts

CBS

•Direct

Labor

• DirectMaterial

•Period

Expenses

•Overhead•Burden

1.0

1.1 1.2 1.31.2.1 1.2.2

A 5

D 1

D 3

D 7

S 3

S 4

O

B S

W B S

Income

Statement

Cashflow

Statement

BalanceSheet

Imputed Costs

Keeney, 2000





Key Cost Concepts• Cost is a resource foregone, in cash or in

kind, to obtain a set of benefits – Type of costs

• Capital

• Expense

• Sunk cost

• Imputed cost

• Opportunity cost

– Economic analysis

– Budgeting

– Earned value – Contingency





Capital Costs

• Must be depreciated or amortized over life of

capital asset (defined by taxing authorities)• Result in owned assets on the balance sheet

– Historical cost (usually at acquisition)

– Accumulated depreciation/amortization

– Historical cost less accumulated depreciation

– May have a salvage value• Cost of capital should be considered

– Net cost for debt and equity sources of assets

– Hurdle rate may be based on cost of capital





Sunk Costs

• Cost already expended• Should not be used in making

decisions about future.

• Should base decisions on futurecosts and impacts.





Imputed Costs

• A cost that does not get reported on financialstatements

• Opportunity costs are an example of imputed

costs





Opportunity Cost

• Benefits foregone as a result of choosingone of more than one alternatives

• Usually used as a comparative measure

• Useful in making decisions• Can use to compare project benefits to

opportunities from other projects.





Opportunity Cost Example

We could upgrade our current billing system, at a cost of $800K or

purchase a new standalone system for the l.d. service we aredesigning for $500K, in 3 months time.Purchasing the new system would require process changes of anadditional $800K to integrate the output with the currently issued

bills. However once the systems and integrated processes are inplace, we expect to save $500K on each of four upcoming plannedservices.

Therefore the opportunity cost of upgrading is

(4x$500K) - ($500K+$800K) = 700Kbecause we are foregoing $700K savings to upgrade now.

This can be compared to the increase in profit expected over thenext 3 months to decide whether to go ahead.





Funding Non profitable Projects

• There are several reasons that firms wouldchoose to fund project that is notprofitable:

– To develop knowledge of technology – To get organization’s “foot in door”

– To obtain parts or service portion of work

– To be in good position for follow-on contract – To improve competitive position

– To broaden product line or line of business

M&M Text, Chpt. 7





Profitability Measurement

• Payback period

• Return On Investment (ROI)

• Discounted cash flow methods

– NPV, net present value – IRR, internal rate of return

– Benefit-cost ratio

All of these measurements require use of

a time-phased budget to assess profitability.





Payback Period• Forecasts how long it will take for the net cash inflow to pay

back the investment outflow

– ignores time value of money – ignores cash flow after payback

9001,5001,200500-2,100Cashflow

1501501501500Debt Service1251251251250Interest

252525250Amortization

4004004004000Depreciation

50011008001000NPAT

Year 4 Year 3 Year 2 Year 1 Year 0

Payback Period = 2.4 years





Return On Investment (ROI)

Many formulas exist for computing ROI.

• Return on Average Investment

• Return on Original Investment

(Average Yearly Profit)

(Original Investment) + (Working Capital)ROI =

(Working Capital) = (Current Assets) – (Current Liabilities)





The future value F of a current sum at its present value PV, depends

upon the interest/investment rate i and the number of years involved, n.

FV = PV(1+ i )n

Net present value NPV of a series of sums is

when II is the initial investment.

An annuity, is the amount of money to be invested (A) each year over myears at a rate of investment (i) to provide the required amount i.e.enough to buy a customer care company.

PV = A (1+i)n -1 / i (1+i)n

NPV = - II MFVi

(1 + k)i

i=1

n

Present Value Concepts





The Reciprocal Relationship of

PV and FV

0.0

1.0

2.0

3.0

4.05.0

6.0

7.0

8.0

- 2 0 - 1 7

- 1 4

- 1 1 - 8 - 5 - 2 1 4 7

1 0 1 3 1 6 1 9

Time Period

V a l u e o f

$ 1

CompoundedValue

Discounted Value

N

OW

10%

5%





Net Present ValueDiscount rate 10%

NPV = 1093

6151127996455-2,100PV

0.68300.75130.8640.90911.00PVIF

9001,5001,200500-2,100Cashflow

1501501501500Debt Service

1251251251250Interest

252525250Amortization

4004004004000Depreciation

50011008001000NPAT

Year 4 Year 3 Year 2 Year 1 Year 0

MGT 0 I d i P j M





Benefit/Cost Ratio

Of Discounted Cash Inflows

Of Discounted Cash OutflowsProfitability Index =

From the NPV Problem:• Discounted Cash Inflows = $3,193• Discounted Cash Outflows = $2,100

PI =

$3,193

$2,100= 1.52 If PI > 1.0,project is favorable.

MGT 550 I t d ti t P j t M t





Internal rate of Return (IRR)

The discount rate that makes the present value ofall cash flows (in and out) equal to zero.

The IRR is found by iteration

- II = 0 MFVi

(1 + IRR)i

i=1

n

MGT 550 I t d ti t P j t M t





NVP or IRR?

• For project decisions, NPV isrecommended over IRR as decision tool.

• NPV is more conservative and also more

consistent than IRR• Since IRR is calculated by a polynomial of

dimension n, it has n roots, not just one.






Module 7 Objectives

• Cost Estimation Techniques

– Describe analogous estimating and parametricmodeling

– Explain bottom-up estimating and its relationship to the

WBS






Cost Estimating Techniques

• Analogous

– “top-down”

– adjustments to actual cost of past projects

• Parametric – uses some measurable characteristic e.g.

• cost per line of code or per screen

• cost per square foot of living space

• Bottom-up

– detailed






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, makingfor 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 befactored into the overall estimate

M&M Text, Chpt 7






Bottom-Up Budgeting

• Advantages:

– Individuals closer to the work are apt to have amore accurate idea of resource requirements

– The direct involvement of low-level managersin budget preparation increases the likelihoodthat they will accept the result with a minimumof aversion

– Involvement is a good managerial trainingtechnique, giving junior managers valuableexperience

M&M Text, Chpt 7






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 questionableM&M Text, Chpt 7






Work Element Costing

• Each work element in the action plan or

WBS is evaluated for its resourcerequirements, and then the cost

• Direct costs for resources and machinery

are charged directly to the project. Labor isusually 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

M&M Text, Chpt 7






Category/Activity Budgeting vs.Program Budgeting

• The traditional organization budget is eithercategory 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 theactual pattern of fiscal responsibility

M&M Text, Chpt 7






Category/Activity Budgeting vs.Program Budgeting

• Under traditional budgeting methods, thebudget could be split up among manydifferent organizational units

• This diffused control so widely that it wasalmost nonexistent

• This problem gave rise to program

budgeting, which alters the budgetingprocess so that budgets can beassociated with the projects that use them

M&M Text, Chpt 7




j g


Program Budgeting

• Program budgeting aggregates income andexpenditures across programs (projects)

• Aggregation by program is in addition to,

not instead of, aggregation byorganizational unit

• These budgets usually take the form of a

spreadsheet with standard categoriesdisaggregated into “regular operations” andcharges to the various projects

M&M Text, Chpt 7




j g


Module 7 Objectives

• Time-phased Budgets

– Explain that the purpose of a budget is to assignresponsibility for costs to a cost center

– Explain the chart of accounts and its relationship to

work packages – Explain how the time-phased budget can be used to

evaluate profitability and cashflow on a project




j g


From Schedule to BudgetID WBS Task Name Dur

14 3 Technical Team Startup 28 days

15 3.1 Identify Team Members 1 day

16 3.2 Verify Team Members Acceptance 6 days

17 3.3 Schedule Kickoff Meeting 1 day

18 3.4 Hold Kickoff Meeting 1 day

19 3.5 Identify Technical Tracks 6 days

20 3.6 Assign Team Members To Technical

Tracks

1 day

21 3.7 Set Up Technical Team Web Site 5 days

22

23 4 Call For Papers 25 days

24 4.1 Write Technical Track Descriptions 15 days

25 4.2 Write Call f or Papers 5 days

M T W T F S S M T W T F S S M T W T F S S M T W T F S S M T

16, '00 Jul 23, '00 Jul 30, '00 Aug 06, '00 Aug 13, '0

Project Budget

0

5

10

15

W1 W2 W3 W4 W5 W6 W7

Resources by Week

($000)

A B C DResource A = Contingency Allowance

Keeney, 2001





Estimate Accuracy

• Project costs will generally be determinedfrom cost and time estimates made byteam members and project stakeholders.

• When expressing or accepting anyestimate, ensure that the accuracy of theestimate is specified

– Most likely value (a mode) – Upper limit (worst case and probability)

– Lower limit (best case and probability)





Monthly Household BudgetMortgage

Utilities

Food

Miscellaneous

Total

$900

$1,000

$1,150

$100$200

$350

$700

$800

$900

$200

$400

$600

$1,900$2,400

$3,000

All Good Long RunAverage

All Bad

.00000001 Not Very Likely(.01)

4

(.01)

4

Keeney, 2001





Contingency Allowances

Where to put them?

• single line item• standard % overall• weighted percentage

• by system or phase• by milestone• by summary task

Problems with this?• Specify potential problems for each method of

showing contingency





Contingency Allowances

• Should be based on realistic expectations

• ARE EXPECTED TO BE SPENT

• Should not be hidden

• Are not for scope changes• Are not for inflation

• ARE USED FOR KNOWN UNKNOWNS





Managerial Reserve Account

• Is for unknown unknowns

• Must be requested by PM

• IS NOT A SLUSH FUND to cover poor

planning





Budgeting: Cashflow ForecastCumulative Cost

TimeTime Now

ACTUAL

BAC

EAC

PLAN





Reading Assignments

• From Chapter 7

– Text• Pp 261 – 292

• Pp 295 – 301

• For Chapter 8

– Text• Pp 302 – 348

intro to project management - 07 - budgeting and cost estimation

Documents