CHAPTER 7: BUDGETING: ESTIMATING COST AND RISKS

(HAND-OUTS)
The objectives of this chapter are to:

 consider some of the various budgeting methods used in organizations;

 address some problems of cost estimation particularly to the details and pitfalls;
 consider some special demands and concerns with budgeting projects;
 and lastly, present some techniques for improving one's skills at budget and cost
estimation.

7.1 Estimating Project Budgets

In order to develop a budget, we must forecast what resources the project will require, the
required quantity of each, when they will be needed, and how much they will cost, including the
effects of potential price inflation.
- In many fields, cost estimating methods are well codified.
- Ever business has its own rules of thumb for its cost estimating.
- It is also helpful to understand that developing projects is much more difficult than developing
budgets for more permanent organizational activities.
- A more interesting estimation that also depends on actual costs early in the life of a project is
based on earned value analysis.
- One aspect of cost estimation and budgeting that is not often discussed has to do with the actual
use of resources as opposed to the accounting department's assumption about how and when the
resources will be used.
- The strategies for data gathering: Top down and Bottom Up.

Top-down Budgeting
- This strategy is based on collecting the judgements and experiences of top and middle
managers, and available past data concerning similar activities. These managers estimate overall
project cost as well as the costs of the major subprojects that comprise it. These cost estimates are
then given to lower-level managers, who are expected to continue the breakdown into budget
estimates for the specific tasks and work packages the comprise the subprojects. This process
continues to the lowest level.
 Bottom-Up Budgeting
- In this method, elemental tasks, their schedules, and their individual budgets are constructed.
-The advantages of the bottom-up process are those generally associated with participative
management.
-While top down budgeting is common, true bottom-ups are rare.

Work Element Costing

- The actual process of building a project budget - either top-down or bottom-up, or combination
of both- tends to be a straightforward but tedious process.

Suppose a work element is estimated to require 25 hours of labor by technician. The specific
technician assigned to this job is paid $17.50/hr. Overhead charges to the project are 84 percent
of direct labor charges.
25 hr x $17.50 x 1.84 = $805.00
but the accuracy of this calculation depends on the precise assumptions behind the 25-hr
estimate.
A typical allowance for personal time is 12 percent of total work time. If personal time was not
included in the 25-hr estimate made above, then the cost calculation becomes
1.12 x 25hr x $17.50 x 1.84 = $901.60
The uncertainty in labor cost estimating lies in the estimate of hours to be expended. Not
including personal time ensures an underestimate.

An Iterative Budgeting Process - Negotiation in Action

- The strength of this planning technique is that primary responsibility for the design of a task
is delegated to the individual accountable for its completion and thus utiizes participative
management ( or employee involvement). If done correctly, estimated resource usage and
schedules are a normal part of the planning process at all planning levels. Therefore,
constructing a WBS at the highest level would estimate resource requirements and duration
for each of the steps in WBS.
• Most projects use some combination of top- down and bottom-up budgeting.
• Both are prepared and compared.
• Any differences are negotiated.
Cost Category Budgeting VS. Project/Activity Budgeting
  Another facet of the budget has to do with the degree to which a budget is category- oriented
or project/activity oriented. The traditional organizational budget is a category-oriented based
upon historical data accumulated through a traditional, category-based, cost accounting
system.
 With the advent of project organization, it became necessary to organize the budget in ways
that conformed more closely to the actual pattern of fiscal responsibility
 The estimation of capital costs raises special problems.
 Organizations are used to budgeting and collecting data by activity
 Projects need to accumulate data and control expenses differently.
 This resulted in program budgeting.

2. IMPROVING THE PROCESS OF COST ESTIMATING

The cooperation of several people is required to prepare cost estimates for a project. If the firm is in a
business that routinely requires bids to be submitted to its customers, it will have “professional”
(experienced) cost estimators on its staff. The major responsibility of the professional estimators is to
reduce the level of uncertainty in cost estimates so that the fi rm’s bids can be made in the light of
expert information about its potential costs. In these cases, it is the job of the PM to generate a
description of the work to be done on the project in sufficient detail that the estimator can know what
cost data must be collected. Frequently,
the project will be too complex for the PM to generate such a description without considerable help
from experts in the functional areas.

A Special Case of Learning

Technological Shock If the parent organization is not experienced in the type of project being
considered for selection, performance measures such as time to installation, time to achieve 80
percent efficiency, cost to install, and the like are quite uncertain and often will be seriously
underestimated.

On Making Better Estimates

Let us begin with the assumption that budget estimating errors are not the result of deliberate
dishonesty, but derive from honest errors on the part of the PM, project cost estimators, or anyone
else involved.
But why do experienced managers err on their budget and schedule estimates?
It is axiomatic that we should learn through experience.

There are two types of estimation error. First, there is random error in which overestimates and
underestimates are equally likely. These are errors that tend to cancel each other. If we sum these
errors over many estimates, their sum will approach zero. Second, there is bias, which is systematic
error. For biased estimates, the chance of over- and underestimates are not equally likely, and their
sum, either positive or negative, will increase as the number of estimates increases.

7.3 Risk Estimation

- The duration of project activities, the amounts of various resources that will be required to complete a
project, and the estimates made of the value of accomplishing a project
- Decisions must be made in the face of the ambiguity that results from uncertain information.
- “Vague terms lead to bad decisions. You need to define success in quantifiable terms so that everyone is
on the same page… you need to robust ways to discuss uncertainties quantified in the language of
profitability.

Project Management in Practice (Simulating the Failure of California’s Levees)

- California’s 2600-mile long system of levees east of San Francisco is arguably the most
worrisome infrastructure risk in America – called a “ticking time bomb” by some – whose
failures would top the economic cost of Katrina.

General Simulation Analysis

- Simulation combined with the sensitivity analysis is also useful for evaluating projects while they
are still in conceptual stage.
- These individual estimated changes in production cost and time, together with upstream and
downstream time and cost changes that might also result are used to generate the required cash
flow information – presuming that the time savings have been properly costed.
PsychoCeramic Science Revisited
1. Click on the cell F17 to identify it as containing an outcome that interests us.
2. Select the menu option Define Forecast near the left end of the tool bar.
3. CB’s Define Forecast dialog box is now displayed as shown in Figure 7-9. In the Forecast Name:
textbox, enter a descriptive name such as Net Present Value of Project. Then enter a descriptive label such
as Dollars in the Units: textbox.
4. Click OK. There is only one Forecast cell in this example, but there are several. Use the same five steps
for each.
5. Before leaving the Define Forecast, there is some additional work that will be helpful. There are
several views of the output of the simulation. Click on the View (double arrow at right) button to choose.
You may also control the precision of the output data, you can filter it if you wish, and you can decide
what information about the results you would like to examine. The latter choice is made by clicking Auto
Extract. Put a check in the “Extract forecast….” box and then check as many statistical output as you
wish. Be sure to make an entry in the :Starting Cell” box and choose any entry outside of the bounds of