Chapter 7

Budgeting: Estimating Costs and Risks

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Outline

• Introduction
• How to estimate project budgets
• Traditional Category Budgeting Versus
Program/Activity Budgeting
• Improving the process of cost estimating
• Other related concepts

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 Budgeting (Slide 1 of 2)

 A budget is a plan for allocating resources. Thus, budgeting

is the allocation of scarce resources to the various endeavors
of an organization.
 The budget is not simply one facet of a plan, nor is it merely
an expression of organizational policy; it is also a monitoring
and control mechanism. The budget serves as a standard for
comparison, a baseline from which to measure the difference
between the actual and planned uses of resources

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 Budgeting (Slide 2 of 2)
 A budget implies many things
 Constraints: Thus, it implies that managers will not get everything they
want or need
 Support:-The budget for an activity implies management support for that
activity
 The higher the budget, the higher the importance of the activity, and
thus the higher the managerial support
 The budget is also a monitoring & control mechanism

 Comparisons are against the baseline budget

 The budget is a reflection of the WBS. We develop the project budget if we

cost the activities within the WBS step by step. The budget is a reflection of the
WBS in another form.
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 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.
 Uncertainty is involved in any forecast, though some forecasts
have less uncertainty than others. A cost estimator can forecast
the number of bricks that will be used to construct a brick wall
of within 1 to 2 percent. The errors, however, are much larger
for an estimate of the number of programmers’ hours or lines of
code that will be required to produce a specific piece of software
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 Estimating Project Budgets
 Cost estimating methods are well established in many fields:-
 Costs can be estimated by scaling the various cost elements appropriately.
a,g, the cost of a four-lane road can be estimated from knowing the
previous cost of a constructed two-lane road.
 Parametric estimating: relies on a well-known statistical correlation
between various factors such as the total cost of a house relative to the
square feet of the living area.
 Every business has its rules of thumb for cost estimations. For example,
a book producer can provide a fairly accurate price for producing a new
book by looking at the number of pages required, the type of illustrations,
and the quality of the paper used.
 Estimating Project Budgets
 Project budgets, although being unique, can be estimated from other
older comparable predecessors, we refer to this as analogous
estimating, where historical data from past similar projects to
estimate aspects of the current project.
 Estimating Project Budgets
 Top-down budgeting:-
 Top and middle managers estimate
overall project cost as well as the costs
of the major subprojects that comprise
it using available past data concerning
similar projects.
 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 that comprise
the subprojects.
 This process continues to the lowest
level.

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 Estimating Project Budgets
 Advantages:-
 management has more control over
budgets.
 Disadvantages
 May lead to under-resourced or over-
resourced some of the WBS
units/activities
 Lower management perceives a
strong bias towards under-estimating
by senior managers

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 Estimating Project Budgets
 Bottom-up budgeting:-
 In this method, elemental tasks, schedules, and
individual budgets are constructed, again following
the WBS.
 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. These are later
converted to the dollar equivalents.
 The PM adds the indirect costs as general and
administrative (G&A). And possibly a project
reserve for contingencies, and then a profit figure to
arrive at the final project budget.
 Estimating Project Budgets
 Advantages:-
 Greater buy-in by low-level managers
 Should be more accurate than top-down
budgeting

 Disadvantages:-

 People tend to overstate their budget

requirements if management tends to cut
the budget
 Managers may lose control over the budget
which is a control mechanism by it self
 Estimating Project Budgets
 Work Elements Costing  The costing element should include
 Suppose a work element is estimated to  The direct cost of labor
require 25 hours of labor by a technician. The  The operating cost of the machine plus a
specific technician assigned to this job is paid depreciation charged
$17.50/hr. Overhead charges to the project are  Overhead cost
84 percent of direct labor charges. The
 General and administrative charges (G&A) as a
appropriate cost appears to
fixed percentage of the direct cost or the total
1.84× 25 hr × $17.50 = $805.00 direct and indirect cost.
Allowing for a personal time of 12%, the new  PMs are advised to have two budgets, one with
cost estimate is overheads and G&A charges, and one without.
1.12 × 25 hr × $17.50 × 1.84 = $901.60 The full budget is used to estimate profits earned,
Personal time = visiting water cooler, toilet, whereas, the other one can be used by the PM to
making calls, etc., direct and control the project without being
confounded to items not related to project costs
 Estimating Project Budgets
An Iterative Budgeting Process–Negotiation-in-Action
 Most projects use some combination of top-down and bottom-up budgeting. Both are prepared and
compared. Any differences are negotiated. Usually, the superior estimate is lower than the
subordinate estimate so both parties have to meet and discuss their differences.
 First, the senior is educated by a subordinate, which usually results in the senior raising the budget
estimate
 Second, the senior based on his positive response to reason, asks the junior to surrender any
protection provided.
 Third, they can discuss work plans to discuss means to lower the budget such as alternatives which
may reduce the budget further.
 The pair now turn their attention to the technology of the task at hand trying to find a more efficient
way to accomplish the goal.
 This continues until a common acceptable cost estimate by both parties is reached

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 Estimating Project Budgets
An Iterative Budgeting Process–Negotiation-in-Action
 Advantages
 Allows a free flow of ideas up and down the system at all levels

 This process tends to reduce the uncertainty in budget estimation

 Disadvantages
 Time-consuming process, not efficient, especially if there are multiple projects running
simultaneously

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 Cost Category Budgeting VS. Project/Activity Budgeting

 The traditional organizational budget is Table 7-1 Typical Monthly Category Budget for a Real Estate
Project (page 1 of 6)
category oriented often following the
traditional accounting system.
 Individual expenses are classified and
assigned to basic budget lines such as
phones, materials, utilities, direct labor,
and so on.
 Table 7-1 shows one page of a typical,
category-oriented monthly budget report
for a real estate project

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 Traditional Category Budgeting Versus Program/Activity
Budgeting
 Under traditional budgeting methods, the budget Table 7-2 Project Budget by Task and Month
for a project could be split up among many
different organizational units, which diffused
control so widely that it was frequently
nonexistent. It was often almost impossible to
determine the actual size of major expenditure
activities in a project’s budget.
 In light of this problem, ways were sought to
alter the budgeting process so that budgets could
be associated directly with the projects that used
them. This need gave rise to project budgeting.
 Table 7-2 shows a project-oriented budget
divided by task/activity and expected time of
expenditure

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 Improving the process of cost estimating

 The cooperation of several people is required to prepare cost estimates

for a project. Which requires the presence of experienced cost estimators
on its staff.
 Even with the finest of experts, things will not go precisely as planned
due to unexpected events that could happen.
 There are two fundamentally different ways to manage the risks, The
simpler way is to make an allowance for contingencies—usually 5 or
10 percent of the estimated cost.
 The second method, which is better, when the forecaster selects “most
likely, optimistic, and pessimistic” estimates
 Improving the process of cost estimating

 Turning now to the problem of estimating Figure 7-3 Form for gathering data on project resource
direct costs, project managers often find it needs.
helpful to collect direct cost estimates on a
form that not only lists the estimated level
of resource needs, but also indicates when
each resource will be needed, and notes if it
is available (or will be available at the
appropriate time).
 Figure 7-3 shows such a form. It also has a
column for identifying the person to contact
in order to get specific resources
 Note that Figure 7-3 contains no
information on overhead costs
Learning Curves

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Learning Curves

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Learning Curves

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Learning Curve Tables
 Learning Curves

 The total time to produce n=20 units is

(141.3)*12.40 =1752.12 hr Figure 7.4:- Effects of ignoring learning effect
 The last five units are produced at a rate of
70 hr/unit, thus the total assembly time is
1752.12+5*70=2012.12 hr.
 We can re-estimate the labor cost
(2102.12)*($12/hr)*1.28=$32,288.56
(higher than the previous estimate)
 Therefore, our first estimate, which ignored
learning effects, understated the cost by
$32,288.56-$26,880=$5,408.56
 Figure 7.4 illustrates this source of error

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Learning Curves
 How to estimate project budgets
Uncertainty
 The accuracy of single-point cost estimates
may be improved by considering estimation
uncertainty and risk and using three estimates
to define an approximate range for an
activity’s cost:
 Most likely: The cost of the activity, based on
realistic effort assessment for the required
work and any predicted expenses.
 Optimistic: The cost is based on an analysis of
the best-case scenario for the activity.
 Pessimistic: The cost based on analysis of the
worst-case scenario for the activity. 7-25
 Improving the process of cost estimating
 The matter of what overhead costs are to be added and in what amounts is unique to the
firm, beyond the PM’s control, and generally a source of annoyance and frustration to one
and all. The allocation of overhead is arbitrary by its nature and it could lead a
presumably winning (profitable) project to fail.
 Nevertheless, sometimes firms support projects that are not profitable for different reasons:-
 To develop knowledge of a technology
All these reasons are adequate
 To get the organization’s “foot in the door” to fund projects that, in the
 To obtain the parts or service portion of the work short term, may lose money
but provide the organization
 To be in a good position for a follow-on contract
with real options for future
 To improve a competitive position growth and profitability
 To broaden a product line or a line of business
 Other Factors
 Cost changes in resource prices over time: a solution to this is to increase the potential cost
estimates of the resources that are suspected to increase, or have a high impact on project
success.
 Prices of various inputs change at different rates and in different directions:- according to the
Bureau of labor statistics (LBS) states that even in a period of stable prices, the prices of some
items rise, while others fall, and still others do not change. This the PM might use a possible set
of deflators/inflators for each of the different classes of labor types of commodities in for
maintaining their bids competitive.
 Waste and Spoilage:- an allowable waste percentage has to be included in the cost-estimating
process. Keep in mind that no single builder will order just enough lumber to build a house.
 Ethical problems: Sometimes bidders submit an underestimated cost for the purpose of winning
the contract, counting on the opportunity to plead for higher costs later on due to project
circumstances once the project is underway.
 Bad Luck:- delays occur for reasons that cannot be predicted. Some machinery that has an
outstanding reliability rate fails. To buffer against such issues, each project should have an
allowance for contingencies.
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 On making Better Estimates
 Project estimates are always subject to
error. Figure 7-5:- Estimation template using ratios
 There are two types of errors
 Random error:- over which overestimates
and underestimates are equally likely. Thus,
these errors tend to cancel each other.
 Bias/systematic error:-for these errors, the
chances of overestimates and underestimates
are not equally likely, and their sum, either
positive or negative, will increase as the
number of estimates increases.
 A measure of bias, the tracking signal
(TS), is shown in raw 4 of Figure 7-5
 We can use an Excel spreadsheet to
analyze the estimator performance.

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 On making Better Estimates

Figure 7-5:- Estimation template using ratios

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 On making Better Estimates
 If the sum of the ratios is positive/negative then the
forecaster is either overestimating or
underestimating. Figure 7-5:- Estimation template using ratios
 Column E shows the absolute value of Column D.
Whereas column F is the mean absolute ratio
(MAR) which is the running average of the values
of column E up to that period.
 The tracking signal listed in column G is the ratio
of the running sum of the values in column D
divided by the MAR for that period.
 If the estimates are unbiased, the running sum in
column D will be close to zero, and diving this over
the MAR will give a very small tracking signal
(close to zero).
 If there is considerable bias, the tracking signal will
be either <1, or >1.
 If the bias is large, the tracking signal will be
correspondingly large positive or negative

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 Risk Estimation

 The duration of project activities, the amounts of various resources that will be required
to complete a project, the estimates made of the value of accomplishing a project, all these
and many other aspects of a project are uncertain.
 While a project manager may be able to reduce uncertainty, it cannot be eliminated.
 Risk estimation and analysis does not remove the ambiguity; it simply describes the
uncertainties in a way that provides the decision maker with a useful insight into their
nature.
 To apply risk analysis, one must make assumptions about the probability distributions
that characterize key parameters and variables associated with a decision and then use
these to estimate the risk profiles or probability distributions of the outcomes of the
decision.
 This can be done analytically or by Monte Carlo simulation
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 Converting Estimates into Project Budgets

 Cost estimates may include revenues (e.g., milestone payments by

the client)
 The costs for each of the project’s work elements
 Operating cost and plus a depreciation charge
 Overhead is to be included:
 Overhead includes G&A (general and administrative) and management
reserves
 G&A should include (1) general office equipment, copying machines, drafting
equipment, coffeemakers, (2) cost of senior management and support staff
 A fully costed work element would include direct costs (labor,
resources, and special machinery) plus overhead and G&A charges.
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 Cost Baseline

Cost baseline includes: Cost estimates + Contingency

reserve
 Cost baseline is a time-phased budget that will be
used to measure and monitor cost performance on the
project
It is developed by summing estimated costs by period
and is usually displayed in the form of an S-curve

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Cost Baseline

Management reserve is a
portion of the project budget
that’s used as a reserve for
management control and
unexpected costs

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 Cost Baseline
Development of S-curve: example

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 Cost Baseline
Development of S-curve: example

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 Cost Baseline
Development of S-curve: example

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