Chapter 6

BUDGETING AND COST ESTIMATION

Low Bids
If you are bidding on a project, do you want your bid

to be as low as possible and still make a profit?

Accept Low Bid

If you are accepting bids on a project, do you want to

accept the lowest bid?

Estimating Project Budgets

On most projects Material + Labor + Equipment + Capital + Overhead + Profits = Bid

In other words Resources + Profits = Bid

So we are left with the task of forecasting resources

Budgeting

A plan for allocating scarce resources to the

various endeavors of an organization A budget implies constraints Thus, it implies that managers will not get everything they want or need It is always related to certain period of time

Budgeting

Continued

The budget for an activity also implies

management support for that activity The higher the budget, relative to cost, the higher the managerial support The budget is also a control mechanism
Many organizations have controls in place that prohibit exceeding the budget Comparisons are against the budget

Estimating Project Budgets

Continued

Like any forecast, this includes some uncertainty There is uncertainty regarding usage and price Especially true for material and labor The more standardized the project and

components, the lower the uncertainty The more experienced the cost estimator, the lower the uncertainty

Estimating Budgets is Difficult

1. 2. 3. 4. 5. 6.

There may not be as much historical data or none at all Even with similar projects, there may be significant differences Multiple people have input to the budget Multiple people have some control over the budget The accounting system may not be set up to track project data Usage of labor and material is very lumpy over time

Types of Budgeting
Top-down 2. Bottom-up 3. Negotiated
1.

Top-Down Budgeting
A certain amount of money is allocated to carry out the project

activities which has to be split between sub projects. The allocation is based on the estimates of senior management (judgments/ experience of similar past projects/activities). Aka: BBS Budget Breakdown Structure These managers estimate overall project cost as well as the cost of major sub projects. The estimates are then given to the lower managers to continue that for smaller activities

Advantages
Overall project budgets can be set/controlled very accurately Management has more control over budgets Do not need to do as much up-front planning The allocation of the costs to sub-activities creates a degree of

competition among the concerned supervisors which is beneficial to the project completion.
Unpredictability, risk factor for small individual tasks taken care

of at a higher level and does not affect the ultimate figures.

Disadvantages
Strong bias toward underestimating costs Leads to low level competition for larger shares of

budget

A Format for Gathering Data on Project Resource Needs

7-13

Bottom-up Budgeting
The estimates of each level in the WBS are completed

and added together by each level of supervision in the project hierarchy.

The elemental tasks, their schedules and their individual budgets are constructed following the WBS

The people doing the work are consulted regarding

the times and budget, to ensure the best level of accuracy.

Contd
Initially

the estimates are based on resourceslabor-hr. Material etc. and later converted to monetary terms. Standard analysis tools such as learning curve analysis and work sampling are employed to improve the estimates. Senior/Junior Managers and Project Managers sit together to set aside differences of opinions regarding estimates. Resulting task budget are aggregated to give the total direct costs of the project. The project manager then adds the indirect costs (overheads), project contingency and a profit figure to arrive at the project price/budget.

Advantages
Estimates are prepared by people who will carry out

the activities. This brings in commitment to achieve those figures at their level. More likely to catch unusual expenses

Disadvantages
Where it is common for costing proposals to be cut by

project managers, the activity level costs are artificially inflated as the staff try to offset the effect of such cuts. The process thus delivers inaccurate estimates and loses credibility. The axiom The whole is greater than the sum of its parts makes this method of estimating inaccurate.

Top-Down versus Bottom-Up Estimating

Conditions for Preferring Top-Down or Bottom-up Time and Cost Estimates
Condition Strategic decision making Cost and time important Macro Estimates X X Micro Estimates

High uncertainty
Internal, small project Fixed-price contract Customer wants details

X
X X X

Unstable scope

Top-Down and Bottom-Up Estimates

Budget Contingencies
The allocation of extra funds to cover uncertainties and improve the chance of finishing on time. Contingencies are needed because Project scope may change Murphys Law is present Normal conditions are rarely encountered

8-20

Time-Phased budget
Months
Activity Survey Design Clear Site Foundation Framing Plumb & Wire Monthly Planned Cumulative 4,000 4,000 9,000 13,000 10,500 23,500 January 4,000 5,000 4,000 7,500 8,000 1,000 9,000 32,500 2,000 4,000 6,000 38,500 38,500 3,000 February March April May Total by Activity 4,000 8,000 4,000 7,500 10,000 5,000

8-21

8-22

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
Thus, Work element cost include Direct cost (labor, resources, special

machinery) plus overhead plus G & A charges

Negotiated Budgets
Most projects use some combination of top-down

and bottom-up budgeting Both are prepared and compared Any differences are negotiated

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 Murphys Law

An Iterative Budgeting Process

IN AN IDEAL WORLD!!!
Usually the initial step toward reducing the difference between the superiors and the subordinates 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 superiors 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

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 These activities correspond to line items in the budget

Examples include phone, utilities, direct labor,

Projects need to accumulate data and control expenses

differently 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

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

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

Typical Monthly Budget

Table 7-1

Project Budget by Task & Month

Table 7-2

Improving The Process of Cost Estimation

Inputs from a lot of areas are required to estimate

a project May have a professional cost estimator to do the job Project manager will work closely with cost estimator when planning a project We are primarily interested in estimating direct costs Indirect costs are not a major concern

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 5 or 10 percent Another is when the forecaster selects most likely, optimistic, and pessimistic estimates

Problems
Even with careful planning, estimates are wrong

Learning Curve

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

An 80% learning curve

Unit 1ST 2ND 4TH 8TH 16TH 32ND Man hours 1000 800 640 512 410 328

1000 X .80 800 X .80 640 X .80 512 X .80 410 X .80

Learning Curves

Learning Curve Formula

Yx aX b Where : Yx = time required for the x unit of output a = time required for the initial unit of output X = the number of units to be produced b = learning curve slope = log(learning %)/log(2)

The project manager should take the learning curve into

account for any task where labor is significant.

Learning Curve Example

Consider a project that requires 25 units of a complex

electronic device to be assembled. The firm has no prior experience in building this specific device. Other firms experience indicate that if a firm were to build many such devices, it would use about 70 hours of direct labor per unit. If labor is paid a wage of $12 per hour, Calculate the labor cost.

Example contd..
First Approach:-

Direct Labor Cost = ($12/hr)*(25 units)*(70hr/unit) = $21,000

Learning Curve Approach:-

From experience, it is known that for the first 20 units there is a learning curve and the usual learning rate for assemblers is about 85%. Assumption: Tn = 70 hours by the unit n = 20 Using the Learning curve formula, T1 = 141.3 hr

Example contd..
Similarly, we can calculate time for all other units,

eventually getting to the total time required to build all 20 units. Total time for 20 units = 1752.12 hr The last five units are produced in the steady state time of 70 hours each. So, total time to produce 25 units is =1752.12 + 5(70hr) = 2102.12 hr New Direct Labor Cost = ($12/hr)*(2101.12 hr) = $25225.44 When ignored learning effects, cost understated by = $25225.44 - $21000 = $4225.44

Effects of Ignoring the Learning Curve

Table 7.3

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

Making Better Estimates

Projects are known for being over budget It is unlikely that this is due to deliberate underestimating There are two types of errors Random : where overestimates and underestimates are likely to be equal Systematic Bias : a systematic error where the chance of overestimating and underestimating are not likely to be equal There is nothing we can do about random errors Want to eliminate systematic errors Two statistical measures Mean Absolute Deviation Tracking Signal

Summary
The

intent of a budget is to communicate organizational policy concerning the organizations goals and priorities There are a number of common budgeting methods: top-down, bottom-up, and the program budget Firms will fund projects whose returns cover direct but not full costs in order to achieve long-run strategic goals of the organization

Summary
If projects include repetitive tasks with significant

human input, the learning phenomenon should be taken into consideration when preparing cost estimates
The learning curve is based on the observation that

the amount of time required to produce one unit decreases a constant percentage every time the output doubles

Summary
Other major factors, in addition to learning, that

should be considered when making project cost estimates are inflation, differential changes in the cost factors, waste and spoilage, personnel replacement costs, and contingencies for unexpected difficulties