Budgeting and Cost Estimation

1. MGMT 483 Week 6 Budgeting and Cost Estimation

2. Budget problems? • The troubles on the Croton Water Filtration Plant project in New York

3. Estimating Project Budgets • The budgeting process always involves forecasting the level and type of resources needed to complete the project. • Many organizations will have well worn (and reasonably accurate) methods for creating the initial project estimate based on past experience. • However - every project is unique • So the estimating process always has some level of uncertainty (and therefore RISK) associated with it. • The PM must understand the organization’s accounting practices to the extent that they are imposed on the project budgeting and control process. Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

4. Cost estimation at NASA • “Cost estimation is part science, part art.” • There are many well defined processes within the cost estimating discipline. There is also a subjective element to cost estimating that makes the discipline an art form learned over time and through experience. • Cost estimating is not a “black box” process. The more understanding and credibility we gain with our customers, the more they will understand the structured process that cost estimators follow and the disciplined process and tools used in an estimate. • The current perception that cost estimating is a “black box” can be demystified by accurate, defensible, well-documented estimates that are consistently presented and can be easily understood. • NASA Cost Estimating Handbook

5. Budgeting • What is a budget? • 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 Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

6. 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 Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

7. Estimating Project Budgets • On most projects • Material + Labor + Equipment + Capital + Overhead + Profits = Bid • In other words • Resources + Profits = Bid • So budgeting is in effect, the task of forecasting resources Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

8. 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 (and therefore the RISK) Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

9. Estimating Budgets is Difficult • 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 • There is more “flexibility” regarding the estimates of inputs (material and labor) • The accounting system may not be set up to track project data Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

10. Types of Budgeting • Top-down • Bottom-up • Negotiated Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

11. Top-Down Budgeting • The technique of developing a budget by comparing this project to past ones using the judgment and experience of management. • Typically an overall budget is assigned to the project to be distributed to the individual tasks. • If the projects being used for comparison are similar enough, this process can result in a fairly accurate total number. • The process of distributing the total can create a lot of conflict among the management team. Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

12. Advantages & disadvantages of top-down budgeting Advantages Disadvantages More difficult to get buy in Leads to low level competition for larger shares of budget • 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 Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

13. Bottom-Up Budgeting • The process of developing budgets by asking the people who will perform the individual tasks on the WBS for their estimates. • These individual numbers are then rolled up to a summary for presentation to management. Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

14. Advantages & disadvantages of bottom-up budgeting Advantages Disadvantages Need a good WBS Can lead to game playing when individuals pad their estimates in anticipation of management cuts. Management has a tendency to trim the budget as they have not originated it • Greater buy in by low level managers • More likely to catch unusual expenses Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

15. Work Element Costing - Method • Using the bottom-up estimates, costs can be applied to each WBS element. • These are typically calculated by taking the labor hour estimate and ‘dollarizing’ it using appropriate labor and overhead rates. • To be accurate, the estimator needs to understand the relationship between the labor estimate and the actual number of hours that will be charged to the project because of personal time and inefficiencies. • A similar process must be used if machine time or other resources are charged to the project. Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

16. An Iterative Budgeting Process – Negotiation-in-Action • Typically the budgeting process requires some negotiation between the PM and senior management. • This is because the PM will be better informed on the technical details while management will know more about the financial realities of the business. • Together they need to discuss the project requirements and life cycle. • If the project is heavily dependent on testing and integration at the end, then it’s important to not short change the budget for the completion process. Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

17. Category Budgeting Versus Program/Activity Budgeting • Organizations are use to budgeting (and collecting data) by category • These activities correspond to “line items” in the budget • Examples include phone, utilities, direct labor,… • Projects need to accumulate data and control expenses differently – by collecting project costs according to the WBS • This results in program or activity budgeting Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

18. Typical Monthly Category Budget Table 7-1 Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

19. Project Budget by Task & Month Table 7-2 Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

20. 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 • Most projects are concerned only with estimating direct costs rather than indirect costs (although the PM will need to know which is required) • PM must build contingencies into the process to account for uncertainty. One way to do this is to use the process of developing likely , optimistic and pessimistic estimates. • Most firms add 5-10 percent for contingencies Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

21. 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 • Systematic • There is nothing we can do about random errors • Want to eliminate systematic errors Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

22. Incorporating Learning Curves • Studies and common sense have shown that as people repeat a task they get better at it. • This idea is formalized in the concept of the learning curve, which states that each time the output doubles the worker hours per unit decrease to a fixed percentage of their previous value. • This effect is important because the estimator must determine the impact learning had on past projects (and their rates) and predict its impact on the one being estimated. Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

23. A Special Case of Learning – Technological Shock • Projects that involve new technologies or processes are very difficult to estimate because past performance is not a useful guide. • An almost certain, immediate result of installing a new cost-saving program is that costs rise • May be resistance to change….or • When we alter a system, we disturb its functioning and it reacts in unpredictable ways Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

24. Other factors that lead to projects being over budget • Changes in resource costs due to factors like inflation – PM must build in appropriate contingencies – identifying areas of greatest exposure • Waste, spoilage, and labour turnover • People, as resources are not freely interchangeable with each other. The project may require five people, but if they are not the right people, the number available is irrelevant. Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

25. Factors common to projects involving intangible outputs such as software development • Ideas based on work by Fred Brooks – The Mythical Man Month • Tendency to underestimate the time intellectual work will take • A lot of risk is involved in projects that consist of a series of components, all of which must work for the project to succeed Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

26. The Mythical Man Month • We have a (mistaken) tendency to assume that workers and time are interchangeable, so adding more workers should reduce the time taken • Brooks asserts that: “adding manpower to a late software project makes it later” • Why? Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.

27. On Making Better Estimates • Data can be collected on the quality of project estimates by using statistical techniques. • The estimate is compared to the actual, and statistics like the Mean Absolute Deviation (MAD), the Mean Absolute Ratio (MAR) and the Tracking Signal can be calculated. • These are all used to detect bias or non-random error in the estimate. Meredith & Mantel (2009) Project management: a managerial approach. 7th ed. Wiley.