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Project Management A Managerial Approach Chapter 7 Budgeting and Cost Estimation.

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1 Project Management A Managerial Approach Chapter 7 Budgeting and Cost Estimation

2 zThe budget serves as a standard for comparison zIt is a baseline from which to measure the difference between the actual and planned use of resources zBudgeting procedures must associate resource use with the achievement of organizational goals or the planning/control process becomes useless zThe budget is simply the project plan in another form

3 Estimating Project Budgets zIn order to develop a budget, we must: yForecast what resources the project will require yDetermine the required quantity of each yDecide when they will be needed yUnderstand how much they will cost - including the effects of potential price inflation zThere are two fundamentally different strategies for data gathering: yTop-down yBottom-up

4 Top-Down Budgeting zThis strategy is based on collecting the judgment and experiences of top and middle managers zThese cost estimates are then given to lower level managers, who are expected to continue the breakdown into budget estimates zThis process continues to the lowest level

5 Top-Down Budgeting zAdvantages: yAggregate budgets can often be developed quite accurately yBudgets are stable as a percent of total allocation yThe statistical distribution is also stable, making for high predictability ySmall yet costly tasks do not need to be individually identified yThe experience and judgment of the executive accounts for small but important tasks to be factored into the overall estimate

6 Bottom-Up Budgeting zIn this method, elemental tasks, their schedules, and their individual budgets are constructed following the WBS or project action plan zThe people doing the work are consulted regarding times and budgets for the tasks to ensure the best level of accuracy zInitially, estimates are made in terms of resources, such as labor hours and materials zBottom-up budgets should be and usually are, more accurate in the detailed tasks, but it is critical that all elements be included

7 Bottom-Up Budgeting zAdvantages: yIndividuals closer to the work are apt to have a more accurate idea of resource requirements yThe direct involvement of low-level managers in budget preparation increases the likelihood that they will accept the result with a minimum of aversion yInvolvement is a good managerial training technique, giving junior managers valuable experience

8 Budgeting zTop-down budgeting is very common zTrue bottom-up budgets are rare ySenior managers see the bottom-up process as risky yThey tend not to be particularly trusting of ambitious subordinates who they fear may overstate resource requirements yThey are reluctant to hand over control to subordinates whose experience and motives are questionable

9 Work Element Costing zThe actual process of building a budget - either top-down or bottom-up - tends to be a straightforward but tedious process zEach work element in the action plan or WBS is evaluated for its resource requirements, and then the cost zDirect 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. zThere is also the General and Administrative (G&A) charge

10 An Iterative Budgeting Process zResource estimates and actual requirements are rarely the same for several reasons: yThe farther one moves up the organizational chart, the easier, faster and cheaper the job looks yWishful thinking leads the superior to underestimate cost (and time) because the superior has a stake in representing the project as a profitable venture yThe subordinates are led to build-in some level of protection against failure by adding an allowance for “Murphy’s Law”

11 An Iterative Budgeting Process zUsually the initial step toward reducing the difference between the superior’s and the subordinate’s estimates is made by the superior zThe superior agrees to be “educated” by the subordinate in the realities of the job zThe subordinate is encouraged by the superior’s positive response and then surrenders some of the protection of the budgetary “slop” zThis is a time consuming process, especially when the project manager is negotiating with several subordinates

12 Category/Activity Budgeting vs. Program Budgeting zThe traditional organization budget is either category oriented or activity oriented zOften based upon historical data accumulated through an accounting system zWith 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

13 Category/Activity Budgeting vs. Program Budgeting zUnder traditional budgeting methods, the budget could be split up among many different organizational units zThis diffused control so widely that it was almost nonexistent zThis problem gave rise to program budgeting which alters the budgeting process so that budget can be associated with the projects that use them

14 Program Budgeting zProgram budgeting aggregates income and expenditures across programs (projects) zAggregation by program is in addition to, not instead of, aggregation by organizational unit zThese budgets usually take the form of a spreadsheet with standard categories disaggregated into “regular operations” and charges to the various projects

15 Program Budgeting zProject Budget by Task and Month Task I J Estimate Monthly Budget (£) A B C D E F G H I J

16 Improving the Process of Cost Estimation zThere are two fundamentally different ways to manage the risks associated with the chance events that occur on every project: yThe most common is to make an allowance for contingencies - usually 5 or 10 percent yAnother is when the forecaster selects “most likely, optimistic, and pessimistic” estimates

17 Funding Non profitable Projects zThere are several reasons that firms would choose to fund a project that is not profitable: yTo develop knowledge of a technology yTo get the organization’s “foot in the door” yTo obtain the parts or service portion of the work yTo be in a good position for a follow-on contract yTo improve a competitive position yTo broaden a product line or a line of business

18 Learning Curves zStudies have shown that human performance usually improves when a task is repeated zIn general, performance improves by a fixed percent each time production doubles zMore specifically, each time the output doubles, the worker hours per unit decrease to a fixed percentage of their previous value zThat percentage is called the learning rate zThe project manager should take the learning curve into account for any task where labor is significant

19 Other Factors zAnywhere from about three-fifths to five-sixths of projects fail to meet their time, cost, and/or specification objectives zThere are several common causes: xArbitrary and impossible goals xScope creep xWildly optimistic estimates in order to influence the project selection process xChanges in resource prices xFailure to include an allowance for waste and spoilage xBad luck

20 Types of Estimation Error zThere are two generic types of estimation error: yRandom error - where overestimates and underestimates are likely to be equal yBias - a systematic error where the chance of overestimating and underestimating are not likely to be equal

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

22 Summary zIf projects include repetitive tasks with significant human input, the learning phenomenon should be taken into consideration when preparing cost estimates zThe 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

23 Summary zOther 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

24 Budgeting and Cost Estimation Questions?

25 Budgeting and Cost Estimation Picture Files

26 Budgeting and Cost Estimation Figure 7-1

27 Budgeting and Cost Estimation Figure 7-2

28 Budgeting and Cost Estimation Figure 7-4

29 Budgeting and Cost Estimation Table Files

30 Budgeting and Cost Estimation

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