Budgeting and Cost Estimation

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Budgeting and Cost Estimation

• Budgets defined
• Two major approaches
• Pros and Cons
• Behavioral issues
• Financial issues

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Projects Make the Best of Scarce Resources
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Developing a Project Budget

• Three major elements
• Forecast what will be needed
• Labor and material
• How much will it cost?
• When will it be needed?
• Thus, the budget reflects the project plan,
  time-phased, in dollars

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NASAs Pathfinder Rover Mars on a Shoestring
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Why Budgeting for Projects is Tougher

• By definition, projects are unique, non-recurring
  efforts
• So theres often little history, little tradition
  to rely on
• Further, projects can last for years
• More uncertainty, more risk

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Potential Project Life Cycles, Figures 7-1 and 7-2
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Two Major Approaches to Budgeting

• Top-Down
• Bottom-Up
• Each has advantages . . . And disadvantages as
  well

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Top-Down Budgeting

• Based on managerial judgment, and historical data
• History can include actual costs from similar
  projects, adjusted for differences and for
  inflation
• Start at the top, and allocate down through the
  WBS

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Pros and Cons of Top-Down Budgeting

• Pros
• Quick, simple
• Fair accuracy overall, though individual elements
  may be in error
• Small tasks need not be individually identified
• Cons
• Limited buy-in by junior managers
• Senior managers views may be biased
• Using data from dissimilar projects, or old
  projects, can mislead

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Bottom-Up Budgeting

• Starts at the bottom of the WBS, with the people
  who do the work
• Then costs are aggregated upward
• Overhead, project reserves, and profit have to be
  added in

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A Format for Gathering Data on Project Resource
Needs, Figure 7-3
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Pros and Cons of Bottom-Up Budgeting

• Pros
• More accurate, in detailed elements
• The benefits of participative management
• Differences of opinion can be resolved
• Cons
• Overlooking a task can be a costly error
• Time-consuming to prepare
• Estimates can be padded at every level

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Behavioral Issues in Budgeting

• Different perspectives, based on managerial level
• Senior people tend to underestimate, junior
  people tend to overestimate
• Lower levels tend to arbitrarily add reserves,
  upper levels to arbitrarily delete them
• Bottom Line Any system can be gamed
• So know what the games are . . .

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Behavioral Issues in Budgeting Emanon Aircraft
Corporation

• Loss of business Problem or symptom?
• Keep asking Why?
• Emanon loses business. Why?
• . . . Because bids are too high. Why?
• . . . Because material estimates are inflated.
  Why?
• . . . Because purchasing is adding its own
  reserve. Why?
• . . . Because they were burned once, and dont
  want to be burned again.

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Financial Issues Worth Considering Inflation

• Inflation can distort estimates in different ways
• Actual costs from the past will be less than
  comparables for today the older the data, the
  greater the disparity
• Long-duration projects can create special
  problems
• Six percent inflation doubles cost in just 12
  years . . .
• . . . And 6 is low in much of the world

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Financial Issues Worth Considering Learning Rate

• As output doubles, labor hours per unit decrease
  by a fixed percentage
• For example, the first unit of output takes 1,000
  hours, and the learning rate is 80

Unit Labor hours reqd for that unit
1 1000
2 800
4 640
8 512
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Effects of Ignoring the Learning Curve, Figure 7-4
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Excel Template for Cost Estimation, Figure 7-5
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Excel Formulas for Figure 7-5
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Estimation Template Using Ratios, Figure 7-7
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Formulas for Figure 7-7
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Case The Stanhope Project
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From The Stanhope Project, Labor Buildup
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Reading Three Perceptions of Project Cost
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From Three Perceptions of Project Cost (Figure
2)
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From Three Perceptions of Project Cost (Figure
3)