Project Management:

A Managerial Approach 4/e

By Jack R. Meredith and Samuel J. Mantel, Jr.

Published by John Wiley & Sons, Inc.

Presentation prepared by RTBM WebGroup

Project Management
A Managerial Approach

Chapter 7

Budgeting and Cost Estimation

Budgeting and Cost
Estimation
The budget serves as a standard for comparison
It is a baseline from which to measure the
difference between the actual and planned use
of resources
Budgeting procedures must associate resource
use with the achievement of organizational goals
or the planning/control process becomes useless
The budget is simply the project plan in another
form
Chapter 7-1
Estimating Project
Budgets

In order to develop a budget, we must:

Forecast what resources the project will require
Determine the required quantity of each
Decide when they will be needed
Understand how much they will cost - including the
effects of potential price inflation
There are two fundamentally different strategies for
data gathering:
Top-down
Bottom-up
Chapter 7-2
Top-Down Budgeting
This strategy is based on collecting the
judgment and experiences of top and middle
managers
These cost estimates are then given to lower
level managers, who are expected to
continue the breakdown into budget
estimates
This process continues to the lowest level
Chapter 7-3
Top-Down Budgeting
Advantages:
Aggregate budgets can often be developed quite
accurately
Budgets are stable as a percent of total allocation
The statistical distribution is also stable, making for high
predictability
Small yet costly tasks do not need to be individually
identified
The experience and judgment of the executive accounts
for small but important tasks to be factored into the overall
estimate Chapter 7-4
Bottom-Up Budgeting
 In this method, elemental tasks, their schedules,
and their individual budgets are constructed
following the WBS or project action plan
 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
 Bottom-up budgets should be and usually are, more
accurate in the detailed tasks, but it is critical that
all elements be included
Chapter 7-5
Bottom-Up Budgeting
Advantages:
Individuals closer to the work are apt to have a
more accurate idea of resource requirements
The direct involvement of low-level managers in
budget preparation increases the likelihood that
they will accept the result with a minimum of
aversion
Involvement is a good managerial training
technique, giving junior managers valuable
experience
Chapter 7-6
Budgeting
Top-down budgeting is very common
True bottom-up budgets are rare
Senior managers see the bottom-up process as
risky
They tend not to be particularly trusting of
ambitious subordinates who they fear may
overstate resource requirements
They are reluctant to hand over control to
subordinates whose experience and motives are
questionable
Chapter 7-7
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

Chapter 7-8
Work Element Costing

Determine resource requirements and

then costs for each task
fixed costs (e.g., materials)
labor time
labor rate
equipment time
equipment rate
overhead
GS&A
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
“Murphy’s Law”
Chapter 7-9
An Iterative Budgeting
Process
 Usually the initial step toward reducing the difference
between the superior’s and the subordinate’s 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 superior’s 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

Chapter 7-10
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
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

Chapter 7-11
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

Chapter 7-12
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
Chapter 7-13
Program Budgeting
 Project Budget by Task and Month
Monthly Budget (£)
Task I J Estimate 1 2 3 4 5 6 7 8

A 1 2 7000 5600 1400

B 2 3 9000 3857 5143
C 2 4 10000 3750 5000 1250
D 2 5 6000 3600 2400
E 3 7 12000 4800 4800 2400
F 4 7 3000 3000
G 5 6 9000 2571 5143 1286
H 6 7 5000 3750 1250
I 7 8 8000 2667 5333
J 8 9 6000 6000
75000 5600 12607 15114 14192 9836 6317 5333 6000

Chapter 7-14
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

Chapter 7-15
Funding Non profitable
Projects
There are several reasons that firms would
choose to fund a project that is not profitable:
To develop knowledge of a technology
To get the organization’s “foot in the door”
To obtain the parts or service portion of the work
To be in a good position for a follow-on contract
To improve a competitive position
To broaden a product line or a line of business
Chapter 7-16
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
 The project manager should take the learning curve into
account for any task where labor is significant
Chapter 7-17
Learning Curves

where
Tn = the time required to complete the nth
unit
T1 = the time required to complete the first
unit
r = log(learning rate)/log(2)
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
Chapter 7-18
Types of Estimation Error
There are two generic types of estimation
error:
Random error - where overestimates and
underestimates are likely to be equal
Bias - a systematic error where the chance of
overestimating and underestimating are not
likely to be equal

Chapter 7-19
BUDGET UNCERTAINTY
AND RISK MANAGEMENT
Budgeting the Project
Risk

Risk management - the art and science

of identifying, analyzing, and
responding to risk factors throughout
the life of a project and in the best
interest of its objectives.
Project risk – any possible event that can
negatively affect the viability of a project
Risk Vs Amount at Stake
Process of Risk Management

What is likely to happen?

What can be done?
What are the warning signs?
What are the likely outcomes?
*Project Risk = (Probability of Event)(Consequences of Event)
Four Stages of Risk
Management

Risk identification

Analysis of probability and consequences

Risk mitigation strategies

Control and documentation

Risk Clusters
Financial • Commercial
Technical • Execution
Contractual/Legal
Common Types
Absenteeism – Skills unavailable
Resignation – Ineffective Training
Staff pulled away – Specs incomplete
Time overruns – Change orders
Risk Factor Identification

Brainstorming meetings

Expert opinion

Past history

Multiple (team based) assessments

Risk Management Assessment
Matrix
Consequences
Low Low High
Likelihood
High

7-31
Risk Mitigation Strategies

Accept
Minimize
Share
Transfer
Contingency Reserves
Task contingency
Managerial contingency
Mentoring
Cross training
Three Basic Causes for
Change in Projects

Errors made by cost estimator about

how to achieve tasks.
New knowledge about the nature of
the performance goal or setting.
A mandate.
Failure Mode and Effect
Analysis (FMEA)

List ways project might fail

Evaluate severity (S) of each failure
Estimate likelihood (L) of each failure
occurring
Estimate ability to detect each failure (D)
Calculate Risk Priority Number (RPN)
Sort potential failures by their RPNs
Other Approaches

Game Theory
Expected Value
Simulation
Summary
The intent of a budget is to communicate
organizational policy concerning the organization’s
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

Chapter 7-20
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

Chapter 7-21
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

Chapter 7-22
Budgeting and Cost Estimation

Questions?

Chapter 7-23
Budgeting and Cost Estimation

Picture Files
Budgeting and Cost Estimation

Figure 7-1
Budgeting and Cost Estimation

Figure 7-2
Budgeting and Cost Estimation

Figure 7-4
Budgeting and Cost Estimation

Table Files
Budgeting and Cost Estimation
Budgeting and Cost Estimation
Budgeting and Cost Estimation
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