Cost Estimation

and Budgeting

Chapter 8

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-1

 Cost management
• Cost reflects organization’s strategic goals,
mission statement and business plan.
• Cost management: to encompass data
collection, cost accounting, cost control, taking
financial information and apply to project to
maintatin a clear sense of money management
for a project.
• Cost estimation: determining whether project is
viable or not; creating time-phased budget

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-2

 Common Sources of Project Cost
 Labor: hiring and paying personnel involved (no of labor,
salary, hourly rates, overheads…)

 Materials: specific supplies to complete project tasks.

 Subcontractors: hiring marketing consultants, industrial
designer

 Equipment & facilities

 Travel: car rental, airfare, hotels, meals..

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 Types of Costs

Direct Vs. Indirect

Recurring Vs. Nonrecurring

Fixed Vs. Variable

Normal Vs. Expedited

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 Direct vs indirect cost
Direct: labor and materials
Total direct labor cost= Hourly rate x Hours needed

Indirect cost
- Overheads (indirect materials, utilities, taxes, insurance,
property and repairs, depreciation, health and retirement…)

- Selling and administrative cost (advertising, shipping,

commission, sales and secretarial support..)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-5

 Recurring vs Nonrecurring costs
Recurring cost: typically continure to operate over
the project life’s cycle.
Non-recurring cost: applied once at the beginning
or end of the project, ex. Preliminary marketing
analysis, personnel training, outplacement
services…

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-6

 Fixed and Variable cost
• Fixed cost: do not vary with respect their usage
(leasing)
• Variable cost: accelerate through usage
(equipment, material)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-7

 Normal and expedited
• Normal: incurred in the routine process of
working to complete the project.
• Expedited: unplanned cost incurred to speed up
the project (crashing cost, overtime. Hiring
additional personnel..)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-8

 Cost Classifications

Non-recurring

Expedited
Recurring

Variable
Normal
Indirect
Direct

Fixed
Costs
Direct Labor X X X X
Building Lease X X X X
Expedite X X X X
Material X X X X

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 Cost Estimation

 Ballpark (order of magnitude) ±30%: when information and time is

scarce

 Comparative ±15% (parametric estimation): based on the

assumption of historical data as reference for similar projects

 Feasibility ±10%: after completion of preliminary project design work

(WBS)

 Definitive ±5% after the completion of most design work and when

scope and capabilities of project are well understood.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-10
 Learning Curves
Each doubling of output results in a reduction
in time to perform the last iteration.

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)

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-11

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-12
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-13
 Estimating senior programmer’s time
No learning effect:
$35/hr x 4 iterations x 1.6 x 40 hours= $ 8960
Learning effect 90%
b= log0.9/log2= -0.1521
40hrs= a* (4)-0.1521 => a= 49.39 hrs
Multiplier for first 3 iterations = 1 +0.9+ 3-0.1521 = 2.746
Total hours for the first 3 interations= 49.39 * 2.746 = 135.62
Total time for 4 iterations= 135.62+ 40= 175.62
Total cost= 175.62 * 35 *1.6= $9834.72

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 Problems with Cost Estimation

 Low initial estimates: misperception of scope,

underestimation to get project approved

 Unexpected technical difficulties

 Lack of definition: poorly defined purpose, goals

 Specification changes

 External factors: inflation, financial crisis, worldwide

shortage of materials
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 Creating a Project Budget
WBS The budget is a plan
that identifies the
resources, goals and
Project
schedule that allows
Plan
a firm to achieve
Scheduling Budgeting those goals

• Top-down
• Bottom-up

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 Top-Down Budgeting
• Top managers estimate/decide on the overall
budget for the project
• These trickle down through the organization
where the estimates are broken down into
greater detail at each lower level
• The process continues to the bottom level

7-17
 argue between departments to get more budget

Top down budgeting

Advantages Disadvantages
• Quite accurate in • Create friction within
aggregate organisation (zero-sum
• Overall project budgets game)
can be set/controlled very
accurately
– A few elements may have
significant error
• Management has more
control over budgets
• Small tasks need not be
identified individually
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 Bottom-Up Budgeting
• Project is broken down into work packages
• Low level managers price out each work
package
• Overhead and profits are added to develop the
budget

7-19
 functional management calculate the cost

Bottom up budgeting

Advantages Disadvantages
• Facilitate the coordination • Reduce top management
within organisation control of budgeting
• Allow top managers a process
clear view for • Significant difference
prioritization among between strategic
projects concern and operation
• Detailed estimation activities
• More likely to catch • People tend to overstate
unusual expenses their budget requirements
• Management tends to cut
the budget
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8-20
 Estimating Projects: Preferred
Approach
• Make rough top-down estimates.
• Develop the WBS/OBS.
• Make bottom-up estimates.
• Develop schedules and budgets.
• Reconcile differences between top-down
and bottom-up estimates

5–21
 Sample Project budget

Activity Direct Cost Budget Total cost

Overhead
Survey 3500 500 4000

Design 7000 1000 8000

Clear site 3500 500 4000

Foundation 6700 750 7500

Framing 8000 2000 10000

Plumb and Wire 3750 1250 5000

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 Sample budget tracking planned
and actual activity costs

Activity Planned Budget Actual Variance

Survey 4000 4250 250

Design 8000 8000 0

Clear site 4000 3500 -500

Foundation 7500 8500 1000

Framing 10000 11250 1250

Plumb and Wire 5000 5505 150

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Total 40650
Education, Inc. Publishing as Prentice Hall 2150 8-23
 Time-phased budget
Activity Jan Feb March Apr May Total by
Activity
Survey 4000 4000

Design 5000 3000 8000

Clear site 4000 4000

Foundation 7500 7500

Framing 8000 2000 1000

Plumb and 1000 4000 5000

Wire
Monthly 4000 9000 10500 9000 6000
planned
Cumulative 4000 13000 23500 32500 38500 38500
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 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
• Murphy’s Law is present
• Cost estimation must anticipate interaction costs
• Normal conditions are rarely encountered
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