Budgeting and Cost Estimation

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

7-1
Projects Make the Best of
Scarce Resources

7-2
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

7-3
NASA’s Pathfinder Rover:
Mars on a Shoestring

7-4
Why Budgeting for Projects is
Tougher
 By definition, projects are unique, non-
recurring efforts
 So there’s often little history, little
tradition to rely on
 Further, projects can last for years
 More uncertainty, more risk

7-5
Potential Project Life Cycles,
Figures 7-1 and 7-2

7-6
Two Major Approaches to
Budgeting
 Top-Down

 Bottom-Up

 Each has advantages . . . And

disadvantages as well

7-7
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

7-8
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

7-9
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

7-10
A Format for Gathering Data on
Project Resource Needs, Figure 7-3

7-11
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

7-12
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 . . .

7-13
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 don’t
want to be burned again.

7-14
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

7-15
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 req’d
for that unit
1 1000
2 800
4 640
8 512 7-16
Effects of Ignoring the
Learning Curve, Figure 7-4

7-17
Excel® Template for Cost
Estimation, Figure 7-5

7-18
Excel® Formulas for Figure 7-5

7-19
Estimation Template Using
Ratios, Figure 7-7

7-20
Formulas for Figure 7-7

7-21
Case: The Stanhope Project

7-22
From: The Stanhope Project,
Labor Buildup

7-23
Reading: Three Perceptions
of Project Cost

7-24
From: Three Perceptions of
Project Cost (Figure 2)

7-25
From: Three Perceptions of
Project Cost (Figure 3)

7-26