Dr Siti Nurhaida Khalil

Chapter 8

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.
 The budget is simply the project plan in another form

Chapter 8-1
 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 2 fundamentally different strategies for data
gathering:
 Top-down
 Bottom-up

Chapter 8-2
 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 8-3
 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 8-4
 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 8-5
 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 8-6
 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 8-7
 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 8-8
 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

Chapter 8-9
 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 8-10
 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 8-11
 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 8-12
 What extra expenses did the contractor incur in
order to finish ahead of schedule?

 How can one tell whether they are spending too

much to finish early, thereby saving not only time
but also overhead cost?
 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 8-13
 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 8-14
 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 8-15
 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 8-16
 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 8-17
 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 8-19
 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 8-20
 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 8-21
 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 8-22
Questions?

Chapter 8-23
 Why do consulting firms frequently subsidize some projects? Is
this ethical?

 Why is it “ethically necessary to be honest” in negotiations

between a superior and subordinate?

Chapter 8-28