4/Budgeting the Project
Chapter 4
Budgeting the Project
This chapter continues the topic of project planning and focuses specifically on project budgeting. With the
technical aspects of project planning discussed in the previous chapter, this chapter addresses the need to develop a
budget in order to obtain the resources needed to accomplish the project’s objectives. The chapter begins with an
overview of budgeting methods and discusses both the top-down and bottom-up approaches. In comparing these
approaches, it is noted that top-down budgeting is usually accurate overall but may include significant errors for
low-level tasks. Bottom-up budgeting, on the other hand, is usually accurate for low-level tasks but risks
overlooking tasks. Following this overview of budgeting methods, the chapter next addresses the issues of cost
estimation and improving cost estimates. The need for PMs to thoroughly understand the organization’s
accounting system is emphasized. Also the issue of budget cuts is addressed. In terms of improving cost
estimates, techniques such as the use of learning curves and tracking signals are presented. Finally, the chapter
concludes with a discussion of budget uncertainty and risk management.
Cases and Readings
Some cases appropriate to the subject of this chapter are:
Harvard: 9-193-071 Porsche AG This 20-page case illustrates how traditional cost measurement systems operate
in an R&D department but offer little information for managing projects.
Harvard: 9-690-051 Campbell Soup Co. This 23-page case describes the cost-justification of a new engineering
project to develop a microwavable package and product for the growing convenience foods market segment. A
28 page teaching note (5-690-094) is available for this case.
A reading appropriate to the subject of this chapter is:
P. Armour. Ten UnMyths of Project Estimation (Communications of the ACM, 45(11), 2002). This reading
discusses some commonly accepted “unmyths” about estimating project costs. An “unmyth”, according to the
author, is something that appears to be true when looked at closely, is not true. The author draws attention to
some accepted practices associated with estimating project costs, duration, productivity, resource needs and so
on and suggests of treating these estimates.
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4/Budgeting the Project
Answers to Review Questions
1. Contrast the disadvantages of top-down budgeting and the bottom-up budgeting.
The main disadvantages of top-down budgeting are that:
o Significant errors may be made for low-level tasks,
o A lower level of budget acceptance is likely due to limited participation, and
o It provides little training opportunities in budgeting for junior managers.
The main disadvantage of bottom-up budgeting is the risk of overlooking tasks.
2. What is the logic in charging administrative costs based on total time to project completion?
Charging administrative costs based on total project completion time is based on the assumption that
administrative costs increase in proportion to the length of the project. In other words, longer projects are
expected to require more administrative resources than shorter projects.
3. Would you expect a task in a manufacturing plant that uses lots of complex equipment to have a learning
curve closer to 70 percent or 95 percent?
The learning rate corresponds to the reduction in time or cost as output doubles. Therefore, a lower learning
rate actually translates into a faster rate of learning. Generally speaking, people have the ability to learn
while machines do not.
Thus, if we assume by complex we mean automated, then the plant would have a slower learning rate of
perhaps 95 percent. On the other hand, if by complex it is assumed that workers need a great deal of skill to
operate the equipment, then a faster learning rate of 70 percent would be expected.
4. How does a tracking signal improve budget estimates?
Calculation of the number called the tracking signal can reveal if there are systematic biases in cost and other
estimates and whether or not these biases are positive or negative. Knowledge of such biases can:
o Be used in preparing future estimates, and
o Allows estimators to understand and correct their biases.
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4/Budgeting the Project
5. Are there other kinds of changes in a project in addition to the three basic types described in Section 4.4?
Might a change be the result of two types at the same time?
The three basic causes of changes listed in Section 4.4, namely:
o Errors made by the cost estimator with regard to how to achieve the tasks identified in the project
plan.
o Increased knowledge by either the team or the client as to the nature of the performance goal, and
o The passage of a new law, standard or policy.
These three causes would appear to capture the vast majority of change in projects.
As the question hints, however, two or more of these causes may occur at the same time. For example,
new knowledge of a competitor’s new product may change the performance goal of a project and also
require a change in how the tasks are achieved.
6. Distinguish among highly probable risks, extremely serious risks, and highly vulnerable areas in risk
identification.
o Highly probable risks have a high probability or likelihood of occurring. The consequences of these
risks can be negligible (a data entry person quits) to very serious (the drug fails in the Phase I clinical
trial).
o Extremely serious risks are risks that have very significant consequences although their probability of
occurrence may be very low to very high.
o Highly vulnerable areas refer to risks that are both highly probable and extremely serious.
Suggested Answers to Discussion Questions
7. Given the tendency of accountants to allocate a project’s estimated costs evenly over the duration of the
task, what danger might this pose for a project manager who faces the following situation? The major task
for a $5 million project is budgeted at $3 million, mostly for highly complex and expensive equipment. The
task has a six month direction, and requires the purchase of the equipment at the beginning of the task to
enable the project team to conduct the activities required to complete the task. The task begins December
1.
The accountant would likely assume that the $3,000,000 is to be allocated evenly over the six month duration
of the task or $500,000 per month. However, most of the $3,000,000 will likely be incurred at the beginning
of the task when the equipment must be acquired and paid for.
The problem for the PM is that the accountant will expect a $500,000 charge in the first month of this task
but will see an expenditure of close to $3,000,000! Based on this the accountant and top management may
become alarmed in terms of the project being completed on budget.
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4/Budgeting the Project
8. The chapter describes the problems of budgeting projects with S-shaped and exponential-shaped life cycle
curves. What might be the budget problems if the life cycle of a project was just a straight diagonal line
from 0 at project start to 100 percent at project completion?
A straight-line project life cycle means that the impact of a budget cut would be constant throughout the
project’s life. A slope greater than 45 degrees means a change in the budget would have a proportionally
larger impact on the project’s completion. Conversely, a slope less than 45 degrees means a change in the
budget would have a proportionately lesser impact on the project’s completion.
Of course it is unlikely in reality to observe a straight-line life cycle.
9. If a firm uses a budgeting program for its projects, is an activity budget not needed? If it is, then of what
value is the program budget?
Activity budgets segregate costs by types of expenditures - phone, labor, etc. - whereas program budgets
group costs according to the task or job that uses resources of all types to accomplish that task.
Program budgets, therefore, relate expenditures directly to the project’s action plan and simplifies the
project manager problem of managing the budget and making trade-offs.
10. As a senior manager, you oversee a project with a total estimated cost of 245 engineer-months of effort.
Three months ago, however, the project had fallen behind by about 25 engineer-months so you authorized
the hiring of three additional engineers, which you felt should more than make up for the delay in th
remaining year of the project (3 x 12 months = 36 engineer-months). You have just received the latest
quarterly project status report and are surprised to learn that the project is now 40 engineer-months
behind schedule! Your first reaction is to calculate how many more engineers need to be hired to make up
for the increased delay. Using Brook’s concept of the “mythical man month,” explain what might be
happening here.
According to the “mythical man month” effect, the three new engineers hired would be unlikely to hit the
ground running. They would almost certainly require training. This training would likely take time away from
other members of the project team. Thus, the extra capacity created by adding these three engineers was
likely more than used up by the other engineers who spent some of their time now training the new team
members.
11. So what went wrong with the purchasing manager’s assistant’s solution (outlined in Section 4.3) to the
problem of having an inadequate supply of hard-to-obtain parts?
The purchasing manager’s assistant’s solution (i.e., including a 10 percent allowance for additional, hard to
obtain parts in every cost proposal) only addressed the symptom of the problem. It did not focus on the
cause (i.e., why the company was short in the first place).
Furthermore, the solution created another problem, namely, that the organization was no longer cost
competitive.
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4/Budgeting the Project
12. Contrast simulation to other risk analysis tools. What are its advantages and disadvantages? If you were
to do an important risk analysis, which tool would you prefer?
o Simulation
A simulation involves the use of a model of a system to analyze the expected
behavior or performance of the system. Most simulations are based on some form
of Monte Carlo analysis which simulates a model’s outcomes many times to provide
a statistical distribution of the calculated results. The advantages of this
methodology are that it gives a graphic picture of the results and can be used to
determine the impact of whatever assumptions on wishes to make. On the
negative side, the outcomes are determined by the parameters used in the model.
o Game theory
This approach assumes that competitors and the environment are enemies trying to
do you in. The decision maker takes a pessimistic mind-set and selects a course of
action that minimizes the maximum harm that can result irrespective of the
probabilities. The advantage of this methodology is that it provides a specific worst
case outcome as opposed to a distribution which may be simpler for many
managers to understand. From a negative perspective, it doesn’t provide any
measure or insights into the upside potential of the project.
o Expected value
This methodology can be used when probability information is available or can be
estimated with the expected value being the value of the outcome multiplied by the
probability of that outcome occurring. The advantage of this method is that it gives
a specific value or outcome and can be used to test the sensitivity of the probability
information. However, the projections are limited by the range of probabilities that
the project manager sees as likely to occur.
Ideally, for a very important risk analysis, one would conduct all three approaches and compare and contrast
the outcomes. In reality, ones choice will be determined by the availability of data and probability estimates.
Solutions to Problems
13. As can be seen from the following Table, the number of hours needed to prepare the slides (given an 85%
learning rate) would be 50 hours in session 1, 42.5 hours in session 2, 36.1 hours in session 4, and 30.7 in
session 8. This enables the total cost per session to be calculated … and thus the total for the eight sessions.
Session
1
2
3
4
5
6
7
8
Total
Hours
50
42.5
38.6
36.1
34.3
32.8
31.7
30.7
V.C.
$5,000
$4,250
$3,865
$3,613
$3,428
$3,285
$3,168
$3,071
Fixed Cost Total Cost Cum Cost Cum Rev
$600
$5,600
$5,600
$5,172
$600
$4,850
$10,450
$10,344
$600
$4,465
$14,915
$15,516
$600
$4,213
$19,127
$20,688
$600
$4,028
$23,155
$25,860
$600
$3,885
$27,040
$31,032
$600
$3,768
$30,809
$36,204
$600
$3,671
$34,479
$41,376
$34,479
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4/Budgeting the Project
The total cost for the eight sessions is $34,479 to which your firm adds a 20 percent profit margin to give a bid
price of $41,375. The per session price, therefore, is $5,172. Comparing the cumulative revenue with the
cumulative cost, your firm will break even in the third session.
14. In Fig. 4.3 the mean bias is 11.35% (0.908/8) and the MAR is 0.160.
For the new estimates based on the multiplicative model, see the Table below.
Period
1
2
3
4
5
6
7
8
Total
Estimate
179
217
91
51
76
438
64
170
Actual
163
240
67
78
71
423
49
157
(At/Et) - 1 |(At/Et) - 1|
-8.9%
8.9%
10.6%
10.6%
-26.4%
26.4%
52.9%
52.9%
-6.6%
6.6%
-3.4%
3.4%
-23.4%
23.4%
-7.6%
7.6%
-12.9%
139.9%
MAR
Tracking
Signal
0.098
0.153
0.247
0.211
0.181
0.189
0.175
0.170
-1.615
1.142
1.027
1.005
-0.276
-0.735
The mean bias is -1.61% (-0.129/8) and the MAR is 0.175. Thus, the new model is slightly less accurate, but
has significantly less bias.
15. As shown in the table below, alternative d has the lowest expected cost and is thus the best alternative.
Alternative
a
b
c
d
Rainy
0.3
6
2
1
5
Cloudy
0.2
3
4
2
4
Sunny
0.5
4
5
7
3
Expected
Cost
4.4
3.9
4.2
3.8
16. The worst possible outcomes for Alternatives a, b, c and d are 6, 5, 7 and 5 respectively.
Alternative
a
b
c
d
Rainy
0.3
6
2
1
5
Cloudy
0.2
3
4
2
4
Sunny
0.5
4
5
7
3
Worst
Case
6
5
7
5
Alternatives b and d have the best (lowest) worst outcome.
17. In the spreadsheet shown below the project cost, nonengineering labor hours, material cost, and downtime
hours were all modeled using a triangular distribution. The engineering labor hours were modeled using a
uniform distribution over the range of 510 to 690 hours. As shown in the spreadsheet below, the project has
a 92.37% chance of meeting the firm’s NPV hurdle.
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4/Budgeting the Project
Hours
Proj Cost
Eng Labor
Non Eng Labor
Matl
Downtime
Total Cost
600
1633
112
Cost
$1,033,333
48,000
57,167
130,000
55,833
1,324,333
There is no solution provided for problem #18.
Incidents for Discussion Suggested Answers
Incidents for Discussion Included in the Chapter
A Budgeting Novice
Question: What do you think Alex should show to his boss, so that the boss would feel more comfortable letting
Alex determine and monitor the project’s budget?
Since the precedent has been set that a top-down approach to budgeting is used at this company, Alex should do
the same.
In the past, Alex has had autonomy to manage both performance and schedule, but has not been permitted to
develop the budget. Thus, it might be helpful for Alex to share documents with his boss that demonstrate his
competency in handling both schedule and performance (assuming his boss is not familiar with these). In addition
to documenting his previous experience, it would be useful for Alex to share with the boss his WBS and
demonstrate how this drove his cost estimates. Finally, Alex might find it useful to share with his boss how having
responsibility for only schedule and performance and not budget, limits his effectiveness as a project manager.
Another advantage for Alex’s boss is that more of his or her time would be freed up if Alex were permitted to work
on budget issues with clients.
Question: What should Alex say to persuade his boss?
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4/Budgeting the Project
Alex could approach his boss with sound estimates and assure the boss that he has involved all the experts in
preparing the budget. Most likely, the boss will still re-work the numbers, but he should be more comfortable that
Alex did his homework in preparing it. Alex must make timely communications to the boss on the project status,
including thorough budget reports.
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Stealth Electronics
Question: What should the CFOP do?
This is a difficult situation due to the lack of experience with building the systems. The only information the CFO
has available is the costs of building the prototype.
The CFO needs to:
o Put more certainty into the estimate of costs and the schedule of the project this will decrease the risk of
cost overruns.
o Make sure that the learning curve is taken into account for each of the steps involved in the project. The
time taken for each should be reduced by a learning rate.
o Work with the project manager to conduct three-time estimates for the durations and costs of each task in
the project.
o Be sure that uncertainty was accounted for in the project … and, based on that information, conduct a risk
analysis.
o Examine various outcomes and determine the probability of what will happen. Crystal Ball would be a
good tool for the CFO to use to conduct a thorough risk analysis.
General Sensor Company
Question: Under these circumstances, would Justin be wise to pursue a top-down or a bottom-up budgeting
approach?
Justin should combine the top-down approach with selected bottom-up inputs and checks on the 50% of cost
stage. He is experienced and comfortable with a top-down approach and this makes sense for the majority of the
project. Selective inputs from lower level workers involved in the tasks would confirm his estimates, or indicate
where more information is needed.
Why? What factors are most relevant?
The most relevant factors are the seriousness of the error, Justin’s experience, and the fact that only one stage is
affected, but it represents 50% of the cost.
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Suggested Case Analyses and Solutions
St. Dismas Assisted Living Facility Project Budget Development -- 2
Teaching Purpose: This installment of the St. Dismas case requires students to address issues related to identifying
and dealing with cost uncertainty
Question 1: The cost per square foot for the units is given in the text together with its standard deviation.
What other areas of cost or revenue are likely to have cost uncertainty?
Other areas of cost and revenue that are likely to be uncertain are the:
o
o
o
o
o
o
o
o
o
Contingency allowances.
Marketing costs.
Personnel replacement costs.
Resource costs.
General services and administration (GS&A) costs.
Overhead allocation to budget.
Influences such as weather on the construction.
Cost increases for equipment or furniture, and
Labor cost increases.
Question: How should these uncertainties be handled?
To handle the uncertainty, the estimators need to gain more knowledge of the areas of uncertainty and clearly
define all the assumptions that were used to determine the budget. Furthermore, they need to review the project
plans thoroughly to identify areas of risk. Finally, they should ensure that they have an effective change order
process in place in case there are the [inevitable] changes during the project.
Assuming cost or revenues are normally distributed, statistical and probability theory could be used to gain
additional insights. Of course, it is important that the project manager, working with the accounting department,
closely monitors all of the project costs.
Question 2: How would you suggest the team handle the issue of Dr. Link’s supposedly inflated medical
equipment costs?
Since these are expensive items, the CFO should recommend using a bottom-up approach to budgeting. The CFO
should set up a team consisting of both experts and the differing doctors to determine the actual equipment needs
and costs. This would (a) enable buy-in from both parties and (b) ensure a more accurate estimate of needs. If
there is sufficient data, the CFO can also include a tracking signal to identify if bias is in the estimates.
Photstat Inc.
Teaching Purpose: This case provides students with an opportunity to analyze the risk of a project with several
uncertain parameters. Students are asked to simulate the completion of this project 1000 times and create a risk
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4/Budgeting the Project
profile for the project. Based on this, students are asked to comment on the implications of using an average value
versus the risk profile. Case should be analyzed using Crystal Ball.
Question 1: What is the expected value of the project?
The spreadsheet below was created to calculate the expected value for this project. It is worth noting that one
simplification was made. Namely, only the cash flows for the first six years as opposed to the first six-and-a-half
years were discounted in calculating the NPV of the project. According to the spreadsheet, the expected value of
this project is $1,221,361 (see cell P5). The expected value would be perhaps $100,000 to $200,000 higher had the
cash flows for the first half of the seventh year also been included.
Expected Value Calculation
B
1
2
3
4
5
C
D
E
F
G
H
I
J
K
L
M
N
O
P
Market Selling
Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow
Size
Price Market Market
VC
Equip Useful
Year
Year
Year
Year
Year
Year
10.00%
Year 1 Year 1 Share Growth Year 1 Inflation
Cost
Life
1
2
3
4
5
6
NPV
100,000 $12.50 30.00% 10.00% $3.00
3.00% $500,000 6.5
-$215,000 $322,905
$365,851
$414,510
$469,639
$532,101 $1,221,361
Question 2: Simulate this project 1000 times and compute the average profit over the 1000 replications. Plot a
histogram of the outcomes of the 100 replications.
The use of Crystal Ball can greatly speed up the development and analysis of the simulation model for this case.
To illustrate this, the spreadsheet shown on the following page was created.
With Crystal Ball, values for the random parameters are generated by defining cells as Assumption Cells rather
than using Excel’s Random Number Generation tool. In this particular case, cells B5 to I5 were defined as
assumption cells. For example, cell B5 corresponds to the market size in the first year of the product’s
introduction. From the case, it is estimated that the market size follows a normal distribution with a mean of
100,000 units and standard deviation of 10,000 units. To define cell B5 as an Assumption Cell, first the cursor was
placed in this cell. Next, the Define Assumption button was selected. Then the Normal distribution was selected
from the Distribution Gallery that appeared. In the next window, 100,000 was entered in the Mean field and
10,000 was entered in the Std Dev field and the OK button selected. Cells C5 to H5 were specified in a similar
fashion.
Cell I5 was a little different in that the useful life of the equipment does not follow a continuous distribution. In
this case, the Custom distribution was selected from the Distribution Gallery. Next 3 was entered in the Value
field and .1 entered in the Prob. field and the Enter button clicked. In a similar fashion, 6 was then entered in the
Value field, .8 in the Prob. field and the Enter button clicked. This was repeated for the probabilities of 8 year
and 10 year useful lives, respectively. After all this information was entered, OK was clicked.
Finally, cell P5 was defined as the Forecast Cell. NPV was entered as a descriptive name in the Forecast Name
field and Dollars in the Units field. The formulas in cells J5:O5 are the same as was previously discussed. To run
the simulation, the Start Simulation button was selected.
The Frequency Chart and Statistics views are shown below.
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4/Budgeting the Project
Crystal Ball’s Frequency Chart View
Crystal Ball’s Statistics View
Question: How does the average of the simulation compare to the expected value you calculated? What are the
managerial implications of this difference?
The average of the simulation was $1,423,668 which is relatively close to the expected value. However, the range
of values observed in the simulation experiment varied from a loss of almost $65,000 to a profit of over $4.5
million. Thus, the simulation experiment demonstrates the uncertainty of the actual outcome of this project.
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