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, nonrecurring 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