Chapter 7
Budgeting:
Estimating Costs
and Risks
Copyright 2015 John Wiley & Sons, Inc.
Budgeting
⚫ A plan for the costs of project resources
⚫ A budget implies constraints
⚫ Thus, it implies that managers will not get
everything they want or need
7-2
Budgeting Continued
⚫ The budget for an activity also implies
management support for that activity
⚫ Higher the budget, relative to cost, higher
the managerial support
⚫ The budget is also a control mechanism
– Many organizations have controls in place
that prohibit exceeding the budget
– Comparisons are against the budget
7-3
Estimating Project Budgets
⚫ On most projects
– Material, Labor, Equipment, Capital,
Overhead, In other words Resources
⚫ So we are left with the task of forecasting
resources
7-4
Estimating Project Budgets Continued
⚫ Like any forecast, this includes some
uncertainty
⚫ There is uncertainty regarding usage and
price
– Especially true for material and labor
⚫ The more standardized the project and
components, the lower the uncertainty
⚫ The more experienced the cost estimator,
the lower the uncertainty
7-5
Budgeting Concepts
⚫ Tradition
⚫ Life cycle costing
⚫ Actual costs and earned value analysis
⚫ Tracing expenses to specific tasks
7-6
Estimating Budgets is Difficult
⚫ There may not be as much historical
data or none at all
⚫ Even with similar projects, there may be
significant differences
⚫ Many people have input to the budget
7-7
Estimating Budgets is Difficult Continued
⚫ Multiple people have some control over
the budget
⚫ There is more “flexibility” regarding the
estimates of inputs (material and labor)
⚫ The accounting system may not be set
up to track project data
⚫ Usage of labor and material is very
lumpy over time
7-8
Types of Budgeting
⚫ Top-down
⚫ Bottom-up
⚫ Negotiated
7-9
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
⚫ Sometimes viewed as zero-sum game
⚫ The process continues to the bottom level
7-10
Advantages
⚫ Overall project budgets 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
7-11
Disadvantages
⚫ More difficult to get buy in
⚫ Leads to low level competition for larger
shares of budget
7-12
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
7-13
Advantages
⚫ Greater buy in by low level managers
⚫ More likely to catch unusual expenses
7-14
Disadvantages
⚫ People tend to overstate their budget
requirements
⚫ Management tends to cut the budget
7-15
Work Element Costing
⚫ Labor rates include overhead and
personal time
⚫ Direct costs usually do not include
overhead
⚫ General and administrative (G&A) charge
7-16
Estimation Examples
⚫ Assume a work element is estimated to
require 25 hours of labor by a technician.
⚫ The specific technician is paid $17.50/hr.
⚫ Overhead charges to the project are 84
percent of direct labor charges
25 hr × $17.50 × 1.84 = $805.00
⚫ Assume 12% personal time
1.12 × 25 hr × $17.50 × 1.84 = $901.60
7-17
An Iterative Budgeting Process–
Negotiation-in-Action
⚫ Most projects use some combination of
top-down and bottom-up budgeting
⚫ Both are prepared and compared
⚫ Any differences are negotiated
7-18
Category Budgeting Versus
Program/Activity Budgeting
⚫ Organizations are used to budgeting (and
collecting data) by activity
⚫ These activities correspond to “line items”
in the budget
– Examples include phone, utilities, direct
labor,…
⚫ Projects need to accumulate data and
control expenses differently
⚫ This resulted in program budgeting
7-19
Typical Monthly Budget
7-20
Project Budget by Task & Month
7-21
Improving The Process of Cost
Estimation
⚫ Inputs from a lot of areas are required to
estimate a project
⚫ May have a professional cost estimator to
do the job
⚫ Project manager will work closely with
cost estimator when planning a project
⚫ We are primarily interested in estimating
direct costs
⚫ Indirect costs are not a major concern
7-22
Problems
⚫ Even with careful planning, estimates are
wrong
⚫ Most firms add 5-10 percent for
contingencies
7-23
Making Better Estimates
⚫ Projects are known for being over budget
– It is unlikely that this is due to deliberate
underestimating
⚫ There are two types of errors
– Random
– Bias
⚫ There is nothing we can do about random
errors
– Tend to cancel each other
⚫ Eliminate systematic errors
7-24
Risk Estimation
⚫ Duration of project activities varies
⚫ Amounts of various resources needed
varies
⚫ Value of accomplishing a project varies
⚫ Can reduce but not eliminate ambiguity
⚫ Want to describe uncertainties in a way
that provides useful insight to their nature
7-25