Budgeting and Cost Estimation

1. Budgeting and Cost Estimation • Budgets defined • Two major approaches • Pros and Cons • Behavioral issues • Financial issues

2. Projects Make the Best of Scarce Resources

3. 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

4. NASA’s Pathfinder Rover: Mars on a Shoestring

5. 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

6. Potential Project Life Cycles, Figures 7-1 and 7-2

7. Two Major Approaches to Budgeting • Top-Down • Bottom-Up • Each has advantages . . . And disadvantages as well

8. 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

9. 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

10. 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

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

12. 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

13. 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 . . .

14. 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.

15. 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

16. 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%

17. Effects of Ignoring the Learning Curve, Figure 7-4

18. Excel® Template for Cost Estimation, Figure 7-5

19. Excel® Formulas for Figure 7-5

20. Estimation Template Using Ratios, Figure 7-7

21. Formulas for Figure 7-7

22. Case: The Stanhope Project

23. From: The Stanhope Project, Labor Buildup

24. Reading: Three Perceptions of Project Cost

25. From: Three Perceptions of Project Cost (Figure 2)

26. From: Three Perceptions of Project Cost (Figure 3)