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Copyright 2012 John Wiley & Sons, Inc.

Chapter 7

Budgeting: Estimating Costs and Risks

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Estimating Project Budgets

  • 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

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Rules of Thumb

  • Some estimates are prepared by rules of thumb

Construction cost by square feet

Printing cost by number of pages

Lawn care cost by square feet of lawn

  • These rules of thumb may be adjusted for special conditions
  • However, this is still easier than starting the estimate from scratch

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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

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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

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Types of Budgeting

  • Top-down
  • Bottom-up
  • Negotiated

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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
  • The process continues to the bottom level

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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

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Disadvantages

  • More difficult to get buy in
  • Leads to low level competition for larger shares of budget

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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

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Advantages

  • Greater buy in by low level managers
  • More likely to catch unusual expenses

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Disadvantages

  • People tend to overstate their budget requirements
  • Management tends to cut the budget

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Work Element Costing

  • Labor rates include overhead and personal time

The book uses estimates of 84% and 12%, respectively, in one example

  • Direct costs usually do not include overhead
  • General and administrative (G&A) charge

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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

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Project Budget by Task & Month

Table 7-2

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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

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Problems

  • Even with careful planning, estimates are wrong
  • Most firms add 5-10 percent for contingencies

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Learning Curves

  • Human performance usually improves when a task is repeated
  • This happens by a fixed percent each time the production doubles
  • Percentage is called the learning rate

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Learning Curve Calculations

Tn = Time for nth unit

T1 = Time for first unit

n = Number of units

r = log decimal rate/log 2

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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

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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

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Applying Risk Analysis

  • Must make assumptions about probability distributions

Key parameters

Variables

  • Estimate the risk profiles of the outcomes of the decision

Also know as probability distributions

  • Simulation is often used

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General Simulation Analysis

  • Simulation combined with sensitivity analysis is useful for evaluating projects
  • Would support project if NPV is positive and is the best use of funds
  • Should avoid full-cost philosophy

Some overheads are not affected by changes

  • Analysis gives a picture in terms of costs and times that will be affected
  • Project is then reviewed using simulation

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