3/15/2018 CHAPTER 5. PROJECT MANAGEMENT. Prepared by: Dr. Maria Elisa Linda T. Cruz

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1 CHAPTER 5. BUDGETING CHAPTER AND 1 INTRODUCTION COST ESTIMATION TO PROJECT MANAGEMENT Prepared by: Dr. Maria Elisa Linda T. Cruz Prepared by: Dr. Maria Elisa Linda T. Cruz 1

2 Chapter 5. Topics 5.1 Estimating Project Budgets 5.2 Improving the Process of Cost Estimation Course Unit Learning Outcomes At the end of the chapter, the students will be able to: 1. Explain the importance of Budgeting and Cost Estimation. 2. Explain the ways of improving the process of cost estimation. 3. Estimate the cost of a small business project. 2

3 Budgeting and Cost Estimation 3

4 Importance of Project Cost Management Project cost management includes the processes required to ensure that the project is completed within an approved budget. Project managers must make sure their projects are well defined, have accurate time and cost estimates and have a realistic budget that they were involved in approving. Budgeting A budget is a plan for allocating resources The act of budgeting is the allocation of scarce resources to the various endeavors of an organization. A budget implies constraints Thus, it implies that managers will not get everything they want or need. 4

5 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 Estimating Project Budgets So we are left with the task of forecasting resources 5

6 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 PROJECT COST LABOR MATERIAL EQUIPMENT PREDE- CESSOR 6

7 PROJECT COST MANAGEMENT PROCESSES COST ESTIMATING Develop an approximation of the costs of the resources to complete project activities. COST BUDGETTING Aggregate the estimated costs of individual activities or work packages to establish an authorized cost baseline. COST CONTROL Controlling changes to the project budget. Estimating Project Budgets In order to develop a budget, we must: Forecast what resources the project will require Determine the required quantity of each Decide when they will be needed Understand how much they will cost - including the effects of potential price inflation There are two fundamentally different strategies for data gathering: Top-down Bottom-up 7

8 Top down VS Bottom up 1. Top down This is where you develop or set the total or top budget and then break it down into the component parts within that budget. 2. Bottom up This is there you start with a list or plan or schedule of the things you want to do and then cost it up to get the total budget. Top-Down Budgeting This strategy is based on collecting the judgment and experiences of top and middle managers. These cost estimates are then given to lower level managers, who are expected to continue the breakdown into budget estimates. This process continues to the lowest level. 8

9 Top-Down Budgeting Advantages: Aggregate budgets can often be developed quite accurately. Budgets are stable as a percent of total allocation Small yet costly tasks do not need to be individually identified. The experience and judgment of the executive accounts for small but important tasks to be factored into the overall estimate. Bottom-Up Budgeting In this method, elemental tasks, their schedules, and their individual budgets are constructed following the WBS or project action plan. The people doing the work are consulted regarding times and budgets for the tasks to ensure the best level of accuracy. Initially, estimates are made in terms of resources, such as labor hours and materials. Bottom-up budgets should be and usually are, more accurate in the detailed tasks, but it is critical that all elements be included. 9

10 Bottom-Up Budgeting Advantages: Individuals closer to the work are apt to have a more accurate idea of resource requirements The direct involvement of low-level managers in budget preparation increases the likelihood that they will accept the result with a minimum of aversion Involvement is a good managerial training technique, giving junior managers valuable experience Budgeting Top-down budgeting is very common True bottom-up budgets are rare Senior managers see the bottom-up process as risky They tend not to be particularly trusting of ambitious subordinates who they fear may overstate resource requirements. They are reluctant to hand over control to subordinates whose experience and motives are questionable. 10

11 Cost Category Budgeting vs. Program/Activity Budgeting Another facet of budgeting has to do with the degree to which a budget is category-oriented or program/activity-oriented. The traditional budget is category-oriented often based upon historical data accumulated through a traditional, category-based accounting system. Cost Category Budgeting vs. Program/Activity Budgeting 11

12 Cost Category Budgeting vs. Program/Activity Budgeting Improving the Process of Cost Estimation There are two fundamentally different ways to manage the risks associated with the chance events that occur on every project: The most common is to make an allowance for contingencies - usually 5 or 10 percent. Another is when the forecaster selects most likely, optimistic, and pessimistic estimates. 12

13 Improving the Process of Cost Estimation The cooperation of several people is required to prepare cost estimates for a project. The major responsibility of the professional estimators is to reduce the level of uncertainty in cost estimations so that the firm s bids can be made in the light of expert information about its potential costs. Improving the Process of Cost Estimation 13

14 HOMEWORK. A customer gives you RO 10,000 to build a small coffee shop. Show an estimated breakdown of expenses by identifying different tasks involved in the project. Answer the following questions. 1. What is the budgeting approach used? Why? 2. Is this the best approach in budgeting? Why? Summary Budgeting is done to allocate limited/scarce resources. Project cost management process is composed of cost estimating, cost budgeting and cost control. Top-down Budgeting and Bottom-up Budgeting are the two budgeting approaches. The most common budgeting approach is topdown. 14

15 Chapter 5. Budgeting and Cost Estimation 15