Budgeting and Risk

Management
Cost management?????

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Budgeting (Slide 1 of 2)

• Budgeting is the allocation of scarce resources to

the various endeavors of an organization
• For a project, a budget is 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

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Budgeting (Slide 2 of 2)

• 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 monitoring & control mechanism
• Many organizations have controls in place that prohibit
exceeding the budget
• Comparisons are against the baseline budget

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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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Budgeting Concepts

• Tradition
• Life cycle costing
• Actual costs and earned value analysis
• Tracing expenses to specific tasks
• Aside from budget, cash flow is also important

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Rules of Thumb

• Some estimates are prepared by rules of thumb

• Previous projects
• 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
• The accounting system may not be set up to
track project data

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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
• Sometimes viewed as zero-sum game

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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
• Other associated expenditure categories are also
consistent e.g. 5% for R&D

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Disadvantages

• Lower management perceives a strong bias towards

under-estimating
• 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, usually by PM

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Advantages

• Greater buy in by low level managers

• Should be more accurate

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Disadvantages

• People tend to overstate their budget requirements

• Management tends to cut the budget
• PM is required to spend a lot of time with
subordinates

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Work Element Costing

• Direct costs usually do not include overhead

• Labor rates include overhead and personal time
• General and administrative (G&A) charge

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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

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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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Opposing Views of Superior
and Subordinate

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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,…
• Example on next slide
• Projects need to accumulate data and control
expenses differently
• This resulted in program budgeting

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Typical Monthly Budget

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Project Budget by Task &
Month

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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
• Their primary job is to reduce uncertainty
• 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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Not Always About The Profit

• To develop knowledge of a technology

• To obtain the parts or service portion of the work
• To be in a good position for a follow-on contract
• To improve a competitive position
• To broaden a product line or a line of business
• To only survive and retain the expertise

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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 Curves

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 Learning Curve Calculations

Tn  T1n r Tn = Time for nth unit

T1 = Time for first unit
log rate 
r n = Number of units
log 2 r = log decimal
rate/log 2
N
Total time  T1  n r

n 1

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Other Factors

• Escalation
• Waste
• Bad Luck
• Inflation unaccounted
• A project costing $1 million with $600,000 going in
salaries in 3 years will result in 2.5% error in budget
calculation if 6% increase in salaries each year is not
accounted for.

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Things can compound to
unimaginable scale!!!
• A software code comprising of 1000 lines of code
with each line having a reliability of 0.999 has a
cumulative chance of success of __%.

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A misconception!!!

• Worker and time are not always interchangeable

• Catching up schedule often requires more labor
• In addition to labor, more training is required along with
enhanced communication
• For programming projects, three programmer need 3 times
more communication as compared to required by two.

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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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7-33
Risk Estimation

• Duration of project activities varies

• Amounts of various resources needed varies
• Can reduce but not eliminate ambiguity entirely

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How to manage risk!!!

“vague terms lead to bad decisions. You need to

define success in quantifiable terms so that everyone
is on the same page . . . . you need robust ways to
discuss uncertainties quantified in the language of
probability.” David Matheson, CEO SmartOrg Inc.

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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

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Sean Cole has been appointed project manager of the Preferred Sensor Company's new
sensor manufacturing process project. Sensors are extremely price-sensitive. and
Preferred has done a great deal of quantitative work so it can accurately forecast
changes in sales volume relative to changes in pricing. The company president, "Dude"
has considerable faith in the firm's sensitivity model and insists that all projects that
affect the manufacturing cost of sensors be run against the sensitivity model in order to
generate data to calculate the return on investment. The net result is that project
managers, like Sean are under a great deal of pressure to submit realistic budgets so
go/no-go project decisions can be made quickly. Dude has canceled several projects that
appeared marginal during their feasibility stages and recently fired a project manager
for overestimating project costs on a new model sensor. The project was killed very
early in the design stage and six months later a competitor introduced a similar sensor
that proved to be highly successful. Sean’s dilemma is how to go about constructing a
budget that accurately reflects the cost of the proposed new manufacturing process.
Sean is an experienced executive and feels comfortable with his ability to come close to
estimating the cost of the project. However, the recent firing of his colleague has made
him a bit gun-shy. Only one stage out of the traditional four-stage sensor manufacturing
process is being changed, so he has detailed cost information about a good percentage
of the process. Unfortunately, the tasks involved in the process stage being modified are
unclear at this point. Sean also believes that the new modification will cause some
minor changes in the other three stages, but these changes have not been clearly
identified. The stage being addressed by the project represents almost 50 percent of the
manufacturing cost.
Questions: Under these circumstances, would Sean be wise to pursue a top-down or a
bottom-up budgeting approach? Why? 7-38
General Ship Company General Ship Company has been
building nuclear destroyers for the Navy for the last 20
years. It has recently completed the design of a new class
of nuclear destroyer and will be preparing a detailed
budget to be followed during construction of the first
destroyer. The total budget for this first destroyer is $90
million. The project has started and the controller feels the
initial project cost estimate prepared by the planning
department was too low because the waste and spoilage
allowance was underestimated. Thus, she is concerned
that there may be a large cost overrun on the project and
wants to work closely with the project manager to control
the costs.

Question: How would you monitor the costs of this

project ?
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7-40
Using Crystall ball for risk
analysis
• What is the probability for positive NPV?
• What is the probability for NPV between 10,000
and 16,000?
• If interest rate is increased to 15%, what is the
probability for positive NPV?
• If inflation is 3%±2%, what is the probability for
positive NPV?

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