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8/13/2019 Intro to Project Management - 07 - Budgeting and Cost Estimation
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MGT 550: Introduction to Project Management
March 31, 2002 1For academic use only.
MGT 550
Introduction to
Project Management
Chapter 7:
Budgeting and
Cost Estimation
Wesley J. Howe School of Technology Management
Course Development Team Members:Michael Poli
Celia Desmond, PMPDavid Keeney, PMP, CQM, CPDT
8/13/2019 Intro to Project Management - 07 - Budgeting and Cost Estimation
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MGT 550: Introduction to Project Management
March 31, 2002 2For academic use only.
Copyright Information
The slides in this file are provided to faculty instructing MGT 500 on behalf of the
Stevens Institute of Technology. Use is restricted to academic endeavorsassociated with the delivery of MGT 550 to students properly enrolled at theStevens Institute of Technology. All other rights are reserved by the original ownersof materials contained in this program.
The slides contain copyrighted material that has been reproduced and/or adapted tothe course syllabus under the doctrine of “fair use for academic purposes”. Allslides in this course are copyrighted by the original source. Requests to reproducematerials for other purposes should be directed to the copyright owner identified inthe bibliography that will be made available to faculty.
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MGT 550: Introduction to Project Management
March 31, 2002 3For academic use only.
Budgeting and Cost Estimation
M&M Text, Chpt. 7
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MGT 550: Introduction to Project Management
March 31, 2002 4For academic use only.
Module 7:
Cost Estimating and Budgeting
Purpose: prepare students to understandthe elements of a project budget and thetechniques commonly used to estimate
costs in a project plan.
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MGT 550: Introduction to Project Management
March 31, 2002 5For academic use only.
Module 7 Objectives
• Review Financial Statements
– Describe the balance sheet, income statement, andcashflow statement
– Explain the basic relationships between each financial
statement – Link the financial statements to measures of project
profitability discussed during project selection
– Explain the differences between the capital budget, theoperating budget, and imputed costs
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MGT 550: Introduction to Project Management
March 31, 2002 6For academic use only.
WBS, OBS, RBS, and CBS
DirectCosts IndirectCosts
CBS
•Direct
Labor
• DirectMaterial
•Period
Expenses
•Overhead•Burden
1.0
1.1 1.2 1.31.2.1 1.2.2
A 5
D 1
D 3
D 7
S 3
S 4
O
B S
W B S
Income
Statement
Cashflow
Statement
BalanceSheet
Imputed Costs
Keeney, 2000
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MGT 550: Introduction to Project Management
March 31, 2002 7For academic use only.
Key Cost Concepts• Cost is a resource foregone, in cash or in
kind, to obtain a set of benefits – Type of costs
• Capital
• Expense
• Sunk cost
• Imputed cost
• Opportunity cost
– Economic analysis
– Budgeting
– Earned value – Contingency
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MGT 550: Introduction to Project Management
March 31, 2002 8For academic use only.
Capital Costs
• Must be depreciated or amortized over life of
capital asset (defined by taxing authorities)• Result in owned assets on the balance sheet
– Historical cost (usually at acquisition)
– Accumulated depreciation/amortization
– Historical cost less accumulated depreciation
– May have a salvage value• Cost of capital should be considered
– Net cost for debt and equity sources of assets
– Hurdle rate may be based on cost of capital
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MGT 550: Introduction to Project Management
March 31, 2002 10For academic use only.
Sunk Costs
• Cost already expended• Should not be used in making
decisions about future.
• Should base decisions on futurecosts and impacts.
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MGT 550: Introduction to Project Management
March 31, 2002 11For academic use only.
Imputed Costs
• A cost that does not get reported on financialstatements
• Opportunity costs are an example of imputed
costs
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MGT 550: Introduction to Project Management
March 31, 2002 12For academic use only.
Opportunity Cost
• Benefits foregone as a result of choosingone of more than one alternatives
• Usually used as a comparative measure
• Useful in making decisions• Can use to compare project benefits to
opportunities from other projects.
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MGT 550: Introduction to Project Management
March 31, 2002 13For academic use only.
Opportunity Cost Example
We could upgrade our current billing system, at a cost of $800K or
purchase a new standalone system for the l.d. service we aredesigning for $500K, in 3 months time.Purchasing the new system would require process changes of anadditional $800K to integrate the output with the currently issued
bills. However once the systems and integrated processes are inplace, we expect to save $500K on each of four upcoming plannedservices.
Therefore the opportunity cost of upgrading is
(4x$500K) - ($500K+$800K) = 700Kbecause we are foregoing $700K savings to upgrade now.
This can be compared to the increase in profit expected over thenext 3 months to decide whether to go ahead.
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MGT 550: Introduction to Project Management
March 31, 2002 14For academic use only.
Funding Non profitable Projects
• There are several reasons that firms wouldchoose to fund project that is notprofitable:
– To develop knowledge of technology – To get organization’s “foot in door”
– To obtain parts or service portion of work
– To be in good position for follow-on contract – To improve competitive position
– To broaden product line or line of business
M&M Text, Chpt. 7
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MGT 550: Introduction to Project Management
March 31, 2002 15For academic use only.
Profitability Measurement
• Payback period
• Return On Investment (ROI)
• Discounted cash flow methods
– NPV, net present value – IRR, internal rate of return
– Benefit-cost ratio
All of these measurements require use of
a time-phased budget to assess profitability.
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MGT 550: Introduction to Project Management
March 31, 2002 16For academic use only.
Payback Period• Forecasts how long it will take for the net cash inflow to pay
back the investment outflow
– ignores time value of money – ignores cash flow after payback
9001,5001,200500-2,100Cashflow
1501501501500Debt Service1251251251250Interest
252525250Amortization
4004004004000Depreciation
50011008001000NPAT
Year 4 Year 3 Year 2 Year 1 Year 0
Payback Period = 2.4 years
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MGT 550: Introduction to Project Management
March 31, 2002 17For academic use only.
Return On Investment (ROI)
Many formulas exist for computing ROI.
• Return on Average Investment
• Return on Original Investment
(Average Yearly Profit)
(Original Investment) + (Working Capital)ROI =
(Working Capital) = (Current Assets) – (Current Liabilities)
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MGT 550: Introduction to Project Management
March 31, 2002 18For academic use only.
The future value F of a current sum at its present value PV, depends
upon the interest/investment rate i and the number of years involved, n.
FV = PV(1+ i )n
Net present value NPV of a series of sums is
when II is the initial investment.
An annuity, is the amount of money to be invested (A) each year over myears at a rate of investment (i) to provide the required amount i.e.enough to buy a customer care company.
PV = A (1+i)n -1 / i (1+i)n
NPV = - II MFVi
(1 + k)i
i=1
n
Present Value Concepts
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MGT 550: Introduction to Project Management
March 31, 2002 19For academic use only.
The Reciprocal Relationship of
PV and FV
0.0
1.0
2.0
3.0
4.05.0
6.0
7.0
8.0
- 2 0 - 1 7
- 1 4
- 1 1 - 8 - 5 - 2 1 4 7
1 0 1 3 1 6 1 9
Time Period
V a l u e o f
$ 1
CompoundedValue
Discounted Value
N
OW
10%
5%
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MGT 550: Introduction to Project Management
March 31, 2002 20For academic use only.
Net Present ValueDiscount rate 10%
NPV = 1093
6151127996455-2,100PV
0.68300.75130.8640.90911.00PVIF
9001,5001,200500-2,100Cashflow
1501501501500Debt Service
1251251251250Interest
252525250Amortization
4004004004000Depreciation
50011008001000NPAT
Year 4 Year 3 Year 2 Year 1 Year 0
MGT 0 I d i P j M
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MGT 550: Introduction to Project Management
March 31, 2002 21For academic use only.
Benefit/Cost Ratio
Of Discounted Cash Inflows
Of Discounted Cash OutflowsProfitability Index =
From the NPV Problem:• Discounted Cash Inflows = $3,193• Discounted Cash Outflows = $2,100
PI =
$3,193
$2,100= 1.52 If PI > 1.0,project is favorable.
MGT 550 I t d ti t P j t M t
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MGT 550: Introduction to Project Management
March 31, 2002 22For academic use only.
Internal rate of Return (IRR)
The discount rate that makes the present value ofall cash flows (in and out) equal to zero.
The IRR is found by iteration
- II = 0 MFVi
(1 + IRR)i
i=1
n
MGT 550 I t d ti t P j t M t
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MGT 550: Introduction to Project Management
March 31, 2002 23For academic use only.
NVP or IRR?
• For project decisions, NPV isrecommended over IRR as decision tool.
• NPV is more conservative and also more
consistent than IRR• Since IRR is calculated by a polynomial of
dimension n, it has n roots, not just one.
MGT 550: Introduction to Project Management
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MGT 550: Introduction to Project Management
March 31, 2002 24For academic use only.
Module 7 Objectives
• Cost Estimation Techniques
– Describe analogous estimating and parametricmodeling
– Explain bottom-up estimating and its relationship to the
WBS
MGT 550: Introduction to Project Management
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MGT 550: Introduction to Project Management
March 31, 2002 25For academic use only.
Cost Estimating Techniques
• Analogous
– “top-down”
– adjustments to actual cost of past projects
• Parametric – uses some measurable characteristic e.g.
• cost per line of code or per screen
• cost per square foot of living space
• Bottom-up
– detailed
MGT 550: Introduction to Project Management
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MGT 550: Introduction to Project Management
March 31, 2002 26For academic use only.
Top-Down Budgeting
• Advantages: – Aggregate budgets can often be developed quite
accurately
– Budgets are stable as a percent of total allocation
– The statistical distribution is also stable, makingfor high predictability
– 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 befactored into the overall estimate
M&M Text, Chpt 7
MGT 550: Introduction to Project Management
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MGT 550: Introduction to Project Management
March 31, 2002 27For academic use only.
Bottom-Up Budgeting
• Advantages:
– Individuals closer to the work are apt to have amore accurate idea of resource requirements
– The direct involvement of low-level managersin budget preparation increases the likelihoodthat they will accept the result with a minimumof aversion
– Involvement is a good managerial trainingtechnique, giving junior managers valuableexperience
M&M Text, Chpt 7
MGT 550: Introduction to Project Management
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MGT 550: Introduction to Project Management
March 31, 2002 28For academic use only.
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 questionableM&M Text, Chpt 7
MGT 550: Introduction to Project Management
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MGT 550: Introduction to Project Management
March 31, 2002 29For academic use only.
Work Element Costing
• Each work element in the action plan or
WBS is evaluated for its resourcerequirements, and then the cost
• Direct costs for resources and machinery
are charged directly to the project. Labor isusually subject to overhead charges.Material resources and machinery may or
may not be subject to overhead.• There is also the General and Administrative
(G&A) charge
M&M Text, Chpt 7
MGT 550: Introduction to Project Management
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MGT 550: Introduction to Project Management
March 31, 2002 30For academic use only.
Category/Activity Budgeting vs.Program Budgeting
• The traditional organization budget is eithercategory oriented or activity oriented
• Often based upon historical data
accumulated through an accounting system• With the advent of project organizations, it
became necessary to organize the budget in
ways that conformed more closely to theactual pattern of fiscal responsibility
M&M Text, Chpt 7
MGT 550: Introduction to Project Management
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MGT 550: Introduction to Project Management
March 31, 2002 31For academic use only.
Category/Activity Budgeting vs.Program Budgeting
• Under traditional budgeting methods, thebudget could be split up among manydifferent organizational units
• This diffused control so widely that it wasalmost nonexistent
• This problem gave rise to program
budgeting, which alters the budgetingprocess so that budgets can beassociated with the projects that use them
M&M Text, Chpt 7
MGT 550: Introduction to Project Management
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j g
March 31, 2002 32For academic use only.
Program Budgeting
• Program budgeting aggregates income andexpenditures across programs (projects)
• Aggregation by program is in addition to,
not instead of, aggregation byorganizational unit
• These budgets usually take the form of a
spreadsheet with standard categoriesdisaggregated into “regular operations” andcharges to the various projects
M&M Text, Chpt 7
MGT 550: Introduction to Project Management
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j g
March 31, 2002 33For academic use only.
Module 7 Objectives
• Time-phased Budgets
– Explain that the purpose of a budget is to assignresponsibility for costs to a cost center
– Explain the chart of accounts and its relationship to
work packages – Explain how the time-phased budget can be used to
evaluate profitability and cashflow on a project
MGT 550: Introduction to Project Management
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j g
March 31, 2002 34For academic use only.
From Schedule to BudgetID WBS Task Name Dur
14 3 Technical Team Startup 28 days
15 3.1 Identify Team Members 1 day
16 3.2 Verify Team Members Acceptance 6 days
17 3.3 Schedule Kickoff Meeting 1 day
18 3.4 Hold Kickoff Meeting 1 day
19 3.5 Identify Technical Tracks 6 days
20 3.6 Assign Team Members To Technical
Tracks
1 day
21 3.7 Set Up Technical Team Web Site 5 days
22
23 4 Call For Papers 25 days
24 4.1 Write Technical Track Descriptions 15 days
25 4.2 Write Call f or Papers 5 days
M T W T F S S M T W T F S S M T W T F S S M T W T F S S M T
16, '00 Jul 23, '00 Jul 30, '00 Aug 06, '00 Aug 13, '0
Project Budget
0
5
10
15
W1 W2 W3 W4 W5 W6 W7
Resources by Week
($000)
A B C DResource A = Contingency Allowance
Keeney, 2001
MGT 550: Introduction to Project Management
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March 31, 2002 35For academic use only.
Estimate Accuracy
• Project costs will generally be determinedfrom cost and time estimates made byteam members and project stakeholders.
• When expressing or accepting anyestimate, ensure that the accuracy of theestimate is specified
– Most likely value (a mode) – Upper limit (worst case and probability)
– Lower limit (best case and probability)
MGT 550: Introduction to Project Management
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March 31, 2002 36For academic use only.
Monthly Household BudgetMortgage
Utilities
Food
Miscellaneous
Total
$900
$1,000
$1,150
$100$200
$350
$700
$800
$900
$200
$400
$600
$1,900$2,400
$3,000
All Good Long RunAverage
All Bad
.00000001 Not Very Likely(.01)
4
(.01)
4
Keeney, 2001
MGT 550: Introduction to Project Management
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March 31, 2002 37For academic use only.
Contingency Allowances
Where to put them?
• single line item• standard % overall• weighted percentage
• by system or phase• by milestone• by summary task
Problems with this?• Specify potential problems for each method of
showing contingency
MGT 550: Introduction to Project Management
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March 31, 2002 38For academic use only.
Contingency Allowances
• Should be based on realistic expectations
• ARE EXPECTED TO BE SPENT
• Should not be hidden
• Are not for scope changes• Are not for inflation
• ARE USED FOR KNOWN UNKNOWNS
MGT 550: Introduction to Project Management
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March 31, 2002 39For academic use only.
Managerial Reserve Account
• Is for unknown unknowns
• Must be requested by PM
• IS NOT A SLUSH FUND to cover poor
planning
MGT 550: Introduction to Project Management
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March 31, 2002 40For academic use only.
Budgeting: Cashflow ForecastCumulative Cost
TimeTime Now
ACTUAL
BAC
EAC
PLAN
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March 31, 2002 41For academic use only.
Reading Assignments
• From Chapter 7
– Text• Pp 261 – 292
• Pp 295 – 301
• For Chapter 8
– Text• Pp 302 – 348
Recommended