Ch04

4/Budgeting the Project

Chapter 4Budgeting the Project

This chapter continues the topic of project planning and focuses specifically on project budgeting. With the technical aspects of project planning discussed in the previous chapter, this chapter addresses the need to develop a budget in order to obtain the resources needed to accomplish the project’s objectives. The chapter begins with an overview of budgeting methods and discusses both the top-down and bottom-up approaches. In comparing these approaches, it is noted that top-down budgeting is usually accurate overall but may include significant errors for low-level tasks. Bottom-up budgeting, on the other hand, is usually accurate for low-level tasks but risks overlooking tasks. Following this overview of budgeting methods, the chapter next addresses the issues of cost estimation and improving cost estimates. The need for PMs to thoroughly understand the organization’s accounting system is emphasized. Also the issue of budget cuts is addressed. In terms of improving cost estimates, techniques such as the use of learning curves and tracking signals are presented. Finally, the chapter concludes with a discussion of budget uncertainty and risk management.

Cases and Readings

Some cases appropriate to the subject of this chapter are:

Harvard: 9-193-071 Porsche AG This 20-page case illustrates how traditional cost measurement systems operate in an R&D department but offer little information for managing projects.

Harvard: 9-690-051 Campbell Soup Co. This 23-page case describes the cost-justification of a new engineering project to develop a microwavable package and product for the growing convenience foods market segment. A 28 page teaching note (5-690-094) is available for this case.

A reading appropriate to the subject of this chapter is:

D.H. Hamburger. The Three Perceptions of Project Cost (Project Management Journal, June 1986). This article clearly describes the importance and impact of cost-related issues on a project. These issues can significantly alter the profitability and even success of a project. Costs are discussed from three viewpoints: that of the project manager, the accountant, and the controller. Not only are the amounts of expenditures and encumbrances important, but their timing is critical also. Perhaps most important is having a project cost system that accurately reports costs and variances in a way that can be useful for managerial decisions.

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Answers to Review Questions

1. The main disadvantages of top-down budgeting are that significant errors may be made for low-level tasks, a lower level of budget acceptance is likely due to limited participation, and it provides little training opportunities in budgeting for junior managers. The main disadvantage of bottom-up budgeting is the risk of overlooking tasks.

2. Charging administrative costs based on total project completion time is based on the assumption that administrative costs increase in proportion to the length of the project. In other words, longer projects are expected to require more administrative resources than shorter projects.

3. The learning rate corresponds to the reduction in time or cost as output doubles. Therefore, a lower learning rate actually translates into a faster rate of learning. Generally speaking, people have the ability to learn while machines do not. Thus, if we assume by complex we mean automated, then the plant would have a slower learning rate of perhaps 95 percent. On the other hand, if by complex it is assumed that workers need a great deal of skill to operate the equipment, then a faster learning rate of 70 percent would be expected.

4. Tracking signals can help identify systematic biases in cost and other estimates. Knowledge of such biases can be used in preparing future estimates. Knowledge of biases also allows estimators to understand and correct their biases.

5. The three basic causes listed in Section 4.4 would appear to capture the vast majority of change in projects. As the question hints, however, two or more of these causes may occur at the same time. For example, new knowledge of a competitor’s new product may change the performance goal of a project and also require a change in how the tasks are achieved.

6. Highly probable risks have a high probability or likelihood of occurring. The consequences of these risks can be negligible (a data entry person quits) to very serious (the drug fails in the Phase I clinical trial). Extremely serious risks are risks that have very significant consequences although their probability of occurrence may be very low to very high. Highly vulnerable areas refer to risks that are both highly probable and extremely serious.

Suggested Answers to Discussion Questions

7. The accountant would likely assume that the $3,000,000 is to be allocated evenly over the six month duration of the task or $500,000 per month. However, most of the $3,000,000 will likely be incurred at the beginning of the task when the equipment must be acquired and paid for. The problem for the PM is that the accountant will expect a $500,000 charge in the first month of this task but will see an expenditure of

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close to $3,000,000! Based on this the accountant and top management may become alarmed in terms of the project being completed on budget.

8. A straight-line project life cycle means that the impact of a budget cut would be constant throughout the project’s life. A slope greater (less) than 45 degrees means a change in the budget would have a proportionally larger (smaller) impact on the project’s completion. Of course it is unlikely in reality to observe a straight-line life cycle.

9. Activity budgets segregate costs by types of expenditures-- phone, labor-- whereas

program budgets group costs according to the task or job that uses resources of all types to accomplish that task. Program budgets, therefore, relate expenditures directly to the project's action plan and simplify the project manager problem of managing the budget and making trade-offs.

10. According to the “mythical man month” the three new engineers hired would probably not hit the ground running and would require training. This training would likely take time away from other members of the project team. Thus, the extra capacity created by adding these three engineers was likely more than used up by the other engineers who spent some of their time now training the new team members.

11. The purchasing manager’s assistant’s solution only addressed the symptom of the problem and not the cause for why the company was short in the first place. In this case the solution created another problem, namely, that the organization is no longer cost competitive.

12. The managers should consider both the average cost and variance of the cost for each plan. Often the tendency is to focus solely on the average cost. However, depending on an organization’s need to avoid risk, in some situations it might be better to sacrifice and select a project with a higher average cost but a smaller variance. By selecting a project with a lower variance, the probability of the actual cost greatly exceeding the average cost is reduced.

Incidents for Discussion Suggested Answers

A Budgeting Novice: Since the precedent has been set that a top-down approach to budgeting is used at this company, Alex should do the same. Alex could approach his boss with sound estimates and assure the boss that he has involved all the experts in preparing the budget. Most likely, the boss will still re-work the numbers, but he should be more comfortable that Alex did his homework in preparing it. Alex must make timely communications to the boss on the project status, including thorough budget reports.

In the past, Alex has had autonomy to manage both performance and schedule, but has not been permitted to develop the budget. Thus, it might be helpful for Alex to share documents with his boss that demonstrate his competency in handling both schedule and performance (assuming his boss is not familiar with these). In addition to documenting

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his previous experience, it would be useful for Alex to share with the boss his WBS and demonstrate how this drove his cost estimates. Finally, Alex might find it useful to share with his boss how having responsibility for only schedule and performance and not budget, limits his effectiveness as a project manager. Another advantage for Alex’s boss is that more of his or her time would be freed up if Alex were permitted to work on budget issues with clients.

Major Dynamic Ground Systems: Careful monitoring of all costs is critical for the success of this project. The PM must monitor waste, scrap, and spoilage costs. These should be tied to performance so that low numbers do not hide low levels of progress. The controller must be able to identify all of the costs, such as those listed above, so that nothing can be hidden or rolled up under such things as “work-in-process inventory” and a true assessment can’t be ascertained until the end of the project.

General Sensor Company: The most relevant factors are the seriousness of the error, Justin’s experience, and the fact that only one stage is affected, but it represents 50% of the cost. Justin should combine the top-down approach with selected bottom-up inputs and checks on the 50% of cost stage. He is experienced and comfortable with a top-down approach and this makes sense for the majority of the project. Selective inputs from lower level workers involved in the tasks would confirm his estimates, or indicate where more information is needed.

Suggested Case Analyses and Solutions

St. Dismas Assisted Living Facility Project Budget Development -- 2

Teaching Purpose: This installment of the St. Dismas case requires students to address issues related to identifying and dealing with cost uncertainty

1. The cost per square foot for the units is given in the text together with its standard deviation. What other areas of cost or revenue are likely to have cost uncertainty? How should these uncertainties be handled?

Other areas of cost and revenue that are likely to be uncertain are the contingency allowances, marketing costs, personnel replacement, resource costs, GS&A, overhead allocation to budget, influences such as weather on the construction, cost increases for equipment or furniture, and labor cost increases.

To handle the uncertainty, the estimators need to gain more knowledge of the areas of uncertainty and clearly define all the assumptions that were used to determine the budget. Furthermore, they need to review the project plans thoroughly to identify areas of risk. Finally, instituting a change order process, in case there is a change during the project would also be worthwhile.

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Assuming cost or revenues are normally distributed, statistical and probability theory could be used to gain additional insights. Of course, it is important that the PM, working with the accounting department, closely monitors all of the project costs.

2. How would you suggest the team handle the issue of Dr. Link’s supposedly inflated medical equipment costs?

Since these are costly items, the CFO should recommend using a bottom-up approach to budgeting. The CFO should facilitate a team with experts and the differing doctors to determine the actual equipment needs and costs. This would enable buy-in from both parties. This would also ensure a more accurate estimate of needs. If there is sufficient data, the CFO can also include a tracking signal to identify if bias is in the estimates.

Photstat Inc.

Teaching Purpose: This case provides students with an opportunity to analyze the risk of a project with several uncertain parameters. Students are asked to simulate the completion of this project 100 times and create a risk profile for the project. Based on this, students are asked to comment on the implications of using an average value versus the risk profile. Case can also be analyzed using Crystal Ball.

1. What is the expected value of the project?The spreadsheet on the following page was created to calculate the expected value for this project. It is worth noting that one simplification was made. Namely, only the cash flows for the first six years as opposed to the first six-and-a-half years were discounted in calculating the NPV of the project. According to the spreadsheet, the expected value of this project is $1,221,361. The expected value would be have been perhaps $100,000 to $200,000 higher had the cash flows for the first half of the seventh year also been included.

2. Simulate this project 100 times and compute the average profit over the 100 replications. Plot a histogram of the outcomes of the 100 replications.A portion of a spreadsheet that was created to simulate this project 500 times is shown on the following page. There are two major differences between this spreadsheet and the one discussed earlier to calculate the expected value of the project. First, the values in columns B-I (beginning in row 20) were generated randomly using Excel’s Random Number Generation tool. Secondly, a conditional formula was entered to calculate the NPV based on the useful life randomly generated in column I. For example, the NPV for the first replication (cell T20) was calculated as:

=IF(I20=3,NPV(T$18,J20:L20),IF(I20=6,NPV(T$18,J20:O20),IF(I20=8,NPV(T$18,J20:Q20),NPV(T$18,J20:S20))))

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Spreadsheet for Calculating Project’s Expected Value

Spreadsheet to Simulate Project’s Completion 500 Times

12345678910

A B C D E F G H I J K L M N O P

Market Selling Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash FlowSize Price Market Market VC Equip Useful Year Year Year Year Year Year 10.00%

Replication Year 1 Year 1 Share Growth Year 1 Inflation Cost Life 1 2 3 4 5 6 NPVExpected Vaue 100,000 $12.50 30.00% 10.00% $3.00 3.00% $500,000 6.5 -$215,000 $322,905 $365,851 $414,510 $469,639 $532,101 $1,221,361

Key Formulas:Cell J5 =($B5*(1+$E5)^(J$4-1))*$D5*(($C5-$F5)*(1+$G5)^(J$4-1))-$H5Cell K5 =($B5*(1+$E5)^(K$4-1))*$D5*(($C5-$F5)*(1+$G5)^(K$4-1)) {Copy to cells L5:O5}Cell P5 =NPV(P3,J5:O5)

1234567891011121314151617181920212223242526272829

A B C D E F G H I J K L M N O PInput Data

Distribution Param. 1 Param. 2Selling Price Uniform 10 15Market Share Normal 30 3Total Market Normal 100,000 10,000VC Normal 3 0.25Useful Life Discrete

3 0.16 0.68 0.2

10 0.1Market Growth Normal 10.00% 0.30%Equip. Cost Normal 500,000 60,000Inflation Normal 3.00% 0.50%

Market Selling Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash FlowSize Price Market Market VC Equip Useful Year Year Year Year Year Year Year

Replication Year 1 Year 1 Share Growth Year 1 Inflation Cost Life 1 2 3 4 5 6 71 93247 $10.77 30.35% 9.98% $2.91 2.71% 491,705 6 -$269,138 $251,416 $284,004 $320,815 $362,399 $409,372 $462,4342 106357 $11.23 28.65% 15.81% $3.05 3.40% 487,126 3 -$237,968 $298,366 $357,294 $427,859 $512,361 $613,552 $734,7283 95416 $13.65 29.67% 7.28% $2.74 2.36% 478,222 6 -$169,089 $339,477 $372,800 $409,394 $449,579 $493,709 $542,1714 115040 $11.99 26.44% 14.44% $3.53 2.14% 477,333 6 -$219,998 $300,788 $351,579 $410,946 $480,338 $561,447 $656,2525 119718 $11.73 26.25% 7.57% $3.17 3.66% 458,354 6 -$189,544 $299,741 $334,230 $372,688 $415,571 $463,388 $516,7076 109221 $11.11 28.87% 8.99% $3.04 3.38% 485,704 8 -$231,192 $286,772 $323,122 $364,080 $410,229 $462,227 $520,8177 71856 $11.20 26.14% 11.71% $2.89 3.27% 505,887 8 -$349,862 $180,006 $207,674 $239,593 $276,419 $318,906 $367,9228 98716 $11.60 30.25% 8.01% $2.87 2.17% 486,020 3 -$225,044 $288,017 $317,861 $350,797 $387,145 $427,260 $471,5319 80465 $14.74 28.37% 7.74% $3.03 3.48% 428,483 6 -$161,139 $298,063 $332,312 $370,497 $413,069 $460,533 $513,45110 101383 $10.69 25.52% 5.69% $3.36 3.65% 445,723 6 -$256,289 $207,528 $227,350 $249,065 $272,855 $298,916 $327,467

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Spreadsheet to Simulate Project’s Completion 500 Times (continued)

A histogram (risk profile) summarizing the 500 replications is shown below.

3. How does the average of the simulation compare to the expected value you calculated? What are the managerial implications of this difference?The average of the simulation was $1,423,668 which is relatively close to the expected value. However, the range of values observed in the simulation experiment varied from a loss of almost $65,000 to a profit of over $4.5 million. Thus, the simulation experiment demonstrates the uncertainty of the actual outcome of this project.

Using Crystal Ball: The use of Crystal Ball can greatly speed up the development and analysis of the simulation model for this case. To illustrate this, the spreadsheet shown on the following page was created. With Crystal Ball, values for the random parameters are generated by defining cells as Assumption Cells rather than using Excel’s Random

Histogram

020406080

100

$165

,251

$625

,251

$1,08

5,251

$1,54

5,251

$2,00

5,251

$2,46

5,251

$2,92

5,251

$3,38

5,251

$3,84

5,251

$4,30

5,251

More

Bin

Freq

uenc

y17181920212223242526272829

Q R S TCash Flow Cash Flow Cash Flow

Year Year Year 10.00%8 9 10 NPV

$522,373 $590,082 $666,567 $851,709$879,837 $1,053,604 $1,261,691 $298,689$595,390 $653,833 $718,013 $1,244,393$767,066 $896,592 $1,047,990 $1,208,590$576,161 $642,457 $716,380 $1,100,677$586,834 $661,218 $745,032 $1,574,923$424,472 $489,715 $564,985 $888,853$520,389 $574,310 $633,819 $272,259$572,449 $638,226 $711,562 $1,119,011$358,745 $393,010 $430,548 $617,600

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Using Crystal Ball to Simulate Project Costs

Number Generation tool. In this particular case, cells B5 to I5 were defined as assumption cells. For example, cell B5 corresponds to the market size in the first year of the product’s introduction. From the case, it is estimated that the market size follows a normal distribution with a mean of 100,000 units and standard deviation of 10,000 units. To define cell B5 as an assumption cell, first the cursor was placed in this cell. Next, the Define Assumption button was selected. Then the Normal distribution was selected from the Distribution Gallery that appeared. In the next window, 100,000 was entered in the Mean field and 10,000 was entered in the Std Dev field and the OK button selected. Cells C5 to H5 were specified in a similar fashion.

Cell I5 was a little different in that the useful life of the equipment does not follow a continuous distribution. In this case, the Custom distribution was selected from the Distribution Gallery. Next 3 was entered in the Value field and .1 entered in the Prob. field and the Enter button clicked. In a similar fashion, 6 was then entered in the Value field, .8 in the Prob. field and the Enter button clicked. This was repeated for the probabilities of 8 year and 10 year useful lives, respectively. After all this information was entered, OK was clicked.

Finally, cell P5 was defined as the Forecast Cell. NPV was entered as a descriptive name in the Forecast Name field and Dollars in the Units field. The formulas in cells J5:O5 are the same as was previously discussed. To run the simulation, the Start Simulation button was selected.

The Frequency Chart and Statistics views are shown below. The average cost of the project is within 1 to 2 percent of the results obtained using Excel’s Random Number Generation tool. Additional details about the use of Crystal Ball can be found in Appendix C.

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B C D E F G H I J K L M N O P

Market Selling Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow Cash FlowSize Price Market Market VC Equip Useful Year Year Year Year Year Year 10.00%

Year 1 Year 1 Share Growth Year 1 Inflation Cost Life 1 2 3 4 5 6 NPV100,000 $12.50 30.00% 10.00% $3.00 3.00% $500,000 6.5 -$215,000 $322,905 $365,851 $414,510 $469,639 $532,101 $1,221,361

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Crystal Ball’s Frequency Chart View

Crystal Ball’s Statistics View

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Test Questions

True/False and Multiple Choice

F 1. ___ The project’s budget is merely the sum of its resource costs.

F 2. ___Overhead and indirect charges should not be assigned to a project.

T 3. ___ Most organizations use top-down budgeting.

F 4. ___ Because project budgeting is for a special case and the organization’s budgeting process is for routine work, the project manager need not be familiar with the organization’s accounting system.

T 5. ___ Budget cuts are usually disastrous to an exponential life-cycle project.

F 6. ___ Activity budgets show expenses by task, time period, and expense category.

F 7. ___ There is no way other than guessing to estimate the impact of learning on a project’s task.

T 8. ___ Calculating the Tracking Signal can not only reveal if estimates are biased, it can also tell how severe the bias is.

F 9. ___ By very careful planning, a project manager can do away with cost uncertainty.

T 10. ___ Expected value is a tool for risk analysis.

F 11. ___ Traditional organizational budgets are task-oriented, rather than activity- oriented.

F 12. ___ Learning curve theory states that performance of labor per unit will improve by a percentage each time production increases by the same percentage.

T 13. ___ Learning curve theory states that performance of labor per unit will improve by a fixed percentage each time production doubles.

T 14. ___ Individual elements of project budgets are generally more accurate in bottom- up budgeting.

T 15. ___The project budget acts a project control.

T 16. ___ A budget is a plan for allocating resources.

F 17. ___ Individual budgets are constructed using the work breakdown structure in the top-down budgeting method.

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T 18. ___ Budgetary gaming is a fact of life using either or both the bottom-up and top-down method.

a 19. ___Why is it necessary to consider the learning curve of resources on a project? a. to estimate labor costs properlyb. to improve project team moralec. because it always takes less time to do a task after someone has done it a

few times.d. collective bargaining contracts require it e. All of the above

e 20. ___ Sources of risk on a project include: a. acts of natureb. the clientc. the skills of the project teamd. senior managemente. only a and b

e 21. ___ A requirement of top-down budgeting is: a. involvement of the project teamb. estimating the detailed level of the project’s tasksc. applying the learning curve to labor time estimatesd. all of the abovee. none of the above

a 22. ___ A problem with bottom-up budgeting is: a. individual team members overstate their budget needsb. lack of involvement from the project teamc. underestimating the project task’s budget requirementsd. all of the abovee. none of the above

e 23. ___ A project budget is: a. an expression of organizational policyb. a plan for allocating resourcesc. a means of assigning cost to the projectd. all of the abovee. only b and c

a 24. ___ The most important consideration in budgeting is: a. cost controlb. maximizing project’s return on investmentc. meeting the project’s scheduled. estimating project resource costse. all of the above

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b 25. ___ The budget strategy based on collecting information from middle managers based on their prior experience is called.

a. bottom-up budgetingb. top-down budgetingc. earned value budgetingd. zero-based budgetinge. none of the above

d 26. ___ The name given to the budget process that aggregates income and expenditures across projects is:

a. activity-oriented budgetb. top-down budgetc. bottom-up budgetd. program-oriented budgete. activity-based costing

Short Answer

27. Define Top-down and Bottom-Up budgeting?Top-down budgeting is an estimate of high level tasks of the project by senior and/or middle managers. A bottom-up budget is when budget estimates are made based on the project’s action plan resource requirements made by those responsible for executing the tasks.

28. List some reasons why you would take on a project that was forecast to lose money.Allow for a follow-up project, improve competitive position, acquire knowledge, get firm’s name out, broaden a product line.

29. Define the term learning rate.The percentage by which the time required to accomplish a task decreases each time the number of task repetitions is doubled.

30. Risk management includes what three areas?Risk Identification, Risk Analysis, and Response

31. What is the Game Theory approach?This is when you operate on the assumption that the worst will happen. The assumption is that competitors and the environment are your enemies. You take on a pessimistic mind-set in making estimates and take action that will minimize harm.

32. List some of the factors commonly left out of cost estimation.Inflation, Learning curve, Waste and spoilage, Risk, Potential delays.

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Ch04