Saturday, May 24, 2008

Tools and Techniques for Cost Budgeting

Budgeting for your project is not simply a matter of taking the cost estimates for various activities and saying, "This is the budget for this task." Estimates provide merely the base or frame upon which you will build a finalized project budget.

You can use a number of tools and techniques to take your bare-bones estimates and create the budget that will guide all your cost-control efforts. The tools and techniques of budgeting are based on the tools and techniques for cost estimating. Several tools and techniques you can use for cost budgeting are described below.

1. Create contingency funds and a management reserve.
The main difference between an estimate and a budget is the additional cushion a budget has built into it. Budgeting takes your estimates a step further by adding contingencies based on previous experience and risks related to particular activities.

Contingency funds are specific provisions for unforeseen increases in costs at the project activity level. In other words, contingencies are added to work packages and activities at the lower level of the work breakdown structure.

While cost budgeting takes place at the project activity level, it also takes place at the project management level. General project budgeting takes into account overall risk and establishes a management reserve for the project. This account contains a percentage of the project's funds that are set aside for potential problems.

The management reserve is held over and above the budgets for individual work packages. The size of a management reserve depends on the type of project, industry standards, and the guidelines for establishing reserves found in the project's risk management plan.

Although a number of factors must be weighed when developing a management reserve, you can follow this general rule of thumb: find the optimal add-on percentage that will minimize risk and yet not be overly cautious. You want to ensure that actual costs don't exceed your estimates, but you also want to remain competitive and avoid creating a "fat" budget.

2. Identify the ranges of accuracy for each of the cost-estimating techniques.
You developed the cost estimates for your project using one or more of the cost-estimating tools and techniques that are listed below. How accurate do you think your estimates are? It depends on the method you used, since the degree of accuracy varies between estimating techniques. Cost budgeting uses the deemed accuracy of your estimates to come up with appropriate contingencies.
  • Parametric modeling. Parametric models provide a rough order of magnitude. These estimates could have a range as great as plus or minus 35 percent. To increase accuracy for budgeting purposes, you may want to run project activities through a more detailed methodology, such as bottom-up estimating.
  • Analogous estimating. The accuracy of estimates improves somewhat if you have based cost estimates on a similar project. An analogous, or top-down, estimate may be accurate to plus or minus 15 percent to 20 percent. The range will decrease relative to an increase in similarity between the two projects.
  • Bottom-up estimating. Bottom-up estimates are the most reliable (plus or minus five percent to 10 percent) since you have examined each activity in the work breakdown structure. When preparing a budget based on detailed and finalized estimates, you can reduce contingencies and overrun allowances due to the reduction in risk.
  • Computerized tools. Project management software greatly simplifies cost budgeting. You can use statistical analysis and simulation to generate a budget based on the probability that actual costs will be over or under the base estimates, giving you an accuracy range as low as plus or minus five percent.
3. Use cost-budgeting techniques based on the cost-estimating techniques you used.
As you work with your base estimates to develop a project budget, remember how your estimates were developed and their level of accuracy, since you will use cost-budgeting techniques based on the cost-estimating techniques you used.

For example, you may have used a parametric model or analogous estimating to develop your cost estimates. If you based estimates on another accurate budget or used an accepted model, why not base the new budget on these, making allowances for any differences? You can use the accuracy range of your estimates to find the "most likely" total cost of your project. Set your budget somewhere between the low and high cost.

If accuracy is not paramount and you are looking for a general contingency, you can use the formula: Most Likely = Estimate + (x percent ÷ 2). Take the maximum cost based on the range of results, divide it in half, and use it as the "most likely" amount. This dollar figure, or percentage amount, is what you add over and above the estimated amount.

Have you used the bottom-up technique to develop the cost estimates for your project? If so, you can use statistical sums to develop the cost budget. The most common approach is to use the Expected Value calculation for each estimate. This formula is: Expected Value = (a + 4m + b) ÷ 6.

In this formula, Expected Value is the mean or average of the base, most likely, and maximum values, a = low or most optimistic forecast, m = the most likely estimate, and b = high or most pessimistic forecast for cost outcomes. Sum up the values for each estimate and base your budget on the total.

You can follow a number of guidelines for setting base budgets when you have used an estimating technique other than bottom-up estimating. Use computerized tools to assess risk and determine appropriate contingencies. You can also use the contingencies from other similar projects as a benchmark. The most likely cost will fall somewhere between the maximum and the base estimate.

In summary, cost budgets are based on the general accuracy of, and statistical information about, cost estimates. Budgeting depends on the assessed risk related to individual activities and the project as a whole. Appropriate contingencies are based on known risks. The higher the impact and probability of the risk, the more contingency you will want to allocate in your budget.

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