Methods of Project Budgeting

Budgeting is simply the process of forecasting what resources the project will require, what quantities of each will be needed, when they will be needed, and how much they will cost. Tables 4-1 and 4-2 depict the direct costs involved in making a short documen­tary film. Table 4-1 shows the cost per unit of usage (cost/hour) of seven different person­nel categories and one facility. Note that the facility does not charge by the hour, but has a flat rate charge. Table 4-2 shows the resource categories and amounts used for each activity required to make the film. The resource costs shown become part of the budget for producing the documentary film. As you will see below, overhead charges may be added to these direct charges.

Most businesses and professions employ experienced estimators who can forecast resource usage with amazingly small errors. For instance, a bricklayer can usually estimate within 1 or 2 percent the number of bricks required to construct a brick wall of given dimensions. In many fields, the methods of cost estimation are well documented based on the experience of estimators gathered over many years. The cost of a building, or house, is usually estimated by the square feet of floor area multiplied by an appropriate dollar value per square foot and then adjusted for any unusual factors.

Budgeting a project such as the development of a new mobile app, however, is often more difficult than budgeting more routine activities—and even more difficult than regular departmental budgeting which can always be estimated as: “Same as last year plus X percent.” But project budgeters do not usually have tradition to guide them. Projects are, after all, unique activities. Of course, there may be somewhat similar past projects that can serve as a model, but these are rough guides at best. Forecasting a budget for a multiyear project such as a large product line or service development project is even more hazardous because the unknowns can escalate quickly with changes in technology, materials, prices, and even the findings of the project up to that point.

Organizational tradition also impacts project budgeting. Every firm has its own rules about how overhead and other indirect costs are charged against projects. Every firm has its ethical codes. Most firms must comply with the Sarbanes-Oxley Act (SOX) and the Health Insurance Portability and Accountability Act (HIPAA). Most firms have their own accounting idiosyncrasies, and the PM cannot expect the accounting department to make special allowances for his or her individual project. Although accounting will charge normal expenditures against a particular activity’s account number, as identified in the WBS, unexpected overhead charges, indirect expenses, and usage or price variances may suddenly appear when the PM least expects it, and probably at the worst possible time. (Price variances due to procurement, and the entire procurement process, are discussed in Chapter 12 of PMBOK, 2013.) There is no alternative—the PM must simply become completely familiar with the organization’s accounting system, as painful as that may be.

In the process of gaining this familiarity, the PM will discover that cost may be viewed from three different perspectives (Hamburger, 1986). The PM recognizes a cost once a commitment is made to pay someone for resources or services, for example when a machine is ordered. The accountant recognizes an expense when an invoice is received—not, as most people believe, when the invoice is paid. The controller per­ceives an expense when the check for the invoice is mailed. The PM is concerned with commitments made against the project budget. The accountant is concerned with costs when they are actually incurred. The controller is concerned with managing the organi­zation’s cash flows. Because the PM must manage the project, it is advisable for the PM to set up a system that will allow him or her to track the project’s commitments.

Another aspect of accounting that will become important to the unaware PM is that accountants live in a linear world. When a project activity has an $8,000 charge and runs over a four-month period, the accounting department (or worse, their software) some­times simply spreads the $8,000 evenly over the time period, resulting in a $2,000 alloca­tion per month. If expenditures for this activity are planned to be $5,000, $1,000, $1,000, and $1,000, the PM should not be surprised when the organization’s controller storms into the project office after the first month screaming about the unanticipated and unac­ceptable cash flow demands of the project!

Next, we look at two different approaches for gathering the data for budgeting a project: top-down and bottom-up.

1. Top-Down Budgeting

The top-down approach to budgeting is based on the collective judgments and experi­ences of top and middle managers concerning similar past projects. These managers esti­mate the overall project cost by estimating the costs of the major tasks, which estimates are then given to the next lower level of managers to split up among the tasks under their control, and so on, until all the work is budgeted.

The advantage of this approach is that overall budget costs can be estimated with fair accuracy, though individual elements may be in substantial error. Another advantage is that errors in funding small tasks need not be individually identified because the over­all budget allows for such exceptions. Similarly, the good chance that some small but important task was overlooked does not usually cause a serious budgetary problem. The experience and judgment of top management are presumed to include all such elements in the overall estimate. In the next section, we will note that the assumptions on which these advantages are based are not always true.

2. Bottom-Up Budgeting

In bottom-up budgeting, the WBS identifies the elemental tasks, whose resource require­ments are estimated by those responsible for executing them (e.g., programmer-hours in a software project). This can result in much more accurate estimates, but it often does not do so for reasons we will soon discuss. The resources, such as labor and materials, are then converted to costs and aggregated to different levels of the project, eventually resulting in an overall direct cost for the project. The PM then adds, according to organi­zational policy, indirect costs such as general and administrative, a reserve for contingen­cies, and a profit figure to arrive at a final project budget.

Bottom-up budgets are usually more accurate in the detailed tasks, but risk the chance of overlooking some small but costly tasks. Such an approach, however, is com­mon in organizations with a participative management philosophy and leads to better morale, greater acceptance of the resulting budget, and heightened commitment by the project team. It is also a good managerial training technique for aspiring project and general managers.

Unfortunately, true bottom-up budgeting is rare. Upper level managers are reluctant to let the workers develop the budget, fearing the natural tendency to overstate costs, and fearing complaints if the budget must later be reduced to meet organizational resource limitations. Moreover, the budget is upper management’s primary tool for control of the project, and they are reluctant to let others set the control limits. Again, we will see that the budget is not a sufficient tool for controlling a project. Top-down budgeting allows the budget to be controlled by people who play little role in designing and doing the work required by the project. It should be obvious that this will cause problems— and it does.

We recommend that organizations employ both forms of developing budgets. They both have advantages, and the use of one does not preclude the use of the other. Making a single budget by combining the two depends on setting up a specific system to negotiate the differences. We discuss just such a system below. The only disadvan­tage of this approach is that it requires some extra time and trouble, a small price to pay for the advantages. A final warning is relevant. Any budgeting system will be useful only to the extent that all cost/revenue estimates are made with scrupu­lous honesty.

Source: Meredith Jack R., Mantel Jr. Samuel J., Shafer Scott M., Sutton Margaret M. (2017), Project Management in Practice, John Wiley & Sons, Inc. 3th Edition.

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