Cost Budgeting

Cost budgeting is the process of aggregating the estimated costs of individual activities or work packages to establish an authorized cost baseline in project management.Since project budgets constitute the funds authorized to execute the project, and project cost performance will be measured against that authorized budget, project budget accuracy is an especially important area of concern for project managers.

Project Budget Accuracy

Project budget accuracy is an often misunderstood concept.Too often an early initiation phase rough estimate gets carried into an approved project budget before detailed planning takes place.In any case, budgeting cost accuracy changes over the life cycle as more specifics regarding the project are known.Mature organizations realize this and make their decisions accordingly.It needs to be recognized that budget estimates at initiation can easily be ±100%, maybe higher for a large complex project.For smaller repetitive projects, this range would be much smaller.

Fig 3-1 shows this in schematic format.In a mature organization, this notion could be the norm and is an important concept to stress.For example, one very mature organization may code its estimation documents in different colors.So, an estimate presented on red paper fills the ROM category, while a yellow one would be assumed in the definitive range.Finally, the formal budget would be called a green estimate.This approach lets everyone know how to adjust their view of the data.More typically, only one value will be visible at any one point and it is often not clear at what stage of analysis the data represents.Project budget discussions need to have this management view.

Source:Gary L.Richardson.Project Management Theory and Practice.CRC Press, 2009.

Budget Reserves

In this section, we will describe three dynamic budgeting issues that have the potential to consume budget funds not defined in the original base plan.Each of these variance situations will occur to some degree during the project life cycle and some arrangement for handling each category needs to be part of the plan and somehow reflected in an overall budget view.The fact is that a project exists in a very dynamic environment with things changing all the time.Any deviation from the plan has the potential to impact scope, time, or cost estimates.Some feel that these dynamics are so radical that planning is a waste of time.This is not the case, but clearly the plan has to recognize the dynamics.The key question is how to incorporate unplanned contingencies in a reasonable manner.

Approved Changes

The most obvious dynamic is unplanned work resulting from requested and approved changes to the original project scope.Each of these actions will occupy the project team’s attention and resources, thereby taking away productive time from the current plan.When a new work unit is approved, the WBS structure needs to be modified to reflect the new scope and all planning related to how the new work fits into the current plan represents additional project work activity.These work activities have an impact on schedule, budget, and required resources for the project.One possible method to show this in the plan is to allocate a level of effort work unit with some attached budget.

Risk Events

A second dynamic occurs from risk related events happening through the whole life cycle.A risk event is called “known unknown”.The traditional method for handling such events is to set aside a contingency allocation that has been estimated to cover anticipated events.This allocation will be held external to the working budget and used as a particular event occurs.Think of this as a phantom work unit that is not in the plan.When the event occurs, the related corrective work unit is moved into the plan and funds are taken out of the risk contingency pool to cover it.The goal is to have a contingency fund that just covers the future needs for this class of dynamic.

Management Reserve

A third dynamic is a class of issues falling into the category of “unknown unknowns”.These are issues that occur, but are not planned or anticipated.Called a management reserve, this class of contingency is designed to deal with unplanned, but required changes that occur during the course of the project.Management reserve is an amount of the owner’s total allocated budget withheld under the owner’s management control, rather than assigned as part of the project’s scope under the control of the project manager.It is the amount of the total budget withheld for management control purposes, rather than designated for the accomplishment of a specific task or set of tasks.It is held and applied through a disciplined process to any additional work that is to be accomplished within the authorized work scope of the contract.It may not be used to offset or minimize existing cost variances.

Cost Baseline

As cost budgeting output, the cost baseline is a real or theoretical construct that captures the approved budget distributed over time.The cost baseline is the basis for the earned value reporting system.It is the budget for the estimated cost of the project spread over the time periods of the project.It is used both for comparison and reporting and is normally a critical element in project status reports, progress reports, and forecasts.The cost baseline serves as affirmation of what the project’s cost structure looks like when the project is originally approved and it should incorporate any approved changes.It is developed by aggregating the costs of the individual work elements and then combining them at time (or work) intervals where meaningful actual cost information will be available.

Fig 3-2 shows a graphical view in which the approved baseline is set higher than the anticipated plan.In this example, the graph is showing the cost baseline versus planned cash expenditures and funding constraints.This presentation is a key item in the project management plan.Many projects, especially large ones, have multiple cost or resource baselines, as well as baselines related to consumable production items (e.g., cubic yards of dirt moved per day).In each case, these are used to measure different aspects of project performance.These various baseline comparisons may also be included in regular project status measurement.In the earned value management technique the cost baseline is referred to as the performance measurement baseline (PMB).

Source:PMBOK Guide (2008).