Module 7 (prepared by Dr. Perkins, 2004 with website updates inserted by DGK March 2006)

Chapter 7, Budgeting and Cost Estimation, provides a quick overview of the methods for estimating project cost before the project starts. Later chapters will tell us how to track these costs during and after the project. Here are some of my ideas on a few of the topics in the chapter, followed by some errata about formulas in the chapter.

Top-Down vs. Bottom-Up Budgeting

In top-down budgeting, the senior managers make the budget and present it to the subordinate managers. In Bottom-up budgeting, the subordinates make the budget. Both methods have their advantages. The third type, iterative budgeting, is when the bosses make a budget, then the subordinates review (or vise versa), they have a meeting and negotiate the actual budget. In many situations there is some iteration, if only by complaining. But not always. Often in construction, especially, jobs are bid by the homeoffice and the people who will do the work are presented with a number they have to meet. Some companies make a practice of not giving the original cost estimate to the field construction people. If the workers get the original budget, the costs are reported exactly as they were estimated, so that for most of the job, the bosses are happily getting exactly what they expect, then the last few items of work are grossly over budget. Usually the superintendent quits just before this. (There are other reasons for keeping the original estimate and later construction cost figures a secret. We'll get to these later.)

 

Cost vs. Financial Accounting

Here we leave the preliminary, pre-project, notion of costs and must consider the total project and how the budget will be used. For the purposes of paying taxes and for major companies listed on stock exchanges, rigorous financial accounting is required. Financial institutions such as banks and bonding companies also require this accounting. Financial accounting results in financial statements of revenues, expenditures, assets and liabilities. In theory these could take any reasonable form, but they tend to have their forms fixed. Accountants have practice standards and these have components that are standard across industries and some that are special for particular industries. You can get financial statements from a web site, you have to register with your name and stuff, but at no cost, then you can see Alaska Airlines Balance Sheet and Income Statement for example. You must remember that the accounting/financial side of your company is interested only in those and similar statements. Consequently, all their requirements are designed to fit into those statements, and the audit of the basis for those statements. Those statements are accurate, at least in theory, to the penny. On the other hand, those statements are not due until 3 months after the reporting period.

Project managers and their bosses, are interested in costs of their projects, but need the cost accounting information as soon as possible, so that they can make adjustments or otherwise make use of the information in management decisions. They usually don't mind if the information for the project as a whole is only accurate to 5%, or if individual items are only accurate to 10% or 15%, so long as the error is random and not biased.

Much miscommunication results from not understanding the two different types of accounting and trying to use one record for the other. For example, some payroll expenses "max out" towards the end of the year. State unemployment, school tax, social security, some insurance payments. Much of the vacation and holiday pay is taken in December. For cost accounting purposes, you show these as a fixed percent through out the year. For financial accounting, the actual payment is recorded. Other items are half and half. Vacation and holiday pay, might be ignored by the financial accountants until they are actually paid, or they may set up an accounting line that gets a donation each pay period, then gets tapped when the the money is spent. Again, for the cost accounting on the project, a fixed percentage is fine.

Two points from the foregoing:

1. Understand that cost (project) accounting and financial accounting are different.

2. The accountants will always win, so know what records they want and how they want them, then work backwards and set up the system to make sure you can get the cost information you need out of the system. Some project managers give up the struggle to get information back from the financial system and prefer to keep their own records, sometimes called "soft ledgers," that keep the important cost records for their projects.

Category vs. Activity Budgeting

Here your authors make a distinction that is not necessary. All the project budgets I have seen are two dimensional spreadsheets with the project task in WBS order ("activities") down the left side and the ("categories') on the top. The main categories are usually labor, equipment, supplies and services, and subcontractors. But any expense might be made a category, if it provides useful information. For example "travel" might be its own category, or might be in supplies and services. Segueing into a topic of later chapters, since each task in the the WBS will have a schedule, it's easy to go from this spread sheet to a three dimensional sheet with time as the third axis, or just to collapse the categories into one and then spread the costs out on a second sheet with time on the top row.

Project Budgeting

The project budget is always separated in the cost accounting. But sometimes the project is not separated in the financial accounting. Accountants and the Board of Directors will make that decision for many reasons that have nothing to do with your project.

Allocation of Overhead

For project (cost) accounting, the reasonable allocation of overhead is obvious. Only the people who work on the project get charged to the project - end of story. But, your paycheck gets printed, your medical insurance premiums get paid, your liability insurance get paid, all out of a "home office" or some other entity that the project people often do not see. How about the pay of the insurance coordinator in the home office? Freebe? You argue that he would be on the company payroll anyway, so should not be charged to your project. The PM seldom has control of these, but the PM does need to know the company policy so the percentage can be put in the budget.

Hard vs. Soft Costs

In managing government construction projects, a distinction is sometimes made between "hard costs," the actual construction costs, and "soft costs" which are all the project costs that are not construction. For example owner's overhead, design (A/E)consultants, and project management which includes both management of the design process and management of the construction process, including inspection. Here is a chart of each of those soft costs and their total, as a percentage of the project budget, based on about 20 municipal projects:

You'll notice that, with the exception of owner indirect, which was a fixed percentage by ordinance, all the percentages increase as the total project budget decreases. The design management, which included the costs of preparing the bid documents, pre-bid meetings and such is about the same on a $6,000,000 project as on a $50,000 project. Construction inspection, in Alaska especially, can be insensitive to project cost. It costs the project the same amount of salary, travel and lodging if the inspector is watching a large job in Ruby or a small job. Logical as these management costs are, and as universal as these principles are, some owners simply will not spend the money on managing small projects. If the project manager is managing multiple projects, it is simple, although not ethical, to shunt expenses for the smaller projects off towards the larger projects. For smaller, stand alone projects, the answer is to develop expedited procedures for projects under a certain dollar limit. Note that with the exception of owner's overhead, these are all project costs and not overhead.

Cost vs. Capital Expenditure

In the tax laws, if an expenditure is for an asset that lasts over one year, the cost of the asset must be depreciated, rather than "expensed" in the year the cost was incurred. (There, I've just distilled a 195 page IRS pamphlet into one sentence.) Often both R&D and construction projects are aimed at developing an asset. Therefore the total cost of the project is depreciated over the estimated lifetime of the asset. If the company is making money from other ventures, it may want to take costs away from the project and try to expense them this year. On the other hand, if the company is losing money, it may want to load expenses into the project, where the accounting statements will only show the depreciation of the asset in this year's financial statement. I'd be careful of any company that was trying to manipulate established company policy to shift tax burden, that is not illegal, usually, but is deceptive to the stockholders of the company. On the other hand, for a one-of-a-kind project, it perfectly ethical to establish an accounting system that strives to minimize the tax burden.

Errata, Learning Curves

Page 286, the author uses "log" several times, when he means "ln."

Not an error, but the author refers you to books with tables and charts, when today we would calculate these on a spread sheet faster than you can find the book with table.

On page 343-344 the authors develop a problem for the learning curve. Here I put it into a spreadsheet. You can get it here, then use the back button.

It is a fact that almost all repetitive activities have a learning curve. It takes less time to do a task the tenth time than the first time. While this is both intuitive and our every day experience, it is a stretch to use the mathematics to "prove" how long something should have taken, if you were not interrupted, or how long something will take, if you are estimating. In most activities random fluctuations in the environment and the human nature of the workers and supervisors make too much "noise" for the curve to be smooth.

Improving the Estimating Process

The author presents an elegant method of determining if your estimator is biased. This might be useful, if you were doing certain types of repetitive estimates and you were getting accurate cost figures to see how accurate your estimates were. There won't be any of this section on your final.

Module 7 Index

ESM 609 Index