The first step in creating a project budget is to generate cost estimates. We will discuss the different ways to do that, but first we need to have a common understanding of various costs that must be considered in any project. In order to begin project budgeting, you first need to understand types of costs and cost estimates.
Types of Costs
Fixed and Variable Costs
A fixed cost is an expense that is not dependent on the amount of goods being produced. An example of this is the rent an organization pays to maintain a business office. Whether that office is managing one project or 10, the rent stays the same. In contrast to this is a variable cost. This is an expense that has a dependent relationship with the deliverables being produced. An example of a variable cost is the raw materials used to make a product. The more products an organization makes, the more materials it needs to meet increasing production demand.
Direct and Indirect Costs
A direct cost is an expense directly related to the goods or services of an organization. An example is the hourly wage of a manufacturing employee who is producing a component of an end product. In contrast, an indirect cost cannot be directly tied to a particular good or service. An example of an indirect cost is a utility cost for the building that the manufacturing employee works in, which houses many employees producing many different products.
There are different methods of estimating costs and different reasons you would use each of the following methods. When deciding which to use, choose the method that yields the most accurate cost estimate based on the information you have at the time. Also, identify the types of costs during your estimation and account for them accordingly when circumstances change. For instance, if your project’s product scope remains the same but quantity increases, your variable costs will increase along with it.
Also known as analogous estimating, historical estimating takes the known costs from a similar project that has been performed in the past and adjusts them accordingly (i.e., for inflation) to generate an estimate for the current project. While this method is typically quick and does not require many resources to complete, it is also the least accurate method and should be used only when information is limited — such as in the early stages of a project.
I used historical estimating a lot in residential construction. An example would be when I knew approximately what a new home would cost to construct, based on what a similar home cost three months earlier. This type of estimation was very helpful before I had finalized drawings that I could use to obtain exact bids from subcontractors.
This method uses rate relationships between cost and variable in order to derive an estimate from simple calculations. For example, let’s say I know a certain type of space costs an average of $250 per square foot to construct and I am constructing that type of space. I take my new project’s square footage and multiply it by $250 to estimate total cost. This is applied to the entire project or project components in conjunction with other methods of estimation. This typically yields a more reliable estimate than historical methodology.
This method is the most accurate. However, it is also the most time consuming and should be used as information and time allow. Bottom-up estimating is simply taking the lowest level of work known at the time (activity or work package), generating the cost estimate for each, and adding up the costs to the highest level in order to get an overall project cost estimate. Because you get more accurate costs by pricing activities individually, this method provides the most reliable estimate.
Wrapping it Up
Developing a project budget can be daunting. First, knowing where to even begin can be a challenge in larger projects. Second, you will be fighting an uphill battle if your scope isn’t clearly defined. Third, stakeholders will expect the initial budget to be accurate. When you think about big projects, however, that is a little unfair. There are many changes to scope and time that occur in multi-year projects. However, it always seems stakeholders remember the first budget number and forget about change orders that occur throughout the project. So, the trick is to plan for changes that might occur during your initial budgeting phase.
This post focused on the basic understanding of project budgeting. Next, I will explain how the budget comes together and how to use contingency and management reserves.
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