Project Budget - Explained
What are Project Costs and Budgeting?
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Table of ContentsWhat are Project Costs?How to Establish a Budget?Managing the BudgetWhat are Contingency Reserves?What are Management Reserves?How to Evaluate the Budget During the Project?What is Earned Value Management?
What are Project Costs?
Developing and controlling a project budget requires extensive estimation by the project team. There are different types of project estimate:
- Conceptual estimate (or “ballpark estimate”) - This is developed early on as part of the project design phase. It is generally built off of the knowledge and expertise of the project team.
- Rough order of magnitude (ROM) estimate - This estimate is built once the project team has some more solid information about the requirements of the project.
- Project detailed estimate - Once the project design is complete, the team will develop a project detailed estimate.
The estimate is generally incorporated into a budget, which serves as a method of tracking project progress and comparing the actual costs against the estimated costs.
The actual project costs are continuously updated in the budget as the project proceeds.
How to Establish a Budget?
A budget is constructed by estimating costs and then attributing those costs to specific functions within the project. Total costs for individual activities will allow the project manager to project costs for particular phases, milestones, and objectives.
Once costs are associated with specific activities, the project manager can use the duration of each activity to determine the amount of funds needed at each state of the project. So, a great deal of effort must be placed into managing the timing and distribution of the budgeted funds.
Managing the Budget
The timing and rate of expenditure in a project will vary based upon the specific projects. Project managers must forecast the need for funds based upon the project plan and estimated costs.
The Work Breakdown Structure (WBS) is the starting point, as it includes all the work necessary to create the product of the project. The sum of all tasks within the WBS constitutes the total budget of the project.
Costs are attributable to the activities within a phase, over a period, or within a function. The schedule of work can be used to determine the estimated costs at any point in the project.
Because the budget is simply an estimate, the actual costs frequently vary from the estimated costs in the budget. As such, the project manager must hand the process of adapting the budget and making certain that the funding resources are available when needed (managing the cash flow).
What are Contingency Reserves?
Projects are filled with unexpected expenses. One way of dealing with this is overestimating costs. A better approach, however, is to budget a separate fund for dealing with unplanned cost increases or overruns. Many such unexpected costs are statistically predictable. Funds allocated for this purpose are called “contingency reserves” or “contingency allowances”.
The contingency reserve may be a percentage of the estimated cost, a fixed number, or may be developed by using quantitative analysis methods. A common method of calculating the contingency reserve is to take a percentage of the original activity cost estimate.
The contingency reserve can be reduced or eliminated as more information about the project becomes available.
What are Management Reserves?
Contingency reserves are set aside for unexpected cost overruns. A different reserve of funds, known as a “management reserve”, is set asset for the manager to employ if the scope of the project changes.
A change in the scope of the project is not an unexpected cost increase. It is an agreed-upon change by the project sponsor and the project manager. Because these funds are not generally spent, they are included in the total budget but are not part of the baseline estimates.
How to Evaluate the Budget During the Project?
A project manager regularly compares the amount of money spent with the budgeted amount. She is responsible for reporting this information to stakeholders.
There are several common approaches for comparing actual and budgeted costs.
What is Earned Value Management?
The earned value management (EVM) method combines the scheduled activities with detailed cost estimates of each activity. More specifically, it compares the anticipated cost of work that is scheduled to be done at a given point in time against what has been done and how much it actually cost.
The project baseline is an essential component of EVM and serves as a reference point for all EVM related activities. EVM provides quantitative data for project decision making.
EVM consists of the following primary and derived data elements. Each data point value is based on the time or date an EVM measure is performed on the project.
The budgeted cost of work scheduled (BCWS) comprises the detailed cost estimates for each activity in the project. The amount of work that should have been done by a particular date is the planned value (PV).
The budgeted cost of work performed (BCWP) is the budgeted cost of work scheduled that has been done. If you sum the BCWP values up to that point in the project schedule, you have the earned value (EV).
The amount spent on an item is often more or less than the estimated amount that was budgeted for that item. The actual cost (AC) is the sum of the amounts actually spent on the items.
The project manager must know if the project is on schedule and within the budget. The difference between planned and actual progress is the variance. The schedule variance (SV) is the difference between the earned value (EV) and the planned value (PV). Expressed as a formula, SV = EV − PV. If less value has been earned than was planned, the schedule variance is negative, which means the project is behind schedule.
The schedule variance and the cost variance provide the amount by which the spending is behind (or ahead of) schedule and the amount by which a project is exceeding (or less than) its budget. They do not give an idea of how these amounts compare with the total budget.
The ratio of earned value to planned value gives an indication of how much of the project is completed. This ratio is the schedule performance index (SPI). The formula is SPI = EV/PV.
A SPI value less than one indicates the project is behind schedule.
The ratio of the earned value to the actual cost is the cost performance index (CPI). The formula is CPI = EV/AC.
Partway through the project, the manager evaluates the accuracy of the cost estimates for the activities that have taken place and uses that experience to predict how much money it will take to complete the unfinished activities of the project—the estimate to complete (ETC).
To calculate the ETC, the manager must decide if the cost variance observed in the estimates to that point are representative of the future. For example, if unusually bad weather causes increased cost during the first part of the project, it is not likely to have the same effect on the rest of the project. If the manager decides that the cost variance up to this point in the project is atypical—not typical—then the estimate to complete is the difference between the original budget for the entire project—the budget at completion (BAC)—and the earned value (EV) up to that point. Expressed as a formula, ETC = BAC − EV
If the manager decides that the cost variance is caused by factors that will affect the remaining activities, such as higher labor and material costs, then the estimate to complete (ETC) needs to be adjusted by dividing it by the cost performance index (CPI). For example, if labor costs on the first part of a project are estimated at $80,000 (EV) and they actually cost $85,000 (AC), the cost variance will be 0.94. (Recall that the cost variance = EV/AC).
To calculate the estimate to complete (ETC) assuming the cost variance on known activities is typical of future cost, the formula is ETC = (BAC – EV)/CPI. If the budget at completion (BAC) of the project is $800,000, the estimate to complete is ($800,000 – $80,000)/0.94 = $766,000.
If the costs of the activities up to the present vary from the original estimates, it will affect the total estimate for the project cost. The new estimate of the project cost is the estimate at completion (EAC). To calculate the EAC, the estimate to complete (ETC) is added to the actual cost (AC) of the activities already performed. Expressed as a formula, EAC = AC + ETC.
Primary Data Points
- Budget At Completion (BAC)
- Total cost of the project
- Budgeted Cost for Work Scheduled (BCWS) / Planned Value (PV)
- The amount expressed in Pounds (or hours) of work to be performed as per the schedule plan
- PV = BAC * % of planned work.
- Budgeted Cost for Work Performed (BCWP) / Earned Value (EV)
- The amount expressed in Pounds (or hours) on the actual worked performed
- EV = BAC * % of Actual work
- Actual Cost of Work Performed (ACWP) / Actual Cost (AC)
- The sum of all costs (in Pounds) actually accrued for a task to date
For example say we should have completed £800 pounds of work by today. We completed £600 worth of work. The BCWP is £600. The BCWS is £800. And if we actually paid £700 then (ACWP) = £700.
Derived Data Points
- Estimate At Completion (EAC)
- The expected TOTAL cost required to finish complete work
- EAC = BAC / CPI
- = AC + ETC
- = AC + ((BAC - EV) / CPI) (typical case)
- = AC + (BAC - EV) (atypical case)
Here atypical means it is assumed that similar variances will not occur in the future.
- Estimate to complete (ETC)
- The expected cost required to finish all the REMAINING work
- ETC = EAC - AC
- = (BAC / CPI) - (EV/CPI)
- = (BAC - EV) / CPI
- Cost Variances (CV)
- How much under or over budget
- CV = EV-AC
- NEGATIVE is over budget, POSITIVE is under budget
- Schedule Variances (SV)
- How much ahead or behind schedule
- SV = EV-PV
- NEGATIVE is behind schedule, POSITIVE is ahead of schedule
- Variance At Completion (VAC)
- Variance of TOTAL cost of the work and expected cost
- VAC = BAC - EAC
- Cost Performance Index
- CPI = EV / AC
- Over (< 1) or under (> 1) budget
- Schedule Performance Index
- SPI = EV / PV
- Ahead (> 1) or behind (< 1) schedule
EVM contributes to:
- Preventing scope creep
- Improving communication and visibility with stakeholders
- Reducing risk
- Profitability analysis
- Project forecasting
- Better accountability
- Performance tracking