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Proj Cost & Schedule Control

Week 2: Financial Plan - Lecture

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Range or Three-Point Estimates

Project Financial Plan | Budgeting Process | Overview on Estimating | Range or Three-Point Estimates | Contingency Estimates | Time Value of Money Tutorial (Reference) Project Financial Plan In Week 1 we looked at the project plan and the primary planning tool, the WBS, while we only touched on cost estimating. In Week 2 we will go into detail on how project costs are determined and how these costs are used in our project financial plans. We will focus on estimating project costs. The WBS is the basic tool used in project planning, and project estimates are typically derived from the detail found in the WBS. These estimates will form the basis for defining our project's budgets. Accurate estimates are essential if budgets are to be maintained during project execution and used as the baseline for our monitoring and control efforts. Several estimating techniques are introduced, including three-point estimates and contingency estimates. Budgeting Process In project management we emphasize the need to have a process to break the work into manageable details. The estimating process is no different. We talked about historical cost in Week 1 to introduce one important method of obtaining data for project estimates. We will now discuss the overall process. Two Budgeting Processes There are two main budgeting processes; top-down planning and bottom-up. These are not mutually exclusive and neither is the "right" way. Both start with a project scope and statement of work. The top-down process is when the executive and higher management create a high level budget and schedule based upon their experience, historical data, and, usually, business restrictions. The bottom-up process is when the people who are going to do the project or their representatives start by creating a detailed WBS with all the tasks required to do the project. They then estimate the cost and time required to do each of the tasks. This is then rolled up to produce a complete plan. I believe you will all agree that these two processes may not produce the same budget. Both have their advantages and disadvantages and as such there may be circumstances that affect the decision of which to use. Budgeting Roles There are many people and organizations involved in the creation of the project budget. The larger the project, the more important it is to follow all the steps. On smaller projects, the project manager will take a larger role in creating the estimates and may shortcut some of the steps due to lack of project resources on smaller efforts. However, it is still important to cover all the functions in the outline even if the person doing the activity changes. There are two main roles responsible for the estimating process. First is the project manager (PM), whom you are already familiar with. The PM is directly responsible for some of the activities and at the very least is responsible to coordinate the efforts of others in the budgeting process. The second is the functional manager (FM). The FM is a name given to the manager of a functional group, such as engineering, marketing, and so forth. There can be and likely will be several FM's involved in the process on any given project, as work for the project is spread across several different groups. The FM is an expert on the work performed within their group and by their people and is typically successful at obtaining estimates from within their own group. A classic procedure for generating the plan using the WBS and the bottom-up process is outlined here:
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View transcript here Overview on Estimating In order to create the budgets we discussed above we require estimates: the more accurate the better. Estimates are typically formed using a combination of estimated costs for labor and materials and allowances for indirect costs, such as inventory costs and overhead. Although seemingly simple in nature, estimating is a complex process that demands significant effort if realistic project budgets are to be developed. Some organizations have full time "estimator" roles. These are experts with keen understanding of project cost items and applying them. There are several models for refining estimating accuracy, which are discussed in the following sections. First we will look at a straightforward estimating example where we use the supplied cost data and conditions to create an estimate for one toaster and for 100,000 toasters. 2-1 Estimating Demonstration Problem A company has received an order for 100,000 toasters from Sears. Using the material, labor, overhead information, Bill of Materials and assembly information provided, answer the questions below: Assembly information: Each toaster takes approximately 20 minutes to assemble. Bill of Materials: (1) case, (2) heating elements, and (1) set of controls.
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Estimate: (a). The cost per toaster. (b). The total cost for producing 100,000 toasters. The cost of LABOR is as follows: The cost of MATERIAL items is as follows: Item Case Heating Element Controls Cost/Unit $2.50 $3.00 Inspection $1.40 Production Assembly Material Inventory and Handling Production Support $15.00 per hour 15% of material costs based on historical information 10% of material costs based on historical information 8% of assembly labor cost based on historical information The cost of OVERHEAD based on historical information is as follows: General and administrative is 20% of total material and labor costs.

Solution Complete estimates on a per unit basis, and calculate total project estimates on the per unit cost. This is less complicated and retains accuracy at the base level.

Material: Case: Heating Element: Controls: Total Materials: Labor: Prod. Assembly: Inventory/Hand.: Production Support: Inspection: Total Labor: 20/60($15.00) 0.15($9.90) 0.10($9.90) 0.08($5.00) = $5.00 = $1.485 = $0.99 = $0.40 = $7.875 $2.50 $3.00(2) $1.40 = $2.50 = $6.00 = $1.40 = $9.90

Overhead: G & A: (a). Total Estimated cost per toaster: (b). Total cost for 100,000 toasters = $21.33(100,000) 0.20($9.90+$7.875)

= $3.555
= $21.33 = $2,133,000.00

Range or Three-Point Estimates Range (or three-point) estimates use the beta distribution formula to refine estimating accuracy when specific data for quantity
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and price are not available. This technique is applicable where historical data indicates that material prices/quantities may fluctuate over time and predictions regarding the price/quantity at the time of project execution are unavailable at the time the estimate is formed. Ranges are developed using low (optimistic), most likely, and high (pessimistic) estimates for variables within the estimate. These numbers are then refined using the beta distribution formula. This equation is meant to provide a "weighting" to the Popt, Pmost, and Ppess to create a beta distribution of possible outcomes for Pexp. The resulting distribution will be biased to the side which is larger, Popt or Ppess (typically toward the Ppess side). When we apply the weighting of 1, 4, and 1 to Popt, Pmost, and Ppess and then add the six "parts" together we get a number that is approximately six times greater then what our estimate should be. As a result, we divide by six to remove the weighting and return the estimate to the original magnitude. As a side note, the 1,4,1 distribution is typical and is also the default in programs like MSP. However, this distribution can be modified for advanced situations to skew the weighting to a side. For example, 1,3,2 for estimates which are typically overoptimistic. Here we will explore an example estimate using the three-point estimate method. 2-2 Three-Point Estimates Demonstration Problem Problem Data You are currently trying to produce a material estimate for your project. You have obtained preliminary quotes for the material as follows: $10/lb. $9/lb. Solution Question: (a) What is the Expected Cost? Answer: Pexp = (Popt + 4 x Pmost + Ppess) / 6 Pexp = (9 + (4 x 10) + 12) / 6 Pexp = $10.17/lb (b) Expected Amount Pexp = (Popt + 4 x Pmost + Ppess) / 6 Pexp = (4,000 + (4 x 5,000) + 7,000) / 6 = 5,170 lbs. (c) The simple method estimate of the expected total cost is the product of the expected price and expected amount that will be used. Expected cost: $10.17/lb. x 5,170 lbs. = $52,578.90

Most likely cost: Optimistic cost:

Pessimistic cost: $12/lb. The production department advises they are still in the design phase and are unable to provide a firm estimate for the total amount of material which will be required to complete the project. Current estimates for total material requirements are as follows: 5,000 lbs. 4,000 lbs.

(d) The complex method for the final estimated cost for the material requires three more steps. 1) Multiply Popt cost by Popt amount to get Popt final. 2) Multiply Ppess cost by Ppess amount to get Ppess final. 3) Apply these two values combined with the simple Pexp value in the three-point equation one last time. $10.17/lb. x 5,170 lbs. = $52,578.90 $9 x 4,000lbs. = $36,000

Most likely quantity: Optimistic quantity:

Expected cost: Most optimistic cost:

Pessimistic quantity: 7,000 lbs. Using a three-point estimate Pexp = (Popt + 4 x Pmost + Ppess) / 6 to calculate: (a) The expected price per pound for the material. (b) The expected quantity of material required. (c) The expected total cost estimate for material for the project using the simple method. (d) The expected total cost estimate for material for the project using the complex method.

Most pessimistic cost: $12 x 7,000lbs. = $84,000 The final estimated cost for the material is: (($36,000 + (4 x $52,578.90) + $84,000)) / 6 = $55,052.60

Expert Says
Test your knowledge of concepts learned in this lecture. Answer the following question by typing
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your reply in the textbox. Then click "Compare Response" to find out what the professor says.

View transcript here

Contingency Estimates Adding contingency to our estimates provides a buffer in the case of uncertainty in our estimates. We sometimes must include contingencies in our project estimates because estimates are not totally accurate. Cost each work item with a high (best case) and low (worst case) estimate. The PMBOK definition of estimating specifies that some indication of estimate accuracy should always be included. Typical accuracy depends on the historical context and degree of analysis and/or research in the estimating process at any given time. Range estimates can be used for developing contingency pricing allowances. Typical ranges may be stated as: Order of magnitude -25%, +75% Budget Definitive -10%, +25% -5%, +10%

Early stage projects, during the selection phase for example, may include order of magnitude items, which will later, upon selection, be refined to definitive estimates. As a result, order of magnitude ranges provide the largest buffer to address the greatest uncertainty. Budget contingency provides less buffer and definitive contingencies provide the smallest buffer. Note how the contingency ranges are biased to the high side. This provides the greatest protection for our estimates to help ensure we are not over budget. In the example below we will use contingency pricing to determine if the final sell price will qualify our project to proceed. Note: When applying the range values to our base cost estimates, we use the high side of the three contingency ranges to effectively raise the estimates due to uncertainty (i.e. worst case scenario). 2-3 Contingency Pricing Demonstration Problem You are a project manager for a computer manufacturer and have been asked to manage the introduction of a new personal computer. Listed below are the initial cost estimates for the parts and labor for the product. Cost Estimate Type of Estimate Solution Use the upper end of each range to estimate maximum potential cost at current accuracy: OM = + 75% Budget = + 25% Definitive = + 10%
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Product Component

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Monitor Keyboard Hard drive CD drive Case

$138.00 $49.00 $110.00 $57.00 $22.00

Order of magnitude Definitive Budget Order of magnitude Budget Definitive Actual cost Definitive NA (b) No: $1,032.35 @ 100% markup (2 x $1,032.35) = $2064.70. An additional 40% reseller mark-up of 40% would bring retail price to (1.4 x $2,064.70) = $2,890.58 which is above the target price of $2,500. When the marked-up retail price is above the retail target price the retailer will not be able to sell the product and therefore will not purchase any product from us. This would cancel the project. (c) Need to firm up estimates for order of magnitude and budget items, and revise estimates before project can proceed. (a) 1.75($138 + $57) + 1.25($110 + $22) + 1.10($49 + $350 + $12) + $74 = $1,032.35 Calculate expected cost with markup and compare to target.

Motherboard/electronics $350.00 Assembly labor Packing and shipping Total cost $74.00 $12.00 $812.00

The target list price for the new PC is $2,500. New products are targeted for 100% markup on introduction, so that price and cost reductions can be taken as required by competitive pressure and still keep the product profitable. We must apply the 100% markup to our contingency price and then apply the reseller target profit markup, which is typically 40%. The estimating department currently defines estimate accuracy as follows: -25%, +75% -10%, +25% -5%, +10%

Order of magnitude Budget Definitive

(a) What cost budget do you recommend for the product based on the applied contingency values? (b) Will the project be approved? (price after markups < target implies approval) (c) What would you recommend to reduce or eliminate any contingency from the budget? Expert Says Test your knowledge of concepts learned in this lecture. Answer the following question by typing your reply in the textbox. Then click "Compare Response" to find out what the Professor says.

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View transcript here

Time Value of Money Tutorial (Reference) This tutorial is provided for the student who wishes to refresh his or her skills in the time value of money for evaluation projects. This may be of use in the course project and understanding some of the examples in the lectures but is not required. Time Value of Money Through a real-life example in which Jack Wilson is trying to reserve some money for his retirement boat, this tutorial will demonstrate: The concept of time value of money: How to calculate simple and compound interest rates How to calculate future value based on present value How to calculate present value based on future value TVM Tables are in Doc Sharing under "Time Value of Money Tables" Category.

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