Cost Management | By Duncan Haughey | Read time minutes
It isn't easy to know how much it will cost when starting a project. Project managers are accountable for their budget estimates, and with so much uncertainty in projects, it can be one of the project managers' most significant challenges.
Creating an accurate budget is an essential skill for a project manager. It can be a daunting task, especially for new project managers; however, once you have created your first budget, you will have an approach to use, and it will become easier for future projects.
There are two approaches you can take when creating a budget:
- Top-down approach: deciding how much the project will cost and dividing the cost between the work packages.
- Bottom-up approach: estimating the project's total cost by costing the lowest-level work packages and rolling them up.
Both approaches have their advantages and disadvantages. As a project manager, you will face both at some time in your career. Let's take a look at each approach in more detail.
Top-Down Budgeting Approach
Often, senior management decides how much a project should cost. This amount gets divided between the work packages. Keep in mind that this approach is more than guessing; you need to explain how you will do the work within the allocated amount of budget for each work package. A project manager should ask whether the budget looks realistic based on experience from past projects. Prior experience from other projects will play a part in validating the budget allocation for work packages.
The advantage of the top-down budgeting approach is that it focuses on achieving the project within the budget allocated and leads to efficiencies and reduction in wasteful practices.
A disadvantage of the top-down budgeting approach is that it assumes that the person creating the budget has enough knowledge and expertise to make a reasonable cost estimate. If they do not, conflict may occur when a person required to execute the project is given an unrealistic budget that is insufficient to deliver the project. There is a risk of deliberately low budgets getting created with the belief that it will encourage cost savings.
Bottom-Up Budgeting Approach
The team, often involving the budget holder, identify the tasks and activities needed to complete the project. The project is based on the lowest-level work packages and rolled up to arrive at the total project cost. In this approach, you calculate each work package's direct and indirect costs.
The advantage of the bottom-up budgeting approach is its accuracy (as long as you have not missed any task or activity). It is helpful for team morale because the project manager involves the team in budget creation. This approach is sometimes called participative budgeting for this reason.
A disadvantage of the bottom-up budgeting approach is the difficulty in getting a full list of tasks and activities needed to complete the project. It is easy to miss some required tasks and activities that throw the budget out later.
Different Cost Types
Two cost types concern project managers when creating budgets: direct and indirect costs.
These costs are easily attributed to the project and charged item-by-item. Some examples include:
- Labour (people)
- Consultant fees
- Raw materials
- Software licences
These costs are for items that benefit more than one project, and only a proportion of their total cost gets charged to the project. Examples are:
- IT equipment (servers, printers, etc.)
- Office space (rent)
- Office equipment
- General administration
- Company insurance
To cover risks, add a contingency reserve or buffer to projects, usually a percentage of the project cost and time. This fund is used when encountering unexpected events during the project. You should adjust your contingency reserve to the risk level identified for the project. A routine, well-practised project will have a lower contingency reserve than a project breaking new ground.
Your budget will consist of direct and indirect costs, with a small amount assigned for contingency reserve.
In addition to the top-down and bottom-up budgeting approaches, there are several other techniques that project managers use to create their budgets. These are five alternative approaches used to develop budget estimates:
- Expert Judgment: This approach uses subject matter experts (SMEs) to calculate the project's total cost. This approach can be helpful because, with the aid of expert knowledge and experience, you can account for factors that are not always apparent to non-experts.
- Supplier Bid Analysis: This approach compares bids from different suppliers to arrive at a cost estimate for the project.
- Analogous Estimating: This approach uses history from similar projects to create an estimate. It looks at the amount past projects cost while accounting for any differences with the new project.
- Three-Point Estimating: This approach uses the weighted average of three estimates -- best-case, most likely case and worst case -- to gain a greater degree of control over how the value of a task or activity is determined.
- Parametric Estimating: This approach uses a statistical relationship between historical data and other variables, such as lines of code in a software application or square footage of a building, to calculate an estimate.
Monitoring the Budget
Once you have finished your budget and your project starts, you should regularly check actual spending against your budget estimate using a spreadsheet, such as this Budget Analysis and Forecasting Template (MS Excel, 15 KB) developed by Brad Egeland. This spreadsheet will tell you whether the project progresses as planned or corrective action is needed.
It is better to come in slightly under budget than over budget. Your customer will be happier, and it will reflect well on your ability to create an accurate budget and stick to it.
Whichever budgeting approach you choose, spend time creating your budget, checking it carefully, and reviewing it often to make sure you stay on track.
Download the Project Budget Calculator (MS Excel, 24 KB)
Recommended read: 11 Rules for Estimating Project Costs by Duncan Haughey.