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Chapter 7 Copyright 2018 John Wiley & Sons, Inc. Budgeting and Risk Management Budgeting (Slide 1 of 2) • Budgeting is the allocation of scarce resources to the various endeavors of an organization • A budget is a plan for the costs of project resources • A budget implies constraints • Thus, it...

Chapter 7 Copyright 2018 John Wiley & Sons, Inc. Budgeting and Risk Management Budgeting (Slide 1 of 2) • Budgeting is the allocation of scarce resources to the various endeavors of an organization • A budget is a plan for the costs of project resources • A budget implies constraints • Thus, it implies that managers will not get everything they want or need 7-2 Budgeting (Slide 2 of 2) • The budget for an activity also implies management support for that activity • Higher the budget, relative to cost, higher the managerial support • The budget is also a monitoring & control mechanism • Many organizations have controls in place that prohibit exceeding the budget • Comparisons are against the budget 7-3 Estimating Project Budgets • Like any forecast, this includes some uncertainty • There is uncertainty regarding usage and price • Especially true for material and labor • The more standardized the project and components, the lower the uncertainty • The more experienced the cost estimator, the lower the uncertainty • Can use previous, similar projects as guides 7-4 Rules of Thumb • Some estimates are prepared by rules of thumb • Construction cost by square feet • Printing cost by number of pages • Lawn care cost by square feet of lawn • These rules of thumb may be adjusted for special conditions • However, this is still easier than starting the estimate from scratch 7-5 Budgeting Concepts • Tradition • Life cycle costing • Actual costs and earned value analysis • Tracing expenses to specific tasks 7-6 Estimating Budgets is Difficult (slide 1 of 2) • • • There may not be as much historical data or none at all Even with similar projects, there may be significant differences Many people have input to the budget 7-7 Estimating Budgets is Difficult • • • • (Slide 2 of 2) Multiple people have some control over the budget There is more “flexibility” regarding the estimates of inputs (material and labor) The accounting system may not be set up to track project data Usage of labor and material is very lumpy over time 7-8 Types of Budgeting • • • Top-down Bottom-up Negotiated 7-9 Top-Down Budgeting • Top managers estimate/decide on the overall budget for the project • These trickle down through the organization where the estimates are broken down into greater detail at each lower level • Sometimes viewed as zero-sum game • The process continues to the bottom level 7-10 Advantages • Overall project budgets can be set/controlled very accurately • A few elements may have significant error • Management has more control over budgets • Small tasks need not be identified individually 7-11 Disadvantages • More difficult to get buy in • Leads to low level competition for larger shares of budget 7-12 Bottom-Up Budgeting • Project is broken down into work packages • Low level managers price out each work package • Overhead and profits are added to develop the budget 7-13 Reserve Analysis • Contingency reserve • Management reserve 7-14 Advantages • Greater buy in by low level managers • More likely to catch unusual expenses 7-15 Disadvantages • People tend to overstate their budget requirements • Management tends to cut the budget 7-16 Work Element Costing • Labor rates include overhead and personal time • Direct costs usually do not include overhead • General and administrative (G&A) charge 7-17 Estimation Examples • Assume a work element is estimated to require 25 hours of labor by a technician. • The specific technician is paid $17.50/hr. • Overhead charges to the project are 84 percent of direct labor charges 25 hr × $17.50 × 1.84 = $805.00 • Assume 12% personal time 1.12 × 25 hr × $17.50 × 1.84 = $901.60 7-18 An Iterative Budgeting Process– Negotiation-in-Action • Most projects use some combination of top-down and bottom-up budgeting • Both are prepared and compared • Any differences are negotiated 7-19 Opposing Views of Superior and Subordinate 7-20 Category Budgeting Versus Program/Activity Budgeting • Organizations are used to budgeting (and collecting data) by activity • These activities correspond to “line items” in the budget • Examples include phone, utilities, direct labor,… • Projects need to accumulate data and control expenses differently • This resulted in program budgeting 7-21 Typical Monthly Budget 7-22 Project Budget by Task & Month 7-23 Improving The Process of Cost Estimation • Inputs from a lot of areas are required to estimate a project • May have a professional cost estimator to do the job • Their primary job is to reduce uncertainty • Project manager will work closely with cost estimator when planning a project • We are primarily interested in estimating direct costs • Indirect costs are not a major concern 7-24 Problems • Even with careful planning, estimates are wrong • Most firms add 5-10 percent for contingencies 7-25 Not Always About The Profit • To develop knowledge of a technology • To get the organization’s “foot in the door” • To obtain the parts or service portion of the work • To be in a good position for a follow-on contract • To improve a competitive position • To broaden a product line or a line of business 7-26 Project Bids and RFPs • The project proposal is essentially a project bid • Putting together a project proposal requires a detailed analysis of the project • Project proposals can take weeks or months to complete • A more detailed analysis may result in not bidding on the project 7-27 Questions To Consider • Which projects should be bid on? • How should the proposal-preparation process be organized and staffed? • How much should be spent on preparing proposals for bids? • How should the bid prices be set? What is the bidding strategy? Is it ethical? 7-28 Project Proposal Contents • Cover letter • Executive summary • The technical approach • The implementation plan • The plan for logistic support and administration • Past experience 7-29 Learning Curves • Human performance usually improves when a task is repeated • This happens by a fixed percent each time the production doubles • Percentage is called the learning rate 7-30 Learning Curves 7-31 Learning Curve Calculations Tn = T1n Tn T1 n r r log (rate) r= log 2 N Total time = T1  n = Time for nth unit = Time for first unit = Number of units = log decimal rate/log 2 r n =1 7-32 A Special Case of Learning – Technological Shock • New systems may promise efficiency, but it may take time to realize 7-33 Other Factors • Escalation • Waste • Bad Luck 7-34 Project Risk Management • Considerable more interest in risk management now • The human factor is probably the major element • Consider risk attitude or tolerance • Tailor risk communication to the audience 7-35 Subprocesses of Risk Management 1. 2. 3. 4. 5. 6. 7. Risk management planning Risk identification Qualitative risk analysis Quantitative risk analysis Risk response planning Risk monitoring and control The risk management register 7-36 Risk Management Planning • Need to know the risk involved before selecting a project • Risk management plan must be carried out before the project can be formally selected • At first, focus is on externalities • Track and estimate project survival • Project risks take shape during planning • Often handled by project office 7-37 Risk Management Planning • Types of risks 1. Preventable 2. Strategy 3. External 7-38 Risk Identification • Risk is dependent on technology and environmental factors • Delphi method is useful for identifying project risks • Other methods include brainstorming, nominal group techniques, checklists, attribute listing, and EWS. • May also use cause-effect diagrams, flow charts, influence charts, SWOT analysis 7-39 Qualitative Risk Analysis • Purpose is to prioritize risks • A sense of the impact is also needed • Each objective should be scaled and weighted • Construct a risk matrix • Same approach can be used for opportunities 7-40 Risk Matrix Figure 7.6 Risk Matrix 7-41 International Project Risk Categories • Cultural • Political • Regional • Virtual 7-42 Quantitative Risk Analysis • More precise than qualitative • Typically more accurate • Three techniques: 1. 2. 3. Failure Mode and Effect Analysis Decision Tree Analysis Simulation 7-43 Risk Response Planning Threats • Avoid • Transfer • Mitigate • Accept Opportunities • Exploit • Share • Enhance • Accept 7-44 Risk Monitoring and Control • Monitoring covered in detail in Chapter 10 • Control covered in Chapter 11 7-45 The Risk Register • Environments that may impact projects • Assumptions made • Risks identified • List of categories and key words • Estimates on risk, states of project’s environment, or on project assumptions • Minutes • Actual outcomes 7-46 Quantitative Risk Assessment 7-47 Failure Mode and Effect Analysis 1. 2. 3. 4. 5. List ways a project can fail Evaluate severity Estimate likelihood Estimate the inability to detect Find the risk priority number (RPN) (RPN = S  L  D) 6. Consider ways to reduce the S, L, and D for each cause of failure 7-48 Decision Tree Analysis Figure 7.7 7-49 General Simulation Analysis • Simulation combined with sensitivity analysis is useful for evaluating projects • Would support project if NPV is positive and is the best use of funds • Should avoid full-cost philosophy • Some overheads are not affected by changes • Analysis gives a picture in terms of costs and times that will be affected • Project is then reviewed using simulation 7-50 Monte Carlo Simulation • Can handle both threats and opportunities and sequential events 7-51 Sensitivity Analysis • Also referred to as “What-if” analysis • Can be used for quantitative and qualitative models • Process includes going back into the model to change one parameter and see impact on final result • Weakness: In reality, a single change in environment doesn’t happen • There is also “scenario sensitivity analysis” 7-52 Dealing With Project Disasters • What to do if a loss is catastrophic? • Even if the probability is low • Buy insurance • What if insurance isn’t available? • Four approaches for project disaster planning • • • • Risk analysis Contingency planning Developing logic charts Tabletop Exercises 7-53 Copyright Copyright © 2018 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. 7-54