Project Management - Cost Estimation
Teach two words to a parrot, Demand and Supply, and get a brand new half-economist. Another two words ‘Planning and Control’ would raise the parrot to the level of a half-administrator.
Planning and control are two ingredients of success. Running a business without planning and control is like groping in the dark. An important tool in planning is a budget. It is a quantitative expression of a plan in monetary terms. It is an itemized summery of probable expenses and income for a given period.
Budgets are estimates, and estimates are worked out through applying a variety of techniques.
Two most widely used approaches are: Top-down and Bottom-up. In top-down approach, total sum of a budget or magnitude would be settled first through consensus or Delphi techniques. Both involve experts who would give an estimate of funds required for setting of say a fertilizer plant or a university. Later, detailed can worked out as to how much of total should go for land, building, libraries, laboratories and play grounds. Input:output method is the same. An experienced weaver can easily break the output (say 1,000 kgs of yarn of 20 counts) into cost of raw cotton, labor and overheads. If Diamer-Bhasha Dam is finalized and made public, the manufacturers of cement & steel can work out how much of their products would be demanded. The entire Material Resource Planning is built on this process, just put quantity of output and get inputs required.
In bottom-up approach, it is the reverse. There a number of methods. One is template method where a proforma would be given for each category of industry say a sugar mill and one has to fill each and every item for arriving at a total figure. Sum of targets by individuals (salesperson, bank-officers etc.) would constitute a valid budget. Also, another method known as task analysis can be used. An object, say a table, is broken down into its components and each components is valued separately to arrive at its cost of manufacture.
Trend projections are widely. This covers growth rate, moving averages and regression. These form part of time-series analysis. Or one may ignore the past trend altogether and start afresh. This approach is known as zero based budgeting. This has been discussed as follows:
Budget differs from estimate. Budget has two sides: income and expenditure or cash inflow and outflow or investment and mean. In other words, it shows how funds would be raised and used. On the other hand, estimate shows only the expenditure side.
Kalabagh Dam, a mega water reservoir, was estimated to cost $20 billion in 2002. It never went to a budget stage where the government of Pakistan had to spell out where from $20 billion would come. It remained as an estimate, a wishful thinking.
Budget differs from standard cost. The former is just a cost per unit but a budget has both unit cost and a quantity.
PURPOSE OF BUDGET
- Budget transforms a long-term plant into annual segments. It is helpful in making up shortfalls to ensure that objectives are achieved in time.
- An organization has a number of departments based on process or products. Budget coordinates their activities to ensure all are pulling in the same direction.
- Funds are scare. Sometime, a top-down approach is followed in budget making process. First decision would be how much to invest and, the second, in what areas like land, building and machinery.
- Budget serves as a bench mark to evaluate the actual performance. Managers are rewarded or penalized, products are promoted or dropped, plants are expanded or retired based on their performance evaluation.
Besides, budget facilitates communication as top-management conveys its expectation to lower-level management. Budget provides transparency in assessing performance and so acts as a motivator. Also, it helps management install a system of “Management by Exception” whereby a manager would only intervene if some glaring deviations are noticed.
Basically there are two types of budget: Operating Budget and Capital Budget. Taking together they form parts of Master Budget.
Operating Budget is concerned with utilization of existing assets. It contains forecast of production, sales, and Selling & Administrative expenses. Normally, it is of one-year duration and consists of several sub-budgets, most important being the sales budget. The operating budget focuses solely on operating income and expenses. Non-operating income and expenses are budgeted separately.
Annual Operating Budget serves as a bench mark for assessing success or failure of actual operations. If there is a short-coming, feedback is provided to the management for doing the needful. It may be rectified through normal repair and maintenance or may require a huge investment of long-term nature.
Capital Budget relates to investments which may be in new projects or expansion of the existing projects or modifications thereof. A capital budget spells out how much investments would be required and how necessary funds would be arranged. It also predicts earning from the project which helps in finding out its viability.
If huge investment is required, as in mega projects like a fertilizer plant, capital budget is further extended to include its socio-economic impact. Sometimes, contradictions are confronted where a project is financially sound but undesirable from socio-economic point of view. This has already been explain in my previous titled Soci-economic apparisal.
A TASTE OF CAPITAL BUDGET
Supposing, some young entrepreneurs want to set up a garment plant at far off place near Larkana in the province of Sindh Pakistan. The area being uderdeveloped, the project would enjoy financial benefits like (i) no custom duty on import of machines, (ii) no sales tax, (iii) concession in markup rate, power tariff and other utilities.
After consulting with textile engineers, economists and financial analysts, the sponsors found out that the project was viable with the following parameters:
- Project cost would be Rs.6 million of which 60% would be provided by the banks at a markup rate of 15% p.a.
- The sponsors would contribute the balance and expect a dividend at the rate of 20%
- The project when completed would be leased out for Rs.1.7 million per annum for the next five years.
It is viable as its payback period is less than its life and IRR is more than cost of funds. This has been explained in the video entitled GARMENT PLANT.
Some major types of Budgets are discussed below:
Firstly, time duration is ascertained. Suppose it is a quarter. Next a budget would be prepared say for January, February and March. As each month passes, it would be deleted and an additional budget month added. In this case, when January passes, it would be deleted and a new budget prepared for February, March and April. So there would always be three months budget available for the manages all the time.
ACTIVITY BASED BUDGET
Traditional budget covers costs items such a salaries, rent, depreciation and travel expense. Activity Based Budget would, on the other hand, list down activity to be performed. In a typical Purchase Department, the activities would be : (i) Short listing of new vendors, (ii) Processing material requisitions received from the Departments, (iii) Combining similar requisitions and placing orders, (iv) Distributing the material received to the requiring departments.
The cost of each activity would be ascertained using techniques like (i) direct tracing, (ii) cause and effect relationship, (iii) modeling & (iv) experimentation. The budget would be prepared on the basis of activities to be performed.
ZERO BASED BUDGET
In traditional budget past trends are carried further. So past in-efficiencies get into future. In contrast, Zero Based Budget is started from the scratch as if there were no past. First a target is fixed and all revenues and costs are budgeted accordingly. Since it is not based on any previous year, it is called zero-based.
The function of each and every department is analyzed and evaluated in a comprehensive manner. All budget items are approved only when justified. When discrepancies arise, Zero Based Budget requires detailed justification from every divisional manager, starting from the lowest levels.
See video entitled "ZERO BASED BUDGETING"
ZERO BASED BUDGET
A budget is developed by participation of all employees. This is opposite to imposed budget. If there 10 departments, each department would given its own budget which would be scrutinized and modified in consultation with the department concerned. Later, all sub-budget would be consolidated.
As opposed to fixed budget, the flexible budget would present a different picture at different level of operations. While fixed costs would remain the same, variable costs would vary with the production and as such unit cost would go on decreasing as production picks up. This is called economies of scale.