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Project Management - Cost Estimation

Updated on March 20, 2012

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.

COST ESTIMATION

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

PLANNING

  • Budget transforms a long-term plant into annual segments. It is helpful in making up shortfalls to ensure that objectives are achieved in time.

COORDINATION

  • 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.

ALLOCATING RESOURCES

  • 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.

PERFORMANCE EVALUATION

  • 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.

MASTER BUDGET

Basically there are two types of budget: Operating Budget and Capital Budget. Taking together they form parts of Master Budget.

OPERATING 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

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:

ROLLING BUDGET

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

PARTICIPATIVE 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.

 

FLEXIBLE BUDGET

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.

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    • mashood_khan profile image

      mashood_khan 7 years ago

      Another great hub with simple lay-man language, techniques and examples to grasp the basic concept in short span of time. I think so, through this hub every one will get some extra knowledge irrespective of having prior knowledge about budgeting, costing and finance.

      Expect More healthy work in the field of PM and Costing. Best of Luck

    • profile image

      Adnan Vali 7 years ago

      Excellent yet simple work by a man i always admire Sir i am a big fan since your days in Hamdard University where you took a single batch for "Project Evaluation and Review Techniques".

    • profile image

      kashan pirzada 7 years ago

      Thanks for sending us this article, Sir You are very much true that Learning is a continuous process. Remember me in your prayers always!

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      Thanks Adnan Vali and Kazhan Pirzada for your comments.

    • ajcor profile image

      ajcor 7 years ago from NSW. Australia

      Thank you hafeezrm for your very clear hub on project management - cheers

    • Jmell profile image

      Jmell 7 years ago from El Paso, Texas, USA

      Hafeezrm.....this information was impressive! (and of great help to young entrepreneurs)

    • profile image

      Jamshad awan 7 years ago

      Really good. A dry subject made easy.

    • profile image

      samreen habib 7 years ago

      Aasalam-0-Alaykum Sir

      .. thanks for sharing this...it was quite informative..

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      Thanks Jamshad Awan and Samreen Habib for your comments. It is good Samreen Habib that you are continuing your interest in learning. It would benefit you in the long run.

    • profile image

      Sana Rao 7 years ago

      Thanx SIR

      ITS REALLY HELPFUL AND INCREASE OUR KNOWLEDGE..MAY U PROVIDE THESE ARTICLE IN OUR ENTIRE LIFE,,,,IT MADE EASY TO UNDERSTAND THE TOPIC WITH EXAMPLE....HOPE U HAVE A NICE JOURNEY,GOD BLESS YOU.

    • profile image

      Sana Rao 7 years ago

      Dear Sir

      Thanks Sir for still providing hub page,u are really appriciate you for this achievment..u r a guideline for us..hope u taught other course as u are master of Project Management.Enjoyoing at HO CHI MINH ON beach...hve a nice trip.God Bless u

    • profile image

      mushtaq2006 7 years ago

      Great work. to explian a complex topic such as budget in simple and straight farward way needs expertises and inside knowledge and Mr. Hafeez-ur- Rehaman has all.

      i am anxiously waiting for your series of articles about project management. they would certainly be a great source of refreshing old knowledge and expand the boundaries.

      Regards,

      Mushtaq Ahmed

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      Thanks Mushtaq Ahmed for your kind words.

    • Rufi Shahzada profile image

      Rufi Shahzada 7 years ago from Karachi

      Dear Sir,

      All the types of BUDGETS are explained so well with appropriate details.

      Thanks!

      RUFI SHAHZADA

    • Syed Kabeer Ehsan profile image

      Syed Kabeer Ehsan 7 years ago

      Dear Teacher,

      book reading is like very booring to me because of the hard language used into it, but i love reading your hub pages because they are not too lengthy and easily understandable, i am waitng for your more project management articles.

      thanque sir.

    • TEERATHMAHESHWARI profile image

      TEERATHMAHESHWARI 7 years ago from karachi

      dear sir ,

      it is realy easy to understand these topics in way u explaing otherwise much difficult to read by forien writer with example of their own region but your article and notes r realy easy to understand along with local and relity based example in class help to clear our concept.

      thank a lot.

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      Thanks Rufi,Ksbeer and Teerath for your comments.

    • profile image

      Umair Ahmed Khan 7 years ago

      Assalam Alaykum Sir!

      Sir this is an excellent article that every person can

      easily understand. all points are explained in such a

      decent manner that a layman can also understand.thanks

      for ur kind efforts sir..

    • hafeezrm profile image
      Author

      hafeezrm 7 years ago from Pakistan

      Thank you Umair and Sana for your comments.

    • profile image

      HIRA SAMI 7 years ago

      THANKU SIR FOR EXPLAINING ALL THESE BUDGETS IN VERY EASY WAY SIR UR HUB PAGES ARE VERY INFORMATIVE I LUV IT....

      THANKU SIR

      WAITING FOR MORE

      hira sami

    • profile image

      bettersuccess 7 years ago

      Really helpful hub...thanks for sharing.you've outlined it very well..i'll keep in touch and expect for more hubs coming from you sir.

    • profile image

      Nadir Naeem 6 years ago

      Thank you sir for this wonderful lecture. We appreciate this explanation both in the form of essay and vedio. Thank you once again. :)

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Hira Sami for your comments

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks bettersuccess for your comments.

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Nadir Naeem for your comments

    • profile image

      Muhammda Saeed 5 years ago

      Dear Sir,

      I found this very interesting and throughly defined. Different aspects and types of budget are well defined here. Moreover the cost estimation that is crucial process for any project is defined here nicely.

      Regards,

      Your Student

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Saeed for your comments.

    • profile image

      anam 5 years ago

      thank u so much sir for sharing ..

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Anam for your comments.

    • profile image

      shaista tabassum 5 years ago

      very nice n excellent written by u and i m very satisfy after reading i hope i will do good with the help of this hub in mid term

      regards

      ur student

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Shaisa Tabassum for your comments.

    • profile image

      Imtiaz Malik 5 years ago

      Thanks sir!

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Mr. Imtiaz Malik for reading the article.

    • profile image

      Mohammad Abbas89 5 years ago

      Excellent Explanation in Simple Words....Thanks

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Mohammad Abbas89 for your comments.

    • profile image

      fahad shahid 5 years ago

      thank you so much sir for sharing information about budgets allah bless you :)

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Fahad Shahid for your comments.

    • profile image

      zohaibnoor 5 years ago

      asa sir ,

      after reading that hub page i have understood the difference between operational and capital budget thank you very much in order to share this ..

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      You are welcome, Zohaib Noor.

    • profile image

      Jaksha 5 years ago

      Sir,

      Thank You for this article, it is indeed in very simple language. I wanted to see some examples which can help me do some budget for web development. Please can you suggest me if you know, where can I look for some examples.

      Thank You,

      Jaksha

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Thanks Jaksha for your comments. Go to this link:

      http://www.newblood.com/blog/2010/06/12/planning-y...

    • profile image

      sameer 5 years ago

      Budgeting is process of allocating scare resources for an organisation............

    • hafeezrm profile image
      Author

      hafeezrm 5 years ago from Pakistan

      Yes Sameer, it is true.

    • profile image

      Hashimi 4 years ago

      How can we Estimate Productivity Rete of Machinery for Example how can we Calculate for Grading we need Grader For one Day How Much per day Grade by (SQ/Meter)

    • hafeezrm profile image
      Author

      hafeezrm 4 years ago from Pakistan

      The question not clear. Anyhow, a machine has certain capacity and life such 5000 hours producing 100 units per hour. From this,rate per shift or day or week can be calculated.

    • profile image

      Naimatullah M Ellahi Rajput 2 years ago

      With regards can I get your personal contact.

      regards,

      Naimatullah M.Ellahi Rajput

      naimatullah2007@hotmail.com.

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