Answer the following essay questions. in a Word document. State your answers in your own words, in complete sentences, and give complete answers/explanations with examples where applicable. Assignment... 1. 2. Describe the most common cost elements to be included in a project cost estimate. (10 points) Compare and contrast the advantages and disadvantages of analogous, parametric and bottom-up estimating. (10 points) 3. Discuss the reasons you would want to use a time-phased budget for a project. Note: The book may not have enough information on this so please consider researching this for more details. (10 points) 4. Identify five common project risk strategies employed to address threats that your project may face. Give an example of each. (10 points) 5. The quality revolution introduced many tools that can be used to improve the quality of project related processes and outcomes. Identify three quality tools and briefly describe how you would use them to improve project related processes and outcomes. (10 points) CHAPTER 9 Budgeting Projects CHAPTER OBJECTIVES After completing this chapter, you should be able to: • Compare and contrast analogous, parametric, and bottom-up methods of estimating cost. • Describe issues in project cost estimating and how to deal with each. • Create a time-phased, bottom-up budget for a project. • Show both summary and bottom-up project budget information with cumulative costs using MS Project. 244 © Diego Cervo/Shutterstock.com • Define project cost terms and tell how each is used in estimating project cost. I sold escalators and elevators for my first job out of business school. As part of my training, before I was sent to the field, I would look over the estimates made by the sales staff. This served to double-check their math so the company had confidence in their estimates. It also served to teach me many of the little nuances that more experienced estimators used. I had my training manuals, lists of standards, main methods of calculation, and so forth, but learning from others’ experience instead of making all my own mistakes helped. One of the last parts in my training was to spend eight weeks at the Denver branch to get seasoned a little bit. Construction was booming in Denver during the late 1970s. In fact, some days I needed to bid more than one job. The first part of putting together a bid was to go the office where the requests for proposals, plans, specifications, and the like were stored. Then, armed with that information, I would put together an estimate. Finally, Phase: Selecting Approval: To Proceed PMBOK® Guide Topics: • Plan Cost Management • Estimate cost • Determine budget • Control cost Initiating Selection Planning Charter Executing Kickoff Closing Project Result Realizing Administrative Closure Benefits Realized the actual bidding took place—usually over the phone. The problem was that creating a detailed estimate would generally take at least half a day. If that was my only duty (it was not), I would still have had a hard time when multiple jobs were let for bid on the same day. Something had to give. Every morning around 10 A.M., I met the construction superintendent for coffee. We would discuss each bid that was due. What other job was it like? How was it bigger or smaller than a recently completed job? What features did it include more or less than a previous job? Did we make money on that job? We used these questions to compare an upcoming job to other recently completed jobs. We would also ask, “What do we think our competition will bid?” By the end of the conversation, we had determined our strategy for bidding the job. If we won the bid, we would complete a detailed cost estimate to see if we were close. After my training, I was transferred to Kansas City. Kansas City had less construction than Denver. I had enough time to perform detailed cost estimates before I submitted bids. Therefore, we were more certain that if we got the bid, we would have a good chance of making money. I worked for the same company in both cities. However, we used two very different methods of estimating cost. Both made sense where they were used. In Denver, if we wanted to bid every job (and you cannot win the job if you do not bid on it), we needed a fast method. In Kansas City, we had the time to develop detailed cost estimates, and so we took the time. There are many methods of estimating project costs and each has its place. Timothy J. Kloppenborg 245 246 Part 2 Planning Projects 9-1 Plan Cost Management This chapter starts with estimating project costs. Once the overall cost is estimated, the next step is to develop the budget by aggregating the costs and determining the project’s cash flow needs. Project managers also need to establish a system to report and control project costs. The final chapter section deals with how to use Microsoft Project to aid in cost management activities. Cost and schedule are closely related. Sometimes, the two move in the same direction. For example, when a schedule calls for materials to be delivered, or for workers to perform, money needs to be available to pay for the materials or workers. Sometimes, they move in opposite directions. For example, if a project needs to be completed earlier than planned, more money will probably need to be found to pay for overtime. Plan cost management is “the process that establishes the policies, procedures, and documentation for planning, managing, expending, and controlling project costs.”1 Cost planning entails developing a cost management plan for your project. The cost management plan is “a component of the project management plan that describes how costs will be planned, structured, and controlled.”2 On small projects, this can be as simple as ensuring accurate estimates are made, securing the funding, and developing cost reporting procedures to ensure that the money is spent correctly. On large projects, each of these processes can be much more involved; in addition, developing and using accurate cash flow estimates become critical. A project cost management plan includes descriptions, procedures, and responsibilities for: • • • • • Costs included (such as internal and external, contingency, etc.), Activity resource estimating, Cost estimating, Budget determination, and Cost control, including metrics, reporting, and change approvals. A project cost management plan needs to be consistent with the methods of the parent organization. In many organizations, project managers are provided with specific guidance on setting up their cost management plan. The plan provides guidance to the project manager and other stakeholders in order to serve several purposes: • • • • First and most fundamentally, it shows how to develop and share relevant, accurate, and timely information that the project manager, sponsor, and other stakeholders can use to make intelligent and ethical decisions. It provides feedback, thereby showing how the project’s success is linked to the business objectives for which it was undertaken. It provides information at a detailed level for those who need details and at appropriate summary levels for those who need that. It helps all project stakeholders focus appropriately on schedule and performance as well as cost.3 9-2 Estimate Cost Estimate cost is “the process of developing an approximation of the monetary resources needed to complete project activities.”4 Cost estimating is linked closely with scope, schedule, and resource planning. To understand cost well, a project manager needs to understand what the work of the project includes, what schedule demands exist, and what people and other resources can be used. As more of this detail becomes known, the cost estimates can be more precise. Chapter 9 Budgeting Projects 247 The first principle in dealing with project costs is for the project manager to never lie to himself. Many times, in dealing with project costs, the project manager will need to negotiate with sponsors, customers, and other stakeholders. If he does not understand what the project costs really are, he is just trading meaningless numbers. That is neither an effective nor an ethical method of establishing and committing to sensible budgets. The second principle in dealing with project costs is for the project manager to never lie to anyone else. Since sponsors, customers, and other stakeholders can often drive hard bargains, it is sometimes tempting to shade the truth to secure necessary funding. This is wrong on two counts. First, it is ethically wrong. Second, as a practical matter, a project manager’s reputation goes a long way for good or for bad. People are more inclined to work with project managers who are viewed as being honest and trustworthy. To estimate project costs accurately, the project manager must understand the various types of cost, the timing and accuracy of cost estimates, the different methods that can be employed to estimate costs, and a variety of cost estimating issues. 9-2a Types of Cost Costs can be better understood by considering various types of classifications such as those shown in Exhibit 9.1. FIXED VERSUS VARIABLE COSTS Cost can first be classified as either being fixed or variable. Fixed costs are those that remain the same regardless of the size or volume of work. For example, if you need to buy a computer for your project, the cost is the same regardless of how much you use it. Variable costs are those that vary directly with volume of use. For example, if you were building a cement wall, the cost of the cement would vary directly with the size of the wall. To understand the importance of fixed versus variable costs, a project manager ideally structures costs and the impact of changes on those costs. When a project manager understands how big a project is likely to be, she will try to determine how to complete all of the project work for the least cost. On many projects, there are choices of how to perform certain activities. Some of these choices reflect a high-fixed-cost and lowvariable-cost alternative such as buying an expensive machine that can make parts with low variable costs versus a more manual process of inexpensive machines but high labor costs. These choices require both some fixed and some variable costs. Ideally, the cost curve for EXHIBIT 9.1 COMPARISON OF COST TERMS Fixed Variable Direct Indirect Recurring Nonrecurring Regular Expedited Internal External Lease Purchase Labor Material Estimate Reserve Source: Adapted from Kim LaScola Needy and Kimberly Sarnowski, “Keeping the Lid on Project Costs,” in David I. Cleland, ed., Field Guide to Project Management, 2nd ed. (Hoboken, NJ: John Wiley & Sons, 2004): 145–147. 248 Part 2 Planning Projects E X H I B I T 9. 2 PROJECT COST AND VOLUME CURVE Expected project volume Total cost Volume the expected project volume appears as shown in Exhibit 9.2. This reflects the lowest possible total cost at the size the project is expected to be. Unfortunately, problems may occur if the volume of the project work is substantially larger or smaller than first expected. If the volume drops a little bit, the total costs may drop very little. If the volume expands a little, the costs may go up significantly. Therefore, when considering fixed and variable cost choices, it is important to understand the project scope. DIRECT VERSUS INDIRECT COSTS A second classification divides project costs into direct and indirect costs. Direct costs are those that only occur because of the project and are often classified as either direct labor or other direct costs. For example, direct labor includes workers who are hired specifically to work on the project and who will be either assigned to a new project or released when the project is complete. Other direct costs may include such items as materials, travel, consultants, subcontracts, purchased parts, and computer time. Indirect costs are those that are necessary to keep the organization running, but are not associated with one specific project. The salaries of the company executives and the cost of company buildings, utilities, insurance, and clerical assistance are examples. These costs are allocated among all of the projects and other work that benefit from them. The methods of allocating these costs have evolved in recent years thanks to activity-based costing, as described in the cost estimating issues section. Exhibit 9.3 shows both direct and indirect costs for a work package. RECURRING VERSUS NONRECURRING COSTS The third cost comparison is recurring versus nonrecurring costs. Recurring costs are those that repeat as the project work continues, such as the cost of writing code or laying bricks. Nonrecurring costs are those that happen only once during a project, such as developing a design that, once approved, guides the project team. Nonrecurring costs tend to occur during project planning and closing, while recurring costs tend to occur during project execution. REGULAR VERSUS EXPEDITED COSTS A fourth cost comparison is regular or expedited. Regular costs are preferred and occur when progress can be made by normal work hours and purchasing agreements. Expedited costs occur when the project must be conducted faster than normal and overtime for workers and/or extra charges for rapid Chapter 9 Budgeting Projects 249 EXHIBIT 9.3 DIRECT AND INDIRECT COSTS IN A WORK PACKAGE PROJECT: ACCOUNTS PAYABLE REFINEMENT WORK PACKAGE: INSTALL MODULE 1 Description: Install accounts payable refinement application and related hardware. Deliverable(s): Installed and functioning accounts payable module. Cost Categories Quantity Total Direct Labor Programmer 120 hrs @ $ 75/hr 9,000 Systems Analyst 40 hrs @ $ 100/hr 4,000 Systems Architect 20 hrs @ $ 120/hr 2,400 Other Direct Hardware 20,000 Software 8,400 Consultant Services 12,000 Direct Overhead (.6 * DL) 9,240 Total 65,040 Source: Kevin P. Grant, University of Texas, San Antonio. Adapted with permission. delivery from suppliers are necessary. The comparison of these costs shows why it is vital to understand schedule pressures and resource demands as costs are estimated. OTHER COST CLASSIFICATIONS The next several cost comparisons require little explanation. They are helpful to understand both in structuring the cost estimates and as checklists to help remember items that may be forgotten. One comparison is costs internal to the parent organization versus those external to it. Major external cost items such as equipment can be either leased or purchased. Direct cost items are often labor or materials. Estimate versus reserve costs form the next comparison. The estimate is “a quantified assessment of the likely amount… It should always include an indication of accuracy.”5 The reserve is “a provision in the project management plan to mitigate cost and/or schedule risk. Often used with a modifier (e.g., management reserve, contingency reserve) to provide further detail on what types of risk are meant to be mitigated.”6 Management reserve is “an amount of the project budget withheld for management control purposes… for unforeseen work that is within the scope.”7 By contrast, contingency reserve is “budget within the cost baseline that is allocated for identified risks that are accepted and for which contingent or mitigating responses are developed.”8 Just as uncertainly exists when estimating how long an activity will take, there is uncertainty regarding how much an activity will cost. Some activities are easy to estimate with precision. Other less familiar activities have many uncertainties, and estimating their cost is more like guessing. If one were to estimate conservatively on each uncertain activity, the total estimate for the project would likely be too high to be approved. To overcome this problem, project managers are encouraged to estimate at least a bit more aggressively. That means some activities will run over their estimates, while others will cost less. Project managers frequently add contingency reserve to cover the activities that run over their aggressive estimates. 250 Part 2 Planning Projects 9-2b Accuracy and Timing of Cost Estimates Project managers need to understand when cost estimates should be developed, how accurate they need to be, and how they will be used. During project initiation, many project managers need to develop cost estimates to have their project charters approved. At this point, very little detail is understood regarding the project, so the estimates are only approximate. However, as the scope becomes well defined in the work breakdown structure (WBS), schedules are planned, and specific resources are assigned, the project manager knows much more and can estimate more precisely. Many organizations have specific names and guidance for their estimates and these vary widely. Normally, estimates should be documented, and the level of confidence in the estimate should be described. Exhibit 9.4 shows several points regarding different types of project cost estimates. ORDER OF MAGNITUDE ESTIMATES Several things should be noted from these comparisons. First, estimates go by several different names. For example, order of magnitude estimates that are often used to seek initial charter approval are also sometimes called “ball park,” “conceptual,” “initial,” or “level-one” estimates. These early estimates are often created during the project initiating stage when very little detail is known about the project. At this point, a very rough order of magnitude estimate that could underestimate the project by as much as 100 percent (that is, the final cost could be double the initial estimate) may be the only possible estimate. There is no way to really know how accurate an estimate is until the project has been completed, but with less detailed knowledge concerning the project in the initiating stage, there is likely to be a larger margin of error. Order of magnitude cost estimates and the parallel high-level looks at each of the other planning areas can quickly give enough information to decide whether to approve the project charter and begin to invest time and money into detailed planning. E X H I B I T 9. 4 PROJECT COST ESTIMATE COMPARISONS Level of Effort Stage Approval Initiating Planning Charter Executing Project Plan Estimate Name Order of Budget Magnitude Definitive Accuracy Level −40% to +100% −10% to +15% Possible Method Analogous Parametric Bottom-Up −30% to +50% Rolling Wave Closing Project Result Admin. Closure Chapter 9 Budgeting Projects 251 BUDGET AND DEFINITIVE ESTIMATES Once a project manager enters into the more detailed planning stage, it is generally possible to create a more accurate cost estimate. This is the same thought that goes into creating a more detailed project schedule, resource estimates, risk profiles, quality plans, and communications plans. Depending on the complexity and size of their projects and organizational norms, some project managers can proceed directly to definitive cost estimates at this point. Others may still need to look at one or more intermediate levels of detail before they have enough detailed knowledge to create cost estimates with accuracy. At the end of project planning, cost estimates should have a small enough margin of error that they can be used to create a project budget, show cash flow needs, and be used as a basis for controlling the project. Most project organizations want an accuracy level of no more than plus or minus 10 to 15 percent, and some require considerably better, such as plus or minus 5 percent. Especially on complex projects such as research and development of major new products, project managers may use rolling wave planning to estimate costs. They do this by creating a definitive estimate for the first stage of the project (and committing to it) and an order of magnitude estimate for the remainder of the project. As the work on the first stage proceeds, the project manager then creates a definitive estimate for the second stage and reevaluates the order of magnitude estimate for the remainder of the project. At each stage, the project manager has more information than at the preceding stage and can create more accurate estimates. 9-2c Methods of Estimating Costs Many methods can be used for estimating project costs. Most of the methods are variations of one of the following techniques. While these methods can sometimes also be used to estimate project scope or duration, in this chapter the discussion centers on using them to estimate project cost. Exhibit 9.4 indicates that as more details of a project are known as planning progresses, more detailed estimating methods may be used. However, Exhibit 9.5 shows that even at the end of project planning, a project manager EXHIBIT 9 .5 WBS DEPICTING ESTIMATING METHODS Level 1 Analogous 2 PM Bottom-up Project AB Analogous CD Parametric EF 3 4 5 Work Packages Source: Kevin P. Grant, University of Texas, San Antonio. Adapted with permission. © Robert Nickelsberg/Getty Images 252 Part 2 Planning Projects may sometimes use a combination of cost estimating methods. If the organization has accurate enough analogous and parametric estimating methods and capable estimators, sometimes portions of a project can be estimated by those methods instead of the more detailed (and time-consuming) bottom-up methods. The method used should account for the extent of complexity, risk, interdependencies, work force specialization, and site-specific issues of the project.9 ANALOGOUS ESTIMATING Analogous estimating is “a technique for estimating the duration or cost of an activity or a project using historical data Parametric estimating can be used to determine the impact of from a similar project.”10 Analogous estimating was variables on project costs. the method used in Denver in this chapter’s opening vignette. To create a bid for a project—in this case, the installation of elevators—a similar project was considered as the starting point. Immediately, questions were asked regarding how this job compared in size and complexity with the previous job. Several things need to be in place for analogous estimates to be effective. First, the organization needs to have experience in performing similar projects and know how much each of those projects actually cost (not just what they were estimated to cost). Second, the estimator needs to know how the proposed project differs from the previous project. Third, the estimator needs to have experience with the methods by which the project will be performed. In the example, sales and construction people jointly discussed how much the project would cost. PARAMETRIC ESTIMATING Parametric estimating is “an estimating technique in which an algorithm is used to calculate cost or duration based on historical data and project parameters.”11 A bit more information is needed to complete a parametric cost estimate. Exhibit 9.5 shows this graphically by suggesting that another level of detail in the WBS might be used. In the chapter opener example of estimating the cost of elevator installation projects, parametric estimates might involve finding a bit more information regarding the project. For example, one might want to know how tall the elevator was, how fast it needed to travel, how large the platform would be, the trim level, the complexity of the controls, and the like. Each of those factors would have an impact on the elevator installation cost. For example, the cost per foot traveled might be calculated (this would cover the cost of providing and installing guide rails, wiring, etc.). Another cost might be associated with speed because faster elevators require bigger motors, more stability, stronger brakes, and so on. BOTTOM-UP ESTIMATING Bottom-up estimating is “a method of estimating project duration or cost by aggregating the estimates of the lower-level components of the WBS.”12 For a bottom-up estimate, the WBS needs to be broken down to the most detailed level, and the specifications need to be very clear. In the elevator example, bottom-up estimates were created in Kansas City. Details to be estimated included exactly how many buttons the control panel had, exactly what kind of light fixtures were mounted in the ceiling, what kind of finish was requested, and so on. The cost was estimated for each item. For example, for the process of installing the guide rail, first Chapter 9 Budgeting Projects 253 there was a small amount of time, such as one hour, to set up or get everything in place to do this step. Then, it took a certain fraction of an hour of labor to secure each foot of the rail into position. A material charge was incurred for the guide rails themselves and the fasteners that held them in place. The cost of supervision was charged for the foreperson who ensured the work was scheduled and performed properly. Finally, overhead costs (indirect costs) were allocated to each dollar of fixed costs. Bottom-up estimating is the most detailed, time-consuming, and potentially accurate way to estimate. Many projects use this method eventually to serve as a basis for estimating cash flow needs and for controlling the project. One important caution on bottomup estimating is to ensure that every item is included. If a portion of the project is left out, that portion is underestimated by 100 percent! Some organizations first create a bottom-up estimate and then compare it to a top-down view to consider adjusting it if the top-down view yields a much higher number. Exhibit 9.6 summarizes differences in cost estimating methods. 9-2d Project Cost Estimating Issues Regardless of what method is used to estimate project costs, several issues need to be considered. Some of these issues are pertinent to all projects; others only pertain to certain projects. These issues are shown in Exhibit 9.7. SUPPORTING DETAIL Supporting detail for project cost estimates includes describing the scope, method used to create the estimate, assumptions, constraints, and range of possible outcomes. The project scope tends to be the least well defined at the project outset and becomes increasingly well-defined throughout project planning. Each estimate should state exactly what scope it involves. Version control is critical for this. The method used might be analogous, parametric, or bottom-up. The name of the method and exactly how the method is used should be described. When creating an estimate, many assumptions and constraints are used. Assumptions should be outlined because two different people coming from two different backgrounds EXHIBIT 9.6 COST ESTIMATING METHOD COMPARISON ANALOGOUS PARAMETRIC BOTTOM-UP Amount of Information Required Least Middle Most Amount of Time Required Least Middle Most Accuracy Obtained Lowest Middle Highest EXHIBIT 9 .7 ISSUES IN PROJECT COST ESTIMATING Supporting detail Activity-based costing Causes of variation Life cycle costing Vendor bid analysis Time value of money Value engineering International currency fluctuations 254 Part 2 Planning Projects may assume that two different things will happen. Even if everyone involved with planning a project assumes the same thing, it still may not happen. Assumptions that are not true often cause more work or other problems for a project. As more detail becomes known, a project manager may review assumptions with an eye toward uncovering assumptions that have now proven to be false. When this happens, the project manager can investigate any impact this may have on the project budget (and schedule and scope). Examples of assumptions that may arise when estimating the cost of direct labor might include the following: • • • • • Workers will be paid at the prevailing wage rate of $14 per hour. Workers are already familiar in general with the technology being used on the project. Workers will be paid for 40 hours per week whether there is always that much work for them or not. Overtime will never be authorized. The project schedule can be delayed if the only alternative is to pay overtime. Constraints are also important to bring to the surface since they often dictate the methods available for performing the project work. Examples of constraints include: • • • • Only in-house workers will be used. No extra space will be provided. No extra budget will be allowed. The current version of the XYZ software will be incorporated into the design. The range of possible outcomes should always be stated with any project cost estimate. If the range is not stated, people may lock onto the first number they hear. If the actual project costs could be 100 percent higher than the order of magnitude estimate, the project manager had better state that loud and clear, or she may find herself continually explaining why she is grossly over budget. In fact, many estimators resist giving an order of magnitude estimate because they fear they will be held to it. A natural tension exists between managers who try to effectively manage their departments by establishing budgets as soon as possible and project managers who try to provide budget estimates as late as possible (once they know more about the project). CAUSES OF VARIATION There are many causes of variation in project costs. On routine projects using proven technology and an experienced and well-known project team, the causes may be relatively few and easy to categorize. On other projects where some of these factors are not true, more causes of uncertainty in project costs may exist, and some of those may be from unknown sources. Statisticians classify variation as coming from either normal or special causes, as shown in Exhibit 9.8. Variation occurs in all work processes. The more routine a process is and the more work is driven by machines, the less variation occurs. Projects, however, tend to have novel work and high human interaction, so there are many opportunities for variation. Normal variation comes from many small causes that are inherent in a work process. For instance, the variation in the productivity of a programmer writing code could be from phone calls, instant messages, and in-person interruptions that occur each day. Special cause variation, on the other hand, is when something out of the ordinary occurs. For example, a lightning strike could cause such a large power surge that it overwhelms the normal protectors and destroys some of the computers. Most causes of variation are of the normal variety, and improving work methods (as discussed in Chapter 11) can help to reduce this type of variation. Special causes, however, are handled more as risks as discussed in Chapter 10. Both types of variation add to project costs and need to be considered. Chapter 9 Budgeting Projects 255 EXHIBIT 9 .8 NORMAL AND SPECIAL CAUSE VARIATION Average Special Cause Variation Special Cause Variation +/−3 Sigma Normal Cause Variation VENDOR BID ANALYSIS On some projects, most or all of the cost is internal to the parent organization. On other projects, a substantial portion of the budget goes to securing services and supplies from vendors. Vendor bid analysis is used to determine whether the price being asked by the vendors appears to be reasonable. If several vendors compete for the work, it is reasonable to believe that the lowest responsible offer is fair. In the absence of competition, however, other methods may be needed to ensure a fair price. On some items, prices are determined in the marketplace and reported in business papers and websites for anyone to read. On specialized services and products, one often must negotiate with a vendor. In the absence of any other method, for an expensive item, a project manager may need to develop a should cost estimate. That is, try to determine how much effort the vendor may need to expend and add a fair profit margin to arrive at the price you believe the vendor should charge. VALUE ENGINEERING Value engineering is “an approach used to optimize project life cycle costs, save time, increase profits, improve quality, expand market share, solve problems, and/or use resources more effectively.”13 Value engineering can be a very powerful method of double-checking all of the chosen methods for accomplishing work and the features of the project deliverable. Frequently, stakeholders find a feature that was in the specifications costs more money to create than they wish to pay. In a project to update an older church, the liturgical committee proposed many controls for special lighting that would only be used on special occasions. The general contractor suggested simplifying the controls, while retaining all of the new lights, at a savings of $100,000! While the liturgical committee was disappointed, the church council readily agreed. Value engineering is so common in some industries that a separate stage is incorporated late in the project planning to ensure that time is spent in this effort to reduce project cost and/or time and to improve project quality and/or usefulness. 256 Part 2 Planning Projects ACTIVITY-BASED COSTING (ABC) Another issue project managers need to understand when estimating costs is what type of accounting system the organization uses. Historically, most companies used functional-based accounting systems. When using these systems, overhead (indirect) costs are assigned to a cost pool, which is allocated to direct costs based most frequently on volume. When direct costs were a large percentage of total costs, this made sense. In more contemporary times, indirect costs form a much larger percentage of total costs, so careful allocation of them is necessary both for selecting the projects that truly will contribute the most profit and for ensuring a focus on controlling the highest costs. ABC is another accounting approach, by which indirect costs are allocated to fixed costs based upon four different types of drivers. The cost drivers are number of units produced (frequently, the only method used in functional-based accounting), number of batches run, number of product variations, and amount of facility utilized. ABC requires more involved methods for allocating indirect costs, but yields more accurate cost information. By furnishing more specific information on cost drivers, ABC also helps to support process improvement and justify spending money on expensive equipment. Project managers need to understand how costs are allocated in their organization so they can accurately estimate the amount of indirect costs that will be assigned to their projects. LIFE CYCLE COSTING Life cycle costing is another concept project managers need to understand when estimating their project costs. Many project selection decisions are made based upon the total costs of both creating the project and of using the result of the project during its useful life. This total cost is called the life cycle cost. Many times, tradeoff decisions are considered that might involve spending more during the project to create a product that costs less to operate during its useful life. In an age when environmental concerns are appropriately being considered more heavily, to calculate total life cycle costs, a project manager may also need to consider disposition costs of the product after its useful life is complete. This can entail designing more recyclable parts (even at a higher cost) into the product. TIME VALUE OF MONEY AND INTERNATIONAL CURRENCY FLUCTUATIONS When considering costs in the future, project managers need to understand how to calculate the time value of money. One dollar today is presumably worth more than one dollar next year. Discounting the value of future revenue and cost streams to account for this enables better project decisions. Project managers need to discount future dollars by the appropriate factor. Often, the finance department at a company tells the project manager what rate to use. The rate depends upon the underlying inflation rate plus the cost of capital. On international projects, it can also depend upon international currency fluctuations. 9-3 Determine Budget Once the project costs have been estimated, it is time to establish the project budget. Determine budget is “the process of aggregating the estimated costs of individual activities or work packages to establish an authorized cost baseline.”14 To develop the budget, the project manager starts by aggregating all of the various costs. Once those are totaled, it is time to determine how much money is required for reserve funds. Finally, the project manager must understand cash flow—both in terms of funding and requirements for costs. Chapter 9 Budgeting Projects 257 9-3a Aggregating Costs When the entire project costs, both direct and indirect, have been added up, the result is a cost baseline, which is “the approved version of the time-phased project budget, excluding any management reserves, which can be changed only through formal change control procedures and is used as a basis for comparing actual results.”15 The work packages that are identified when creating a WBS not only take time, but they also cost money. The project budget can be aggregated from the work packages. Exhibit 9.9 shows how six work packages appear on a Gantt chart with the cost of each work package listed on a monthly basis. The total cost for the month is shown and the cumulative cost for the project below that. Finally, a graph appears at the bottom that shows the cumulative cost of the project at each point in time. This represents the time-phased project budget. This will be used as the project progresses for control purposes. Note the cumulative cost curve approximates an “S” shape with slow expenditures (and progress) early in the project, rapid in the middle, and slow late in the project. This is common as projects often require much planning early and have a variety of activities to finish at the end. EXHIBIT 9 .9 AGGREGATION OF PROJECT BUDGET FEB MAR APR MAY JUN $15,000 $10,000 $10,000 $25,000 $10,000 WP 1221 WP 1222 WP 1231 WP 1232 WP 1233 WP 1241 WP 1221 ($10,000) WP 1222 ($10,000) WP 1231 ($45,000) WP 1232 ($20,000) WP 1233 ($15,000) WP 1241 ($20,000) $10,000 $5,000 Cost per month $15,000 $20,000 $50,000 Cumulative cost $15,000 $35,000 $85,000 $110,000 $120,000 $5,000 $15,000 $30,000 $20,000 $120K $100K $80K $60K $40K $20K 0 Source: Kevin P. Grant, University of Texas, San Antonio. Adapted with permission. 258 Part 2 Planning Projects 9-3b Analyzing Reserve Needs Another view of project cost variation is to consider how well it is understood and how each type is handled. This is displayed in Exhibit 9.10. Variation in project costs (and schedules) can be partially explained by the presence of certain events. These events are classified as known knowns, known unknowns, or unknown unknowns depending on the extent to which they are understood and predicted. Known knowns are discovered during planning and can be estimated directly. An example could be that when a construction crew takes soil samples, they discover that extra pilings are required to stabilize the new building, and they add the cost into the project estimate to cover that expense. Known unknowns are events discovered during risk identification that may or may not occur. An example could be snowstorms that cause traffic problems for three days at a critical time, preventing workers from getting to their jobs. In the next chapter on risk, methods for calculating this cost are shown. It will appear as contingency reserves. Finally, sometimes things that are totally unexpected happen that cause an increase in cost and/or schedule. For example, perhaps a very dependable supplier goes out of business due to the sudden death of the owner. These unknown unknowns (commonly called unk unks by people who have felt burned by them) also need to be covered in the project budget. The money used to cover them is frequently called management reserve and is usually authorized by company executives. The amount placed into contingency reserve is calculated during risk analysis. The amount placed into management reserve is determined by how much uncertainty management feels exists in the project. Typical ranges are from 5 percent of project costs for a well-understood, routine project to 30 percent or more of project costs for poorly understood, unusual projects. These costs are not to be used to overcome poor estimating or project execution. Once the cost baseline is determined and both contingency and management reserves have been added, it is time to determine if sufficient funds are available. On many potential projects, a funding limit exists. The project sponsor for internal projects and the customer for external projects need to be very clear if the necessary funds exceed the limit of what is available. If enough funds are not available, this is the time to look hard at all of the estimates, schedule, and scope to determine what changes need to be made before the project management plan is accepted. It does no good for anyone to deliberately start a project with insufficient funds. 9-3c Determining Cash Flow Projects require cash to keep moving. Suppliers and workers need to be paid in a timely fashion. The difficulty that sometimes occurs is that the project’s customer may not pay for the work until it is completed—often months after project bills need to be paid. Therefore, the timing of cash coming in and going out for a project is just as important as the amount of money required. EXHIBIT 9.10 ESTIMATING COSTS OF PROJECT VARIATION HOW VARI A TION IS UNDERSTO OD KNO WN K N OWN S K NOWN UNKNOWNS UN KNOWN UNKNO WNS How It Is Discovered Scope definition Create WBS Risk identification Situation occurs Stage When It Is Usually Uncovered Initiating or planning Initiating or planning Executing Method of Estimating Costs Estimate directly Contingency reserves Management reserves Chapter 9 Budgeting Projects 259 EXHIBIT 9.11 PROJECT CUMULATIVE CASH AND REVENUE Cumulative Cost/Revenue ($) Revenue Cost Start End Time Just as the demands on individual workers can be applied to individual activities in the project schedule to determine where overloads may occur, expenses can be applied to individual activities in the schedule to see when cash is needed. Revenue can also be tracked to interim deliverables in the project schedule to show when revenue can be expected. If a project is internal to a company, the timing of cash availability is also important to understand. While workers may work every day and suppliers may deliver frequently, cash may be supplied through organizational budgets only on a periodic basis. A project manager needs to ensure that the cumulative amount of cash coming into the project either from internal budgeting or from customer payments meets or exceeds the demands for paying cash out. This cash flow is shown in Exhibit 9.11 where incoming cash is in large increments, yet outgoing cash is almost continuous. The cumulative revenue at project completion minus the cumulative cost at project completion equals the profit (or surplus) generated by the project. 9-4 Establishing Cost Control The approved project budget with contingency reserves (and any amount of management reserve that has already been approved) serves as a baseline for project control. The budget shows both how much progress is expected and how much funding is required at each point in time. These are used for establishing project control. Control cost is “the process of monitoring the status of the project to update the project costs and managing changes to the cost baseline.”16 Cost control is discussed in Chapter 14. When establishing cost control, a typical measuring point is a milestone. Major milestones are often identified in the milestone schedule in the project charter, and additional milestones may be identified in constructing the project schedule. Project managers can use the cash flow projections they have made to determine how much funding they expect to need to reach each milestone. This can then be used for determining how well the project is progressing. The sponsor and project manager often jointly determine how many milestones to use. They want enough milestones to keep track of progress, but not so many that they become an administrative burden. Microsoft Project and other software can be used to automate the cost reporting. 260 Part 2 Planning Projects 9-5 Using MS Project for Project Budgets MS Project supports both bottom-up and summary level cost modeling. Bottom-up cost modeling is primarily based on the cost of each resource assignment. Assignment costs are totaled in the related activity’s Cost field. The resulting activity costs are summarized in the parent WBS levels. Summary level cost modeling consists of a summary level estimate for all the effort represented by that level, with no underlying detail entered. This can be helpful when the detail is not known, but the schedule must provide an overview of the entire estimated time and cost schedule. 9-5a Develop Bottom-Up Project Budget To develop a bottom-up project budget, a project manager needs to understand four things: assignment costs, activity costs, project total costs, and the different perspectives from which to view costs. ASSIGNMENT COSTS The following data are used to compute each assignment’s cost value: • • • Assignment work hours—calculated when the work assignment is made (Assignment units × Resource calendar hours per each day of the activity duration) Resource standard rate Resource overtime rate (only if modeling overtime) An assignment cost value is the total number of assignment hours times the standard rate. Each resource has a standard cost rate, and some resources may have an overtime cost rate as well. These can be assigned when defining the resource as described in Chapter 8, or assigned later as shown in Exhibit 9.12. ACTIVITY COSTS The activity cost value is the sum of all assignment cost values plus any activity fixed cost value as shown in Exhibit 9.13, which displays the Task Usage view in the top pane (with the Cost column inserted) and the Resource Work form in the lower pane. In Exhibit 9.13, row 12 is a summary. Rows 9, 10, 11, and 13 are activities. The unnumbered rows are assignments. Row 9 is the activity “Prepare budgets.” Patrick is scheduled to work 30 hours on that activity. Remembering his cost rate is $30 per hour, it is possible to see how the cost is totaled. The assignment Units and Work values E X H I B I T 9. 1 2 ASSIGN COST RATES Source: Microsoft product screen shots reprinted with permission from Microsoft Corporation. Chapter 9 Budgeting Projects 261 E X H I B I T 9. 1 3 TASK USAGE VIEW WITH RESOURCE WORK FORM Source: Microsoft product screen shots reprinted with permission from Microsoft Corporation. for some of the “Select Trip Issues & Sites” activity are shown in the lower pane. To generate the Task Usage view with Resource Work form: 1. 2. 3. 4. 5. On the Task tab, View group, enter Task Usage. On the View tab, Split View group, click Details. On the View tab, Split View group, enter Task Form (if not already displayed). Right click in the form in the lower page and enter “Work.” In the upper pane, expose the Start column and right click in the Start column header to add a column. Enter “Cost” when prompted. VARIOUS PERSPECTIVES The preceding discussion has been from the view of the WBS perspective. Cost data may also be viewed from a resource perspective, using the Resource Usage view. In this view, assignment costs are summarized at the resource level. In Exhibit 9.14, the most indented rows are activities. The “Unassigned” set represents activities with no assigned resources. Resources with no show/hide control have no assignments. The zoom scale is set to month over weeks. 9-5b Develop Summary Project Budget AGILE Early in planning, sometimes detail is not yet known for later project phases. However, stakeholders still want an ongoing projection of the completion date and cost. A solution is to add a dummy activity under each phase summary for which not enough information to plan in detail is known yet. Estimate both the phase duration and the phase cost. Put the duration estimate in the dummy activity’s Duration field. Put the cost estimate in the dummy activity’s Cost field. Remember to remove each dummy activity when detail is added. On agile projects, it is common to use a dummy activity to summarize the work for future iterations that is not yet defined. Since the number of workers is often known and the length of the iteration is known, the amount of cost can be seen, but the exact work activities are only determined in iteration planning. 262 Part 2 Planning Projects E XH I BI T 9. 14 RESOURCE USAGE VIEW Source: Microsoft product screen shots reprinted with permission from Microsoft Corporation. In Exhibit 9.15, the “Process Improvement” row has a dummy activity, “Assessment & Process changes.” No resources are assigned to it. E XH I BI T 9. 15 DUMMY ACTIVITY FOR LATE PHASE Source: Microsoft product screen shots reprinted with permission from Microsoft Corporation. Chapter 9 Budgeting Projects 263 Summary The cost management plan outlines how to structure and control project costs. On a small project, it can be very simple. On a large, complex project, it may need more structure. It guides the project manager during the project. Cost estimating can be challenging because some activities may have a great deal of variation. Many methods are available to assist in cost estimating. Use a simple method if it will suffice, and more rigor if necessary. Generally as project planning identifies more specifics, more detailed and accurate cost estimates can be made. Cost budgeting includes aggregating individual costs, analyzing needs for cost reserves where uncertainty exists, and determining cash inflow and outflow. Establishing cost controls includes establishing cost reporting systems. MS Project can assist in developing either bottom-up project budgets or summary project budgets. Key Terms from the PMBOK ® Guide plan cost management, 246 cost management plan, 246 estimate cost, 246 estimate, 249 reserve, 249 management reserve, 249 contingency reserve, 249 analogous estimating, 252 parametric estimating, 252 bottom-up estimating, 252 value engineering, 255 determine budget, 256 cost baseline, 257 control cost, 259 Chapter Review Questions 1. 2. 3. 4. 5. 6. 7. What type of costs does not depend on the size of a project? During which phase of a project do recurring costs typically occur? What are some examples of expedited costs? What is the purpose of an order of magnitude cost estimate? Under which conditions can analogous estimating be effective? Which method of estimating can produce the most accurate estimate: parametric or bottom-up? What are some examples of supporting detail pertaining to cost estimates? 8. 9. 10. 11. 12. 13. 14. Is it possible to completely avoid variation in a project? Why or why not? What can be used to determine whether a vendor’s bid is reasonable? What is value engineering? What is the “time value of money,” and why is it relevant to project management? For a routine project, what is a typical percentage of total project costs that should be placed into contingency reserves? For an unusual project? What is used to compare actual project spending with planned expenditures to determine if corrective action is needed? What three types of data does Microsoft Project use to compute each assignment’s cost value? Discussion Questions 1. 2. 3. 4. Explain the importance of creating a cost management plan. Why is it important for project managers to understand the fixed and variable costs of a project? Describe the difference between direct and indirect project costs. During which phase(s) of a project do nonrecurring costs typically occur? Give an example of a nonrecurring cost. 5. 6. The project manager at a software company predicts her project’s costs based on previous projects she has worked on that were similar. (She takes into account the differences between her current and previous projects, as well.) What type of cost estimating is she using? Why is it important for assumptions to be listed in the cost estimate? 264 7. 8. Part 2 Planning Projects What is the difference between contingency reserves and management reserves? When would each be used? You are the project manager in charge of construction of a new school building. Give one possible example each of a known known, known unknown, and unknown unknown you might encounter. 9. 10. Using the same project described in #8, what are a few examples of milestones at which you might measure cost control? Give an example of how a project manager could run into problems with cash flow, even when he is within budget on the overall project. Exercises A baker has a contract to bake three dozen chocolate chip cookies for a customer’s party. Create a bottom-up estimate that includes both items needed for the project and the cost. According to your estimate, how much should the baker charge for the cookies? 2. Using the data for Problem 09.02, create a timephased budget for the project. Show how much 1. 3. the daily and cumulative costs for the project are just as the monthly and cumulative costs are shown in Exhibit 9.9. Using the data for Problem 09.03, create a timephased budget for the project. Show how much the daily and cumulative costs for the project are just as the monthly and cumulative costs are shown in Exhibit 9.9. PMBOK ® Guide Questions 1. 2. 3. 4. The “process that establishes the policies, procedures, and documentation for planning, managing, expending, and controlling project costs” is referred to as: a. determine budget b. estimate costs c. plan cost management d. control costs Activity cost estimates, the basis of estimates and other supporting detail are outputs of which process? a. determine budget b. estimate costs c. plan cost management d. control costs As the project progresses from initiation through planning and executing, and additional detail is gathered, the range of values for the project cost estimate will: a. broaden b. stay the same c. narrow d. be replaced with a single number is “the process of aggregating the estimated costs of individual activities or work packages to establish an authorized time-phased project budget or cost baseline.” a. Determine cash flow b. Determine budget c. Determine cost estimates d. Determine funding requirements 5. 6. 7. A(n) is used to compare actual project spending with planned expenditures over time to determine if corrective action is needed. a. cost baseline b. funding limit reconciliation c. reserve analysis d. activity resource estimate Jason, a project manager, is working with his team to estimate the total cost of developing a web-based CRM system. After reviewing the planned scope of work with Jason, his sponsor suggests that Jason use the budget from a previous, similar project as the basis for his project budget. The estimating process that Jason’s . sponsor is using is called a. three point estimating b. parametric estimating c. analogous estimating d. single point estimating One of the principle benefits of creating a bottomup estimate during planning is that the estimate: a. can be created quickly b. is very accurate c. matches the high level estimate in the project charter d. will not change once the project is in flight Chapter 9 Budgeting Projects 8. 9. The amount of project budget reserved for unforeseen project work that addresses the “unknown unknowns” that can affect a project is . the a. project buffer b. funding limit c. contingency reserve d. management reserve Ellen is estimating how much it will cost to re-carpet the executive conference room. After selecting the grade and pattern of carpet, Ellen multiplies the carpet price per square yard times the number of square yards in the conference 10. 265 room to derive the total price of the material. This estimating method is called . a. expert judgment b. analogous estimating c. parametric estimating d. three-point estimating The budget within the cost baseline that is allocated for identified risks, for which mitigating responses are developed, is called the . a. contingency reserve b. management reserve c. control account d. activity cost estimate Example Project Create a time-phased budget for your example project using bottom-up estimating. To the extent your sponsor supplies rates for workers, use those. Approximate rates for ones you cannot get. Ask your sponsor how they treat indirect costs. Be sure to include direct labor costs for yourself and your teammates. Budget your costs at the starting salary you expect to receive when you graduate (or your current salary if you are employed). Divide your annual salary by 2,080 hours and add 20 percent for fringe. State all assumptions and constraints you have used when creating your budget. State how confident you are in your estimates and what would make you more confident. Give examples of known knowns and known unknowns on your project. Tell how you have budgeted for both of them as well as how you have budgeted for unknown unknowns. References A Guide to the Project Management Body of Knowledge (PMBOK® Guide), 5th ed. (Newtown Square, PA: Project Management Institute, 2013). Good, Gordon K., “Project Development and Cost Estimating: A Business Perspective,” AACE International Transactions (2009) TCM.01.01– TCM 01.14. Goodpasture, John C., Project Management the Agile Way: Making It Work in the Enterprise (Fort Lauderdale, FL: J. Ross Publishing, 2010). Hansen, Don R., and Maryanne M. Mowen, Managerial Accounting, 9th ed. (Mason, OH: Cengage South-Western, 2010). Kim, Byung-Cheol, and Kenneth F. Reinschmidt, “Combination of Project Cost Forecasts in Earned Value Management,” Journal of Construction Engineering and Management 137 (11) (November 1, 2011): 958–966. Kim, Yong-Woo, et al. “A Case Study of Activity-Based Costing in Allocating Rebar Fabrication Costs to Projects,” Construction Management and Economics 29 (May 2011): 449–461. Kinsella, Steven M., “Activity-Based Costing: Does It Warrant Inclusion in A Guide to the Project Management Body of Knowledge (PMBOK® Guide)?” Project Management Journal 33 (2) (June 2002): 49–56. Kwak, Young Hoon, and Rudy J. Watson, “Conceptual Estimating Tool for Technology Driven Projects: Exploring Parametric Estimating Techniques,” Technovation 25 (12) (2005): 1430–1436. Li, Huimin, et al. “Factors That Affect Transaction Costs in Construction Projects,” Journal of Construction Engineering and Management 139 (1) (January 1, 2013): 60–67. Milosevic, Dragan Z., Project Management Toolbox: Tools and Techniques for the Practicing Project Manager (New York: John Wiley & Sons, 2003). Needy, Kim LaScola, and Kimberly Sarnowski, “Keeping the Lid on Project Costs,” in David I. Cleland, ed., Field Guide to Project Management, 2nd ed. (Hoboken, NJ: John Wiley & Sons, 2004). Rad, Parviz F., Project Estimating and Cost Management (Vienna, VA: Management Concepts, Inc., 2002). 266 Part 2 Planning Projects Rad, Parviz F., and Vittal S. Anantatmula, Project Planning Techniques (Vienna, VA: Management Concepts, Inc., 2005). Tichacek, Robert L., “Effective Cost Management: Back to Basics,” Cost Engineering 48 (3) (March 2006): 27–33. Todd, Greg, “Five Considerations to Improve Project Estimates,” Information Management (November/ December 2009): 45–47. Uppal, Kul B., “Cost Estimating, Project Performance and Life Cycle,” AACE International Transactions (2009): TCM.03.01–TCM.03.09. Endnotes 1. PMBOK® Guide 550. 2. PMBOK® Guide 534. 3. Adapted from Kim LaScola Needy and Kimberly 4. 5. 6. 7. Sarnowski, “Keeping the Lid on Project Costs,” in David I. Cleland, ed., Field Guide to Project Management, 2nd ed. (Hoboken, NJ: John Wiley & Sons, 2004): 150. PMBOK® Guide 539. Ibid. PMBOK® Guide 558. PMBOK® Guide 545. 8. PMBOK® Guide 533. 9. Greg Todd, “Five Considerations to Improve 10. 11. 12. 13. 14. 15. 16. Project Estimates,” Information Management (November/December 2009): 47. PMBOK® Guide 528. PMBOK® Guide 548. PMBOK® Guide 530. PMBOK® Guide 566. PMBOK® Guide 537. PMBOK® Guide 534. Ibid. PROJECT MANAGEMENT IN ACTION The Value of Budget Optimization At a major midwestern electric utility, budgeting for the ongoing capital expansion of the electric power system represents a process at the core of the organization’s strategy and operations. During extensive annual planning efforts, a three-year capital project portfolio is developed for implementation and budgeted. The budgeting process is used to ensure that available capital is carefully scrutinized by management and applied judiciously to those projects providing the greatest strategic value on a schedule minimizing overall risk. Maintaining the forecasted budget and completing projects as planned ensures the integrity of the electrical system and the financial strength of the business. The budgeting process itself is actually conducted year-round as planners, engineers, project managers, and financial experts endeavor to balance multiple competing objectives into a rational, achievable, and ongoing capital spending plan. There is little margin for error. Annual spending for major capital projects is typically over $250 million, representing approximately 500 projects to be completed across a five-state area. Underbudgeting means that projects potentially critical to the reliability of the electrical network may not be completed. Overbudgeting could result in investment dollars not yielding a return and reducing earnings. As with any enterprise, the electric utility capital budget is restricted by annual spending targets necessary to maintain prudent financial ratios. In the case of capital spending, one key element involves maintaining a targeted debt-to-equity ratio. For this reason, judgments need to be made about the cost versus the value of projects considered for investment and the risks associated with potentially postponing projects to maintain favorable financial ratios. To enable this entire process to work continuously and effectively, the utility adopted a project portfolio optimization process to create, analyze, and refine the budget for the project portfolio. This process involves executive management in creating a strategic value and risk scoring methodology that is applied during the planning phase for each project. The method assigns a value and risk score based on each individual project’s forecasted impact in five critical strategic areas: financial, reliability, customer, regulatory, and system operations. A computer-based mathematical algorithm Chapter 9 Budgeting Projects is used to optimize all possible spending portfolios to maximize value and minimize risk at specified budget levels. Within hours, the utility can analyze multiple optimized budget scenarios at various annual spending levels involving thousands of projects and nearly $1 billion of investment. This methodology has several key benefits for the electric utility that can be applied to any organization attempting to make budgeting decisions for complex project portfolios. • • • Budget strategy well understood and communicated through the organization—The process starts with an annual review by executive management of the strategy categories to which value and risk assessments will be applied. These categories and relative importance weightings can be adjusted to match the organization’s current strategic emphasis. These categories and their relative weightings are published, communicated, and used throughout the organization. Budget optimized for strategic objectives—The scores of value and risk for each project are applied to the strategy categories and optimized to provide maximum value and minimum risk for the capital spending available. Computer software allows instant scenario changes and what-if options to be analyzed. The outcome provides management with consistent and well-understood decision-making information. Consistent organizational strategy ensured— Projects are submitted for budget consideration in the capital portfolio from throughout the utility’s five-state operating area. There is a diverse array of business and financial reasons for each project to be evaluated. The use of a single enterprise- • • • 267 wide tool allows all projects to be analyzed on an equal basis, providing assurance that the organizational strategy is universally applied. Risk thresholds and tolerance understood— Postponing projects to conserve capital brings with it certain risks. The budget optimization process provides detailed risk analysis information on all deferred projects. Widespread communication of these risks and expert analysis of the consequences and probability allow management to make calculated and carefully considered decisions. Importantly, management gains recognition of its own risk tolerance and risk threshold levels as a result. Planning horizon and purchasing power expanded— The most significant result of the budget optimization process is the certainty with which implementation (the project execution phase) of the budget plan can be approached. The high levels of up-front management scrutiny leave little doubt about executive support for the plan going forward. This enables the planning horizon to be significantly expanded into future years and brings with it an enormous level of labor and material purchasing power in the market. Project dynamics accounted for—Although the threeyear budget plan is updated annually, there are still elements of uncertainty associated with implementation of a large project portfolio. These changes might be items such as significant shifts in public policy or regulations, fundamental changes to the business model, unexpected weather events, and so on. These midstream shifts can be dealt with readily, if needed, by changing project scoring criteria, reoptimizing the project mix, and reevaluating the resulting information for options going forward. Source: Paul R. Kling, PE, PMP, director of project management and controls, Duke Energy. CHAPTER 10 Project Risk Planning CHAPTER OBJECTIVES After completing this chapter, you should be able to: • Identify and classify risks for a project and populate a risk register. • Describe various risk assessment techniques and tell when each is appropriate to use. • Prioritize each risk on a project using an appropriate assessment technique and develop and defend at least one strategy for each of the highpriority risks. • Compare and contrast the various strategies for dealing with risks. 268 © Logan Mock-Bunting/Getty Images • Describe how to plan for risk management, identify risks, analyze risks, and create response plans for identified risks. The Texas Medical Center (TMC) is composed of 49 not-for-profit institutions that are dedicated to the highest standards of patient care, research, and education. These institutions include thirteen renowned hospitals and two specialty institutions, two medical schools, four nursing schools, and schools of dentistry, public health, pharmacy, and virtually all health-related careers. People come from all walks of life and from all over the world to have access to the best healthcare anywhere. Member institutions specialize in every imaginable aspect of healthcare, including care for children and cancer patients, heart care, organ transplantation, terminal illness, mental health, and wellness and prevention. Currently 11 major construction projects are underway, including the Texas Children’s Hospital’s 407,000-square-foot Neurological Research Institute and 720,000-square-foot Maternity Center, along with a 12-story, 27,000-square-foot concrete-frame addition to the M. D. Anderson Cancer Center of the University of Texas Medical Center. Collectively these major Phase: Selecting Approval: To Proceed PMBOK® Guide Topics: • Plan risk management • Identify risks • Perform qualitative risk analysis • Perform quantitative risk analysis • Plan risk responses Initiating Selection Planning Charter Executing Kickoff Closing Project Result Realizing Administrative Closure Benefits Realized projects will add facilities that will be staffed by up to 27,000 additional employees. When complete, TMC will have 40 million square feet of occupied space. If you consider downtown business space, by itself it forms the seventh largest downtown business district in the United States. With hurricane season approaching, TMC held a conference for over 100 contractors to review how to prepare for a potential hurricane. Contractors must have a plan in place detailing how they are going to secure their construction sites and keep materials from becoming airborne missiles in the event of a hurricane. Conference attendees were given a handout describing TMC’s hurricane guidelines. These guidelines call for storm preparations to be completed twenty-four hours before tropical storm winds are predicted to hit land. Examples of storm preparations include dismantling scaffolds and privacy screens, securing giant cranes, emptying and weighting down dumpsters, photographing all buildings and assets, and unblocking all streets for emergency access. While project managers cannot prevent hurricanes, through careful risk planning, actions can be taken to greatly mitigate the impact. Rhonda Wendler, Texas Medical Center News Imagine you are asked to plan for risks on two different projects. One is a major construction project at TMC with hurricane season approaching. The other is planning a small fund-raising event for charity. Would you handle the risks on these two projects the same way? Would you invest the same level of time and energy into planning these two projects? The answers are yes and no. Yes, you would approach the risks in the same way. But you would not spend the same amount of time planning for risk on both projects. You would spend considerably more time and money on risk management planning for the major construction project that is vulnerable to a hurricane than for the small fund-raiser project. Just as in other types of project planning, there is an approach to planning for risks that all projects follow; however, the depth of planning depends greatly on the potential risks of the project. In other words, a smart project manager gladly spends $100 in risk planning to save $1,000 in expected consequences, but does not gladly spend $1,000 to save $100. The purpose of risk management is to reduce the overall project risk to a level that is acceptable to the project sponsor and other stakeholders. The methods that project 269 270 Part 2 Planning Projects AGILE managers use in risk management start with identifying as many risks as possible. Once the risks are identified, each risk is analyzed so that the project team can concentrate their attention on the most critical risks. Analysis always consists of a qualitative or judgmental approach and sometimes also includes a quantitative approach. In the final risk management process, the project team decides how to respond to each potential risk. Once all of the risk management planning has initially been accomplished, the response plans are incorporated into the overall project management plan. Changes may need to be made to the schedule, budget, scope, or communication plans to account for certain risks. These risk management planning processes are covered in this chapter. Risk management also includes monitoring and controlling the risks according to plan. These are covered, along with ongoing risk planning, in Chapter 14, Determining Project Progress and Results. On agile projects, while early risk planning, assessment, and response planning is similar at a high level, more detailed and timely risk management occurs in three places: in planning each subsequent iteration, in daily stand-up meetings, and in retrospectives at the end of each iteration. 10-1 Plan Risk Management Plan risk management is “the process of defining how to conduct risk management activities for a project.”1 To plan for project risks, a project manager must first understand the project’s objectives. A project manager develops this understanding initially by realizing what project success in general is and then by understanding the specific priorities of the most important project stakeholders, as discussed in Chapter 5. Exhibit 10.1 summarizes current project success research results. The first set of general project success measures is meeting agreements. This includes meeting the technical requirements while not going over the cost and schedule agreements. The second set of project success measures focuses on the project’s customers. Specifically, did the project result meet the customers’ needs, was the project result used by the customers, and did it enhance the customers’ satisfaction? The third set deals with the future of the performing organization. The specific measures in this area vary, but essentially they ask whether the project helped the performing organization. The performing organization is “an enterprise whose personnel are most directly involved in doing the work of the project.”2 Typical measures here include market share, new markets and/or technologies, and commercial success of the project output. The final set of project success measures deals with the project team. Did they become better and more dedicated employees? E X H I B I T 10 .1 PROJECT SUCCESS MEASURES • • • • Meeting Agreements Cost, schedule, and specifications met Customer’s Success Needs met, deliverables used, customer satisfied Performing Organization’s Success Market share, new products, new technology Project Team’s Success Loyalty, development, satisfaction Source: Timothy J. Kloppenborg, Debbie Tesch, and Broderick King, “21st Century Project Success Measures: Evolution, Interpretation, and Direction,” Proceedings, Project Management Institute Research and Education Conference, July 2012, Limerick, Ireland. Chapter 10 Project Risk Planning 271 EXHIBIT 10.2 SPECIFIC PROJECT STAKEHOLDER PRIORITIES IMPROVE KEEP Scope X Quality X ≤1 month to save $5,000 Time Cost Want to save Contribution to Organization X Contribution to Society X Source: Adapted from Timothy J. Kloppenborg and Joseph A. Petrick, Managing Project Quality (Vienna, VA: Management Concepts, Inc., 2002), 46. The specific priorities of the project’s most important stakeholders can be summarized in a table such as Exhibit 10.2. A project manager and team need to understand not only what the project plans call for but also what area(s) the most important stakeholders would like to improve and what area(s) they are willing to sacrifice to enable those improvements. For example, consider a project that calls for building a four-bedroom house of 2,800 square feet. Perhaps the homeowner (the most important stakeholder) insists on keeping the size at 2,800 square feet and insists on the normal quality (no leaks, square walls, etc.), but would like to improve on the cost (pay less money). To improve on the cost objective, one of the other objectives probably needs to be sacrificed. Perhaps the homeowner would be willing to move in a month late if the savings were $5,000. Once the project team understands the project success measures and priorities, attention is turned to understanding the project risks. All projects have some risk, and the more unique a project is, the more risk may be present. It is impossible to remove all sources of risk. It is undesirable to even try to remove all risk because that means the organization is not trying anything new. A risk is anything that may impact the project team’s ability to achieve the general project success measures and the specific project stakeholder priorities. This impact can be something that poses a threat or “a risk that would have a negative effect on one or more project objectives.”3 The impact, on the other hand, could be something that poses an opportunity or “a risk that would have a positive effect on one or more project objectives.”4 Wise project managers strive to develop a risk management plan, which is “a component of the project management plan that describes how risk management activities will be structured and performed,”5 and have it in place before risk events occur. By documenting risk information in a proactive manner, a project manager can eliminate or reduce the impact of some threats and capitalize on some opportunities. The risk management plan is also useful for communicating with the various project stakeholders and for later analysis to determine what worked well and may be good practice to use on future projects, and what went poorly and should be avoided on future projects. Some risk management plans include all of the topics in this chapter. Others are smaller. For example, a risk management plan template for an IT consulting company is shown in Exhibit 10.3. 272 Part 2 Planning Projects E XH I B I T 1 0 . 3 RISK MANAGEMENT PLAN GUIDANCE FOR AN IT CONSULTING COMPANY Risk management includes guidance on how to perform three risk management activities: 1. 2. 3. Decide what level of risk premium to charge for the project. The team must rate factors such as project size, complexity, technology, and type. The combined ratings dictate that a risk premium of 0, 10, or 20 percent be added to the estimated project cost or, for very risky projects, that executive approval is mandated. Mitigate risk external to the firm through contract clauses and risk internal to the firm through agreements. Manage the risk very carefully through specifically designed weekly conference call meetings and reports. Source: Rachana Thariani, PMP®. 10-1a Roles and Responsibilities It is good practice to encourage wide participation in risk management activities. One reason is that everyone has a different perspective. The more perspectives that are considered, the more likely important risks will be uncovered early. Another good reason is that people often resist when they are told what to do, but work with great enthusiasm if they participated in the planning. The surest way to get the various project stakeholders to buy into a risk management approach is to involve them right from the beginning in risk management planning. Potential critics can be turned into allies if their concerns are included. The risk management plan should define who has responsibility for each risk management activity. On small projects, this is often the project manager or a core team member for most activities. On larger projects, the plan can be more elaborate, with subject matter experts involved at many points. 10-1b Categories and Definitions Most projects have many types of possible risks. Therefore, it is helpful to look at risks in a systematic manner so as to consider as many types of risks as possible. One way to look at risk is by considering when it occurs in the project life cycle. For example: • • • • Certain types of risks, such as a customer not agreeing on the price, may occur during project initiation. Others, such as not finding a capable supplier, may occur during project planning. Risks such as delivery difficulties from a supplier may occur during project execution. Risks such as the project deliverable not actually working properly may even appear near the project conclusion. The number and costs of project risks over a project life cycle are graphed in Exhibit 10.4. More project risks are typically uncovered early in the life of a project. However, the cost per risk discovered early is often less since there is time to make changes in plans. Risks discovered late in a project can be very expensive. Experienced project managers work hard to uncover risks as early in the project as feasible. Usually, some risks are uncovered during project chartering. On small, simple projects this may be the biggest risk identification push, but on other projects, a great deal of time and effort may also be expended during project planning. In addition to being categorized by when they might occur in a project, risks can also be categorized by what project objective they may impact, such as cost, schedule, scope, and/or quality. Risks can also be classified as external to the performing organization and Chapter 10 Project Risk Planning 273 EXHIBIT 10.4 RISKS OVER THE PROJECT LIFE CYCLE Number of Risks Discovered Initiating Planning Cost per Risk Discovered Executing Closing Project Life Cycle Stage E X H I B I T 10 . 5 FOURTEEN MOST IMPORTANT RISKS IN PANAMA CANAL EXPANSION Changes in design and quantities Extreme bad weather General inflation Inadequate claims administration Ineffective contracting process Inefficient planning Insufficient revenues Lack of controls Lack of skilled and local labor Local labor strikes Material, equipment, and labor cost Organizational risks Owner-driven changes Referendum delays Source: Luis F. Alarcon, et al., “Risk Planning and Management for the Panama Canal Expansion Program,” Journal of Construction Engineering and Management (October 2011): 762–770. internal to it; or by operational and strategic. Many organizations have developed lists of risks for certain types of projects they routinely perform. Additionally, many writers have created general lists of risk factors for certain types of projects. For example, Exhibit 10.5 shows the biggest fourteen risks on the Panama Canal expansion (which might be similar on other major construction projects), Exhibit 10.6 shows major risk categories for international projects generally, and Exhibit 10.7 shows common risks for information systems projects. Any of these categorizations can be shown as a risk breakdown structure—“a hierarchical representation of risks according to their categories.”6 274 Part 2 Planning Projects EXHIBIT 10.6 TOP RISKS IN EACH FACTOR FOR INTERNATONAL PROJECTS CUL T URAL VIRTUA L Number of languages Communication issues Trust level Number of countries Economic culture Management experience Number of religions Number of time zones POLITICAL REGIONAL Government desire for project Crime rate Government unrest Climate/weather Laws and regulations Housing availability Relationship with government Safety issues and procedures Source: Robert W. Steffey and Vittal S. Anantatmula, “International Projects Proposal analysis: Risk Assessment Using Radial Maps,” Project Management Journal (April 2011): 62–70. EXHIBIT 10.7 TOP RISKS IN EACH FACTOR FOR SOFTWARE PROJECTS EX ECU TION M A NAGEM ENT US ER C O O R DI NA T IO N Configuration management system User evaluation of progress Formality of status reports User understanding of complexity Specification approval process Care in user manual preparation Post-project audits Coordination with user Regularity of technical reviews Informal communication channels HUMAN RESOURCE MANAGEMENT PROJECT PLANNING Flexibility of working hours Frequency of software reuse Individual performance incentives Planning tools used Technical assistance availability Minimum cost software design Recognition for extra work Removal of unnecessary requirements Enforced attendance system Individual accountability Source: Sam Thomas and M. Bhasi, “A Structural Model for Software Project Risk Management,” Journal of Management (March 2011): 71–84. Yet another method of classifying project risk is by what is known about each. Something that is a “known known” can be planned and managed with certainty. Therefore, it is not a risk. An example is that cement will harden. The next level is “known unknowns,” which are risks that can be identified and may or may not happen. These risks should be identified, and a contingency reserve needs to be established to pay for them. An example on a long construction project is that bad weather will probably happen at some points, but no one Chapter 10 Project Risk Planning 275 knows exactly when or how bad it will be. The final level is for the true uncertainties. These are called “unknown unknowns” (or “unk unks” by people who must deal with them). Since they cannot even be envisioned, it is hard to know how much reserve time and money is needed to cover them. They are usually covered by a management reserve, and the amount of this reserve is often negotiated based upon the confidence level the project manager and key stakeholders have regarding how well they understand the project. An example could be a 100-year flood that covers a construction site that everyone thought was on high enough ground to stay dry—an event so rare it is expected to happen only once a century. 10-2 Identify Risks Once the risk management planning is in place, it is time to begin identifying specific risks. Identify risks is “the process of determining which risks might affect the project and documenting their characteristics.”7 Project managers are ultimately responsible for identifying all risks, but often they rely upon subject matter experts to take a lead in identifying certain technical risks. 10-2a Information Gathering A large part of the risk identification process is gathering information. The categories shown in Exhibits 10.5, 10.6, and 10.7 and/or project stages can be a good starting point in this information gathering. The project manager either needs to act as a facilitator or get another person to serve as facilitator for information gathering. This is essentially a brainstorming activity, during which time the question “what could go wrong?” is repeatedly asked of everyone who is present. It is helpful to use Post-it Notes and write one risk per note to prepare for further processing the risks during risk analysis. Classic rules for brainstorming are used. For example, every idea is treated as a useful idea. The risks will be assessed next. If one suggested risk does not prove to be important, it does not hurt to keep it on the list. Also, sometimes a risk that is obviously not important—or is even humorous—may cause another person to think of an additional risk they would not have considered otherwise. While it is helpful to have as many stakeholders together as possible to “piggy-back” on each other’s ideas, with the information technology available today, much of the same interaction can be achieved by global and virtual teams. It just takes a bit more careful planning. Variations and extensions of possible risks can help a team to identify additional risks. Several other techniques are also used in risk identification. Sometimes, team members interview stakeholders. Other times SWOT analysis is “analysis of strengths, weaknesses, opportunities, and threats to a project”8 might be used. Remember, risks can be both threats to overcome and opportunities to exploit. Yet another method of identifying risks is the Delphi technique, which is “an information gathering technique used as a way to reach a consensus of experts on a subject. … Responses are summarized and recirculated for further comment.”9 Finally, a team can use a structured review to identify risks. 10-2b Reviews A project manager and team can review a variety of project documents to uncover possible risks. Exhibit 10.8 lists some of the documents a project manager may use and typical questions he or she would ask for each. Project teams can often identify risks from each type of review shown. Balance must be given to the extent of the reviews and the amount of useful information regarding risks expected to result. As with the brainstorming mentioned previously, it is better to identify many possible risks and later determine that some of them are not major, rather than to not identify what does turn out to be a big risk. 276 Part 2 Planning Projects EXHIBIT 10.8 PROJECT RISK REVIEWS TYPE OF REVIEW Charter Stakeholder register Communication plan Assumptions Constraints WBS Schedule Resource demands Touchpoints Literature Previous projects Peers Senior management QUESTION Is there clarity and common understanding in each section? What could upset any of them? Where could poor communications cause trouble? Can you verify that each assumption is correct? How does each constraint make the project more difficult? What risks can you find going through the WBS item by item? What milestones and other merge points might be troublesome? At what points are certain people overloaded? What difficulties may arise when some project work is handed off from one person to another? What problems and opportunities have been published concerning similar projects? What projects and opportunities have similar projects in your own organization experienced? Can your peers identify any additional risks? Can senior management identify any additional risks? 10-2c Understanding Relationships Project managers can also seek to identify risks by learning the cause-and-effect relationships of risk events. One useful technique is a flow chart that shows how people, money, data, or materials flow from one person or location to another. This is essentially what the team does when it reviews the project schedule, provided it looks at the arrows that show which activities must precede others. A second method of understanding risk relationships is to ask why a certain risk event may happen. This can be accomplished through root cause analysis, which is “an analytical technique used to determine the basic underlying reason that causes a variance or defect or risk. A root cause may underlie more than one variance or defect or risk.”10 A simple approach to root cause analysis is to simply consider each risk one at a time and ask, “Why might this happen?” At this point, since many potential risks have probably been identified, project teams do not spend a large amount of time on any single risk. If necessary, the project team can perform more detailed root cause analysis of the few risks that have been designated as major risks during risk analysis. One more type of relationship project managers like to understand is trigger conditions, or “an event or situation that indicates a risk is about to occur.”11 A trigger can be specific to an individual risk, such as when a key supplier stops returning phone calls, which may jeopardize their delivery of materials. 10-2d Risk Register The primary output of risk identification is the risk register. When complete, the risk register is “a document in which the results of risk analysis and risk response planning are recorded.”12 At this point (the end of risk identification), the risk register includes only the risk categories, identified risks, potential causes, and potential responses. The other items are developed during the remainder of risk planning. An example of a partial risk register is shown in Exhibit 10.9. The risk register is a living document. As a risk is identified, it is added. More information regarding a risk can be added as it is discovered. As risks are handled, they can Chapter 10 Project Risk Planning 277 be removed because they are no longer of the same level of concern. On smaller projects, a spreadsheet works fine for a risk register. On larger, more complex projects, some organizations use databases. 10-3 Risk Analysis If a project team is serious about risk identification, they will uncover quite a few risks. Next, the team needs to decide which risks are major and need to be managed carefully, as opposed to those minor risks that can be handled more casually. The project team should determine how well they understand each risk and whether they have the necessary reliable data. Ultimately, they must be able to report the major risks to decision makers. 10-3a Perform Qualitative Risk Analysis © Andreas G. Karelias/Shutterstock.com Perform qualitative risk analysis is “the process of prioritizing risks for further analysis or action by assessing and combining their probability and impact.”13 All project teams should perform this task. If they understand enough about the risks at this point, they proceed directly to risk response planning for the major risks. If not, they use more quantitative techniques to help them understand the risks better. DIFFERENTIATING BETWEEN MAJOR AND MINOR RISKS The primary questions project teams use in qualitative risk analysis are “how likely is this risk to happen?” and “if it does happen, how big will the impact be?” This was shown in Exhibit 4.8 (see page 96). A somewhat more involved example is shown in Exhibit 10.9. Note that for each dimension—probability and impact—in Exhibit 10.10 a scale of 1 to 5 is used with descriptions. The scale does not matter as long as it is applied consistently and is easy for everyone to understand. Note also the dark line. This line separates the major and catastrophic risks that need either further analysis and/or specific contingency plans from minor and moderate risks that can just be listed and informally monitored. Without making a distinction like this, project teams may be tempted to either ignore all risks or to make contingency plans for all risks. Ignoring all risks almost guarantees the project has problems. Making contingency plans for even minor risks is a terrible waste of time and draws focus away from the really big risks. Project teams sometimes also ask, for each risk, when is it likely to occur in the project. This can be useful because those risks that are likely to occur earlier often need to be assigned a higher priority. Teams also sometimes ask how easy it is to notice and correctly interpret the trigger condition. Risks with triggers that are difficult to notice or interpret often are assigned a higher priority. CAUSE-AND-EFFECT RELATIONSHIPS One additional Teams should assess potential risks and predict possible outcomes involved in a project. type of qualitative risk analysis is to determine causeand-effect relationships. This is part of root cause analysis, which was described in the previous section on understanding relationships. While effects are often more visible, it is often easier to change the effect by changing the underlying cause. For example, assume that a construction worker is not laying 4 4 2 Communications Communications Procurement Potential bottlenecks in document reviews and decision making may affect task completion according to the Project Schedule. Secondary risk—related to Risk 6. Inability to acquire resources in a timely manner may negatively impact related activities in the Project Schedule. Going through hierarchical reporting structure will impact real time decision making. State functional POC’s may have competing priorities that will hinder their ability to response in a timely manner. Delays in procurement process may negatively impact project schedule. Source: http://mn.gov/hix/images/BC9-1-ITAttachmentN.pdf, accessed April 26, 2013. 4 Technology Potential difficulty integrating new technology into existing infrastructure. Difficulty integrating to States endto-end Infrastructure. 3 Potential duplication of rules or conflicting rules that lead to different outcomes. Since there are various vendor products (IBM/Curam, Connecture) each with its own rules engines, it is not clear which rules engine takes precedence. Greater possibility of rework in subsequent phases. Greater possibility of delay in finalizing requirements. Greater possibility of “Scope Creep”. Technology 5 Business Requirements Greater possibility of gaps in functionality. Incomplete requirements were identifed in the RFP and Exhibits (see Risk 7). Greater possibility of missing State specfic functionality. PROB CATEGORY IMPACT PARTIAL RISK REGISTER R I S K D E S CR I P T I O N ( E V E N T ) E X H I B I T 10 . 9 5 4 4 4 4 4 IMPACT 10 16 16 16 12 20 SCORE Add lead time as early as possible. Evaluate procurement requirements during the change order process. Make sure Commerce procurement staff are engaged in the PO development process. Identifying multiple Pointsof-Contact for each functional area from vendor and state to eliminate bottlenecks. Identifying a Point-of-Contact for each functional area from vendor and state to eliminate bottlenecks. Work with the State to define infrastructure requirements and ensure we are providing any necessary information to the MN-IT staff. (See Risk Response Plan for resolution.) EngagePoint will provide and explanation of how to mitigate this risk. State will provide closure and decisions regarding requirements and system scope. A schedule of future Business ArchitectureandTechnicalsessionsis being developed. MAXIMUS will begin conducting the detailed BA sessions 09/20/2012. Additional requirements will be gathered in those sessions and documented in subsequent versions of the Requirements Validation Documentation. M I T I G A T I O N ST R A T E G Y RESOLUTION 278 Part 2 Planning Projects Chapter 10 Project Risk Planning 279 EXHIBIT 10.10 QUALITATIVE RISK ASSESSMENT PROBABILITY IM P A C T INSIGNIFICANT (1) MIN OR (2 ) MO DE R ATE (3 ) MA J OR (4 ) CATASTROPHIC (5) Almost certain (>90% chance) high high extreme extreme extreme Likely (50–90%) moderate high high extreme extreme Moderate (10–50%) low moderate high extreme extreme Unlikley (3–10%) low low moderate high extreme Rare (
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