How to Construct Your Project Budget
From the The Money Files Blog
by Elizabeth Harrin
A blog that looks at all aspects of project and program finances from budgets, estimating and accounting to getting a pay rise and managing contracts.
Written by Elizabeth Harrin from RebelsGuideToPM.com.
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Date
Olivier Lazar gave a presentation at the PMI Global Congress EMEA earlier this year and he talked briefly about how to construct your project budget. I wanted to share some of his ideas and some of my own here.
So, let’s look at the three components of a project budget.
1. The Budget at Completion (BAC)
This part of your overall project budget comes from the work breakdown structure and your estimating processes. (I’ve written a lot on this blog about estimating. Check out some of my videos on estimating terminology and processes here.)
2. Management Reserves
This is a pot of money put aside for use at management discretion. Typically you’ll get your sponsor to approve the spending from this allocation; it’s not a pot that you can dip into whenever you feel like it.
Olivier gave the example of a decision on a project that was made internally and that incurrs a cost that cannot be passed on to the client. On one of my recent projects – although an internal one, so we weren’t exactly billing the other department for our services – we did that. The change involved upgrading a system. There was no tangible benefit to the users of moving to a new infrastructure but it was part of the longer term IT roadmap. We couldn’t in good faith have passed this on, had it been an external client, as it wasn’t a change they requested or that we could ‘sell’ as having any user advantage. But it was still the right thing to do.
3. Risk Response Budget
The final section of your budget is made up of the money put aside to deal with risks if they happen. This allocation should cover the cost of putting your risk response plans into action. If a project risk has a response plan that is going to cost you £100k and a probability of 10% you would budget £10k in your risk response plan. Remember, the risk response plan is to deal with realised risks (i.e. the ones that become issues). You typically don’t put the whole amount for the risk response plan (in this case, £100k) in your budget because you are crossing your fingers that the risks won’t happen. Or at least, not all of them will happen, so you’ll have enough money to go round.
Any money is better than nothing, but the challenge here is that if this risk does actually happen it will still cost you £100k to respond to. You had better hope those other risks don’t materialise as you won’t have enough risk response funds to go around.
Those three elements make up the budget for your project. They don’t necessarily equal the price you would pitch your services at.
Create the selling price
Olivier expanded his point about budget construction to add a bit more about how you would calculate the selling price for the project, as an external contractor.
Add overheads
Overheads are things like heating, lighting, staff costs. They are the cost to you of doing the work and should include everything from mobile phone subscriptions to catered lunches.
Most companies I have had experience working with have had a fixed rate per employee that they add to budgets to give this figure. These are called ‘on costs’. They only relate to staff though (pension contributions, hiring costs etc). Make sure to add in any other overheads specific to this project that do not relate to people such as hiring meeting rooms.
Add margin
This is how much profit you expect to make on the project. If you are a business you aren’t doing it at cost. Otherwise you’d make no money on it at all and your shareholders won’t be happy. You’ll have to work out what is an acceptable margin to make on the project – 2%? 70%?
Adding these two additional lines gives you the price at which you would be willing to sell the project to the customer.
Olivier added these caveats:
- If you mis-estimate the tasks, the margin goes down.
- If you eat the margin then you may breakeven on the project – chalk it up as a lesson learned.
- If you eat all the margin and go into your overheads then the end result might be laying people off.
If you make people redundant and have no one to deliver your projects you’ll lose work and the ultimate situation is that you could go out of business.
That’s why estimating is important: without it you can’t keep your business profitable.
The same goes for internal project managers: you still need to know that your project is making the organisation something and adding value, not creating more cost for no benefit.
Read more about Olivier’s presentation in this article about using budgets to help manage project risk.
Posted on: October 02, 2015 09:07 AM |
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Comments (7)
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fosco frongia
Senior project manager| ENTE PATRIMONIALE CHIESA GESU' CRISTO SUG
Fino Mornasco, Como, Italy
I was reflecting about risk response budget: basically it is defined including the Expected Monetary Value (EMV) we calculated for every risk quantitatively analyzed. The EMV is determined by risk impact and probability (I x P).
As you commented this manner to proceed is challenging due to it is based on this consideration: the probability that all risks defined would happen during the life of the project is extremely reduced.
I think this is the correct manner to proceed in the most part of the cases because normally are satisfied these two conditions below:
A) The number of risk identified and budgeted is sufficient to cover all risk which really occurs (at least with sufficient probability).
B) The EMV of them is balanced or, in other words, there are not risks which EVM is sensibly superior respect the other ones.
If these two conditions are not realized probably we should apply different criteria.
Two examples, which are based in very extreme scenarios, can explain my thought better:
A) no more than two risks individuated with these parameters – risk a: I=1.000 P= 60% EMV=600; risk b: I=600 P=10% EVM=60 – in this case the contingency will be 660 but will we be so relaxed to include it in our budget?
B) A sufficient number of risks individuated (e.g. 50) and total contingency (? I x P) =1.000 the risk a is characterized by EVM= 500 and P=60%. Are we sure that our total contingency will be sufficient?
What do you think about my though and, are there other criteria already defined to solve this kind of situations?
NAGESH RAMAMURTHY
Principal Consultant| Aadhya Consulting
Bangalore., Karnataka, India
Historically, I have seen project risks possessing typical characteristics. When mapped, they are related to decision makers dealing with risks, type of project, size & duration of the project, appetite of the sponsor and lastly phase of the project. As we get close to project completion, uncertainty unfolds and risk response budget diminishes including reduced chances to dig into management reserves. While there are established relationship between risk and time, project managers should start allocating costs of risks into project phases.
I would rename OVERHEADS as the Environment cost and ideally it is included in Cost to Company or performing organization.
Good article.
Pravin, thanks for your thoughts!
Fosco, sorry I have only just seen your question. I am not aware of any other tools, and I think you are right to point out that there are flaws. I think in any project management situation we have to use professional judgement to use the right tools. In some instances this approach might work well, and in other situations another approach might work better. You'll have to use your best judgement to apply the right tool.
fosco frongia
Senior project manager| ENTE PATRIMONIALE CHIESA GESU' CRISTO SUG
Fino Mornasco, Como, Italy
Many thanks Elizabeth, your suggested approach is the mine too. I think which is important to act in this manner but considering that, first of all, our professional judgment should be defensible
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