PM592 Week 2 Lecture

7/27/2019 PM592 Week 2 Lecture

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7/11/13 Proj Cost & Schedule Control

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Week 2: Financial Plan - Lecture

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Range or Three-Point Estimates

Project Financial Plan | Budgeting Process | Overview on Estimating | Range or Three-Point Estimates |

Contingency Estimates | Time Value of Money Tutorial (Reference)

Project Financial Plan

In Week 1 we looked at the project plan and the primary planning tool, the WBS, while we only touched on cost estimating. InWeek 2 we will go into detail on how project costs are determined and how these costs are used in our project financialplans.

We will focus on estimating project costs. The WBS is the basic tool used in project planning, and project estimates aretypically derived from the detail found in the WBS. These estimates will form the basis for defining our project's budgets.

Accurate estimates are essential if budgets are to be maintained during project execution and used as the baseline for ourmonitoring and control efforts. Several estimating techniques are introduced, including three-point estimates and contingencyestimates.

Budgeting Process

In project management we emphasize the need to have a process to break the work into manageable details. The estimatingprocess is no different. We talked about historical cost in Week 1 to introduce one important method of obtaining data forproject estimates. We will now discuss the overall process.

Two Budgeting Processes

There are two main budgeting processes;top-down planningandbottom-up. These are not mutually exclusive and neither isthe "right" way. Both start with a project scope and statement of work. The top-down process is when the executive andhigher management create a high level budget and schedule based upon their experience, historical data, and, usually,business restrictions. The bottom-up process is when the people who are going to do the project or their representatives startby creating a detailed WBS with all the tasks required to do the project. They then estimate the cost and time required to doeach of the tasks. This is then rolled up to produce a complete plan. I believe you will all agree that these two processes maynot produce the same budget. Both have their advantages and disadvantages and as such there may be circumstances thataffect the decision of which to use.

Budgeting Roles

There are many people and organizations involved in the creation of the project budget. The larger the project, the moreimportant it is to follow all the steps. On smaller projects, the project manager will take a larger role in creating the estimatesand may shortcut some of the steps due to lack of project resources on smaller efforts. However, it is still important to coverall the functions in the outline even if the person doing the activity changes.

There are two main roles responsible for the estimating process. First is the project manager (PM), whom you are alreadyfamiliar with. The PM is directly responsible for some of the activities and at the very least is responsible to coordinate theefforts of others in the budgeting process. The second is the functional manager (FM). The FM is a name given to themanager of a functional group, such as engineering, marketing, and so forth. There can be and likely will be several FM'sinvolved in the process on any given project, as work for the project is spread across several different groups. The FM is anexpert on the work performed within their group and by their people and is typically successful at obtaining estimates fromwithin their own group.

A classic procedure for generating the plan using the WBS and the bottom-up process is outlined here:
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Overview on Estimating

In order to create the budgets we discussed above we require estimates: the more accurate the better. Estimates aretypically formed using a combination of estimated costs for labor and materials and allowances for indirect costs, such asinventory costs and overhead. Although seemingly simple in nature, estimating is a complex process that demandssignificant effort if realistic project budgets are to be developed. Some organizations have full time "estimator" roles. These areexperts with keen understanding of project cost items and applying them. There are several models for refining estimating

accuracy, which are discussed in the following sections.

First we will look at a straightforward estimating example where we use the supplied cost data and conditions to create anestimate for one toaster and for 100,000 toasters.

2-1 Estimating Demonstration Problem

A company has received an order for 100,000 toasters from Sears. Using the material, labor, overhead

information, Bill of Materials and assembly information provided, answer the questions below:

Assembly information: Each toaster takes approximately 20 minutes to assemble.

Bill of Materia ls: (1) case, (2) heating elements, and (1) set of controls.
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The cost of

MATERIAL items

is as follows:

Item Cost/Unit

Case $2.50

HeatingElement

$3.00

Controls $1.40

The cost of OVERHEAD

based on historical

information is as

follows:

General andadministrative is 20% oftotal material and laborcosts.

Material:

Case: $2.50 = $2.50

Heating Element: $3.00(2) = $6.00

Controls: $1.40 = $1.40

Total Materials: = $9.90

Labor:

Prod. Assembly: 20/60($15.00) = $5.00

Inventory/Hand.: 0.15($9.90) = $1.485

Production Support: 0.10($9.90) = $0.99

Inspection: 0.08($5.00) = $0.40

Total Labor: = $7.875

Overhead:

G & A: 0.20($9.90+$7.875) = $3.555

(a). Total Estimated cost pertoaster:

= $21.33

(b). Total cost for 100,000toasters

= $21.33(100,000) = $2,133,000.00

Estimate:

(a). The cost per toaster.

(b). The total cost for producing 100,000 toasters.

The cost of LABOR is as follows:

Production Assembly $15.00 per hour

Material Inventory and Handling15% of material costs basedon historical information

Production Support10% of material costs basedon historical information

Inspection8% of assembly labor costbased on historicalinformation

Solution

Complete estimates on a per unit basis, and calculate total project estimates on theper unit cost. This is less complicated and retains accuracy at the base level.

Range or Three-Point Estimates

Range (or three-point) estimates use the beta distribution formula to refine estimating accuracy when specific data for quantity


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and price are not available. This technique is applicable where historical data indicates that material prices/quantities mayfluctuate over time and predictions regarding the price/quantity at the time of project execution are unavailable at the t ime theestimate is formed. Ranges are developed using low (optimistic), most likely, and high (pessimistic) estimates for variableswithin the est imate. These numbers are then refined using the beta distribution formula.

This equation is meant to provide a "weighting" to the Popt, Pmost, and Ppess to create a beta distribution of possibleoutcomes for Pexp. The resulting distribution will be biased to the side which is larger, Popt or Ppess (typically toward thePpess side). When we apply the weighting of 1, 4, and 1 to Popt, Pmost, and Ppess and then add the six "parts" together weget a number that is approximately six times greater then what our estimate should be. As a result, we divide by six toremove the weighting and return the estimate to the original magnitude.

As a side note, the 1,4,1 distribution is typical and is also the default in programs like MSP. However, this distribution can bemodified for advanced situations to skew the weighting to a side. For example, 1,3,2 for estimates which are typicallyoveroptimistic.

Here we will explore an example estimate using the three-point estimate method.

2-2 Three-Point Estimates Demonstration Problem

Problem Data Solution

You are currently trying to produce amaterial estimate for your project. You haveobtained preliminary quotes for the material

as follows:

Most likely cost:$10/lb.

Optimistic cost: $9/lb.

Pessimistic cost: $12/lb.

The production department advises they arestill in the design phase and are unable toprovide a firm estimate for the total amountof material which will be required tocomplete the project. Current estimates fortotal material requirements are as follows:

Most likely quantity:5,000 lbs.

Optimistic quantity: 4,000 lbs.

Pessimistic quantity: 7,000 lbs.

Using a three-point estimatePexp = (Popt + 4 x Pmost + Ppess) / 6 tocalculate:(a) The expected price per pound for the

material.(b) The expected quantity of materialrequired.(c) The expected total cost estimate formaterial for the project using the simplemethod.(d) The expected total cost estimate formaterial for the project using the complexmethod.

Question: (a) What is the Expected Cost?Answer: Pexp = (Popt + 4 x Pmost + Ppess) / 6Pexp = (9 + (4 x 10) + 12) / 6

Pexp = $10.17/lb

(b) Expected AmountPexp = (Popt + 4 x Pmost + Ppess) / 6Pexp = (4,000 + (4 x 5,000) + 7,000) / 6 = 5,170 lbs.

(c) The simple method estimate of the expected total cost is the product ofthe expected price and expected amount that will be used.

Expected cost:$10.17/lb. x 5,170 lbs. = $52,578.90

(d) The complex method for the final est imated cost for the material requiresthree more steps. 1) Multiply Popt cost by Popt amount to get Popt final. 2)Multiply Ppess cost by Ppess amount to get Ppess final. 3) Apply these twovalues combined with the s imple Pexp value in the three-point equation onelast time.

Expected cost:$10.17/lb. x 5,170 lbs. = $52,578.90

Most optimistic cost: $9 x 4,000lbs. = $36,000

Most pessimistic cost: $12 x 7,000lbs. = $84,000

The final estimatedcost for the material

is:

(($36,000 + (4 x $52,578.90) +$84,000)) / 6 = $55,052.60

Expert Says

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Contingency Estimates

Adding contingency to our estimates provides a buffer in the case of uncertainty in our estimates. We sometimes mustinclude contingencies in our project estimates because estimates are not totally accurate. Cost each work item with a high(best case) and low (worst case) estimate. The PMBOK definition of estimating specifies that some indication of estimateaccuracy should always be included. Typical accuracy depends on the historical context and degree of analysis and/orresearch in the estimating process at any given time. Range estimates can be used for developing contingency pricing

allowances. Typical ranges may be stated as:

Order of magnitude -25%, +75%

Budget -10%, +25%

Definitive -5%, +10%

Early stage projects, during the selection phase for example, may include order of magnitude items, which will later, uponselect ion, be refined to definitive estimates. As a result, order of magnitude ranges provide the largest buffer to address thegreatest uncertainty. Budget contingency provides less buffer and definitive contingencies provide the smallest buffer. Notehow the contingency ranges are biased to the high side. This provides the greatest protection for our estimates to help ensurewe are not over budget.

In the example below we will use contingency pricing to determine if the final sell price will qualify our project to proceed.Note: When applying the range values to our base cost estimates, we use the high side of the three contingency ranges toeffectively raise the estimates due to uncertainty (i.e. worst case scenario).

2-3 Contingency Pricing Demonstration Problem Solution

You are a project manager for a computer manufacturer and have been asked tomanage the introduction of a new personal computer. Listed below are the initial costestimates for the parts and labor for the product.

Product ComponentCost Estimate Type of Estimate

Use the upper end of each range toestimate maximum potential costat current accuracy:

OM = + 75%Budget = + 25%Definitive = + 10%
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Monitor $138.00 Order of magnitude

Keyboard $49.00 Definitive

Hard drive $110.00 Budget

CD drive $57.00 Order of magnitude

Case $22.00 Budget

Motherboard/electronics $350.00 Definitive

Assembly labor $74.00 Actual cost

Packing and shipping $12.00 Definitive

Total cost $812.00 NA

The target list price for the new PC is $2,500. New products are targeted for 100%markup on introduction, so that price and cost reductions can be taken as requiredby competitive pressure and still keep the product profitable. We must apply the100% markup to our contingency price and then apply the reseller target profitmarkup, which is typically 40%. The estimating department currently definesestimate accuracy as follows:

Order of magnitude-25%, +75%

Budget -10%, +25%

Definitive -5%, +10%

(a) What cost budget do you recommend for the product based on the appliedcontingency values?(b) Will the project be approved? (price after markups < target implies approval)(c) What would you recommend to reduce or eliminate any contingency from thebudget?

(a) 1.75($138 + $57) + 1.25($110 +$22) + 1.10($49 + $350 + $12) +$74 = $1,032.35

Calculate expected cost withmarkup and compare to target.

(b) No: $1,032.35 @ 100% markup(2 x $1,032.35) = $2064.70.

An additional 40% reseller mark-upof 40% would bring retail price to(1.4 x $2,064.70) = $2,890.58which is above the target price of$2,500.

When the marked-up retail price isabove the retail target price theretailer will not be able to sell theproduct and therefore will notpurchase any product from us. Thiswould cancel the project.

(c) Need to firm up estimates fororder of magnitude and budgetitems, and revise estimates beforeproject can proceed.

Expert Says

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Time Value of Money Tutorial (Reference)

This tutorial is provided for the student who wishes to refresh his or her skills in the time value of money for evaluationprojects. This may be of use in the course project and understanding some of the examples in the lectures but is notrequired.

Time Value of Money

Through a real-life example in which Jack Wilson is trying to reserve somemoney for his retirement boat, this tutorial will demonstrate:

The concept of time value of money:

How to calculate simple and compound interest ratesHow to calculate future value based on present valueHow to calculate present value based on future value

TVM Tables are in Doc Sharing under "Time Value of Money Tables" Category.
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PM592 Week 2 Lecture

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