When specific schedule activities have not been defined and estimated, parametric estimating can be applied to the planning components to provide a high-level budget for the affected work. This will generally be necessary when the project is in the conceptual stage of development and the details of the work are not known. It is also true in rolling wave planning for later phases. In this case, the later phases are not planned in detail, pending the availability of missing information. For the next phase, the necessary detail will be produced only as an outcome of the current work.
In these situations, using parametric estimating at the phase or other planning component level can set the budget. For parametric estimating to be most effective, the following should be considered:
• The model that is used should be based on accurate historical information; • The model should work for different sizes of projects (in other words, the model
should be scalable); and
• The parameters used in the model should be quantifiable.
Reserve analysis sets aside reserves to be used for unplanned changes. The changes might be due to anticipated risks and thus involve the cost of the contingency plan, or they might be due to an anticipated rate of errors and rework ("known unknowns", or contingency reserves). On the other hand, they might be the result of unexpected events that require workarounds, and for which no contingency plan exists ("unknown unknowns", or management reserves).
Management reserves are not part of the project cost baseline, but they are included in the budget for the project. Cost budget reserves are discussed in more detail in a subsequent section.
Funding Limit Reconciliation
The timing of funds and planned costs for projects must solve two problems: solvency and fiscal timing.
For a project to be solvent, funds must always be available to meet planned costs. This means that, for any given period, the level of available funds will always be slightly higher than the amount required by the total time-phased budget baseline. The principle is the same as the funding requirement for a personal bank checking account.
Funds must also match the timing of the planned costs within the organization's fiscal cycles. This is the case even if the planned costs shift due to schedule changes. Funds are authorized for disbursement to the project in cycles that are set by the customer or organization to follow their fiscal cycles. The funds can then be spent only for work performed in the same fiscal cycle.
Example: Funds for work in a company's fiscal year 2007 will be disbursed shortly before the start of the fiscal year. They can then be used only to pay for invoices that relate to work that was completed in the same fiscal year. Unused funds expire at the end of the fiscal year, and, conversely, if there are overruns, they must be accommodated through additional funds disbursed in the same fiscal year.
Because work may accelerate or slip across fiscal cycle boundaries, every time the schedule changes, the funds made available must be reconciled with the actual budgeted costs. When the disbursed funds cannot cover the additional costs, or when there will be excess funds in one cycle and a shortage in the next, the usual technique is to shift other portions of the work between the fiscal periods. This maneuver reduces the overrun or consumes the excess. This is done by imposing date constraints on some work packages, schedule milestones, or WBS components in the project schedule.
Reconciling the funding limit is normally performed by the finance function within the organization. It is unusual to simply request changes in the fund disbursement schedule, because the planned expenditures on a given project must be balanced with the total available cash flow in the organization, taking into account the priorities of other projects and business operations. If funding were constantly being shifted, managing the cash flow would become extremely difficult.
The Cost Budgeting process produces the following outputs:
• Cost baseline;
• Project funding requirements;
• Updates to the cost management plan; and • Requested changes.
Cost Baseline
The primary goal of the Cost Budgeting process is to determine the cost baseline. Once the cost budget is approved, it becomes the cost baseline. The cost baseline will be used to measure and monitor cost performance on the project. As noted earlier, the cost baseline is developed by summing estimated costs by period and is usually displayed in the form of an S-curve.
Some projects may have multiple cost or resource baselines to measure different aspects of project performance. For example, internal labor costs may be tracked separately from external costs of contractors or from total labor hours.
Project Funding Requirements
Funding requirements are derived from the cost baseline and must exceed the cost baseline in every period by an amount that will cover expenditures associated with both early progress and cost overruns. Funding occurs in incremental amounts. Each increment must be sufficient to cover all expenditures in every period between the posting of the first increment and the posting of the next increment.
The diagram below shows the comparison of the funding levels to the cost baseline results. The funding requirements are always higher than the project cost baseline's S-curve, as the total funds include the cost baseline plus the management contingency reserve. Some portion of the management contingency reserve can be included incrementally in each funding increment or funded when needed, depending on organizational policies.
Cost Management Plan Updates
The cost management plan is updated with approved change requests that resulted from the Cost Budgeting process if those approved changes impact the management of costs.
Requested Changes
When budgets are allocated to fit within constraints, some control accounts may not have funding that is sufficient to accomplish the required scope. A change request is then necessary to request additional funding, reduce the scope, or perhaps adjust other planning documentation such as the risk response plan. Requested changes are processed for review and distribution through the Integrated Change Control process.
Cost Budget Reserves
As noted previously, reserves analysis is a Cost Budgeting technique used to identify the areas in need of reserves. Typically, budget allocations provide challenges to individual control accounts. In order to mitigate the risk of insufficient funds, it is appropriate to establish a cost reserve.
Types of Reserves Contingency Reserve
A contingency reserve is an amount set aside to account for known risks or uncertainties identified in the estimates. For example, during the estimating process, an estimate for the likely amount may have been established, but a more pessimistic or conservative amount was considered plausible. The budgeting strategy in this case could be to set the budget at the lower amount and to reserve the difference in a special contingency amount. The project manager's strategy will be to actively monitor the planning component that the reserve covers so that the costs are controlled within the lower amount. The reserve is available as a safety net, but can be released if it is not required.
These contingency reserves are estimated costs to be used at the discretion of the project manager to deal with estimating errors and with risk events that have been identified in the risk register (the catalogue of identified project risks).
These risk events are called "known unknowns," because although their size cannot be predicted with certainty and they may not occur at all, their causes are familiar, and their impacts tend to follow similar patterns on similar projects. Their risk response plans and associated contingency reserves are part of the project scope, schedule, and cost baselines.
Management Reserve
In some cases large, unexpected risks that impact the project budget may materialize. These risks are referred to as "unknown unknowns," because their size, cause, and likelihood are all impossible to predict. An example might be a labor strike in the middle of a long construction project.
In the case of these unknown unknowns, the project manager may need to draw on additional funding that was not part of the budget. For this reason, the sponsor's
management may agree to set aside an additional reserve called the management reserve that may be drawn upon to deal with unplanned events, but only with their specific approval.
Since such events by definition cannot be foreseen, the project management team may perform a reserve analysis based on the experiences of prior, similar projects. This management reserve is excluded from the cost budget, but is part of the total funding request.
Appropriate Use of Reserves
Reserves should not be used to accommodate scope changes. Any addition to project scope must be formally initiated with a change request, and corresponding adjustments to budget and schedule baselines must be negotiated.
Mature project management cultures understand the benefits of identifying uncertainties and establishing a reserve mechanism to actively manage risks and uncertainties. Less mature organizations may treat reserves with skepticism and may automatically disallow any budget category identified as a contingency. Often these same organizations wonder why they are constantly struggling with projects that cannot be completed within their budgets.
The uncertainty of cost estimates and the occurrence of risk events are unavoidable. Because they are not certain, they should not be factored into the base estimates for the project work. To shield the project from the turbulence that would result when these estimating errors and risk events surface, the project management team should put in place the appropriate reserves, and carefully control their use to meet only the intended purposes.
Reserve Analysis and Estimating Methods
To develop and establish the appropriate cost reserves, the project management team must use the reserve analysis technique, defined earlier.
The method that should be used to establish cost reserves for a planning component or work package depends on the type of estimating method that was originally used to establish the budget. Recall the estimating methods previously discussed:
• Analogous (also known as Top-down); • Parametric; and
• Bottom-up.
In addition, range estimating, also known as three-point estimating, may be used. Three- point estimates for activity durations are based on three types of estimates:
• Most likely: The duration of the schedule activity, given the resources likely to be assigned, realistic expectations of availability for the schedule activity,
dependencies on other participants, and interruptions;
• Optimistic: The activity duration is based on a best-case scenario of what is described in the most likely estimate; and
• Pessimistic: The activity duration is based on a worst-case scenario of what is described in the most likely estimate.
An activity duration estimate can be constructed by using an average of the three estimated durations. That average will often provide a more accurate activity duration estimate than the single-point, most likely estimate. In the diagram below, a weighted average has been used to determine the estimate, as more weight has been given to the most likely estimate.
The following table describes how one might establish the cost reserve based on the estimating method applied.
Estimating Method Establishing the Reserve Analogous/Top-
Down Estimating
Evaluate the degree to which the historical project(s) used as the basis for the analogous estimate differ in terms of complexity, resource types, and optional elements of scope. Establish a general contingency percentage based on the accuracy level predicted of the estimate, e.g., 30%, and apply that percentage contingency to each control account.
Parametric Estimating
Evaluate the sensitivity of the parametric measures and devise a contingency. For example, for material, if measurements were accurate within 10%, use a 10% contingency. Also, consider adding a contingency for scrap or wasted material, or expected product defect rates.
Bottom-Up Estimating
Collect the contingencies estimated for specific activities or work packages into a common contingency account. Range, or Three-
Point, Estimating
Establish a contingency based on the difference between the "Most Likely" estimate and three-point estimate, as illustrated on the following page.
The diagrams below illustrate the calculation of contingency for three-point estimates. It is important to establish a reserve proportionate to the amount of uncertainly represented by the range of the estimate.
In the diagram below, using statistical analysis one can determine that the confidence of achieving M is about 30%, which is not high.
By adding a reserve represented by the difference between the three-point estimate and the most-likely estimate (E M), the confidence of success is closer to 60%.
Confidence intervals are a statistical concept that is beyond the scope of this course. However, given an estimate that was generated using the three-point estimating technique, a project manager should be able to determine an appropriate contingency amount
For example, if the supporting detail of a work package estimate noted that the Three-Point Estimating technique was used with the optimistic estimate being $2,500, the most likely estimate being $3,000, and the pessimistic estimate being $5,000, then the project manager would calculate an estimate E = (O + 4M + P) / 6, or [$2,500 + (4 x $3,000) + $5,000] / 6 = $3,250. The project manager could then establish a reserve amount based upon the formula of E - M, or $250 ($3,250 - $3,000).
Similarly if the supporting detail of a work package estimate noted that the Three-Point Estimating technique was used with the optimistic estimate being $100, the most likely estimate being $1,000, and the pessimistic estimate being $10,000, then the project manager would calculate an estimate E = [$100 + (4 x $1,000) + $10,000] / 6 = $2,350. The project manager could establish a reserve amount based upon the formula of E - M, or $1,350 ($2,350 - $1,000).
Note that in the two examples above, the amount of the reserve changes to reflect the amount of uncertainty represented by the range of the estimate. In the second example, there is a greater variance between the optimistic, most likely, and pessimistic estimates, so the reserve amount is greater to reflect this uncertainty.
REFERENCES
PMI, "PRACTICE STANDARD FOR EARNED VALUE MANAGEMENT", PMI 2005 S.J. Amos, "SKILLS & KNOWLEDGE OF COST ENGINEERING", AACEI, 2004 A.Damodaran, "STRATEGIC RISK TAKING", WHARTON School Publishing 2007 W.E. Deming, "OUT OF THE CRISIS", THE MIT PRESS, 1986
“MASTERING PROJECT MANAGEMENT BASICS” Boston University, 2005 M. Imai, "THE KEY TO COMPETITIVE SUCCESS" McGRAW-HILL/Irwin 1986 A.H.Bell, "MANAGEMENT COMMUNICATION", WILEY, 2010