Budgeting and cost control
Budgeting and cost control comprise the estimation of costs, the setting of an agreed budget, and management of actual and forecast costs against that budget.
A budget identifies the planned expenditure for a project, programme or portfolio. It is used as a baseline against which the actual expenditure and predicted eventual cost of the work can be reported.
Initial cost estimates can be comparative or parametric. These are refined as the feasibility and desirability of the initiative are investigated and a greater understanding of scope, schedule and resources is developed.
Once approval is given, these refined estimates form the baseline cost. By allocating costs to the activities in a schedule, a profile of expenditure is produced.
The three major components of a P3 budget are:
- the base cost estimate;
- management reserve.
The base cost estimate is made up of known costs such as:
- resourcing (e.g. staff costs or consultants’ fees);
- consumables (e.g. power or IT supplies);
- expenses (e.g. travel and subsistence);
- capital items.
Costs have four possible attributes. They may be direct, indirect, fixed or variable:
- direct costs are exclusive to the project, programme or portfolio; they include resources directly involved in delivering and managing the work;
- indirect costs include overheads and other charges that may be shared out across multiple activities or different departments;
- fixed costs remain the same regardless of how much output is achieved, such as the purchase of an item of plant or machinery;
- variable costs, such as salaries, fluctuate depending on how much resource is used.
Costs may be organised into a cost breakdown structure (CBS) where different levels disaggregate costs into increasingly detailed categories.
Contingency is money set aside for responding to identified risks.
A management reserve covers things that could not have been foreseen, such as changes to the scope of the work or unidentified risks. The more uncertainty there is, the more management reserve is required; so highly innovative work will need a larger management reserve than routine work.
Once the cost estimate, contingency and management reserve are agreed with the sponsor, these become the budget. The simplest way of illustrating the use of the budget against time is the ‘s-curve’. This shows cumulative expenditure against time and gets its name from its typical shape. This profile of expenditure is used in project financing and funding. It allows a cash flow forecast to be developed, and a drawdown of funds to be agreed.
There should be strict guidelines or rules for managing the contingency and management reserve funds. The P3 manager will have control of the base cost. The sponsor retains control of the contingency and management reserve funds, which may be held as part of broader organisational funds.
Once the work is under way, actual and forecast expenditures are regularly monitored. Costs are tracked either directly by the P3 management team, or indirectly through operational finance systems. Where P3 managers are reliant upon information from operational systems, the information needs to be checked to ensure that costs have been posted correctly.
The normal payment process means that three types of costs must be tracked:
- committed costs – these reflect confirmed orders for future provision of goods and/or services;
- accruals – work partially or fully completed for which payment will be due;
- actual costs – money that has been paid.
The forecast cost is then the sum of commitments, accruals, actual expenditure and an estimate of the cost to complete the remaining work.
A report showing an ‘s-curve’ for the original budget alongside an ‘s-curve’ of actual spend to date, can quickly show how actual expenditure is varying from that originally predicted and form the basis for forecasting.
Actual expenditure inevitably varies from planned expenditure. While the P3 manager will have responsibility for day-to-day management of costs there must be thresholds that require the involvement of the sponsor. These are known as tolerances and, if expenditure is predicted to exceed the tolerances, the manager must escalate this to the sponsor in the form of an issue.
Periodically, the viability of the project, programme or portfolio must be reviewed formally. In the latter stages of the work this review must consider ‘sunk costs’. Sunk costs are actual and committed expenditure that cannot be recovered, plus any additional costs that would be incurred by cancelling contracts. Completing an overspent project or programme may be considered worthwhile if the remaining cost to complete the work is less than the eventual value.
After the initial comparative or parametric estimates, the detailed cost of a project will be estimated bottom-up using the work breakdown structure (WBS).
By classifying costs in accordance with the WBS, CBS and organisational breakdown structure (OBS), they can be reported in any combination of cost type, resource type and part of the project. Estimates may be drawn from internal costs (such as salaries) or external costs (such as provider quotations); they may be drawn from previous experience of similar projects or be more speculative where the work is innovative. Where cost estimates are difficult to pin down, three-point estimates of optimistic, pessimistic and most likely costs allow a statistical analysis of the overall project cost.
The baseline cost can be used as the basis for earned value management (EVM). This assumes that the cost of performing the work constitutes its value. The value of work performed at any point can then be compared to the actual cost of performing it and the value of work planned to have been performed at that point. The type of work in a project is usually in a narrow range. This enables earned value management to make predictions about future performance based on performance to date more accurately than techniques such as critical path analysis.
Many internal resources on a project will not be fully dedicated to the project. They may be part of a matrix organisation where their time is split between business-as-usual and multiple projects. In this situation, it is important to have a system of cost allocation that accurately reflects the costs consumed by the project.
Programmes frequently cut across operational departments and may be funded from different sources. The programme manager must understand how the budget is funded so that cost reports can be fed back to the appropriate stakeholders.Within a diverse programme there may be innovative projects and routine projects. As well as projects, costs will be incurred in business-as-usual areas. The estimating accuracy across the programme will also vary widely. At any point in time the programme will include projects that are well defined and accurately costed, projects that are in the future and yet to be defined, benefits realisation work that is clearly part of the programme, and business-as-usual work that is arguably part of the programme.
This variation makes it difficult to provide an overall picture of the programme’s financial position. The financial performance of a programme cannot easily be represented as a simple ‘s-curve’ and suitable reporting mechanisms will have to be set out and agreed with stakeholders.
A programme support function will need to establish clear cost accounting procedures that are adhered to by all projects and benefits realisation work. Business change managers will need to be clear on business-as-usual costs that can be allocated to the programme.
Portfolios are aligned to corporate financial cycles. Budgets for portfolios are less concerned with the cost of delivering a specific result, and more to do with what can be delivered within a defined budget.
The prioritisation and balancing phases of the portfolio life cycle depend upon a good understanding of the costs of the component projects and programmes. One of the most common causes of cost control problems is over-optimism about what can be delivered within the available budget.
It is unlikely that cost variance reporting will be appropriate for the portfolio as a whole, but it may be appropriate for categories of project and programme within the portfolio.
The portfolio management team is responsible for setting standards of cost estimating, accounting and reporting across all the component aspects of the portfolio so that sound decisions can be made.