V2 - M 3.2 Cost Estimation and Budgeting

OTM 452 Project management

Dr. Amir Fard Bahreini

Module 3.2

Cost Estimation and Budgeting

LEARNING OBJECTIVES

• Explain why estimating is essential in project management
• Compare top-down and bottom-up estimating approaches
• Identify four core estimating techniques and when to use each
• Understand what makes estimates more or less accurate
• Classify cost categories: direct, indirect, fixed, variable
• Distinguish contingency from management reserves
• Interpret and apply a cost baseline for tracking purposes

MAIN MENU

Estimating Basics: Why & When

Top-Down vs. Bottom-Up Approaches

Estimating Techniques

Cost Categories and Budget Buffers

Cost Baseline & Time-Phasing

© 2025 UW–Madison | Dept. of OIM | Amir Fard Bahreini. No copying, reproduction, or online posting without explicit permission. All rights reserved.

Participation Today

For participation in this lecture, you need to submit the Excel file you worked on throughout class.

Part I

Estimating Basics

© 2025 UW–Madison | Dept. of OIM | AFB • All rights reserved

Why Estimating Matters

Estimating is the difference between: "I hope this works..." and "Here’s how much time and money it will take — and why."

In real-world projects, accurate cost estimates:

• Help secure funding

• Allow informed go/no-go decisions

• Guide resource planning

• Protect against overrun and scope creep

PMs don't need to guess well, they need to estimate well.

What Makes Estimating So Hard?

Project estimating can be difficult because:

Imagine trying to guess the cost of renovating your house but you haven’t seen the kitchen, don’t know the square footage, and the contractor might ghost you mid-project.

Good estimators don’t just throw numbers they build in reality.

Part II

Top-Down vs. Bottom-Up Approaches

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Top-Down Estimating – Overview and Applications

Top-down estimating is a macro-level estimation technique where the total project cost is estimated using overall parameters, such as historical data, expert judgment, or analogous projects. Estimates are then allocated to lower-level activities based on proportions or heuristics.

Use top-down estimation for feasibility studies, early funding requests, and initial resource allocation. Key Characteristics include

Top-Down Estimating – Overview and Applications

Bottom-Up Estimating – Structured Detail

Bottom-up estimating involves calculating cost estimates at the work package or activity level, then aggregating them to determine the total project cost. This method relies on a detailed Work Breakdown Structure (WBS) and is typically used during the planning phase.

Bottom-up estimation is foundational for budgeting, cost control, and performance measurement tools like Earned Value Management (EVM) ~ which we'll cover in M4. Process

Bottom Up Estimating – Overview and Applications

• Flexibility in modeling various scenarios

• Built-in functions

• Customizable templates for both simple and complex estimates

• Auditability via comments and versioning

• Wide familiarity across industries

Particularly valuable in early-stage projects, small teams, or when integration with accounting software isn’t needed.

Why Use Excel for Estimating?

Excel is commonly used in estimating because of its:

Use top-down to initiate; bottom-up to plan and control.

Top-Down vs. Bottom-Up – Side-by-Side Comparison

Part III

Estimating Techniques

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Project managers use various estimation techniques depending on data availability, scope definition, and risk sensitivity. The four most common methods are:

Three-Point Estimating

Parametric Estimating

Expert Judgment

Analogous Estimating

Each method varies in complexity, data requirements, and output precision. Often, multiple techniques are combined.

Analogous Estimating – Comparative Analysis

Analogous estimating uses the actual cost of previous, similar projects or tasks to estimate the cost of the current project. Adjustments are made based on known differences in scope, size, or complexity.

Formula:Current Estimate = Past Project Cost × Adjustment Factor Use Case: Early-phase estimating when detailed data is limited.

Pros and Cons

Parametric Estimating – Scalable Metrics

Parametric estimating uses a statistical relationship between historical data and other variables (e.g., cost per unit) to estimate total project cost.

Formula:Estimate = Unit Cost × Quantity Example: If paving a road costs $500/meter and the project involves 3,000 meters: → Estimate = 3,000 × $500 = $1.5M

Additional Notes

Three-Point Estimating – Risk-Adjusted Forecast

Three-point estimating provides a weighted average of cost or duration by incorporating:

• Optimistic (O): Best-case scenario

• Most Likely (M): Realistic scenario

• Pessimistic (P): Worst-case scenario

Expected Cost (E) = (O + 4M + P) / 6

Estimate for testing phase: O = $3,000 | M = $5,000 | P = $8,000 E = (3,000 + 4×5,000 + 8,000)/6 = $5,167

Pros and Cons

Expert Judgment – Experience-Based Estimating

Expert judgment draws on the knowledge and intuition of experienced stakeholders or subject matter experts (SMEs) to develop cost estimates.

Typical Use Cases

• When scope is ambiguous or novel

• In R&D or innovation-heavy environments

• As a validation tool for other methods

Always document the rationale and assumptions used by experts.

Pros and Cons

Estimating Accuracy Over Project Lifecycle

• Estimation accuracy improves as project scope becomes clearer. The table below outlines typical accuracy ranges:

02:40

Analogous Estimating

Lab Estimating techniques walkthrough

Kohler Co. Smart Home Product Launch

Kohler Co. is preparing to launch its new “Intelligent Shower System”, a digitally controlled, voice-activated shower experience that tracks water usage and personal preferences. The project is broken into five key components. As the project manager, you must apply the appropriate estimating technique to each work package. You’ve received some raw data from team leads, but the estimates are incomplete. Your task is to match the right technique, calculate the estimate, and briefly explain your reasoning.

QUESTION

For each WBS component:

• Identify the appropriate estimating technique.

• Show your calculation (except for expert judgment).

• Briefly discuss with your team why that method fits based on scope and data availability.

Part IV

Cost Categories & Budget Buffers

© 2025 UW–Madison | Dept. of OIM | AFB • All rights reserved

Cost Categories

Classifying project costs helps with budget planning, cost control, reporting, and identifying areas for cost reduction. The two common classification from cost accounting standpoint:

Indirect Costs

Fixed Costs

Variable Costs

Direct Costs

Costs that support multiple projects or departments, not directly traceable

Costs that can be traced directly to a specific project activity

Costs that remain constant, regardless of activity volume

Costs that change in proportion to usage or output

Rent, equipment lease, software subscriptions

Contractor hours, consumables, utilities

Labor, materials, subcontractors, travel

Utilities, admin salaries, depreciation

Basis of rate of change

Basis of Traceability

01:00

Cost Classification

Reserves in Budgeting – Why Buffers Matter

Project budgets typically include built-in reserves to accommodate uncertainty.

• Contingency Reserve: For known risks (in scope)

• Management Reserve: For unknown, unforeseeable events (outside of scope)

Both reserves are essential tools in risk-responsive budgeting.

Contingency Reserve – Planned Buffer

A Contingency Reserve is a budgeted amount set aside to cover identified risks that remain uncertain in timing or cost impact. Key Features:

• Part of the cost baseline

• Often calculated as a % of activity or total estimate

• Assigned at work package or control account level

Example

• If testing has a high risk of delay, 10% of its cost may be added as a contingency.

Management Reserve – Executive-Level Buffer

Example

• A management reserve might be used when a sudden regulatory change requires adding unexpected features to a product, increasing costs beyond the planned scope.

A Management Reserve is a fund held outside the cost baseline to address unforeseen risks or changes not previously identified. Key Features:

• Controlled by higher management (not the project team)
• Not assigned to any specific task or WBS item
• Use often requires approval and formal change request

Part V

Cost Baseline & Time-Phasing

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The Cost Baseline is the time-phased, approved version of the budget used to measure and monitor project performance.

Include

Used for

Earned Value Management (EVM) Performance comparisons (Planned Value vs. Actual Cost) Funding release and cost control

Estimated costs for all approved work Associated contingency reserves Excludes management reserve

Part II

Time-Phasing the Budget – S-Curve Overview

• Time-phasing means distributing the project budget over the timeline when costs are expected to be incurred.

S-Curve Graph:

• Cumulative cost over time

• Slow start → rapid increase (execution) → taper off

Why S-curve? Because most projects start slow (planning), then spend quickly (execution), then slow again (closure). Time-phasing is essential for forecasting, cash flow, and performance tracking.

Time-Phased Budget – Beyond the Curve

• A time-phased budget allocates project costs across a timeline based on when work (and spending) actually occurs typically shown as an S-curve.

• But it’s more than a graph, it’s about financial coordination and cash flow readiness.

Budget vs. Estimate – Know the Difference

Estimate = Informed prediction of cost Budget = Authorized funding to be used

Two Scenario of creating time phased budgets

#1

#2

Calculate the cumulative budget when you only have distribution of budget, without time periods budget filled out and must rely on WBS to set up your time phased budget.

Calculate the cumulative budget when you already have information about distribution of budget over project time periods.

Lab tIME-PHASED bUDGETING walkthrough

Lab tIME-PHASED bUDGETING walkthrough

Question: Given the time-phased work packages, complete the baseline budget form for the project.

Lab tIME-PHASED bUDGETING walkthrough

Question: Given the time-phased work packages and network, complete the baseline budget form for the project.

Let’s revisit what we covered today:

• Identify and apply various estimating techniques
• Differentiate between budgets, reserves, and cost types

• Build time-phased budgets in Excel

• Communicate project costs clearly to stakeholders

• Validate estimates and avoid red flags

THANK YOU

“A good estimate is not what you hope it will cost — it’s what it will actually cost."

Pros

• Accounts for uncertainty
• Improves realism in high-risk areas

Limitations

• Requires reliable data for each scenario
• Sensitive to outliers and estimation bias

Strengths

• Invaluable in early scoping
• Supports rapid estimation

Limitations

• Prone to cognitive bias
• Subjectivity varies between experts

• Decompose project into tasks or work packages (via WBS)

• Estimate cost of each component (labor, materials, equipment)

• Sum all components to arrive at total cost

• Based on historical cost, expert judgment, or models

• Typically used in early project phases (feasibility, concept)

• Suitable when detailed scope is not yet available

• Every project is unique

• Scope is often evolving

• Costs shift (inflation, vendors, labor)

• Risks and unknowns hide real effort

• Optimism bias (“We’ll figure it out...right?”)

Suitable ForRepetitive tasks or measurable outputs Risk Factors Unit cost inflation, poor data integrity