How to Estimate and Calculate a Project Budget

I regularly conduct introductory project management workshops. Usually, students aspiring to embark on a project manager role attend my workshops. A few minutes into the training, this next question crops up almost all the time.

How do you estimate project tasks?

Now, this question is not surprising as estimation is typically the first thing you do in a project. Estimation is the backbone of project planning. A good plan can make the project successful, whereas a poor plan can destroy the project.

I have written this article to describe different estimation techniques and a step-by-step approach for doing cost estimation.

Although I have written this article to discuss cost estimating and project budgeting, you may use these techniques to estimate other project parameters, such as duration and resources.

What are cost estimation and project budgeting?

Cost estimation is a quantitative assessment of the amount likely to be spent to complete a project task (work package or activity). Project cost estimating involves developing an approximation of the money required for all the tasks in the project.

The project budget is the sum total of the cost required to complete all the tasks in a project and contingency reserves for the known risks. It can be simply calculated by aggregating the lower-level cost estimates in a WBS.

Project budgeting is a process and not an event in a project. The cost estimates are refined, and the budget is updated many times throughout the project.

The project budget is developed at the start of a project and later refined as more information becomes available about the project work and a detailed WBS is prepared.

The estimation accuracy improves as the project scope is refined and better understood. As the project moves toward completion, the uncertainty decreases, and cost estimates become more reliable.

At the beginning of the project, a Rough Order of Magnitude (ROM) estimate is created. It is likely to be wildly inaccurate, with an accuracy range of -25% to +75%. It can result in a wide range of outcomes.

Since ROM is a ballpark estimate, it is used in the project’s initial phase. It helps to get initial budgetary approvals and get the project off the ground.

A ROM estimate can be further refined into preliminary estimates when more information becomes available and assumptions are tested later during the project.

Finally, after creating detailed WBS, definitive estimates are developed whose accuracy can range from -5% to +10%.

Why project budgeting is important

Projects cannot be executed without a detailed and well-defined project budget. Here are five reasons why you should formally develop a project budget:

1. The project budget is essential for securing the funding. By looking at the budgetary numbers, stakeholders will get to know how much funding is required and when funds are needed.
2. A detailed project budget is essential for making a good project plan, without which a project will likely fail.
3. Project management is defined as balancing project constraints. Cost is one of the three primary constraints in a project: scope, time, and cost. Creating a budget is essential for managing a project, as budgetary estimates address cost constraints.
4. A well-planned budget is a foundation for monitoring and controlling costs. Project managers can compare the actual costs against the approved budget to determine if there is a variance. It helps them check how the project is progressing and whether they need to take corrective actions.
5. Making a formal budget helps companies to remain financially viable. If the budgeting is done correctly, it will help improve project profitability and overall success.

Six cost estimation methods

1. Expert judgment

This method involves getting estimates from people with specialized knowledge, skills, or experience in cost estimation and understanding your project’s domain area. You may hire a consultant if you do not have an in-house expert.

This technique relies on the expertise and knowledge of the people who provide the estimates. It requires a certain minimum level of understanding of the application area of the project and its environment. The accuracy of estimates found using this technique depends entirely on the knowledge and experience of the experts involved,

Expert judgment is a fundamental technique used for all the other estimating techniques.

2. Top-down estimation

This technique estimates the cost of the overall project. It then decomposes the whole project into smaller components and allocates part of the total budget to these components. It is generally used when a project has been allocated a fixed budget.

Top-down estimation could be significantly inaccurate as it is difficult to estimate the cost of the whole project without understanding its components.

3. Analogous estimation

Merriam Webster defines “analogous” as “similar or comparable to something else either in general or in some specific detail.”

As the name suggests, this method looks at historical data from previous similar projects to arrive at an estimate for the current project.

The analogous estimation uses Expert Judgment and budgetary data from past projects to determine a cost estimate for the current project.

Analogous estimation is considered the least accurate technique for cost estimating, but you can do it quickly with limited information.

Example: Let’s assume you wanted to paint your house and, before beginning the painting, you wanted to determine how much it would cost. So, you reached out to your friend for his advice, who had painted his house a few months ago.

Your friend might say, “I paid $5,000 to paint my house. My house and your house are similar in size, so the painting job should cost you about the same.”

This is an example of analogous estimation based on the similarity of the two projects.

4. Parametric Estimation

Just like analogous estimation, this parametric estimation uses historical data from previous projects to calculate cost estimates for the current project. However, it is not based on the similarity of the projects.

The parametric technique uses a mathematical formula or algorithm to calculate cost based on historical data and project parameters. It uses a statistical relationship between different variables (e.g., square footage in construction) to estimate the cost of a complete project or part of the project.

Parametric estimation is considered the most accurate cost-estimating technique as it is based on mathematical logic. However, it is a costly and time-consuming method.

Example: Let’s assume you wanted to paint your house and, before beginning the painting, you wanted to determine how much it would cost. So, you reached out to your friend for advice, a manager with a real estate company that was into constructing and selling houses.

Your friend might say, “My company pays $1.90 per square foot to a contractor for painting houses. You can use the services of this contractor for painting your house.”

You measured the area to be painted in your house and found that it is 3000 square feet. So, your cost estimate will be $(1.9*3000) or $5,700.”

This is an example of parametric estimation calculated by multiplying the rate per square foot by the area to be painted.

5. Bottom-up Estimation

Bottom-up estimation is the most reliable way to develop cost estimates and create a project budget. This method estimates smaller components of the WBS and aggregates them to calculate the project budget.

The bottom-up technique is generally used during the later phases of a project. Bottom-up estimation can be performed only when you have detailed information about the project and have created a WBS.

The only downside of bottom-up estimating is that it takes too long to gather the details of a project. However, it creates very accurate estimates since it is done for each more minor component of WBS.

6. Three-point Estimation

Three-point estimating is done by taking the average of three different estimates. The following estimates are used to calculate the expected cost.

• Optimistic (O): A cost estimate considering the best-case scenario.
• Pessimistic (P): A cost estimate considering the worst-case scenario.
• Most likely (M): A cost estimate considering the realistic scenario.

The expected cost (E) can be found by using one of the following formulas:

Triangular Distribution Formula
E = (O+P+M)/3
Beta Distribution Formula
E = (O+P+4*M)/6

This method improves the accuracy of a single-point estimate by considering uncertainty and risk.

How to develop a project budget step by step

You can use the following steps to do cost estimation and create a formal project budget:

1. Prepare a ROM budget at the beginning of the project. You can use top-down or analogous estimation techniques for doing this.
2. Get approval of the initial project budget.
3. Create a WBS and define work packages after the scope has been finalized and you understand what needs to be accomplished.
4. Decompose work packages into activities if required.
5. Estimate the cost of each work package and activity as required. Add contingency reserves if quired. To do this, you can use the following methods: expert judgment, analogous, parametric, or three-point estimation.
6. Create a sum total of the work package and activity cost estimates. Add project-level contingency reserves as required to prepare a detailed budget.
7. Refine the budget further to reconcile with the initial budgetary estimates and constraints.
8. Get approval on the final budget.
9. Refine the budget in case any changes impact the project cost or when new information becomes available,

Conclusion

Project budgeting is a complex and time-consuming exercise. The budget depends on other project variables like scope, schedule, quality, risk, and resource requirements. The cost estimates change if any of these variables change.

Generally, it is challenging to estimate the cost of a project because each project is unique. The estimation becomes much more complicated if the size and complexity of a project happen to increase. The techniques discussed in this article can significantly improve cost estimation accuracy.

As a project manager, you have to be constantly on your toes while defining and refining the project budget. You should keep experimenting with different estimation techniques and revise your estimates as project parameters change.

I’ll leave you with some questions to ponder.

Which cost estimation techniques have you used in your project? Which one do you like most?

In your experience, what are the pros and cons of different estimation techniques?

First published on October 7, 2022.