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Practical Budgeting for Project Managers – Part II (#2 in the series Practical Budgeting for Project Managers)
By Ray W. Frohnhoefer

As you start to plan your budget, you should review previous budgets for similar work if they are available. You will need to form the budget based on historical experience and performance, plus your current WBS and estimates. When the schedule is created, you will need to look at resource availability. The most difficult part of the process will be to think through all costs.

Basic Project Costs

  • Human resource costs. Here you want to use the fully burdened rate for all project team members. This includes salaries and wages, bonuses, and other benefits. For co-workers who are salaried employees, this information is usually treated as confidential, but your finance department may be willing to provide a composite rate representative of groups of employees or job classifications. Human resources costs, even for contractors, never have sales taxes involved.
  • Administrative costs. These are costs such as phone, copiers, office supplies in the event they aren’t supplied by your company as a part of their normal operations. These may include sales taxes and other fees.

  • Resource costs. These are other purchases of materials or equipment which may be needed for the project. Be sure to consider all costs, including fees and taxes.

Direct & Indirect Costs

Your project costs may be considered direct or indirect. Direct costs are those costs which are for items or resources specific to your project. These may include salaries, rentals, team training, software, and other materials. For example, the direct costs for a project to install a local area network would include routers and bridges, cabling, connectors, tools, labor to install cables and equipment, vendor training for the equipment, and so on.

Indirect costs are not directly related to the project. These may include shared costs such as the lease for the building your company occupies or utility bills for power and water. Indirect costs aren’t usually within the control of the project manager or project team, so it is rare they need to be considered in your budget. You should discuss this with your project sponsor, however, to find out how the company accounts for these costs.

Capital Budgeting

Capital budgeting involves large ticket purchases. The capital budget is usually determined by techniques such as Net Present Value to maximize shareholder return. The large ticket purchases are usually paid for immediately in cash, but the company is permitted to recognize the expense over time.

By representing the expense over time, it is believed investment will be encouraged. This is perhaps done through a compromise. First, the impact of the expense on the company balance sheet is lessened, enabling a more favorable picture. Second, the time period is determined by an accounting concept of “useful life”. The standards for “useful life” are usually shorter than the operating time of an asset. Computers, for example, are often written off over a three year period, but can often run in production for many years beyond their “useful life” period. Once they have been fully written off (all the expenses recognized), companies still have an operating asset and can invest on other needs, establishing a cycle of upgrades to plant and equipment which enable continuous improvement to the operations of the business.

Capital budget items might include upgrades to plant and equipment, purchase of expensive new equipment, or expensive software licenses. The expenses are usually recognized over time by a technique known as depreciation. Depreciation determines how much of the expense needs to be recognized every year and is usually based on the reduction of value due to wear and tear, the passage of time (obsolescence), depletion, or inadequacy. Capital budgeting and depreciation are complex topics and should not be approached without discussion with your finance or accounting department.

Depreciation Chart

Depreciation Illustrated

The chart above from Quantitative Costs in Project Management by Goodpasture illustrates just two of several techniques to manage depreciation. It illustrates the effect on the company balance sheet and a P&L statement which could represent project expenses passed on to the project manager’s budget.

In the depreciation technique known as “straight line”, equal amounts of the expense are represented on the P&L statement each year (in the case of the crane, one fourth of the $500,000 expense). So in the year the crane was purchased, we see the $500,000 asset on the balance sheet and no depreciation. In subsequent years, the value of the asset is decreased by the $125,000 amount of the straight line depreciation.

The software license illustrates a technique known as “sum of the years”. In this case, a fraction of the expense is represented on the P&L statement each year. The fraction is determined by the number of years added together as the denominator (4+3+2+1=10). I’ve written the years in backwards order, since this is the order in which the years become the numerator. So for the first year, 4/10 or 40% of the expense is represented on the P&L statement. 30%, 20% and 10% are applied for subsequent years until 100% of the asset is fully depreciated.

As I’ve mentioned, the depreciation techniques and decisions are typically made by senior management and the finance department. Be sure to consult with them if there are questions about capital budgets. For those interested in the handling of revenues, the applicable term is amortization.

Ray W. Frohnhoefer, MBA, PMP is the Director of the Project Support Office at EDmin as well as a consultant, speaker, writer, educator, and mentor on Project Management. Ray is currently serving on the Component and Community Relations Governance Committee of the Project Management Institute, a past Component Mentor for PMI Region 7 (Southwest North America), a Past President of PMI, San Diego Chapter, Inc., and an adjunct faculty member at three San Diego universities. You can find out more about his professional roles at http://www.edmin.com/company/index.cfm?function=showBioDetail&id=80 and through his blog, The Project Notebook, at http://projectnotebook.blogspot.com.

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