REVIEW DRAFT: The Total Cost Management (TCM) Framework Section 8.

3 Cost Estimating and Budgeting (October 17, 2001)

Bernard A. Pietlock, CCC, Co-C Chair, AACE Cost Estimating Committee; Douglas W. Leo, CCC, Co-C Chair, AACE Cost Estimating Committee; John K. Hollmann, PE CCE

OBJECTI VE OF THE TOTAL COST MANAGEMENT (TCM) FR AMEWORK

The AACE Technical Board is developing what is being called the Total Cost Management (TCM) Framework. The Framework will be a process map and associated text that provides an overview of the scope of all the various sub-processes or functions of cost engineering and illustrates how all these sub-processes are related to each other using process management conventions. The Framework introductory sections are in final revision process (re: Cost Engineering, March 2001).

neers use or interface with in a process map format. Section 8.3 of the Framework provides the process map for cost estimating and budgeting. This section has already undergone a formal "peer" review with the lead effort being provided by the Cost Estimating Committee chaired by Bernard A. Pietlock, CCC and Douglas W. Leo, CCC. At this time, we are soliciting comments from AACE members on the TCM Framework, section 8.3 "Cost Estimating and Budgeting". Comments must be submitted using the enclosed comment form, and must be accompanied by a signed release form (both found elsewhere in this issue). Please make your comments as specific as possible. The review material is also available in the "technical" section of AACE's Web site at www.aacei.org. All comments must be received by February 15, 2002. At the end of the comment period, the Technical Board will address each comment and revise this section as appropriate.

PREFACE TO SECTION 8.3 COST ESTIMATING AND BUDGETING:

The Framework will lay out the various practices that cost engi-

8.3 Cost Estimating and Budgeting

8.3.1 Description
Cost estimating is the predictive process used to quantify, cost, and price1 the resources required by the scope of an investment option, activity, or project. Budgeting is a sub-process within estimating used for allocating the estimated cost of resources into cost accounts (i.e., the budget) against which cost performance will be measured and assessed. The budget is the baseline for the cost control process (see Sections 3.2 and 7 .2). Cost estimating is a process used to predict uncertain actual costs. In that regard, a goal of cost estimating is to minimize the uncertainty of the estimate given the level and quality of scope definition. The outcome of cost estimating normally includes both an expected cost and a probabilistic cost distribution. As a predictive process, historical reference cost data (where applicable) can improve the reliability of cost estimating. Cost estimating, by providing the basis for budgets, also shares a goal with cost control of maximizing the certainty of the actual cost outcome. The cost estimating process is generally applied during each phase of the asset or project life cycle as the asset or project scope is defined, modified, and refined. As the level of scope definition increases, the estimating methods used become more definitive and produce estimates with increasingly narrow probabilistic cost distributions. The specific estimating tools and techniques used vary widely depending upon the life cycle phase, the type of asset or project, and the level of definition of scope information available. The analysis, development, and maintenance of estimating tools and techniques are steps that are considered part of the estimating process. The cost estimating process is typically performed concurrent to or iteratively with the asset and project planning and evaluation processes described in Chapters 4 and 8. Concurrent approaches are used because the breakdown of scope into controllable items and activities and the subsequent quantification of resource requirements are planning tasks for which cost estimating skills and knowledge add value. Because costs are often dependent on time duration, the estimation of the time duration of activities (see scheduling in Section 8.2) is best considered concurrently with costs. Iterative approaches are used because outcomes of a cost 32

estimate often lead to changes in scope or plans. While some steps of the cost estimating process are mechanistic and conducive to semi-automation (e.g., determinations of quantities by computer-aided design tools, and so on), estimating is a predictive process for which judgment and experience add value. Effective cost estimating requires an understanding of the work being planned. In some industries such as engineering and construction, cost estimating is a recognized discipline because of the specialized knowledge required. In all industries, many individuals contribute to the performance of the estimating process.

8.3.2 Process Map for Cost Estimating and Budgeting

At its core, cost estimating involves the application of techniques (i.e., costing) that convert quantified technical and programmatic information (i.e., inputs) about an asset or project into finance and resource information (i.e., outputs). The outputs of estimating are used primarily as inputs for business planning, cost analysis and decisions or for project cost and schedule control processes. The process is supported by tools and data that are created and maintained to support the various types of estimates that need to be prepared during the life cycle of the asset or project. Figure 8.3.1 illustrates the process map for cost estimating and budgeting. Sections 8.3.3 and 8.3.4 describe the inputs and outputs in more detail.

8.3.3 Inputs to Cost Estimating and Budgeting

.1 Scope Definition. The investment option (see Section 4.1) or project scope (see Section 8.1) is defined with enough supporting information to support the classification of estimate to be prepared (see Section 8.3.5.1). .2 Technical Deliverables. The scope definition is supplemented with documents, databases, and other detailed technical information to support quantification of the scope. These deliverables are the output of work defining processes (e.g., engineering, design, and so on) that are outside of the TCM process. .3 Work Breakdown Structure. The work breakdown structure (see Section 8.1) provides the overall organization of project work to be estimated. .4 Chart or Code of Accounts. Coding structures that support the cost

Cost Engineering Vol. 43/No. 12 DECEMBER 2001

Two-way arrows represent concurrent/iterative with other processes

Business Requirements & Objectives (3.1 & 7 .1) Chart of Accounts (6.1 & 10.1

Scope Technical Definition Deliverables and WBS (4.1 & 8.1)

Schedule Durations (8.2)

Resource Quantities (8.4)

Historical Cost Information (3.2 & 7 .2)

Quantification of Scope Content (take-off)

Costing

Pricing and Bidding

Budgeting

Estimate Review

Develop and Maintain Cost Estimating Data

Simulation and Optimization

Cost Information for Analysis (4.2, 8.5, 8.6, 8.7)

Cash Flow Analysis

Cost Control Baseline (3.2 & 7 .2)

Estimate Basis (3.2 &7 .2)

Develop and Maintain Cost Estimating Tools and Techniques

Estimate Information

Schedule (8.2)

Historical Cost Information (3.2 & 7 .2)

Chart of Accounts (6.1 & 10.1)

Figure 8.3.1 Process Map for Cost Estimating and Budgeting

accounting process (see Sections 6.1 and 10.1) are provided. Each stakeholder with cost accounting and cost control responsibilities may have their own chart of accounts; coordination may require that stakeholders map their accounts with each other so that cost information can be exchanged. Budgeting allocates estimated costs to the proper cost accounts. There may also be a separate chart or code of accounts for cataloguing information in a cost estimating database; this chart may differ from that used for cost budgeting and accounting. .5 Historical Cost Information. The development and maintenance of cost estimating tools and data are often, but not always, based on feedback of actual asset (see Section 3.2) and project (see Section 7 .2) cost performance information. .6 Estimate Information. Information from previous estimates for this asset or project (or from other assets or projects as applicable) supports the development and maintenance of cost estimating tools and databases. sions made, and some indication of the level of risk and uncertainty. .5 Refined Scope Development. Results and learnings from the estimating process often lead to modifications and refinements in the scope description, implementation plans, and WBS (see Sections 4.1 and 8.1.) .6 Refined Plan and Schedule. Results and learnings from the estimating process often lead to modifications in asset or project work plans and schedules (see Sections 4.2 and 8.2.). The estimate and schedule are generally developed concurrently or iteratively. .7 Estimate Information. Information from the estimate supports the development and maintenance of cost estimating tools and databases.

8.3.5 Tools, Techniques, and Sub-Processes for Cost Estimating and Budgeting
At the core of the estimating process is the costing step and that step always involves the use on an estimating algorithm or formula. The algorithm transforms project technical and programmatic descriptive information into cost and resource terms. These estimating algorithms are often referred to as cost estimating relationships (CERs). In its simplest form, a CER will appear as: Cost Resource = Factor x Parameter where: Cost Resource = $ (labor, material, total etc.), or time (labor hours, equipment rental hours, etc.) Factor = a unit cost factor in terms of cost resource/parameter unit Parameter = quantification of a scope item

8.3.4 Outputs from Cost Estimating and Budgeting

.1 Cost Control Baseline. A tabulation of costs in accounts that are optimized for cost accounting and cost control purposes. For some control methods, the costs are time-phased by account or group of accounts. As cost performance measures are made, they are assessed against the cost baseline (see Sections 3.2 and 7 .2). .2 Resource Requirements. Quantities of resources such as labor, material, and equipment are outputs of the estimating quantification process and costing algorithms. The resource requirements are used as a basis for resource planning (see Section 8.4) and procurement (see Section 8.7). .3 Cost Information for Analyses. Investment Decision Making (see Section 4.2), Value Engineering (see Section 8.5), Risk Analysis (see Section 8.6), and Procurement Planning (see Section 8.7) all require cost information from the estimating process as their input. Risk Analysis is typically performed concurrently with estimating. Risk analysis yields contingency costs used in estimating.

In mathematical terms, the CERs are either stochastic in nature (based on .4 Estimate Basis. Because cost estimates are approximations based in conjectural cost relationships and statistical analysis), deterministic (based varying degree upon assumptions and interpretations of scope and plans, on conclusive, definitive cost relationships), or some combination of these. stakeholders are prone to misunderstanding what a cost estimate repreThe stochastic approaches are often called parametric estimating and sents. Communicating the basis of an estimate reduces misunderstandanalysis and the deterministic approaches are often called definitive, detail ings, error and misuse. The estimate basis is also used in change manunit cost, or line-item estimating. Parametric algorithms can be highly comagement (see Section 7 .2) to understand scope content of changes. The plex. As successive estimates are prepared over the course of a projects estimate basis generally includes a description of the scope, methodololife cycle, the estimating techniques tend to go from stochastic (e.g., ordergies, references and defining deliverables used, assumptions and exclu1 Refer to section 8.3.5 for descriptions of these and other tools and techniques for estimating and budgeting. Cost Engineering Vol. 43/No. 12 DECEMBER 2001 33

of-magnitude, conceptual, etc.) to deterministic (e.g., detailed, definitive, etc.) with increasingly narrow probabilistic cost distributions. Basic estimating algorithms are often adjusted by the application of factors or indice ratios to make the result match the current estimate situation. Factors, as drawn from project history or a standard database, almost always reflect conditions from past experience that do not match those in the current estimate situation. The conditions that may vary from the database basis include time differences, escalation and inflation, exchange rates, labor rates, labor productivity, material mark-ups, location factors, environmental impacts, and taxes, duties, and fees. Parameters or quantity measures used reflect idealized models that do not precisely match actual technical or programmatic conditions. The conditions that may vary from the measurement basis include waste and spoilage allowance, accuracy of measurement (take-off) allowance, and specification, function, or content differences. The tools and techniques and sub-processes (including costing) of cost estimating and budgeting include: .1 Classification of Cost Estimates. Given the goals of reducing uncertainty in the estimating process and improving communication of estimate results, it is desirable to establish standard estimate classifications for the enterprise. The classification system will define the specific input information needed to produce a desired estimating outcome quality at each phase of the asset or project life cycle. Classification schemes help define the requirements for scope definition and they will indicate estimating methodologies appropriate to that scope definition (Recommend Practices 17R97 and 18R97 provide classification methods recommended by AACE International). .2 Cost Estimating Algorithm Development. Stochastic estimating methodologies often require that custom algorithms be developed and maintained to support the estimating process. These algorithms are commonly based upon statistical analyses or modeling of historical or other cost information. The algorithms are needed to convert scope quantification input to appropriate cost output. .3 Cost Estimating Database Development. All estimating algorithms are dependent upon having data such as labor and material unit rates, indicies and factors, equipment costs, and other resource rate and other cost factor information. The type of data that is used in the algorithm to convert scope quantification input to cost output is specific to the algorithm and estimating methodology used. The data may be obtained from published sources or it may be developed in-house. Published sources must be analyzed to determine adjustments needed to make the data applicable to the enterprises situation. The quality of databases is a key determinate of estimate output quality. .4 Quantification. The scope definition of an investment or a project is generally described in various planning and technical documents, databases, or other deliverables. To cost and price the scope, information in the scope documents must first be quantified in terms or formats required by the estimating algorithms. For example, an algorithm that estimates the cost of developing software programs may require the number of lines of software code as an input. Likewise, a construction estimating algorithm may require the linear meters of pipe as an input. The output of quantification is referred to as a take-off when the quantities are measured from a drawing. .5 Costing - Estimating Algorithms. Costing includes the core technique of estimating which is the translation of quantified technical and programmatic scope planning information into expressions of the resource and financial investment or expenditure required to effect the plan. The translation is done with a mathematical algorithm. Costing does not in itself consider business concerns of how work is to be charged, billed, marked up, or otherwise accounted for by various stakeholders (see pricing and budgeting). Life Cycle Costing is costing applied to the entire life cycle of the asset including creation or modification, operation or use, and decommissioning or retirement to support investment option development and decision making. .6 Simulation and Optimization. The factors and parameters in an estimating algorithm may have a range of possible values that could occur, or that could be selected from within the scope. For estimating, simulation refers to methods used to apply alternate factor and parameter combinations in the estimating algorithm - these methods result in a distribution of possible outcomes. Optimization refers to simulation methods that have a goal of finding an optimum output. These techniques are valuable for value engineering (see Section 8.5) to optimize scope decisions in terms of cost. They are also used for evaluating cost risk (see in Section 8.6). .7 Pricing and Bidding. Pricing includes charging techniques that various stakeholders in the plan (bidders, contractors, etc.), apply to costings to allow for overhead and profit, to improve cash flow, or to otherwise address 34

market conditions and serve their business interests. Because a budget may include cost information obtained from outside parties (e.g., bidders), it is important to understand the nature of cost obtained from priced sources. For example, contractors often unbalance an estimate or bid by allocating costs to those items for which payment will be obtained early in a project. Activity based costing calls for minimizing arbitrary or unbalanced allocations so that optimum cost decisions or control may be obtained. .8 Budgeting. Budgeting includes the sub-process for allocating the estimated cost of asset or project items into cost accounts against which cost performance will be measured and assessed. Budgeting results in a baseline for cost control performance assessment (see section 7 .2). The cost accounts used from the chart of accounts must also support the cost accounting process (see Sections 6.1 and 10.1). Budgets are often timephased in accordance with the schedule or to address budget and cash flow constraints. .9 Cash Flow Analysis. To serve as a basis for earned value and other methods of cost control (see Sections 3.2 and 7 .2), the budget is timephased to determine expected rates of cost expenditure for each account or group of accounts. As rates of investment are often constrained by the enterprise for financial reasons, the estimate and schedule are usually developed concurrently. The rate of investment may alternatively examine the rates of cost commitment (i.e., obligation made to expend) or actual cash disbursement. .10 Estimate, Budget, or Bid Review. Estimates are typically complex compilations of input from multiple stakeholders. To assure the quality of an estimate (or budget or bid), a review process is called for. The review seeks to assure that the estimate reflects the asset or project goals and scope, is suitable for cost accounting and control purposes, serves the stakeholders financial requirements, and that all parties agree on and understand its content and probabilistic nature. Prior to the review, the estimate basis is documented to support the review and, after the review, it is updated as needed to support subsequent change management processes. The estimate should be benchmarked against or compared to historical experience and/or past estimates of the enterprise and of competitive or comparable enterprises to assess its appropriateness, competitiveness, and to identify improvement opportunities.

8.3.6 Key Concepts for Cost Estimating and Budgeting

The following concepts and terminology described in this and other chapters and sections are particularly important to understanding the cost estimating and budgeting process of total cost management: .1 Activity Based Costing (ABC). (see Section 4.2.) Cost management and control is improved when all costs are attributed or budgeted to the item or activity causing or driving the expenditure rather than through arbitrary or non-causal allocations. .2 Algorithm and Cost Estimating Relationship (CER). (see Section 8.3.5) .3 Budgeting. (see Section 8.3.5.8) .4 Chart or Code of Accounts. (See Section 8.3.3.4) .5 Contingency. (see Section 8.6.) Every project cost estimate should include distinguishable contingency costs somewhere in the estimate. Contingency is an amount added to an estimate to allow for unknown items, conditions, or events that experience shows will likely occur. .6 Cost Accounting. (see Sections 6.1 and 10.1). Accounting provides the measure of commitments and actual expenditures. The process, tools, and systems an enterprise uses to handle cost performance measurement information will often drive the chart or code of accounts and constrain how cost may be estimated and budgeted. Accounting also serves financial reporting purposes in addition to cost control purposes. .7 Cost Control Baseline. (see Section 8.3.4.1) .8 Costing and Life Cycle Costing. (see Section 8.3.5.5) .9 Estimate Basis. (see Section 8.3.4.4) .10 Pricing. (see Section 8.3.5.7) .11 Scope. (see Sections 4.1 and 8.1). The estimate and budget must reflect the scope of the asset or project. .12 Quantification and Take-off. (see Section 8.3.5.4) .13 Uncertainty. A cost estimate or budget is always an approximation. Therefore, understanding the probabilistic characteristics of the estimate is essential. Measures of uncertainty (range, confidence intervals, and so on) are often key determinates of estimate quality.

Cost Engineering Vol. 43/No. 12 DECEMBER 2001