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Date Posted: 6/8/16
By Kevin Carpenter, contact: kcarpenter@kca-us.com

What's the price of oil next year?  What's my resourcing rate going to be? Which projects will be permitted to go forward?  By how much will my scope be cut? How is my budget going to be affected?
 
These uncertainty questions and more are top of mind for most project leaders as companies react to low prices and depressed revenues.  In down cycles, budgeting becomes the key activity for many managers in the corporation and often becomes the focus of effort to the detriment of other management activities. 
 
In this article, I'll address the issue of budgeting for projects and the company in the face of a broad, uncertain future.
 
First, let's consider the basic purpose of a budget.  A budget exists to allocate resources (human, capacity, and capital) to projects and activities to forecast and manage the company's cash flow against two competing objectives:

  1. Don't spend more than the budget and put the cash flow of the company at risk
  2. Don't underspend because those unused dollars could have been allocated to other projects and generate additional value.

If left to be managed at the project level, these competing objectives cause all manner of problems when the combined project budgets are rolled up to the company level.
 
Let's say we have 100 projects underway and each project is telling us they will spend $750,000 +- 25%.
The simplistic approach would be to total the projects to $75 Million and state that as the company's budget.  If times get tough and the company has only $65 Million to spend, everyone is asked to cut 13% from their number to keep the total at the targeted level.
 
However, the project managers anticipate these sorts of cuts, and turn in a budget number a bit higher than the $750,000.  If they pick the 80th percentile of their possible (uncertain) +- 25% range, they submit $873,000 to be "safe" so that when the inevitable cuts come, they can still do most of the project as planned.  Of course, if all the Project Managers do this, the total proposed budget climbs by over $12 Million. 
 
A Better Way to Budget in an Uncertain Environment
Budgets by definition are always wrong.  There is virtually zero chance of the company spend to total $75 Million.  Even more dangerous, setting the budget at the deterministic midpoint creates a 50% chance you will spend more and a 50% chance you will spend less than the budgeted number.  If those objectives mentioned earlier are exactly equal, if the pain of overspending the budget equals the consequences of underspending and leaving capital idle, then the midpoint is fine.  However, these objectives are only equal in a stable and predictable business environment.  When was the last time we had one of those?  When times are tight most companies would rather prevent overspending.  When the industry is booming, it's far more important to use every dollar on projects and have no idle funds.  Setting the budget at a point in the range of outcomes other than the midpoint acknowledges this issue and intentionally manages the budget to the company's risk profile.
 
If going over budget has more negative consequences than coming in under, then setting the budget to the 80th percentile might be the exact way to manage the risk.  This is saying that "we're okay with a greater chance of underinvesting to offset the chance we spend too much".
 
So it turns out the Project Manager that picked the 80th percentile had the correct theory, but the wrong application of the approach.  Setting a budget at a value other than the Median (the $750,000) is appropriate if you want to manage the risk and balance the two competing objectives mentioned earlier.

On BudgetHowever, here's the difference.   That decision to set the percentile cannot be made at the Project Manager level and must be intentionally managed at the corporate budget level.  If we took all 100 projects with their +- 25% forecasts and totaled their 80th percentiles, the corporate budget becomes $87.3 Million.  However, if we model all the projects with the same range of spend and take the 80th percentile of the total portfolio, our budget is $76.2 Million. This $11 Million difference is now available to fund an additional seven or eight projects, further adding value to the company's portfolio.  

For the process, each Project Manager submits their forecasted activities with their total range of future spend.  A single deterministic point for each project is meaningless.  The Corporate Finance Managers model these ranges and select their percentile budget "number" to balance their risks of being over or under budget.  The Project Managers now focus more on project execution than financing.  "On budget" has less of a focus as it's recognized the project will come in somewhere between the +- 25% of the original target.  However, it is critical that if the Project Manager finds they are spending less than the $750,000, this does not give them license to spend "their" budget in expanding scope or features.  Their perceived "under spend" is really just the variability of their forecast and not a true "surplus", and will likely be offset by the variability of other projects going "above" their mid-point number.  The Project must be held to the activities and deliverables in the plan.
 
So what about the directive to cut spend when revenues are depressed?  If the decision is made to limit the 80th percentile spend to $65 Million, one alternative is to ask all projects to target $640,000 +- 25%, but that gets us back to arbitrary cuts rather than deliberate optimization. Another is to perform a portfolio optimization that will suggest cutting the portfolio by 15 projects.  The correct answer of course, falls somewhere between these extremes.  Alternatives to trim scope, delay schedules, stretch out deployments, defer features and upgrades, or negotiating lower support fees can all be part of a solution to manage to a target, and each project should perform the analysis required to examine the options and their impacts to the value as well as the costs.  It's when we let the budget dictate how we execute our projects that we start to get into real trouble and poor decisions are sure to follow.
 
Assigning the responsibility to set the percentile budget point at the corporate level is the correct approach for many reasons:

  • The corporation has the responsibility to manage the risk of exceeding the budget against the risk of idle capital.
  • Allowing the percentile points to be set at the project level over-estimates the total spend and leaves considerable capital underutilized.
  • The approach allows the Project Manager to manage the project execution rather than project financing.
  • The process provides an explicit approach to balancing objectives, minimizing downside risk, and optimizing the project portfolio. 

 
How are budget decisions made in your company?  It is a thoughtful approach to balance objectives and optimize each project, or is it an arbitrary fire drill to "make our numbers"?  If you would like to see how to pull additional value from your portfolio even in times of reduced budgets, we can help you apply this approach quickly to your set of projects and optimize each project to your particular constraints.
 
Next time, we'll look at organization culture changes that occur when times are tight and how to avoid some truly bad outcomes.

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