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A large business intends to make a profit. Shareholders and directors focus on the bottom line to determine if the entire company has cleared a profit, but what about specific segments, or units, within the organization? As an office-equipment manufacturer, can we determine how the stapler product line is doing?

Business unit profitability analysis can help us determine how profitable a given business unit is. In the analysis, we will evaluate sales and expenses for that unit. Expenses include equipment, floor space, salaries, etc. There are a couple of approaches to business unit profitability analysis, but the underlying principle is the same:

• What is our income for the business unit?
• What are the expenses?

We’ll get into the details below, but we can consider a business unit profitable if sales are greater than the expenses. Once that question is answered, we can ask if that margin is good enough. Let’s take a look at some approaches we can use to analyze business unit profitability.

Full Cost Approach

The full cost approach looks at ALL expenses related to the business unit and assumes they impact that business unit. For example, the building space used to make both staplers and binders still benefits the stapler production: according to the full cost approach, these expenses count against the stapler business unit also.

Other full cost expenses could include managers’ or directors’ salaries, taxes, rent, utilities, and marketing.

Analytical Approaches

There are a couple of ways to approach business unit profitability analysis. We can use a full cost approach or a contribution approach.

Contribution Approach

Much like product profitability analysis, the contribution approach narrows the focus to only look at sales and expenses related directly to the stapler product line. Profit margin is then sales minus direct expenses.

The benefit to this approach is that it cuts out those other expenses, such as floor space for production. Since our company makes office supplies, we will always have that expense, even if we cut out stapler production. Why should we count these expenses against the stapler line?

Product profitability analysis is the process of linking a company’s overall profit back to the profit of a specific product. A company’s overall profit is the money they have left at the end of an accounting period after subtracting total costs from total revenue.

Profit is the amount of revenue that remains after accounting for all expenses, debts, and other costs. So, product profitability, then, refers to how much money a product makes minus what it costs to build, sell, and support it.

Profit is what you have left over after accounting for all expenses and costs of a product. Let’s say your company makes office staplers of all shapes and sizes. After all expenses, you clear 18%. That means that you clear 18 cents per dollar of revenue.

Product profitability analysis ties costs back to a product and matches revenues to that specific product. When you run the analysis, you will likely discover an interesting phenomenon: 80% of sales come from 20% of your customers or products.

It doesn’t mean we stop focusing on the products that don’t earn us money, in fact, we can use product profitability analysis on those products to determine next steps for improving profit margins on those products.

Remember that profitability analysis ties revenues and costs to each product. We’ll continue with our Red Line stapler product. The Red Line is only one product in a line of many. We’ll need to separate all revenue and expenses for this particular product in order to analyze our profitability.

The product team is responsible for learning key details about their market and users, to help them build a solution that finds a product-market fit. Some of these strategic details include:

• The interest and demand levels of the potential user base.
• The size of the total addressable market for a product.
• The right way to price the product, to maximize both market share and profit.
• The resources (measured in personnel, time, and budget) it will take to build the product.

Determining true cost

There are many factors to consider when calculating the true cost to produce an item. To understand the true cost of producing an item, every fixed and variable cost that exists needs to be taken into consideration. Some costs to remember to factor into the overall costs are:

• Utilities
• Inventory
• Property leases
• Loan repayments
• Equipment leases
• Employee wages

Other factors that accountants should write into the profit margin are:

• Shrinkage (stolen items)
• Unexpected shortages
• Markdowns
• Employee discounts
• Damaged inventory
• Shipping

Testing the market

It’s important to know the market price of an item to decide whether customers are willing to pay enough for the item to make it profitable. This applies to items already in production and to new items a business is thinking about producing. To effectively gauge the market price for an item, there are many considerations, like:

• Retail and online prices
• Competitor prices
• Product research
• Economic trends
• Market saturation

Making assessments

Constant pricing assessments on a monthly, weekly or even daily basis keep the company engaged and informed about which products are meeting profit expectations and which ones aren’t. One common practice is completing monthly product profitability assessments and placing all products into categories like “growth,” “core” and “probation.” Professionals give items in the probation category an action plan to improve their sales. If sales don’t improve, the company may phase out this item.

Understanding margins

Profit margins are the difference between the cost of producing items and total revenue for those items. Anything a company can do to reduce the cost of producing an item raises the revenue for that item. Some ways to do this include:

• Reducing overhead
• Streamlining the checkout process
• Becoming more energy efficient
• Reducing shipping costs
• Reducing labor costs

Keeping detailed documentation

Detailed documentation about the profitability of each product prevents a company from keeping unprofitable products longer than necessary. Collecting documentation from the marketing team, sales team and operations teams helps clarify what margin targets need to be in order for the product to remain viable. This also allows professionals to quickly identify downward trends. Additionally, detailed documentation helps with the creation of logical strategies, timely reviews and measurable targets.

Looking at external factors

External factors can impact opportunities and concerns around the profitability of products. The sales, marketing and operations teams can collaborate to assess the impact on each product, take immediate actionable steps or do long-term planning with an understanding of relevant external factors. Some external factors that impact product profitability include:

• Expected market changes
• Competition for the product
• Demand increases or decreases
• Shelf space at stores
• Spinoff products

Subtract all direct and direct costs from total revenue.

After you’ve tallied up all direct and indirect costs, you can now subtract that number from your product revenue. If what remains is a positive number, congratulations: You have a profitable product.

Return on investment (ROI) or return on costs (ROC) is a ratio between net income (over a period) and investment (costs resulting from an investment of some resources at a point in time). A high ROI means the investment’s gains compare favourably to its cost. As a performance measure, ROI is used to evaluate the efficiency of an investment or to compare the efficiencies of several different investments. In economic terms, it is one way of relating profits to capital invested.

Return on investment (ROI) is a performance measure used to evaluate the efficiency or profitability of an investment or compare the efficiency of a number of different investments. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost.

Return on investment, or ROI, is a mathematical formula that investors can use to evaluate their investments and judge how well a particular investment has performed compared to others. An ROI calculation is sometimes used along with other approaches to develop a business case for a given proposal. The overall ROI for an enterprise is sometimes used as a way to grade how well a company is managed.

If an enterprise has immediate objectives of getting market revenue share, building infrastructure, positioning itself for sale, or other objectives, a return on investment might be measured in terms of meeting one or more of these objectives rather than in immediate profit or cost saving.

To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio.

The return on investment (ROI) formula is as follows:

 ROI= Current Value of Investment−Cost of Investment/ Cost of Investment

Purpose

In business, the purpose of the return on investment (ROI) metric is to measure, per period, rates of return on money invested in an economic entity in order to decide whether or not to undertake an investment. It is also used as an indicator to compare different investments within a portfolio. The investment with the largest ROI is usually prioritized, even though the spread of ROI over the time period of an investment should also be taken into account. Recently, the concept has also been applied to scientific funding agencies’ (e.g., National Science Foundation) investments in research of open source hardware and subsequent returns for direct digital replication.

ROI and related metrics provide a snapshot of profitability, adjusted for the size of the investment assets tied up in the enterprise. ROI is often compared to expected (or required) rates of return on money invested. ROI is not time-adjusted (unlike e.g. net present value): most books describe it with a “Year 0” investment and two to three years’ income.

Marketing decisions have an obvious potential connection to the numerator of ROI (profits), but these same decisions often influence assets’ usage and capital requirements (for example, receivables and inventories). Marketers should understand the position of their company and the returns expected. For a marketing ROI percentage to be credible, the effects of the marketing program must be isolated from other influences when reported to executives.  In a survey of nearly 200 senior marketing managers, 77 percent responded that they found the “return on investment” metric very useful.

Return on investment may be extended to terms other than financial gain. For example, social return on investment (SROI) is a principles-based method for measuring extra-financial value (i.e., environmental and social value not currently reflected in conventional financial accounts) relative to resources invested. It can be used by any entity to evaluate the impact on stakeholders, identify ways to improve performance and enhance the performance of investments.

Limitations with ROI usage

As a decision tool, it is simple to understand. The simplicity of the formula allows users to freely choose variables, e.g., length of the calculation time, whether overhead cost is included, or which factors are used to calculate income or cost components. The use of ROI as an indicator for prioritizing investment projects alone can be misleading since usually the ROI figure is not accompanied by an explanation of its make-up. ROI should be accompanied by the underlying data that forms the inputs, this is often in the format of a business case. For long-term investments, the need for a Net Present Value adjustment is great and without it the ROI is incorrect. Similar to discounted cash flow, a Discounted ROI should be used instead. One limitation associated with the traditional ROI calculation is that it does not fully “capture the short-term or long-term importance, value, or risks associated with natural and social capital” because it does not account for the environmental, social, and governance performance of an organization. Without a metric for measuring the short- and long-term environmental, social and governance performance of a firm, decision makers are planning for the future without considering the extent of the impacts associated with their decisions. One or more separate measures, aligned with relevant compliance functions, are frequently provided for this purpose.

Benefits of the ROI Formula

There are many benefits to using the return-on-investment ratio that every analyst should be aware of.

Universally Understood

Return on investment is a universally understood concept so it’s almost guaranteed that if you use the metric in conversation, then people will know what you’re talking about.

Simple and Easy to Calculate

The return-on-investment metric is frequently used because it’s so easy to calculate. Only two figures are required the benefit and the cost. Because a “return” can mean different things to different people, the ROI formula is easy to use, as there is not a strict definition of “return”.

Steps in Standard Costing

Set the standard cost

• A standard quantity is predetermined and standard price per unit is estimated.
• Budgeted cost is calculated by using standard cost.

Record the actual cost

• Calculate actual quantity and cost incurred giving full details.

Variance Analysis

• Comparison of the actual cost with the budgeted cost.
• The cost variance is used in controlling cost.
• Take suitable corrective action.
• Fix responsibilities to ensure compliance
• Create effective control system.
• Resetting the budget, if required.

Types of standards

Ideal Standards:

These represents the level of performance attainable when prices for material and labour are most favorable, when the highest output is achieved with the best equipment and layout and when maximum efficiency in utilization of resources results in maximum output with minimum cost.

Normal Standards:

These are the standards that may be achieved under normal operating conditions. The normal activity has been defined as number of standard hours which will produce normal efficiency sufficient goods to meet the average sales demand over a term of years.

Basic or Bogey standards:

These standards are use only when they are likely to remain constant or unaltered over long period.

According to this standard, a base year is chosen for comparison purposes in the same way as statistician use price indices. When basic standards are in use, variances are not calculated as the difference between standard and actual cost. Instead, the actual cost is expressed as a percentage of basic cost.

Current Standard:

These standards reflect the management’s anticipation of what actual cost will be for the current period. These are the costs which the business will incur if the anticipated prices are paid for goods and services and the usage corresponds to that believed to be necessary to produce the planned output.

Variance

• The difference between standard cost and actual cost of the actual output is defined as Variance. A variance may be favourable or unfavourable.
• If the actual cost is less than the standard cost, the variance is favourable and if the actual cost is more than the standard cost, the variance will be unfavourable.
• It is not enough to know the figures of these variances in fact it is required to trace their origin and causes of occurrence for taking necessary remedial steps to reduce / eliminate them.

Variance Types

The purpose of standard costing reports is to investigate the reasons for significant variances so as to identify the problems and take corrective action. Variances are broadly of two types, namely, controllable and uncontrollable.

Controllable Variance

Controllable variances are those which can be controlled by the departmental heads whereas uncontrollable variances are those which are beyond their control. If uncontrollable variances are of significant nature and are persistent, the standards may need revision.

Variance Analysis

Variance analysis is the dividing of the cost variance into its components to know their causes, so that one can approach for corrective measures.

Variances of Efficiency:

Variance arising due to the effectiveness in use of material quantities, labour hours. Here actual quantities are compared with predetermined standards.

Variances of Price Rates:

Variances arising due to change in unit material prices, standard labour hour rates and standard allowances for indirect costs. Here actual prices are compared with predetermined ones.

Variances of Due to Volume:

Variance due to effect of difference between actual activity and the level of activity estimated when the standard was set.

Reasons of Material Variance

• Change in Basic price.
• Fail to purchase anticipated standard quantities at appropriate price.
• Use of sub-standard material.
• Ineffective use of materials.
• Pilferage

Material Variance

Material Cost Variance = (Standard Quantity X Standard Price) – (Actual Qty X Act Price).

Material Price Variance = Actual Quantity (Standard Price – Actual Price).

Material Usage Variance = Standard Price (Standard Quantity – Actual Quantity).

A standard costing system involves estimating the required costs of a production process. But before the start of the accounting period, determine the standards and set regarding the amount and cost of direct materials required for the production process and the amount and pay rate of direct labor required for the production process. In addition, these standards are used to plan a budget for the production process.

Standard costing compares the standard costs and revenues with the actual results of the process, finds the reasons for the variances, provides information about deviations to management for taking steps to improve it.

Standard costing is the practice of substituting an expected cost for an actual cost in the accounting records. Subsequently, variances are recorded to show the difference between the expected and actual costs. This approach represents a simplified alternative to cost layering systems, such as the FIFO and LIFO methods, where large amounts of historical cost information must be maintained for inventory items held in stock.

Standard costing involves the creation of estimated (i.e., standard) costs for some or all activities within a company. The core reason for using standard costs is that there are a number of applications where it is too time-consuming to collect actual costs, so standard costs are used as a close approximation to actual costs.

At the end of the accounting period, use the actual amounts and costs of direct material. Then utilize the actual amounts and pay rates of direct labor to compare it to the previously set standards. When you compare the actual costs to the standard costs and examine the variances between them, it allows managers to look for ways to improve cost control, cost management, and operational efficiency.

There are both advantages and disadvantages to using a standard costing system. The primary advantages to using a standard costing system are that it can be used for product costing, for controlling costs, and for decision-making purposes.

Whereas the disadvantages include that implementing a standard costing system can be time consuming, labor intensive, and expensive. If the cost structure of the production process changes, then update the standards.

Since standard costs are usually slightly different from actual costs, the cost accountant periodically calculates variances that break out differences caused by such factors as labor rate changes and the cost of materials. The cost accountant may periodically change the standard costs to bring them into closer alignment with actual costs.

Standard costs of these inputs:

1. Direct materials
2. Direct labor
3. Manufacturing overhead

• Variable manufacturing overhead
• Fixed manufacturing overhead

Uses of Standard Costing

Though most companies do not use standard costing in its original application of calculating the cost of ending inventory, it is still useful for a number of other applications. In most cases, users are probably not even aware that they are using standard costing, only that they are using an approximation of actual costs. Here are some potential uses:

Inventory costing. It is extremely easy to print a report showing the period-end inventory balances (if you are using a perpetual inventory system), multiply it by the standard cost of each item, and instantly generate an ending inventory valuation. The result does not exactly match the actual cost of inventory, but it is close. However, it may be necessary to update standard costs frequently, if actual costs are continually changing. It is easiest to update costs for the highest-dollar components of inventory on a frequent basis, and leave lower-value items for occasional cost reviews.

Budgeting. A budget is always composed of standard costs, since it would be impossible to include in it the exact actual cost of an item on the day the budget is finalized. Also, since a key application of the budget is to compare it to actual results in subsequent periods, the standards used within it continue to appear in financial reports through the budget period.

Price formulation. If a company deals with custom products, then it uses standard costs to compile the projected cost of a customer’s requirements, after which it adds a margin. This may be quite a complex system, where the sales department uses a database of component costs that change depending upon the unit quantity that the customer wants to order. This system may also account for changes in the company’s production costs at different volume levels, since this may call for the use of longer production runs that are less expensive.

Overhead application. If it takes too long to aggregate actual costs into cost pools for allocation to inventory, then you may use a standard overhead application rate instead, and adjust this rate every few months to keep it close to actual costs.

A flexible budget performance report is used to compare actual results for a period to the budgeted results generated by a flexible budget. This report varies from a traditional budget versus actual report, in that the actual sales figure is plugged into the budget model, which then uses formulas to alter the budgeted expense amounts. This approach results in budgeted expenses that are significantly more relevant to the actual performance that an organization experiences.

If the flexible budget model is designed to adjust to actual sales inputs in a reasonable manner, then the resulting performance report should closely align with actual expenses. This makes it easier to spot anomalies in the report, which should be rare. Management can then focus on the significant variances to see if any actions should be taken to ensure that actual results remain close to expectations.

The flexible budget model and its related reports are a significant improvement over the more common static model, where there is only one version of a budget, and that budget does not change. When a static model is the basis of comparison, the likely outcome is large favorable variances or unfavorable variances for many line items, since the static model may have been based on a sales level that is no longer relevant to actual conditions.

There are three common types of flexible budgets as follows:

Intermediate Flexible Budget: There are some expenses that do not vary with revenue, instead, they vary based on some other measure such as electricity expense based on the number of units consumed. An intermediate flexible budget takes into account changes in expenses based on such other activity measures as well.

Basic Flexible Budget: In this budget, those expenses that vary with revenue are expressed as a percentage of sales or as cost per unit and adjusted as the output level changes.

Advanced Flexible Budget: Further there are expenses that remain the same in a certain level of activity and beyond such a level they change. An advanced flexible budget takes into account the change in expenses based on the change in such levels.

The flexible budget responds to changes in activity, and may provide a better tool for performance evaluation. It is driven by the expected cost behavior. Fixed factory overhead is the same no matter the activity level, and variable costs are a direct function of observed activity. When performance evaluation is based on a static budget, there is little incentive to drive sales and production above anticipated levels because increases in volume tend to produce more costs and unfavorable variances. The flexible budget-based performance evaluation provides a remedy for this phenomenon.

Flexible Budgets for Planning

The flexible budget illustration for Mooster’s Dairy was prepared after actual production was known. While this tool is useful for performance evaluation, it does little to aid advance planning. But flexible budgets can also be useful planning tools if prepared in advance. For instance, Mooster’s Dairy might anticipate alternative volumes based on temperature-related fluctuations in customer demand for ice cream. These fluctuations will be very important to production management as they plan daily staffing and purchases of milk and cream that will be needed to support the manufacturing operation.

A rolling budget is continually updated to add a new budget period as the most recent budget period is completed. Thus, the rolling budget involves the incremental extension of the existing budget model. By doing so, a business always has a budget that extends one year into the future.

It’s is a new, revised set of financial plans for the next accounting period used to replace the prior one in a continuous budgeting system. In other words, it’s a newly updated budget that takes the place of the old version when it expires.

A rolling budget calls for considerably more management attention than is the case when a company produces a one-year static budget, since some budget updating activities must now be repeated every month. In addition, if a company uses participative budgeting to create its budgets on a rolling basis, the total employee time used over the course of a year is substantial. Consequently, it is best to adopt a leaner approach to a rolling budget, with fewer people involved in the process.

Advantages and Disadvantages of the Rolling Budget

This approach has the advantage of having someone constantly attend to the budget model and revise budget assumptions for the last incremental period of the budget. The downside of this approach is that it may not yield a budget that is more achievable than the traditional static budget, since the budget periods prior to the incremental month just added are not revised.

Types:

Sales Budget/Revenue Budget

Sales Budget the very first budget that an enterprise has to prepare because all other budgets depend on the revenue budget. In this budget, enterprises are forecasting their sales in terms of Value and Volume. In preparing the sales budget below, factors have been considered by the sales manager.

Master Budget

A master budget is a summary of all the above budget, which is verified by top management after taking inputs from various functional heads. It also shows the profitability of the business.

Capital Expenditure Budget

It contains forecasting of capital expenditure like expenditure on Plant & Equipment, Machinery, Land & building, etc.

Financial Budget

In the financial budget, the enterprise has to forecast the requirement of funds for running the business, whether it is long term or short term. In this budget, the company is also planning to invest their excess cash in that manner so that they can get a maximum return, or if the money is required for business, then they can pull out that money from the investment easily.

Overhead Budget

In this budget, enterprises are estimating the cost of indirect material, indirect labor, operational cost like rent, electricity, water, traveling, and many others. The overhead budget is divided into two parts one is fixed overhead, and one is variable overhead. It is also known as the expense budget.

Production Budget

The production budget purely depends upon the sales budget. In the production budget product manager estimates the monthly volume production according to the demand and also maintains the inventory level. In this budget, the cost of production is also estimated. Below are the factors of the production budget.

• Labor
• Raw Material
• Plant & Machinery

Factors:

Fixed Expenses

Fixed expenses are easy to forecast. It has most compelling evidence. As an illustration, office or factory rent is easy to predict. There is a remote possibility that it will change.

Variable Expenses

Variable expenses vary based on the volume of the production and sales. Hence, variable expenses can be updated regularly. The volume of sales and production is decided on the external factors and internal factors.

Other Expense

Following expenses are also considered:

• Interests paid on loan from the bank.
• Payment to shareholders by way of dividends
• Any other non-operational expenses

Zero-based budgeting (ZBB) is a method of budgeting in which all expenses must be justified for each new period. The process of zero-based budgeting starts from a “zero base,” and every function within an organization is analyzed for its needs and costs. Budgets are then built around what is needed for the upcoming period, regardless of whether each budget is higher or lower than the previous one.

3 primary things that a budget must meet:

• Expenses determination: How much will you spend?
• Revenue from the project: How much will you earn?
• Profit prediction: The target profit you will require after all expenses?

As the name says “Zero-based budgeting” is an approach to plan and prepare the budget from the scratch. Zero-based budgeting starts from zero, rather than a traditional budget that is based on previous budgets.

With this budgeting approach, you need to justify each and every expense before adding it to the actual budget. The primary objective of zero-based budgeting is the reduction of unnecessary cost by looking at where costs can be cut.

To create a zero base budget involvement of the employees is required. You can ask your employees what kind of expenses the business will have to bear and figure out where you can control such expenses. If a particular expense fails to benefit the business, the same should be axed from the budget.

Differences between Traditional Budgeting and Zero Base Budgeting

• In traditional Budgeting, the previous year’s budget is taken as a base for the preparation of a budget. Whereas, each time the budget under zero-based budgeting is created, the activities are re-evaluated and thus started from scratch.
• The emphasis of the traditional budgeting is on the previous expenditure level. On the contrary, zero-based budgeting focuses on forming a new economic proposal, whenever the budget is set.
• Traditional Budgeting works on cost accounting principle, thereby, it is more accounting oriented. Whereas the zero-based budgeting is decision oriented.
• In the traditional budgeting, justification of the line items and expenses are not at all required. On the other hand, in zero-based budgeting, proper justification is required, taking into account the cost and benefit.
• In traditional budgeting, the top management take decisions regarding any amount that will be spent on a particular product. In contrast, in zero-based budgeting, the decision regarding the spending a specific sum on a particular product is on the managers.
• Zero-based budgeting is better than traditional budgeting when it comes to clarity and responsiveness.
• Traditional budgeting follows a monotonous approach. On the contrary, zero-based budgeting follows a straightforward approach.

Steps to create a Zero based budget

• Identifying the decision units that need a justification for every line item of expenditure in the proposed budget.
• Preparing Decision Packages. Each decision package is an identifiable and separate activity. These decision packages are connected with the objectives of the company.
• The next step in ZBB is to rank the decision packages. This ranking is done on the basis of cost-benefit analysis.
• Finally, funds are allocated on the basis of the above findings by following a pyramid ranking system to ensure maximum results.

Zero Based Budgeting Advantages

• Accuracy: Against the traditional budgeting method that involves mere some arbitrary changes to the earlier budget, this budgeting approach makes all departments relook every item of the cash flow and compute their operation costs. This methodology helps in cost reduction to a certain extent as it gives a true picture of costs against the desired performance.

• Efficiency: Zero-based Budgeting helps a business in the allocation of resources efficiently (department-wise) as it does not look at the previous budget numbers, instead looks at the actual numbers.

• Budget inflation: As mentioned above every expense is to be justified. Zero-based budget compensates the weakness of incremental budgeting of budget inflation.
• Reduction in redundant activities: This approach leads to identify optimum opportunities and more cost-efficient ways of doing things by eliminating all the redundant or unproductive activities.

• Coordination and Communication: Zero-based budgeting provides better coordination and communication within the department and motivation to employees by involving them in decision-making.

Although this concept is a lucrative method of budgeting, it is also important to know the disadvantages as listed below:

Zero Based Budgeting Disadvantages

• Time-Consuming: This Zero-based budgeting approach is a highly time-intensive for a company to do annually as against incremental budgeting approach, which is a far easier method.

• High Manpower Turnover: The foundation of zero-based budgeting itself is a zero. Budget under this concept is planned and prepared from the scratch and require the involvement of a large number of employees. Many departments may not have adequate human resource and time for the same.
• Lack of Expertise: Providing an explanation for every line item and every cost is a problematic task and requires training for the managers.

The Project Budget is a tool used by project managers to estimate the total cost of a project. A project budget template includes a detailed estimate of all costs that are likely to be incurred before the project is completed.

A project budget is the total projected costs needed to complete a project over a defined period of time. It’s used to estimate what the costs of the project will be for every phase of the project.

Large commercial projects can have project budgets that are several pages long. Such projects often have a large number of costs associated with them, such as labor costs, material procurement costs, and operating costs. The Project Budget itself is a dynamic document. It is continuously updated over the course of the project.

Some tools and techniques for estimating cost:

Vendor bid analysis: Sometimes you will need to work with an external contractor to get your project done. You might even have more than one contractor bid on the job. This tool is about evaluating those bids and choosing the one you will accept.

Determination of resource cost rates: People who will be working on the project all work at a specific rate. Any materials you use to build the project (e.g., wood or wiring) will be charged at a rate too. Determining resource costs means figuring out what the rate for labour and materials will be.

Cost of quality: You will need to figure the cost of all your quality-related activities into the overall budget. Since it’s cheaper to find bugs earlier in the project than later, there are always quality costs associated with everything your project produces. Cost of quality is just a way of tracking the cost of those activities. It is the amount of money it takes to do the project right.

Reserve analysis: You need to set aside some money for cost overruns. If you know that your project has a risk of something expensive happening, it is better to have some cash available to deal with it. Reserve analysis means putting some cash away in case of overruns.

Creating a Project Budget

As noted above, there are many components necessary to build a budget, including direct and indirect costs, fixed and variable costs, labor and materials, travel, equipment and space, licenses and whatever else may impact your project expenses.

To meet all the financial needs of your project, a project budget must be created thoroughly, not missing any aspect that requires funding. To do this, we’ve outlined seven essential steps towards creating and managing your project budget:

1. Use Historical Data

Your project is likely not the first to try and accomplish a specific objective or goal. Looking back at similar projects and their budgets is a great way to get a headstart on building your budget.

2. Reference Lessons Learned

To further elaborate on historical data, you can learn from their successes and mistakes. It provides a clear path that leads to more accurate estimates. You can even learn about how they responded to changes and kept their budget under control. Here’s a lessons learned template if you need to start tracking those findings in your organization.

3. Leverage Your Experts

Another resource to build a project budget is to tap those who have experience and knowledge be they mentors, other project managers or experts in the field. Reaching out to those who have created budgets can help you stay on track and avoid unnecessary pitfalls.

4. Confirm Accuracy

Once you have your budget, you’re not done. You want to take a look at it and make sure your figures are accurate. During the project is not the time to find a typo. You can also seek those experts and other project team members to check the budget and make sure it’s right.

5. Baseline and Re-Baseline the Budget

Your project budget is the baseline by which you’ll measure your project’s progress once it has started. It is a tool to gauge the variance of the project. But, as stated above, you’ll want to re-baseline as changes occurs in your project. Once the change control board approves any change you need to re-baseline.

Advantages of budgeting in a business:

Establishing Guidelines: Project budget allows you to establish the main objectives of a project. Without proper budgeting, a project may not be completed on time. It allows the project manager to know how much he can spend on any given aspect of the project.

Cost Estimating: Once a budget is in place, the project manager can determine how much money can be spent on each component of the project. Hence it also determines what percentage of the available funds can be allocated to the remaining elements of the project. It gives the chance to decide whether or not the project can be completed in the available budget.

Prioritizing: Another advantage of having a project budget is that it helps you to prioritize the different tasks of the project. Sometimes it might seem to be completed at once, but it doesn’t happen due to some inefficiency. A budget will allow you to prioritize which parts of the project can be completed first.

Expected value (also known as EV, expectation, average, or mean value) is a long-run average value of random variables. It also indicates the probability-weighted average of all possible values.

Expected value is a commonly used financial concept. In finance, it indicates the anticipated value of an investment in the future. By determining the probabilities of possible scenarios, one can determine the EV of the scenarios. The concept is frequently used with multivariate models and scenario analysis. It is directly related to the concept of expected return.

Formula for Expected Value

The first variation of the expected value formula is the EV of one event repeated several times (think about tossing a coin). In such a case, the EV can be found using the following formula:

EV = P(x) *n

Where:

EV: The expected value

P(X): The probability of the event

N: The number of the repetitions of the event

The expected value (EV) is an anticipated value for an investment at some point in the future. In statistics and probability analysis, the expected value is calculated by multiplying each of the possible outcomes by the likelihood each outcome will occur and then summing all of those values. By calculating expected values, investors can choose the scenario most likely to give the desired outcome.

EV=∑P(Xi)×Xi

Example:

Examples of using expected value

It turns out that all events have some aspect of risk and value. Insurance companies use this to determine how much to charge you for your premiums. They add up everyone in your reference class, and determine how much it costs them on average in payouts. They then add a little on the top to make a profit, which makes buying insurance net negative (the costs minus the benefits to you) on expectation, just like buying a lottery ticket. However, this doesn’t mean getting insurance is a bad idea! A lot of people don’t like taking on excessive risk (a small chance of becoming bankrupt feels much worse than paying up for insurance you might never need), so buying insurance is rational. Another way to put this is that we have diminishing marginal returns to extra money (or concave utility functions, for the mathematically inclined).

Pascal’s wager is also an example of using expected value to think about the world. Humans all bet with their lives either that God exists or that he does not. Pascal argues that a rational person should live as though God exists and seek to believe in God. If God does actually exist, such a person will have only a finite loss (some pleasures, luxury, etc.), whereas they stand to receive infinite gains (as represented by eternity in Heaven) and avoid infinite losses (eternity in Hell).