Budget and Cost Analysis
Budget and Cost Analysis tests whether you can build and compare cost estimates soundly: choosing an estimating method, distinguishing constant from then-year dollars, discounting future costs, and identifying the costs that are relevant to a decision.
Estimating methods
- Analogy: scale from a similar system; fast, least accurate.
- Parametric: cost estimating relationships derived by regression from historical data.
- Engineering or bottom-up: build from labor, material, and quantity; most accurate and most expensive.
- Extrapolation from actuals, and learning curves, where each doubling of cumulative quantity reduces unit labor by a fixed percentage (an 80 percent curve means the second unit costs 80 percent of the first). Data quality matters most: a parametric estimate is only as good as the historical database and the statistical fit behind it.
Economic analysis
Constant (base-year) dollars strip inflation; then-year dollars include escalation. Never mix the two in one comparison. Discount future amounts to present value, PV = FV / (1 + i)^n, using the real rates published under OMB Circular A-94. Include only relevant, incremental costs: sunk costs are excluded, and opportunity cost counts. Escalate once - applying an inflation index to a figure already stated in then-year dollars double counts inflation.
Worked example
Two options for a support function: in-house costs $240,000 fixed plus $18 per transaction; a contractor charges $42 per transaction all-in. Set 240,000 + 18Q = 42Q, so 24Q = 240,000 and Q = 10,000 transactions. Above 10,000, in-house is cheaper; below, the contractor wins. If volume is projected at 14,000, in-house costs $492,000 versus $588,000 - a $96,000 advantage before transition costs.
Discounting check
A $1,000 benefit received two years out at a 10 percent real discount rate is worth 1,000 / 1.21 = $826 today; comparing it directly to a $1,000 cost today overstates the benefit.
Traps
Including sunk costs; double counting escalation; using nominal cash flows with a real discount rate; and choosing on full cost when only the incremental difference matters.