An Insider’s Guide to Project Budgeting: The Essentials, Best Practices, and More
How often are you having to deal with Project Budget overruns? No matter the size or scale of your agency, project budgets will always be a critical operational function to manage profitability and capacity.
As your agency iterates on product and navigates what has been a bumpy ride in the past few years of the digital services industry, nailing down budgeting is more important than ever.
This post will outline what you need to know to install a great project budgeting system that will produce consistent outputs across all your projects, regardless of the pricing model used, or how much internal vs external cost is flowing through that project or retainer.We’ll also show you how to avoid common missteps that those who have come before you have made. A streamlined path just for you. Let’s get started!
What Is Project Budgeting?
Project budgeting is like a multifaceted gem, meaning different things to different people. It’s not just about crunching numbers; it’s about delivering successful projects. Think of it as the compass that guides everyone involved, ensuring the project sails smoothly to its destination.
- First and foremost, there’s the client. They’re the ones setting sail with a vision in mind. For them, project budgeting is about making sure they get precisely what they want, without delays or cost overruns. They want their dreams to materialize on time and on budget.
- Then, there’s the team on board. They need clear directions, like a map showing the way. Project budgeting tells them about expectations, constraints, and the next steps they should take. It’s their guidebook for a successful voyage.
- The leadership team, akin to the ship’s captains, requires insights into the project’s performance. They need to know where any lurking issues might be, just like a captain would monitor the ship’s systems to prevent disasters.
- Operations, like the ship’s crew, need to understand the scope and timelines. It’s their way of forecasting and preparing for the journey ahead, ensuring the voyage stays on course.
- Project managers act as the navigators, charting the path. They rely on the project budget to understand the project’s scope, timelines, constraints, and requirements. This knowledge is their compass to manage the project successfully.
- The finance team plays the role of quartermasters, managing the ship’s resources. They rely on project budgeting to handle invoicing and expenses, updating forecasts, and generating financial reports.
At its core, project budgeting is about creating a shared understanding of what a project entails. It serves as a common reference point, ensuring that all these stakeholders can access the information they need to perform their roles effectively. It’s like the North Star, guiding the project through rough waters and helping everyone assess performance. It’s a bridge between scoping and pricing, intertwining functions that ultimately lead to project success.
Importance and Benefits of Efficient Project Budgeting
In digital services, failure and disappointment often stem from unmet expectations. Successfully meeting these expectations, however, is an arduous task when the expectations themselves are left in a state of vagueness.
Regrettably, many agencies initiate projects without a meticulously defined set of expectations for all stakeholders. This lack of clarity paves the road to disappointment. The consequences are far-reaching, including projects exceeding budgets and timelines. This results in unforeseen financial burdens for the client and, more commonly, decreased profit margins for the agency. Consequently, teams find themselves grappling with unanticipated overtime and weekend work, along with the nagging sense of unfulfilled success.
It is indeed alarming how frequently we observe agencies employing project budgeting processes that not only fail to align with post-project performance assessments but also neglect to outline initial expected margins. This oversight invariably leads to the illusion of post-mortem failure, when, in reality, the project was doomed from the outset due to a fundamentally flawed plan.
Efficient project budgeting is the compass that guides firms to swiftly clarify the most critical project expectations. This ensures that every stakeholder comprehends the prerequisites for a successful project and the precise criteria against which performance will be measured upon completion. The result is a landscape of more profitable projects, contented clients, satisfied teams, diminished overtime, and a consistent stream of valuable insights for refining the agency’s operations over time. In essence, it’s the roadmap to lasting success in the dynamic world of project management.
Essential Components of a Project Budget
The two most important elements of an effective project budget are Scope and Price. These two concepts are often conflated as being the same thing, but it’s extremely important to differentiate between them.
- Scope asks the question: “What will it cost us to do this work?”
- Price asks the question: “What will the client pay us for this work?”
While they can be related, they are separate concepts and should have adequately separate workflows. One of the biggest mistakes we see agencies make when budgeting projects is not adequately separating these two ideas, which can lead to some common mistakes.
For example, we’ve seen agencies that go through the process of budgeting a project by scoping how many hours they think it will take, and then multiplying those hours by an hourly rate they’d like to target.
When they present the price to the client, the client pushes back and makes it clear that the price needs to be lowered in order to fit into their budget.
Instead of adjusting the price down, while leaving the scope the same – the agency will start lowering the number of hours in the project budget in order to achieve the lower price, even though the scope of the project hasn’t actually changed.
This leads to inaccurate expectations for the team about how much time it will take to complete the work – therefore leading to a feeling of failure at the end of the project when the team inevitably spends more time than what was in the budget to complete the work.
Another example is agencies confusing markup as being a scoping mechanism, as opposed to a pricing mechanism. They apply “markup” to pass-through expenses, but never consider how much internal cost that markup is meant to offset or how it influences their margin.
These are just two simple examples of a project budgeting process that fails to adequately separate price from scope.
The sequencing of these two things is important as well. The first and most important step in project budgeting is to begin with the scope. While I’m not suggesting that the price needs to be based on this scope (it could be based on a number of things, including value, or what other people are charging) but the inescapable truth is that regardless of the price, and what that price is based on, the profitability of that project will always be related to the scope. That being the case, it doesn’t make much sense to think about pricing until we understand the scope, because without understanding scope, we’ll have no way of knowing if a price is setting us up for sustainable margins or not.
So, what are the key elements that make up an effective project scope?
Key Elements of a Project Scope
The first element of a project scope is your Delivery Costs. This will start with the labor costs that you incur to deliver your services to the client. The cost will typically be a function of the hours you anticipate it will take to complete the project, multiplied by the Average Cost Per Hour (ACPH) for that time.
Delivery Costs = Hours to Complete * ACPH
It’s unlikely that it makes sense for you to calculate each employee’s ACPH and time involved in a project, especially if you’re early on in the project lifecycle and it’s unclear exactly who will be working on that project. It’s for that reason that taking a blended ACPH across your team or segmented by functional discipline is recommended to start.
Note that ACPH is based on Gross Capacity. For the project managers in the room – don’t worry, we’re not forgetting about utilization rates and overhead costs. We’re going to factor all of that in when we get to pricing.
Did you know that Parakeeto’s Free Toolkit has a built in ACPH calculator? Get yours today at the link below.
Next, included in a Project Scope are what we call Pass-Through Expenses. These expenses are all of the costs that are going to flow through your agency and onto other vendors. This is money you don’t get to keep and that is related to things that are directly attributable to the project. Print budgets, ad spends, any white label services – they’re all considered Pass-Through Expenses and should be factored into the scope.
Things that we would not include here are overhead, or shared delivery expenses (like an adobe subscription that gets used for all our clients). Again, don’t worry, we’re not ignoring this, we’re just being deliberate about where to factor those things in to limit unnecessary complexity in the budgeting process. Pass-Through Expenses also doesn’t take into account any markup you may be applying here, we’re not forgetting about that either, we’ll get to markup in the pricing step.
Finally, we have contingencies, that are essentially additional padding applied to both Pass-Through and Delivery Costs to account for uncertainty or risk. Especially in the case of flat fee or value-based work, you will likely have some uncertainty or variability in the scope of work and you’ll often want to pad both of these variables to leave yourself some room for unforeseen extras.
Once you’ve put those things together, you should have a clear understanding of the scope of the project, in other words, what you expect it to cost your agency to complete the project work being promised to the client in question.
With this information clearly laid out, you’re now able to move into the pricing exercise with the clarity required to confidently find your pricing floor, negotiate with clients, and determine a price and pricing model that sets everyone up for success.
Key Elements of a Project Price
Next, we have a few different elements that make up a project’s price.
Margin Target (% of AGI, not Revenue)
Starting from the top, you’re going to want to bake in profitability to your price, and that’s why we start with a margin target. However, the biggest mistake agencies make at this stage is basing this margin on a concept of project level “net profit”. I won’t go into this in detail (you can read about that here, but here is the TL;DR on why you shouldn’t base your margin on net profit):
This is one of the biggest precision traps in the agency world. While it’s certainly important to consider overhead and utilization in the targets we set for pricing, trying to measure net-profit at the project level is both significantly more complex, and significantly less accurate and helpful. It’s a flawed concept at a fundamental level, because it tries to factor in externalities that have nothing to do with an individual project (like overhead, and utilization).
Instead, agencies should focus on setting Delivery Margin (or Gross Margin) targets for their projects, and set that Delivery Margin target at a level that sets them up to have a strong bottom line after factoring in the cost of Utilization and Overhead costs. Go deeper on Delivery Margin here.
In order to determine what your target should look like, you want to start with understanding what your bottom line target is. From there, you want to add 20-30% to account for overhead, then another 10-20% to account for utilization and time-off.
For example, if I was targeting a 30% net profit, I might add 25% for overhead, and another 15% for utilization drop-off, which brings my Project Delivery Margin Target to:
Net Margin Target + Overhead + Utilization Drop Off = Project Delivery Margin Target
30% + 25% + 15% = 70%
What we can tell you from helping hundreds of agencies with this is that 70%+ is a target that works for 95% of agencies, unless they have an unusual business model with significant overhead costs, or an unusually low utilization ceiling.
Once you have your margin target, the next step is to determine your pricing floor, in other words, the minimum amount of money you need to receive from the client in order to achieve your margin target. This gives you a starting point for determining what to ask the client for, and allows you to have clarity on where the floor is for discounting and negotiation (before having to start actually modifying the scope of work):
The formula to determine this is the following:
Price Floor = (Delivery Costs / (1-Margin Target)) + Pass-Thru Expenses
For example, if we’ve figured out it will cost us $5,000 to complete a project (delivery costs), plus another $2,000 in pass through expenses, and our delivery margin target is 75%, our floor price would be:
($5,000 / (0.25)) + $2,000 = $22,000
What this means is that in order to give ourselves a good chance at meeting the margin target we want to achieve, we need to ask the client for at least $22,000, regardless of what pricing model we end up choosing.
In this example, the Agency Gross Income (AGI) for this project will be a function of the Delivery Costs / (1-margin target), or in the above example, $20,000. Which is what the 70% margin is being calculated on.
Remember that the $2,000 in pass-through expenses doesn’t belong to us, so we’re not factoring it into our margin calculation, we simply add in on top of the minimum AGI calculated above.
Also, a note to the reader currently pulling their hair out thinking: BUT WHAT ABOUT MARKUP!?!?… don’t worry, we’re getting to that.
The final step in determining your price is to decide on a pricing model. This is important for a few reasons.
- It will determine how the price is presented to the client
- It will also influence how the budget is presented to the client
- It will influence who’s taking on risk in the engagement, and change how the project and budget need to be managed and reported on back to the client.
- It will change the account management strategy and how scope changes or timeline changes will influence the project.
- If you’d like to figure out which pricing model is best for your agency, do it here!
In this example, let’s imagine we’re going to present a price of $25,000 for the above scope of work to the client. There are several ways we can present this price to them:
- It’s a flat fee of $25,000
- It’s $20,000 of agency fees, plus $5,000 of Materials
- It’s $20,000 of agency fees, $4,000 of materials, and $1,000 of markup
- It’s 250 hours at $100/hr
- It’s 125 hours at $200/hr
- It’s 5 months at $5,000/mo
- It’s 5 sprints at $5,000/sprint
- It’s a 25% management fee on $100,000 of advertising spend
- It could be a combination of any number of these concepts.
What’s critically important to note here is that in all of these scenarios, the underlying math (the revenue, AGI, and cost, and delivery margin) are all exactly the same. The pricing model is simply a way for us to present the price to the client, and determine who’s taking on the risk.
It’s important to remember that each pricing model will have different advantages as it relates to risk vs reward. For example, a flat fee that is related to deliverables would allow you to capture more profit in the event that you came in under budget (thereby having lower costs than anticipated) but would also likely end up meaning a lower profit margin in the event that things went over budget.
In contrast, pricing models that are affixed to time will limit potential upside, but have the benefit of limiting downside, since a properly managed project means you’re likely going to be paid if the project goes over budget. It’s important to consider how much risk there is in a project when determining how to position the pricing model to the client, as well as how likely it is for the scope to change throughout the project lifecycle, as frequent changes in a fixed scope project will mean constantly having to open up the scope of work which can create a lot of friction and frustration in the engagement, and hurt your ability to focus on delivery for the client.
A Note on Markup
It’s also important to note how markup influences the price. In the above example, markup is simply a tool used to justify the price and influences how the price is talked about. But in the above example, it doesn’t actually change the price and therefore has no impact on the underlying economics of the project.
Remember that Markup is a pricing concept, if it can help you justify a higher price than you otherwise could without using it as a component of the way price is presented to the client, that’s great – take full advantage of that opportunity. Just don’t confuse it for a scoping mechanism, and avoid using it in a way that reduces your level of clarity on the essential underlying economics of a project’s scope & price.
Project Budget Example
Let’s walk through a project budget together. Suppose we’re a website design and development agency and we’re looking to budget for a new website build for a client.
Let’s start with our project scope. The scope consists of our Delivery Costs, Pass-Through Expenses and Contingencies. Starting with Delivery Costs, we know that our costs here will be our hours to complete, multiplied by the ACPH we have.
If we used this calculator and took an average of our team members ACPH and landed on $60/hr, we’ll then multiply that by how many hours it will take our team members to complete the work to get our Delivery Costs:
$60/hr * 30 hours = $1800
Delivery costs come in at $1800.
Next, we’ll need to factor in Pass-Through Expenses. Ask yourself – is there any part of the revenues from this project that will be passed onto other vendors? In a scenario where our websites don’t include copy on the site, we may have Pass-Through Expenses to pay the white-labeled copywriting costs if the clients want this. Let’s assume these costs amount to $500.
Delivery Costs: $1800
Pass-Through Expenses: $500
Total Project Costs: $2300
Finally, we’ll add in contingencies to the scope. Let’s factor in a 10% contingency, to account for the unknown unknowns that we may encounter. Let’s add contingencies to these separately:
$1800 * 1.10 = $1980
$500 * 1.10 = $550
Total Project Costs: $2530
Now, onto the pricing side of things.
First, we’ll take our scope ($1980) and decide on a margin target, and calculate the pricing floor using those numbers. A strong Delivery Margin at the project level is 70%, so let’s go with that. Then, using our formula, we’ll tack on the Pass-Through Expenses afterwards.
Price Floor = (Delivery Costs / 1-Margin Target) + Pass- Through Expenses)
Price Floor = ($1980 / 1 – 0.70) + $550
Price Floor = $7,150
Now we know that at a minimum, we can charge $7,150 for this project to be at our target margin level. Finally, choose a pricing model that works for you, and run with it.
Did you know that Parakeeto clients have a customized Estimator to do all of this math for them? If you’re interested in working with us, you can apply for a call here.
Implementing and Tracking the Project Budget
When you’re working on a project with a team, it’s crucial to get everyone on the same page about the budget. To do this, you need to explain it clearly to ensure success.
First, your budget should contain all the essential information that everyone on the team needs to know. This includes what the project is all about, how long it will take to finish, what you’re spending on external stuff, how much you’re charging the client, and how much money you expect to make from the project. It also needs to have a timeline, a plan for dealing with unexpected issues, and how you’ll handle any risks that might pop up. This way, everyone knows what’s going on and can do their job well.
After that, you need to keep an eye on how things are going compared to the budget. To do this, you should measure things the same way you set up the budget. For example, if you’re worried about spending too much time in one area, you can keep track of how much time people are spending on different tasks. If you’re using a financial model to measure progress, you’ll need to use the same rates and costs as you did in the budget. It also helps to match expenses with what you budgeted for so that everything lines up nicely. Using something called “cost-performance indexing” can help you figure out if your project is on the right track – more on this here.
In simple terms, having a clear budget and keeping an eye on things in the same way you set it up helps your team work smoothly, stay on budget, and make sure the project goes well. It’s like having a roadmap that everyone understands, making the journey much smoother.
Common Project Budgeting Mistakes and How to Avoid Them
There are a few common mistakes that we have come across in our experience, and we’re aiming to outline those here so that you can dodge them on your own journey.
Not Separating Scoping and Pricing
As briefly touched on above, the most common mistake we see is having the scoping and pricing processes merged together and not separated out. Understand the cost side of things before you move onto the pricing side.
Not Separating Delivery Costs and Pass-through Costs
Delivery Costs, or those costs that are directly related to delivering your project to the client for revenue that your team is responsible for earning should always be separate from Pass-Through Costs. Those are – the costs that are passing through your agency onto an external vendor. These are things like white labeled services, print budgets, ad spends, etc. They’ll give you a false sense of what this project is costing you to deliver – potentially leading you to believe that it’s costing you more than you anticipated.
Separate these out to avoid this pitfall.
Not Separating Revenue from AGI
Similar to above, we see agency owners forgetting to separate the Pass-Through Expenses not only from the Delivery Costs but from the revenue they’re bringing in. On a project that you are passing on revenue from the client onto an external vendor providing services that you don’t do in house, you may get a false sense of the total revenues on the project. That’s why we always remove pass-through expenses from revenues, giving us our AGI (Agency Gross Income).
Separate these out to learn your true “income” on a project.
Pricing Floors / Margin Targets
We often see an issue with agency owners failing to set pricing floors accurately. Either an agency owner won’t do it at all, which of course leaves significant risk, or they’ll ironically spend too much time trying to calculate their pricing floors with overhead costs and utilization factored in, which shouldn’t impact the fundamental profitability of a given project. They’ll be too “in the weeds” with their pricing floor calculations that it will be hard to manage, and not usually worth the effort.
If overhead costs are factored into the pricing floor calculations, you’re effectively pricing your services based on your company’s net margin. But here’s the thing – there are variables in this equation like Utilization that shouldn’t impact this number. They’re separate concepts, therefore they should be left out of the pricing process.
Ensure your services are profitable at a fundamental level, then you can factor in your overheads at a later stage.
Confusing Markup as a Scoping Mechanism instead of a Pricing Mechanism
Many agencies tend to add an extra fee to their expenses without really thinking about how it affects their overall profit. They mistakenly assume that this extra fee changes the scope of the project, but it should only impact the final price. This means that the fee, called “markup,” doesn’t change what needs to be done in the project but only how the price is presented. For example, if a project costs $10,000 with $4,000 in additional expenses, the total is the same whether you say it’s a $10,000 project, a $5,000 project with $4,000 in expenses and $1,000 markup, or any other way. The point is that “markup” is just about pricing, and it only affects profitability if it makes the client pay more compared to a price without mentioning this extra fee.
Not Considering how Different Pricing Models Influence Risk in an Engagement
Depending on the model by which you price your services, you or your client will be taking on more risk. This level of risk should be factored into your scoping and pricing exercise, in particular around your contingencies. Otherwise, you may be leaving yourself vulnerable.
Failing to Clarify all of this before a Project Begins, leaving Stakeholders in the Dark
Finally, a failure to apply these tactics prior to an engagement leaves the risk that stakeholders involved will be in the dark.
It’s important for your team to understand the goals of the project, and how it relates to the “actuals” as a project progresses. That way, team members will understand how to prioritize time to ensure a successful delivery.
In the realm of project budgeting, clear communication and meticulous planning are key to success. This guide has covered the essential aspects of project budgeting, emphasizing the importance of separating scope from pricing, and going over exactly how to do it on your own.
Efficient project budgeting sets the stage for clear project expectations and improved profitability. It helps avoid the pitfalls of vague project scopes, which often lead to budget and timeline overruns.
A well-structured project budget acts as a roadmap, ensuring a smooth journey from start to finish. Armed with the knowledge and tools provided in this guide, you’re better prepared to navigate the intricacies of project budgeting and steer your projects toward lasting success.