fundamental of Project Management

DIRECTED READING: THREE PERCEPTIONS OF PROJECT COST * : D.H. Hamburger

Project cost seems to be a relatively simple expression, but “cost” is more than a four letter word. Different elements of the organization perceive cost differently, as the timing of projectcost identification affects their particular organizational function. The project manager charged with on-time, on-cost, on-spec execution of a project views the “on cost” component of his responsibility as a requirement to stay within the allocated budget, while satisfying a given setof specified conditions (scope of work), within a required time frame (schedule). To mostproject managers this simply means a commitment to project funds in 328329accordance with a prescribed plan (time-based budget). Others in the organization are less concerned with the commitment of funds. The accounting department addresses expense recognition related to aproject or an organizational profit and loss statement. The accountant’s ultimate goal is reporting profitability, while positively influencing the firm’s tax liability. The comptroller (finance department) is primarily concerned with the organization’s cash flow. It is that person’s responsibility to provide the funds for paying the bills, and putting the unused or available money to work for the company.

To be an effective project manager, one must understand each cost, and also realize that the timing of cost identification can affect both project and corporate financial performance. Theproject manager must be aware of the different cost perceptions and the manner in which they are reported. With this knowledge, the project manager can control more than theproject’s cost of goods sold (a function often viewed as the project manager’s sole financial responsibility). The project manager can also influence the timing of cost to improve cash flow and the cost of financing the work, in addition to affecting revenue and expense reporting in the P&L statement.

Three Perceptions of Cost

To understand the three perceptions of cost—commitments, expenses, and cash flow—consider the purchase of a major project component. Assume that a $120,000 compressor with delivery quoted at six months was purchased.  Figure 1  depicts the order execution cycle. At time 0 an order is placed. Six months later the vendor makes two shipments, a large box containing the compressor and a small envelope containing an invoice. The received invoice is processed immediately, but payment is usually delayed to comply with corporate payment policy (30, 60, 90, or more days may pass before a check is actually mailed to the vendor). In this example, payment was made 60 days after receipt of the invoice or 8 months after the order for the compressor was given to the vendor.

Figure 1: Three perceptions of project cost.

Commitments—The Project Manager’s Concern

Placement of the purchase order represents a commitment to pay the vendor $120,000 following satisfactory delivery of the compressor. As far as the project manager is concerned, once this commitment is made to the vendor, the available funds in the project budget are reduced by that amount. When planning and reporting project costs the project manager deals with commitments. Unfortunately, many accounting systems are not structured to support project cost reporting needs and do not identify commitments. In fact, the value of a purchase order may not be recorded until an invoice is received. This plays havoc with the project manager’s fiscal control process, as he cannot get a “handle” on the exact budget status at a particular time. In the absence of a suitable information system, a conscientious project manager will maintain personal (manual or computer) records to track his project’s commitments.

Expenses—The Accountant’s Concern

Preparation of the project’s financial report requires identification of the project’s revenues (when applicable) and all project expenses. In most conventional accounting systems, expenses for financial reporting purposes are recognized upon receipt of an invoice for a purchased item (not when the payment is made—a common misconception). Thus, the compressor would be treated as an expense in the sixth month.

In a conventional accounting system, revenue is recorded when the project is completed. This can create serious problems in a long-term project in which expenses are accrued during each reporting period with no attendant revenue, and the revenue is reported in the final period with little or no associated expenses shown. The project runs at an apparent loss in each of the early periods and records an inordinately large profit at the time revenue is ultimately reported—the final reporting period. This can be seriously misleading in a long-term project which runs over a multi-year period.

To avoid such confusion, most long-term project P&L statements report revenue and expenses based on a “percentage of completion” formulation. The general intent is to “take down” an equitable percentage of the total project revenue (approximately equal to the proportion of the project work completed) during each accounting period, assigning an appropriate level of expense to arrive at an acceptable period gross margin. At the end of each accounting year and at the end of the project, adjustments are made to the recorded expenses to account for the differences between actual expenses incurred and the theoretical expenses recorded in the P&L statement. This can be a complex procedure. The misinformed or uninformed project manager can place the firm in an untenable position 329330by erroneously misrepresenting the project’s P&L status; and the rare unscrupulous project manager can use an arbitrary assessment of the project’s percentage of completion to manipulate the firm’s P&L statement.

There are several ways by which the project’s percentage of completion can be assessed to avoid these risks. A typical method, which removes subjective judgments and the potential for manipulation by relying on strict accounting procedures, is to be described. In this process a theoretical period expense is determined, which is divided by the total estimated project expense budget to compute the percentage of total budget expense for the period. This becomes the project’s percentage of completion which is then used to determine the revenue to be “taken down” for the period. In this process, long delivery purchased items are not expensed on receipt of an invoice, but have the value of their purchase order prorated over the term of order execution. Figure 2 shows the $120,000 compressor in the example being expensed over the six-month delivery period at the rate of $20,000 per month.

Cash Flow—The Comptroller’s Concern

The comptroller and the finance department are responsible for managing the organization’s funds, and also assuring the availability of the appropriate amount of cash for payment of the project’s bills. Unused funds are put to work for the organization in interest-bearing accounts or in other ventures. The finance department’s primary concern is in knowing when funds will be needed for invoice payment in order to minimize the time that these funds are not being used productively. Therefore, the comptroller really views project cost as a cash outflow. Placement of a purchase order merely identifies a future cash outflow to the comptroller, requiring no action on his part. Receipt of the invoice generates a little more interest, as the comptroller now knows that a finite amount of cash will be required for a particular payment at the end of a fixed period. Once a payment becomes due, the comptroller provides the funds, payment is made, and the actual cash outflow is recorded.

Figure 2: Percentage of completion expensing.

It should be noted that the compressor example is a simplistic representation of an actual procurement cycle, as vendor progress payments for portions of the work (i.e., engineering, material, and delivery) may be included in the purchase order. In this case, commitment timing will not change, but the timing of the expenses and cash outflow will be consistent with the agreed-upon terms of payment.

The example describes the procurement aspect of project cost, but other project cost types are treated similarly. In the case of project labor, little time elapses between actual work execution (a commitment), the recording of the labor hours on a time sheet (an expense), and the payment of wages (cash outflow). Therefore, the three perceptions of cost are treated as if they each occur simultaneously. Subcontracts are treated in a manner similar to equipment purchases. A commitment is recorded when the subcontract is placed and cash outflow occurs when the monthly invoice for the work is paid. Expenses are treated in a slightly different manner. Instead of prorating the subcontract sum over the performance period, the individual invoices for the actual work performed are used to determine the expense for the period covered by each invoice.

Thus the three different perceptions of cost can result in three different time-based cost curves for a given project budget. Figure 3 shows a typical relationship between commitments, expenses, and cash outflow. The commitment curve leads and the cash outflow curve lags, with the expense curve falling in the middle. The actual shape and the degree of lag/lead between the curves are a function of several factors, including: the project’s labor, material, and subcontract mix; the firm’s invoice payment policy; the delivery period for major equipment items; subcontract performance period and the schedule of its work; and the effect of the project schedule on when and how labor will be expended in relation to equipment procurement.

Figure 3: Three perceptions of cost.

The conscientious project manager must understand these different perceptions of cost and should be prepared to plan and report on any and all approaches required by management. The project manager should also be aware 330331of the manner in which the accounting department collects and reports “costs.” Since the project manager’s primary concern is in the commitments, he or she should insist on an accounting system which is compatible with the project’s reporting needs. Why must a project manager resort to a manual control system when the appropriate data can be made available through an adjustment in the accounting department’s data processing system?

Putting Your Understanding of Cost to Work

Most project managers believe that their total contribution to the firm’s profitability is restricted by the ability to limit and control project cost, but they can do much more. Once the different perceptions of cost have been recognized, the project manager’s effectiveness is greatly enhanced. The manner in which the project manager plans and executes the project can improve company profitability through influence on financing expenses, cash flow, and the reporting of revenue and expenses. To be a completely effective project manager one must be totally versed in the cost accounting practices which affect the firm’s project cost reporting.

Examination of the typical project profit & loss statement (see Table 1) shows how a project sold for profit is subjected to costs other than the project’s costs (cost of goods sold). The project manager also influences other areas of cost as well, addressing all aspects of the P&L to influence project profitability positively.

Specific areas of cost with examples of what a project manager can do to influence cost of goods sold, interest expense, tax expense, and profit are given next.

Cost of Goods Sold (Project Cost)

·  Evaluation of alternate design concepts and the use of “trade-off” studies during the development phase of a project can result in a lower project cost, with-out sacrificing the technical quality of the project’s output. The application of value engineering principles during the initial design period will also reduce cost. A directed and controlled investment in the evaluation of alternative design concepts can result in significant savings of project cost.

·

Table 1: Typical Project Profit & Loss Statement

Revenue (project sell price)	$ 1,000,000
(less) cost of goods sold (project costs)	($ 750,000)
Gross margin	$250,000
(less) selling, general & administrative expenses	($180,000)
Profit before interest and taxes	$ 70,000
(less) financial expense	($ 30,000)
Profit before taxes	$ 40,000
(less) taxes	($ 20,000)
Net profit	$ 20,000

·  Excessive safety factors employed to ensure “onspec” performance should be avoided. Too frequently the functional members of the project team will apply large safety factors in their effort to meet or exceed the technical specifications. The project team must realize that such excesses increase the project’s cost. The functional staff should be prepared to justify an incremental investment which was made to gain additional performance insurance. Arbitrary and excessive conservatism must be avoided.

·  Execution of the project work must be controlled. The functional groups should not be allowed to stretch out the project for the sake of improvement, refinement, or the investigation of the most remote potential risk. When a functional task has been completed to the project manager’s satisfaction (meeting the task’s objectives), cut off further spending to prevent accumulation of “miscellaneous” charges.

·  The project manager is usually responsible for controlling the project’s contingency budget. This budget represents money that one expects to expend during the term of the project for specific requirements not identified at the project onset. Therefore, these funds must be carefully monitored to prevent indiscriminate spending. A functional group’s need for a portion of the contingency budget must be justified and disbursement of these funds should only be made after the functional group has exhibited an effort to avoid or limit its use. It is imperative that the contingency budget be held for its intended purpose. Unexpected problems will ultimately arise, at which time the funds will be needed. Use of this budget to finance a scope change is neither advantageous to the project manager nor to management. The contingency budget represents the project manager’s authority in dealing with corrections to the project work. Management must be made aware of the true cost of a change so that financing the change will be based on its true value (cost-benefit relationship).

·  In the procurement of equipment, material, and subcontract services, the specified requirements should be identified and the lowest priced, qualified supplier found. Adequate time for price “shopping” should be built into the project schedule. The Mercury project proved to be safe and successful even though John Glenn, perched in the Mercury capsule atop the Atlas rocket prior to America’s first earth orbiting flight, expressed his now famous concern that “all this hardware was built by the low bidder.” 331332The project manager should ensure that the initial project budget is commensurate with the project’s required level of reliability. The project manager should not be put in the position of having to buy project reliability with unavailable funds.

·  Procurement of material and services based on partially completed drawings and specifications should be avoided. The time necessary for preparing a complete documentation package before soliciting bids should be considered in the preparation of the project schedule. Should an order be awarded based on incomplete data and the vendor then asked to alter the original scope of supply, the project will be controlled by the vendor. In executing a “fast track” project, the project manager should make certain that the budget contains an adequate contingency for the change orders which will follow release of a partially defined work scope.

·  Changes should not be incorporated in the project scope without client and/or management approval and the allocation of the requisite funds. Making changes without approval will erode the existing budget and reduce project profitability; meeting the project manager’s “on-cost” commitment will become extremely difficult, if not impossible.

·  During periods of inflation, the project manager must effectively deal with the influence of the economy on the project budget. This is best accomplished during the planning or estimating stage of the work, and entails recognition of planning in an inflationary environment for its effect by estimating the potential cost of two distinct factors. First, a “price protection” contingency budget is needed to cover the cost increases that will occur between the time a vendor provides a firm quotation for a limited period and the actual date the order will be placed. (Vendor quotations used to prepare an estimate usually expire long before the material is actually purchased.) Second, components containing certain price-volatile materials (e.g., gold, silver, etc.) may not be quoted firm, but will be offered by the supplier as “price in effect at time of delivery.” In this case an “escalation” contingency budget is needed to cover the added expense that will accrue between order placement and material delivery. Once the project manager has established these inflation-related contingency budgets, the PM’s role becomes one of ensuring controlled use.