cps notes

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ANNACIVIL BLOG CPS NOTES

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COST CONRTROL MONITORING AND ACCOUNTING

Cost control involves processing of cost accounting reports received from various responsibility centres or operating divisions, relating the cost incurred with standards, analysing the reasons for variances, and presenting the results of monitoring to the project management for making decisions for the future and not of the past.

In construction projects, generally there are two parties whose investments are involved-clients

and contractors.

Client involvement starts with his decision to go a head with the project. His expenses continue during design, execution and commissioning stages. After taking into consideration the contract commitments, escalation and contingencies, he formulates his cost budget for the project.

He plans his cash flows and employs an individual or a small group to monitor costs, so as to keep the costs within the budgeted limits and to meet the cash-flow requirement of the project.

Contractor executes contracted works and it is he who bears the cost of input resources and site

expenses include the cost of men, materials, machinery and capital. He also incurs expenditure on interest on loans, statutory payments, insurance, depreciation and so on.

Cost control preliminaries 1. Cost control approach: It is to simplify and implement, without creating any interdepartmental and interpersonal conflicts. Maximisation of profits is generally the main motto of the contractors, the contractors cost control system can be designed to control each stage of accounting operations that contribute to profit. These stages are: Stages in profit Computation Nature of Control A. Sales income Sales control B. Less direct cost Direct cost control C. Gross margin (A-B) D. Less variable overheads Variable overheads control E. Contribution (C-D) Contribution control F. Less fixed overheads Fixed overhead control G. Operating profit (E-F) Budgetary control 2. Control Estimates: For cost control, it is necessary to have a master control estimate for establishing overall cost control. It is prepared during planning stage itself. It is made of direct costs, indirect costs and funds allocated for contingencies and escalation.



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3. Cost Planning: Cost breakdown levels can be divided as: Level Scope Cost control responsibility 0 Total project cost Cost accountant 1 Sub-project cost Cost accountant 2 Task/logistics Respective managers/ Contractors /functional heads 3 Work-package costs Cost centres The costs at each level may be divided into the following cost elements:

a) Direct manpower costs-Salary, wages and other costs b) Direct material at-site delivered costs c) Direct equipment, plant and services cost. d) Sub-contract costs e) Indirect on-site costs- variable, fixed f) Indirect external costs- head office overheads, management related and commercial fixed and

variable costs. 4. Budgeting Costs: For control and monitoring purposes, the original detailed cost estimate is typically converted into a project budget. Definition: The project budget is the well co-ordinated management approved financial plan of operations, indicating the amounts required for achieving assigned targets, and the expected receipts from sales or the value of work done.

A project budget reflects the financial plan of the operations, divided into responsibility centres with specific goals clearly outlined along with the costs expected to be incurred.

The primary purpose of having a budget is to assign financial targets and resources to each

responsibility centres, to co-ordinate their activities, to form the basis for controlling programme, and to make the participants cost consciousness instead of purposeless routine working. The base of the budget is the project plan and its schedule of work.

In a construction project, the client and the contractor have separate budgets.

The clients construction budget is primarily a capital budget designed to formulate time-phase

funds requirement and the sources from which these funds are to be provisioned. It also includes the expenditure on procurement of land, consultant fee, contractors, payment etc.

The contractors budget is resources, cost and sales income oriented budget. It includes income

and expenditure statements, cash flow, balance sheet etc. Importance of Project Budget: 1. It is essentially a planning document. It outlines the financial plan of the project. 2. It specifies the future financial course of action for steering the project. 3. It specifies a standard for measuring effectiveness and efficiency with which activities are to be

performed.



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4. It is a financial commitment for actions, an instrument for allocation of responsibility, a means of communication, an aid for co-ordination, a tool for motivation, an authority for implementation and a device for controlling performance.

5. A project without a budget is like a missile without guidance system or a ship without navigational instruments.

Problems in Forming the Project Budget:

1. One particular problem in forming a project budget in terms of cost accounts is the inclusion of contingency amounts [funds to cover incidental, unforeseen expenses]. These allowances are included in project cost estimates to accommodate unforeseen events and the resulting costs. However, in advance of the project completion, the source of contingency expenses is not known. Realistically, a budget accounting item for contingency allowance should be established whenever a contingency amount was included in final cost estimate.

2. A second problem in forming a project budget is the inclusion of inflation. Typically final cost estimates are formed in terms of real rupees, and an item reflecting inflation cost is added on as a percentage or lumpsum. This inflation allowance would then be allotted to individual cost items in relation to the actual expected inflation over the period for which costs will be incurred.

Commonly Used budget monitoring parameters are the following: a) Budget Cost of Work Scheduled (BCWS): It represents a time phased schedule of the budget. b) Budgeted Cost of Work Performed (BCWP): It shows the approved cost of the work performed on

data date. c) Actual Cost for the Work Performed (ACWP): Cost incurred on accomplishing a work on data date. Cost variance (CV) = BCWP-ACWP Schedule variance (SV) = BCWP-BCWS Cost performance index (CPI) = BCWP/ACWP Schedule performance index (SPI) = BCWP/BCWS BCWP-ACWP Cost variance % = x 100 BCWP

= CV x 100 / BCWP BCWP - BCWS Schedule variance % = x 100 BCWS

= SV x 100 / BCWS



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In addition to cost amounts, information on material quantities and labour inputs within each job account is also typically retained in the project budget. With this information, actual materials usage and labour employed can be compared to the expected requirements. Cost accounts may vary according to the project. These accounts record all the transactions associated with project. Examples of Project Cost accounts

Clearing and Preparing Site 1. Substructure

i) Excavation and Shoring ii) Piling iii) Concrete masonry iv) Mixing and placing v) Formwork vi) Reinforcing

2. Outside utilities (water, gas, sewer, etc.) 3. Superstructure

i) Masonry ii) Structural steel iii) Wood framing, partitions, etc. iv) Exterior finishes (brickwork, terracotta, cutstone,

etc. v) Roofing, drains, gutters, flashing, etc. vi) Interior finish and trim

a) Finish flooring, stairs, doors, trim b) Glass, windows, glazing c) Marble, tile, terrazzo d) Lathing and plastering e) Soundproofing and insulation f) Finish hardware g) Painting and decorating h) Waterproofing and insulation i) Sprinklers and fire protection

vii) Service work a) Electrical work b) Heating and ventilating c) Plumbing and sewage d) Air conditioning e) Fire alarm, telephone, security, miscellaneous

4. Paving, curbs, walks 5. Installed equipment (elevators, revolving doors, mailchutes,

etc.) 6. Fencing



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Example of Project budget for a Constructor: This budget is developed from a project to construct a wharf. The costs are divided into direct and indirect expenses. Within direct costs, expenses are divided into material, subcontract, temporary work and machinery costs. Material cost

(in crores) Subcontract

work Temporary

work Machinery

cost Total cost

Steel piling 292,172 129,178 16,389 0 437,739 Tie-rod 88,233 29,254 0 0 117,487 Anchor wall 130,281 60,873 0 0 191,154 Backfill 242,230 27,919 0 0 300,149 Coping 42,880 22,307 13,171 0 78,358 Dredging 0 111,650 0 1,750 111,650 Fender 48,996 10,344 0 0 61,090 Other 5,000 32,250 0 0 37,250 Sub-total 849,800 423,775 29,560 1,750 1,304,885 Summary: Total direct cost = 1,304,885 Indirect cost: Common temporary work = 19,320 Common machinery = 80,934 Transportation = 15,550 Office operating costs = 294,458 Total indirect cost = 410,262 Total project cost = 1,715,147 5. Measurement of Cost Performance: Project earned value, depending upon the nature of the project, can be measured in one or more of the three parameters:- i.e. cost, work hours and quantity of work done. Its progress is expressed in percentage: Budgeted cost work performed Project progress (%) = X 100 Budgeted cost of total project 6. Cost Reports:

The cost reports of construction/production centres should reflect a comparison of standard and actual costs. In case of functional departments, cost comparison should be made between budgeted and actual costs.

The project cost controller monitors the responsibility centre cost reports. He updates the project

budgeted costs, changes order, keeps track of variations in control estimates, and forecasts the trends pertaining to the remaining project costs.

7. Management Role in Cost Control:

Cost control can be called effective if the management:

Implements efficient cost control procedures and systems.



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Develops and updates the control estimates. Analyses cost trends to discover potential cost problems and takes remedial measure to control

cost. Encourages a cost conscience and time conscience attitude. Continuously examines methods of execution with an object of total project cost reductions.

FORCASTING FOR ACTIVITY COST CONTROL For the purpose of project management and control, it is not sufficient to consider only the past records of costs and revenues incurred in a project. Good managers should focus upon future revenues, future costs and technical problems. Cost analysis aims to predict future costs. These cost forecasts serve two main purposes: 1. To appraise the project management of the possible cost over-run or under-run for taking timely

corrective actions such as modifying cash flow and updating financial forecasts and project profitability expectations.

2. To update key personnel on anticipated cost changes in their field of responsibility, so as to create cost consciousness for exploring means for minimising wastage and reducing costs.

Job status report explicit estimates of ultimate cost in each category of expense are prepared, which

are used to identify the actual progress and status of an expense category. Estimates might be made from simple linear extrapolations of the productivity or cost of the work to

date on each project item. The forecast total cost, Cf is Cf = Ct / Pt Where, Ct is the cost incurred to time t and Pt is the proportion of activity completed at time t. Alternatively, the use of measured unit cost amounts can be used for forecasting the total cost. The

basic formula for forecasting cost from unit costs is,

Cf = W Ct Where, Cf = forecast total cost W = total units of work Ct = average cost per unit of work experienced up to time t. The unit cost equation may be replaced with the hourly productivity and the unit cost per hour (or

other appropriate time period), resulting in the equation: Cf = W ht ut Where the cost per work unit (Ct ) is replaced by the time per unit ht , divided by the cost per unit of time, ut .



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More elaborate forecasting systems might recognise peculiar problems associated with work on

particular items and modify these simple proportional cost estimates. For example, if productivity is improving as workers and managers become more familiar with the project activities, the estimate of total costs for an item might be revised downward. In this case, the estimating equation would become: Cf = Ct + (W Wt) Ct Where forecast total cost Cf is the sum of cost incurred to date, Ct and the cost resulting from the remaining work (W Wt) multiplied by the expected cost per unit time period for the remainder of the activity, Ct . Variance analysis reveals the extent and causes of variances. On the other hand, performance,

efficiency determines how efficiently the task was done and what will be its implications on the future trends.

The future trends in productivity cost and time performance can be predicted as under: Cost performance index (CPI) = BCWP/ACWP Schedule performance index (SPI) = BCWP/BCWS Estimated Unit Rate Task productivity Index = Actual Unit Rate An index of 1.0 or greater indicates a favourable performance and less than 1.0 implies an

unfavourable trend.

Performance indices vary during execution of a project. Minor variations are normal, but the

significant changes in indices call for forecasting of the probable performance on completion. These forecasts can be prepared by extrapolating the past data to produce the best fit curve, and

thereafter extending the same for predicting performance on completion as under:

a) Assuming the future trend at the originally planned rate, probable completion value. = (ACWP BCWP) + planned BCWS on completion.

b) Assuming that the future rate of progress will continue at the present trend.



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Planned BCWS on completion Probable completion value =

Performance index or Trend There can be situations where the originally specified time and cost objectives are revised.

For example, the original completion time of the project is extended, or agreed contract amount is

increased. In such cases forecasts corresponding to various situations can be worked out using methods given

above.

Illustration of Proportion Completion versus Expenditure of an Activity 100% 80% 60% Percent Completion 40% 20% 0% 0% 20% 40% 60% 80% 100% Percent of Budgeted Expenditure

Planned Expenditure Forecast expenditure Actual Expenditure



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FINANCIAL ACCOUNTING SYSTEMS AND COST ACCOUNTS Cost accounts provide only one of the various components in a financial accounting system. Accounting information is generally used for three distinct purposes: 1. Internal reporting to project managers for day-to-day planning, monitoring and control. 2. Internal reporting to managers for aiding strategic planning. 3. External reporting to owners, government, regulators and other outside parties. External reports are constrained to particular forms and procedures by contractual reporting

requirements or by generally accepted accounting practices. Preparation of such external reports is called financial accounting.

In contrast, cost or managerial accounting is intended to aid internal managers in their

responsibilities of planning, monitoring and control. Financial accounts of an organisation always contain project costs. In an organisation all the expenses

transactions are recorded in a general ledger. The general ledger of accounts is the basis for management reports on particular project as well as

financial accounts for the entire organisation. Other components of a financial accounting system includes:

1. The accounts payable journal: This is intended to provide records or bills received from vendors,

material suppliers, subcontractors and other outside parties. Invoices of charges are recorded as checks issued in payment. Charges to individual cost accounts are posted to general ledger.

2. Accounts receivable journals: To provide opposite function to that of accounts payable. In this journal billings to clients are recorded as well as receipts. Revenues received are posted to general ledger.

3. Job cost ledgers: Summarizes the costs associated with particular project arranged in the various cost

accounts used for the project budget.

4. Inventory records: These are maintained to identify the amount of materials available at any time. In traditional book keeping system, day to day transactions are first recorded in journals. With double entry book keeping, each transaction is recorded as both a debit and credit to particular accounts in the ledger.

For example: Payment of a suppliers bill represents a debit or increase to a project cost account and a credit or reduction to companys cash account. Periodically, the transaction information is transferred to ledger accounts. This process is called Posting and may be done instantaneously or daily in computerized systems. In receiving accounting information, the concepts of flows and stocks should be kept in mind. Daily

transactions reflect flows of rupees entering or leaving the organisation. Similarly, use or receipt of particular materials represents flows from or to inventory.



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An account balance represents the resulting cumulative amount of funds resulting from these daily flows. Information on both flows (cash inflow and outflow) and stocks are needed to give an accurate view of an organisations state.

In addition, forecasts of future changes are needed for effective management. Information from the

ledger is assembled for the organisations financial reports, including balance sheets and income statements for each period.

These reports are the basic products of the financial accounting process and are often used to assess

the performance of an organisation. Methods of Accounting 1. Completed Contract method: In this method income is only reported for completed projects. Work on project underway is only reported on the balance sheet representing an asset if contract billings exceed costs or liability if cost exceeds billings. When a project is completed, total net profit (or loss) is reported in the final period as income.

2. Percentage of Completion method: The actual costs are reported on the income statement plus a proportion of all project revenues equal to the proportion of work completed during the period. The proportion of work completed is computed as the ratio of costs incurred to date and the total estimated cost of the project.

If 20% of project is completed on a particular period at a direct cost of 1,80,000 and on a project with expected revenues of 10,00,000.

Then revenues earned = 1,000,000 x 0.2 = 200,000 The profit for this period = 200,000 180,000 = 20,000 for this period.

Note that billings and actual receipts might be in excess or less than the calculated revenues of 200,000. On the balance sheet of an organisation using the percentage of completion method, an asset is usually reported to reflect billings and the estimated or calculated earnings in excess of actual billings. Example: Consider a 3 year project to construct a plant with the following cash flow for a contractor.

Year Contract expenses Payment Received 1 2 3

700,000 180,000 320,000

900,000 250,000 150,000

Total 12,00,000 13,00,000 Architect determines 60% of completed cost in first year and 75% in the second year. Under the Percentage of Completion method, the net income in one year is 7,80,000 i.e. 60/100 of 13,00,000. So profit = 80,000



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Under the Completed Contract method the entire profit of 100,000 (13,00,000 12,00,000) would be reported in year 3. 1. The % of completion method of reporting period has the advantage of representing the actual

estimated earnings in each period. As a result, the income stream and resulting profits are less susceptible to changes on the completion of a project. But in completed contract method, the income stream and resulting profits are susceptible to precipitate swings on completion of a project.

2. There are tax disadvantages from using the % of completion method since corporate taxes on expected profits may become due during the project rather than being deferred until the project completion.

3. % of completion has the disadvantage of relying upon estimates which can be manipulated to obscure the actual position of a company.

4. % of completion accounting provides only rough estimate of the actual profit or status of a project. Also, the completed contract method of accounting is entirely retrospective and provides no guidance for management.

Calculating Net Profit: Example: Suppose that a company began six jobs in a year, completing three jobs and having three jobs still underway at the end of the year. Details of the six jobs are shown in table given below. What would be the companys net profit? i) Percentage-of-completion ii) Completed contract method accounting conventions?

Net Profit on Completed Contracts ( Amounts in thousands) Job 1 Job 2 Job 3 Total Net Profit on Completed Jobs

1,436 356 - 738 1,054

Status of jobs underway Job 4 Job 5 Job 6 Original contract price 4,200 3,800 5,630

Contract Changes (Change orders, etc.) 400 600 -300

Total Cost to Date 3,600 1,710 620

Payments Received or Due to Date 3,520 1,830 340

Estimated Cost to Complete 500 2,300 5,000

As shown in the table, a net profit of 1,054,000 was earned on the three completed jobs. Under the completed contract method, this total would be total profit. Under the percentage of completion method, the years expected profit on the projects underway would be added to this amount. For Job 4, the expected profits are calculated as follows: Current contract price = original contract price + contract charges = 4,200 + 400 = 4,600



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Credit or Debit to date = Total costs to date Payments received or due to date = 3,600 3,520 = - 80 Contract value of uncompleted work = Current contract price payments received or due = 4,600 3,520 = 1,080 Credit or Debit to come = Contract value of uncompleted work Estimated cost to complete = 1,080 500 = 580 Estimated final gross profit = Credit or debit to date + Credit or debit to come = - 80 + 580 = 500 Estimated total project costs = Contract price Gross profit = 4,600 500 = 4,100 Estimated profit to date = Estimated final gross profit x Proportion of work complete = 500 (3,600 / 4,100) = 439 Similar calculations for the other jobs underway indicate estimated profits to date of 166,000 for Job 5 , and -32,000 for Job 6. As a result, the net profit using percentage of completion method would be 1,627,000 for the year. Note that this figure would be altered in the event of multi-year projects in which net profits on projects completed or underway in this year were claimed in earlier projects.

Control of Project Cash Flows:

Cash flow is the movement of money into or out of a company.

It ensures that sufficient cash is available to meet the demand.

It provides a reliable indicator to lending institutions that advances made can be paid according to an agreed programme.

It ensures that cash resources are fully utilised to the benefit of the owner and investor of the company.

Main points in the determination of cash flows are:

1. Payments (cash outflow): This is the aggregate of the payments which a contractor will make over a period of time for the resources he uses in a project. Ex: labour, plant, materials etc;

2. Receipts (cash inflow): These are the receipts which a contractor will receive over a period for the work he has completed.

3. Timing of Payment: The size of the deficiency can be estimated and the time period over which this deficiency applies can be assessed.



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Use of S- Curve: It is used to forecast the cash requirements of a project. The cumulative expenditure for a project normally takes the shape of letters. By plotting the cumulative expenditure against cumulative project duration, it is possible to calculate project cash requirements. The s-curve shape arises during early contract stage, because of lesser number of activities and hence, the expenditure curve is relatively flat.

100% 80%

Percent Revised Completion Estimate of Future 60% Expenditure

40% 20%

0% 0% 20% 40% 60% 80% 100% Percent of Budgeted Expenditure As the other activities commence, expenditure increases and the curve develops into steeper middle portion. Towards the end of the project, many activities will be completed and there will be rundown of construction work, resulting in a flattened curve.

Planned Expenditure Actual Expenditure



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expenditure 1/3 duration 1/3 duration 1/3 duration Cumulative Expenditure expenditure expenditure

Duration

1/4 th of the expenditure represents the activity build up period of 1/3 rd the contract duration and a further quarter occupies rundown period of 1/3 rd contract duration. Half of the cumulative expenditure is gained over the centre are third of s curve. Cash flow status report: 1. Costs: This is a summary of charges as reflected by the job cost accounts, including expenditures and

estimated costs.

2. Billings: This row summarizes the state of cash flow with respect to the owner of the facility; this row would not be included for the reports to owners. The amount of allowable billing is specified under the terms of contract between an owner and an engineering, architect or constructor. In this case, total billings have exceeded the estimated project completion proportion.

3. Payables: The payables row summarizes the amount owed by the contractor to material suppliers,

labour, sub-contractors. The total payables is equal to the total project expenses shown in the first row of costs.

4. Receivables: This row summarizes the cash flow of receipts from the owner. Note that the actual

receipts from the owner may differ from the amounts billed due to delayed payments or retainage on the part of the owner. The net-billed equals the gross billed less retention by the owner.

5. Cash Position: This row summarizes the cash position of the project as if all expenses and receipts

for the project were combined in a single account.

An Example of a Cash Flow Status Report

Cost Charges Estimated %Complete Projected Charge

Billing Contract Gross bill % Billed Profit

Total Payables Paid Open Retention Labour Receivables Net bill Received Retention Open Cash Position

Paid Unpaid Net Cash balance



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Job status reported provides a primary tool for project cost control. Different reports with varying amounts of detail and item reports would be prepared for different individuals involved in a project.

Reports to upper management would be summaries, reports to particular staff individuals would

emphasize their responsibilities (purchasing, payroll, etc.) and detailed reports would be provided to the individual project managers.

These schedule and cost reports would have to be tempered by the actual accomplishments and

problems occurring in the field. Ex: If work already completed is of sub-standard quality, these reports would not reveal such problem.

Even though the reports indicated a project on time and on budget, the possibility of re-work or inadequate facility performance due to quality problems would quickly reverse the rosy situation.

Schedule Control In addition to cost control, project managers must also give attention to monitoring schedule.

Construction typically involves a deadline for work completion, so contractual agreement will force attention to schedules.

Delays in construction represent additional costs due to late facility occupancy or other factors. In cost control, costs incurred are compared to budgeted costs, in the same way, in schedule control,

actual activity durations may be compared to expected durations.

In this process of forecasting, the time to complete particular activities may be required.

Df = W ht Where, Df is the forecast duration W is the amount of work ht is the observed productivity to time t. It is important to devise efficient and cost effective methods for gathering information on actual

project accomplishments. Generally, observations of work completed are made by inspectors and project t managers and then work completed is estimated.

Once estimates of work completed and time expanded on particular activities is available, deviations

from the original duration estimate can be estimated.



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100 %

80 % Revised estimate of Future progress 60 % 40 % 20 % 0 % 0 % 20 % 40 % 60 % 80 % 100 % Fig. Shows scheduled project progress versus actual progress on a project. This fig is constructed by

summing up the % of each activity, which is completed at different points in time. This summation can be weighted by the magnitude of effect associated with each activity.

From the fig. the project was a head of the original schedule for a period including point A, but is now

late at point B by an amount equal to the horizontal distance between the planned progress and actual progress observed to date.

Scheduled adherence and the current status of a project can also be represented on geometrical models

of a facility. For example, an animation of the construction sequence can be shown on a computer screen, with

different colours or other coding scheme indicating the type of activity underway on each component of the facility.

In evaluating schedule progress, it is important to bear in mind that some activities possess float or

scheduling leeway, whereas delays in activities on the critical path will cause project delays. In particular, the delay in planned progress at time t may be soaked up in activities float or may cause

project delay. As a result, it is preferable to update the project schedule to get an accurate portrayal of the schedule

adherence. After applying a scheduling algorithm, a new project schedule can be obtained. Improving the Scheduling Process Despite considerable attention by researchers and practitioners, the process of construction, planning

and scheduling still presents problem and opportunities for improvement.

B A



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Most of the project scheduling is performed with critical path scheduling method, project cash flow

analysis and resource constrained scheduling. Many commercial software programs are available to perform these tasks.

The most important innovations in construction scheduling are likely to appear in the areas of data

storage, ease of use, data representation, communication and diagnostic or interpretation aids. Integration of scheduling beneficial innovation; many scheduling systems do not provide such

integration of information. With regard to ease of use, the introduction of interactive scheduling systems, graphical output

devices and automated data acquired should produce a very different environment than has existed. In the past, scheduling was performed as a batch operation with output contained in lengthy table of

numbers. The lower costs associated with computer systems as well as improved software make user friendly environments a real possibility for field operations on large projects.

Finally, information representation is an area which needs substantial improvements. A network

model of project activities is an extremely useful device to represent a project but activity inter-relationships cannot be represented in network models.

What is needed is a much more flexible and complete representation of project information. RELATING COST AND SCHEDULE INFORMATION Actual project involves a complex inter-relationship between time and cost. Additional resources

applied to a project activity might result in a shorter duration but higher costs. The project manager can easily recognise the relation between time and cost in projects. But it is

difficult to find effective project control systems which include both elements. Project costs and schedules are recorded and reported in separate application programs. Project

manager must then perform the tedious task of relating the two sets of information. The primary difficulty in integrating schedule and cost information is the level of details required for

the effective integration. A single project activity involves numerous cost account categories. Ex: An activity for the preparation of a foundation would involve cement, workers, concrete forms,

reinforcement, transportation of materials and other resources. Even a more disaggregated activity definition such as erection of foundation forms would involve numerous resources such as forms, nails, carpenters, labour and material transportation.

Different cost accounts would normally be used to record these various resources. Similarly,

numerous activities might involve expenses associated with particular cost accounts.

Ex: a particular material such as standard piping might be used in numerous schedule activities. To integrate cost and schedule information the charges for specific activities and specific cost accounts must be the basis of analysis.



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A method of relating time and cost information is to define individual work elements representing the resources in a particular project activity. Work elements represent an element in a two-dimensional matrix of activities and cost accounts.

A numbering or identifying system for work elements would include both the relevant cost

account and the associated activity. In some cases, it might also be desirable to identify work elements by the responsible organisation or individual.

In this case, a three-dimensional representation of work elements required with the third

dimension corresponding to responsible individuals.

Illustration of a Cost Account and Project activity Matrix:

DIRECT COST CONTROL It involves the evaluation and analysis of the following variances:

a) Direct cost variance b) Direct materials variance c) Direct labour cost variance d) Other direct expenses variance.

Project activity group

Cost amount for super structure 204.1 204.2 204.3 204.4 204.5 204.6 204.7

I st floor

X

X

X

X

X

II nd floor

X

X

X

III rd floor

X

X

X

X

IV th floor

X

X

X

V th floor

X

X

X

X



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Main Cost Variance Breakdown:

Nature of Cost Variances

Sales Value Production cost Administration Variances Variances Cost Variances Work done Work done Variable Fixed Quantity Price Overheads Overheads Variance Variance Variance Variance Variable Cost Variance Fixed cost Variance Prod. Overhead Adm. Overhead Variances Variances Variable Overhead Direct cost Variances Variances Indirect Labour Indirect materials Indirect Other Cost Variances Variances Variances Labour Cost Material Cost Other Direct Expenditure Variances Variances Variances Productivity Rate Equipment cost Other Direct Variance Variance Variance Variance Usage price Variance Variance



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INDIRECT COST BEHAVIOUR An estimate at the time of costing by computing all the indirect costs in detail or evaluating by using predetermined company norms. The estimator will add these indirect costs to the direct costs for calculating the final product cost. But this is not adequate for planning, budgeting and control costs. In order to analyse the cost behaviour a planner or the cost accountant further splits up each item of indirect costs into three broad categories i.e.; variable costs, fixed cost and semi-variable costs.

a) Variable costs: It tends to vary directly with the volume of production, i.e. work done or output. No production means no cost. Cost rises as the volume of production increases. These costs changes at a constant rate (assumed) to changes in the volume of production as shown below.

Variable cost Cost

Volume of output

Examples of indirect variable costs are telephone running expenses, camp messing expenses and office stationary expenses.

b) Fixed costs: It do not show any applicable fluctuations with changes in production levels. These costs are either one-time costs like the camp construction cost or periodic costs such as supervisors salary for a period of six months or are monthly receiving expenses like monthly rent for project office and monthly depreciation for project construction equipment.

Fixed cost Cost

Volume of output



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c) Semi-variable costs: These are partly fixed and partly variable in nature. Examples of these are telephone expenses which consists of fixed installation expenses and variable operating expenses which vary with the volume of work or production activities.

Variable cost component Cost Fixed Cost component Volume of Output



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12. Cost Control, Monitoring and Accounting

12.1 The Cost Control Problem

During the execution of a project, procedures for project control and record keeping become indispensable tools to managers and other participants in the construction process. These tools serve the dual purpose of recording the financial transactions that occur as well as giving managers an indication of the progress and problems associated with a project. The problems of project control are aptly summed up in an old definition of a project as "any collection of vaguely related activities that are ninety percent complete, over budget and late." The task of project control systems is to give a fair indication of the existence and the extent of such problems.

In this chapter, we consider the problems associated with resource utilization, accounting, monitoring and control during a project. In this discussion, we emphasize the project management uses of accounting information. Interpretation of project accounts is generally not straightforward until a project is completed, and then it is too late to influence project management. Even after completion of a project, the accounting results may be confusing. Hence, managers need to know how to interpret accounting information for the purpose of project management. In the process of considering management problems, however, we shall discuss some of the common accounting systems and conventions, although our purpose is not to provide a comprehensive survey of accounting procedures.

The limited objective of project control deserves emphasis. Project control procedures are primarily intended to identify deviations from the project plan rather than to suggest possible areas for cost savings. This characteristic reflects the advanced stage at which project control becomes important. The time at which major cost savings can be achieved is during planning and design for the project. During the actual construction, changes are likely to delay the project and lead to inordinate cost increases. As a result, the focus of project control is on fulfilling the original design plans or indicating deviations from these plans, rather than on searching for significant improvements and cost savings. It is only when a rescue operation is required that major changes will normally occur in the construction plan.

Finally, the issues associated with integration of information will require some discussion. Project management activities and functional concerns are intimately linked, yet the techniques used in many instances do not facilitate comprehensive or integrated consideration of project activities. For example, schedule information and cost accounts are usually kept separately. As a result, project managers themselves must synthesize a comprehensive view from the



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different reports on the project plus their own field observations. In particular, managers are often forced to infer the cost impacts of schedule changes, rather than being provided with aids for this process. Communication or integration of various types of information can serve a number of useful purposes, although it does require special attention in the establishment of project control procedures.

12.2 The Project Budget

For cost control on a project, the construction plan and the associated cash flow estimates can provide the baseline reference for subsequent project monitoring and control. For schedules, progress on individual activities and the achievement of milestone completions can be compared with the project schedule to monitor the progress of activities. Contract and job specifications provide the criteria by which to assess and assure the required quality of construction. The final or detailed cost estimate provides a baseline for the assessment of financial performance during the project. To the extent that costs are within the detailed cost estimate, then the project is thought to be under financial control. Overruns in particular cost categories signal the possibility of problems and give an indication of exactly what problems are being encountered. Expense oriented construction planning and control focuses upon the categories included in the final cost estimation. This focus is particular relevant for projects with few activities and considerable repetition such as grading and paving roadways.

For control and monitoring purposes, the original detailed cost estimate is typically converted to a project budget, and the project budget is used subsequently as a guide for management. Specific items in the detailed cost estimate become job cost elements. Expenses incurred during the course of a project are recorded in specific job cost accounts to be compared with the original cost estimates in each category. Thus, individual job cost accounts generally represent the basic unit for cost control. Alternatively, job cost accounts may be disaggregated or divided into work elements which are related both to particular scheduled activities and to particular cost accounts. Work element divisions will be described in Section 12.8.

In addition to cost amounts, information on material quantities and labour inputs within each job account is also typically retained in the project budget. With this information, actual materials usage and labour employed can be compared to the expected requirements. As a result, cost overruns or savings on particular items can be identified as due to changes in unit prices, labour productivity or in the amount of material consumed.

The number of cost accounts associated with a particular project can vary considerably. For constructors, on the order of four hundred separate cost accounts might be used on a small project. These accounts record all the transactions associated with a project. Thus, separate accounts might exist for different types of materials, equipment use, payroll, project office, etc. Both physical and non-



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physical resources are represented, including overhead items such as computer use or interest charges. Table 12-1 summarizes a typical set of cost accounts that might be used in building construction. Note that this set of accounts is organized hierarchically, with seven major divisions (accounts 201 to 207) and numerous sub-divisions under each division. This hierarchical structure facilitates aggregation of costs into pre-defined categories; for example, costs associated with the superstructure (account 204) would be the sum of the underlying subdivisions (i.e. 204.1, 204.2, etc.) or finer levels of detail (204.61, 204.62, etc.). The sub-division accounts in Table 12-1 could be further divided into personnel, material and other resource costs for the purpose of financial accounting, as described in Section 12.4.

TABLE 12-1 Illustrative Set of Project Cost Accounts 201 Clearing and Preparing Site 202 202.1 202.2 202.3 202.31 202.32 202.33

Substructure Excavation and Shoring Piling Concrete Masonry Mixing and Placing Formwork Reinforcing

203 Outside Utilities (water, gas, sewer, etc.) 204 204.1 204.2 204.3 204.4 204.5 204.6 204.61 204.62 204.63 204.64 204.65 204.66 204.67 204.68 204.69 204.7 204.71 204.72 204.73 204.74 204.72

Superstructure Masonry Construction Structural Steel Wood Framing, Partitions, etc. Exterior Finishes (brickwork, terra cotta, cut stone, etc.) Roofing, Drains, Gutters, Flashing, etc. Interior Finish and Trim Finish Flooring, Stairs, Doors, Trim Glass, Windows, Glazing Marble, Tile, Terrazzo Lathing and Plastering Soundproofing and Insulation Finish Hardware Painting and Decorating Waterproofing Sprinklers and Fire Protection Service Work Electrical Work Heating and Ventilating Plumbing and Sewage Air Conditioning Fire Alarm, Telephone, Security, Miscellaneous

205 Paving, Curbs, Walks 206 Installed Equipment (elevators, revolving doors, mail chutes, etc.)



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207 Fencing

In developing or implementing a system of cost accounts, an appropriate numbering or coding system is essential to facilitate communication of information and proper aggregation of cost information. Particular cost accounts are used to indicate the expenditures associated with specific projects and to indicate the expenditures on particular items throughout an organization. These are examples of different perspectives on the same information, in which the same information may be summarized in different ways for specific purposes. Thus, more than one aggregation of the cost information and more than one application program can use a particular cost account. Separate identifiers of the type of cost account and the specific project must be provided for project cost accounts or for financial transactions. As a result, a standard set of cost codes such as the MASTERFORMAT codes may be adopted to identify cost accounts along with project identifiers and extensions to indicate organization or job specific needs. Similarly the use of databases or, at a minimum, inter-communicating applications programs facilitate access to cost information, as described in Chapter 14.

Converting a final cost estimate into a project budget compatible with an organization's cost accounts is not always a straightforward task. As described in Chapter 5, cost estimates are generally disaggregated into appropriate functional or resource based project categories. For example, labour and material quantities might be included for each of several physical components of a project. For cost accounting purposes, labour and material quantities are aggregated by type no matter for which physical component they are employed. For example, particular types of workers or materials might be used on numerous different physical components of a facility. Moreover, the categories of cost accounts established within an organization may bear little resemblance to the quantities included in a final cost estimate. This is particularly true when final cost estimates are prepared in accordance with an external reporting requirement rather than in view of the existing cost accounts within an organization.

One particular problem in forming a project budget in terms of cost accounts is the treatment of contingency amounts. These allowances are included in project cost estimates to accommodate unforeseen events and the resulting costs. However, in advance of project completion, the source of contingency expenses is not known. Realistically, a budget accounting item for contingency allowance should be established whenever a contingency amount was included in the final cost estimate.

A second problem in forming a project budget is the treatment of inflation. Typically, final cost estimates are formed in terms of real dollars and an item



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reflecting inflation costs is added on as a percentage or lump sum. This inflation allowance would then be allocated to individual cost items in relation to the actual expected inflation over the period for which costs will be incurred.

Example 12-1: Project Budget for a Design Office

An example of a small project budget is shown in Table 12-2. This budget might be used by a design firm for a specific design project. While this budget might represent all the work for this firm on the project, numerous other organizations would be involved with their own budgets. In Table 12-2, a summary budget is shown as well as a detailed listing of costs for individuals in the Engineering Division. For the purpose of consistency with cost accounts and managerial control, labour costs are aggregated into three groups: the engineering, architectural and environmental divisions. The detailed budget shown in Table 12-2 applies only to the engineering division labour; other detailed budgets amounts for categories such as supplies and the other work divisions would also be prepared. Note that the salary costs associated with individuals are aggregated to obtain the total labour costs in the engineering group for the project. To perform this aggregation, some means of identifying individuals within organizational groups is required. Accompanying a budget of this nature, some estimate of the actual man-hours of labour required by project task would also be prepared. Finally, this budget might be used for internal purposes alone. In submitting financial bills and reports to the client, overhead and contingency amounts might be combined with the direct labour costs to establish an aggregate billing rate per hour. In this case, the overhead, contingency and profit would represent allocated costs based on the direct labour costs.

TABLE 12-2 Example of a Small Project Budget for a Design Firm

Personnel Architectural Division Engineering Environmental Division Total Other Direct Expenses Travel Supplies Communication Computer Services Total

Budget Summary

$ 67,251.00

45,372.00 28,235.00 $140,858.00

2,400.00 1,500.00

600.00 1,200.00 $ 5,700.00

$ 175,869.60

$ 95,700.00



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Overhead Contingency and Profit Total

$ 418,127.60

Senior Engineer Associate Engineer Engineer Technician Total

Engineering Personnel

Detail

$ 11,562.00 21,365.00

12,654.00

$ 45,372.00

Example 12-2: Project Budget for a Constructor

Table 12-3 illustrates a summary budget for a constructor. This budget is developed from a project to construct a wharf. As with the example design office budget above, costs are divided into direct and indirect expenses. Within direct costs, expenses are divided into material, subcontract, temporary work and machinery costs. This budget indicates aggregate amounts for the various categories. Cost details associated with particular cost accounts would supplement and support the aggregate budget shown in Table 12-3. A profit and a contingency amount might be added to the basic budget of $1,715,147 shown in Table 12-3 for completeness. TABLE 12-3 An Example of a Project Budget for a Wharf Project (Amounts in Thousands

of Dollars)

Material Cost

Subcontract Work

Temporary Work

Machinery Cost Total Cost

Steel Piling Tie-rod Anchor-Wall Backfill Coping Dredging Fender Other Sub-total

$292,172 88,233

130,281 242,230 42,880

0 48,996

5,000 $849,800

$129,178 29,254 60,873 27,919 22,307

111,650 10,344

32,250 $423,775

$16,389 0 0 0

13,171 0 0

0 $29,560

$0 0 0 0 0 0

1,750 0 $1,750

$437,739 117,487 191,154 300,149 78,358

111,650 61,090

37,250 $1,304,885

Summary Total of direct cost

$1,304,885



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Indirect Cost Common Temporary Work

Common Machinery Transportation

Office Operating Costs Total of Indirect Cost

Total Project Cost

19,320 80,934 15,550

294,458 410,262. $1,715,147

12.3 Forecasting for Activity Cost Control

For the purpose of project management and control, it is not sufficient to consider only the past record of costs and revenues incurred in a project. Good managers should focus upon future revenues, future costs and technical problems. For this purpose, traditional financial accounting schemes are not adequate to reflect the dynamic nature of a project. Accounts typically focus on recording routine costs and past expenditures associated with activities. Generally, past expenditures represent sunk costs that cannot be altered in the future and may or may not be relevant in the future. For example, after the completion of some activity, it may be discovered that some quality flaw renders the work useless. Unfortunately, the resources expended on the flawed construction will generally be sunk and cannot be recovered for re-construction (although it may be possible to change the burden of who pays for these resources by financial withholding or charges; owners will typically attempt to have constructors or designers pay for changes due to quality flaws). Since financial accounts are historical in nature, some means of forecasting or projecting the future course of a project is essential for management control. In this section, some methods for cost control and simple forecasts are described.

An example of forecasting used to assess the project status is shown in Table 12-4. In this example, costs are reported in five categories, representing the sum of all the various cost accounts associated with each category:

Budgeted Cost The budgeted cost is derived from the detailed cost estimate prepared at the start of the project. Examples of project budgets were presented in Section 12.2. The factors of cost would be referenced by cost account and by a prose description.

Estimated total cost The estimated or forecast total cost in each category is the current best estimate of costs based on progress and any changes since the budget was formed. Estimated total costs are the sum of cost to date, commitments and exposure. Methods for estimating total costs are described below.

Cost Committed and Cost Exposure!! Estimated cost to completion in each category in divided into firm commitments and estimated additional



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cost or exposure. Commitments may represent material orders or subcontracts for which firm dollar amounts have been committed.

Cost to Date The actual cost incurred to date is recorded in column 6 and can be derived from the financial record keeping accounts.

Over or (Under) A final column in Table 12-4 indicates the amount over or under the budget for each category. This column is an indicator of the extent of variance from the project budget; items with unusually large overruns would represent a particular managerial concern. Note that variance is used in the terminology of project control to indicate a difference between budgeted and actual expenditures. The term is defined and used quite differently in statistics or mathematical analysis. In Table 12-4, labour costs are running higher than expected, whereas subcontracts are less than expected.

The current status of the project is a forecast budget overrun of $5,950. with 23 percent of the budgeted project costs incurred to date.

TABLE 12-4 Illustration of a Job Status Report

Factor Budgeted

Cost Estimated Total Cost

Cost Committed

Cost Exposure

Cost To Date

Over or (Under)

Labour Material

Subcontracts Equipment

Other Total

$99,406 88,499

198,458 37,543

72,693 496,509

$102,342 88,499

196,323 37,543

81,432 506,139

$49,596 42,506 83,352 23,623

49,356 248,433

--- 45,993 97,832

--- ---

143,825

$52,746 ---

15,139 13,920

32,076 113,881

$2,936 0

(2,135) 0

8,739 5,950

For project control, managers would focus particular attention on items indicating substantial deviation from budgeted amounts. In particular, the cost overruns in the labour and in the "other expense category would be worthy of attention by a project manager in Table 12-4. A next step would be to look in greater detail at the various components of these categories. Overruns in cost might be due to lower than expected productivity, higher than expected wage rates, higher than expected material costs, or other factors. Even further, low productivity might be caused by inadequate training, lack of required resources such as equipment or tools, or inordinate amounts of re-work to correct quality problems. Review of a job status report is only the first step in project control.

The job status report illustrated in Table 12-4 employs explicit estimates of ultimate cost in each category of expense. These estimates are used to identify the actual progress and status of an expense category. Estimates might be made from



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simple linear extrapolations of the productivity or cost of the work to date on each project item. Algebraically, a linear estimation formula is generally one of two forms. Using a linear extrapolation of costs, the forecast total cost, Cf , is:

(12.1)

where Ct is the cost incurred to time t and pt is the proportion of the activity completed at time t. For example, an activity which is 50 percent complete with a cost of $40,000 would be estimated to have a total cost of $40,000/0.5 = $80,000. More elaborate methods of forecasting costs would disaggregate costs into different categories, with the total cost the sum of the forecast costs in each category.

Alternatively, the use of measured unit cost amounts can be used for forecasting total cost. The basic formula for forecasting cost from unit costs is:

(12.2)

where Cf is the forecast total cost, W is the total units of work, and ct is the average cost per unit of work experienced up to time t. If the average unit cost is $50 per unit of work on a particular activity and 1,600 units of work exist, then the expected cost is (1,600)(50) = $80,000 for completion.

The unit cost in Equation (12.2) may be replaced with the hourly productivity and the unit cost per hour (or other appropriate time period), resulting in the equation:

(12.3)

where the cost per work unit (ct) is replaced by the time per unit, ht, divided by the cost per unit of time, ut.

More elaborate forecasting systems might recognize peculiar problems associated with work on particular items and modify these simple proportional cost estimates. For example, if productivity is improving as workers and managers become more familiar with the project activities, the estimate of total costs for an item might be revised downward. In this case, the estimating equation would become:

(12.4)



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where forecast total cost, Cf, is the sum of cost incurred to date, Ct, and the cost resulting from the remaining work (W - Wt) multiplied by the expected cost per unit time period for the remainder of the activity, ct.

As a numerical example, suppose that the average unit cost has been $50 per unit of work, but the most recent figure during a project is $45 per unit of work. If the project manager was assured that the improved productivity could be maintained for the remainder of the project (consisting of 800 units of work out of a total of 1600 units of work), the cost estimate would be (50)(800) + (45)(800) = $76,000 for completion of the activity. Note that this forecast uses the actual average productivity achieved on the first 800 units and uses a forecast of productivity for the remaining work. Historical changes in productivity might also be used to represent this type of non-linear changes in work productivity on particular activities over time.

In addition to changes in productivities, other components of the estimating formula can be adjusted or more detailed estimates substituted. For example, the change in unit prices due to new labour contracts or material supplier's prices might be reflected in estimating future expenditures. In essence, the same problems encountered in preparing the detailed cost estimate are faced in the process of preparing exposure estimates, although the number and extent of uncertainties in the project environment decline as work progresses. The only exception to this rule is the danger of quality problems in completed work which would require re-construction.

Each of the estimating methods described above require current information on the state of work accomplishment for particular activities. There are several possible methods to develop such estimates, including:

Units of Work Completed For easily measured quantities the actual proportion of completed work amounts can be measured. For example, the linear feet of piping installed can be compared to the required amount of piping to estimate the percentage of piping work completed.

Incremental Milestones Particular activities can be sub-divided or "decomposed" into a series of milestones, and the milestones can be used to indicate the percentage of work complete based on historical averages. For example, the work effort involved with installation of standard piping might be divided into four milestones:

o Spool in place: 20% of work and 20% of cumulative work. o Ends welded: 40% of work and 60% of cumulative work. o Hangars and Trim Complete: 30% of work and 90% of cumulative

work.



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o Hydro tested and Complete: 10% of work and 100% of cumulative work.

Thus, a pipe section for which the ends have been welded would be reported as 60% complete.

Opinion Subjective judgments of the percentage complete can be prepared by inspectors, supervisors or project managers themselves. Clearly, this estimated technique can be biased by optimism, pessimism or inaccurate observations. Knowledgeable estimators and adequate field observations are required to obtain sufficient accuracy with this method.

Cost Ratio The cost incurred to date can also be used to estimate the work progress. For example, if an activity was budgeted to cost $20,000 and the cost incurred at a particular date was $10,000, then the estimated percentage complete under the cost ratio method would be 10,000/20,000 = 0.5 or fifty percent. This method provides no independent information on the actual percentage complete or any possible errors in the activity budget: the cost forecast will always be the budgeted amount. Consequently, managers must use the estimated costs to complete an activity derived from the cost ratio method with extreme caution.

Systematic application of these different estimating methods to the various project activities enables calculation of the percentage complete or the productivity estimates used in preparing job status reports.

In some cases, automated data acquisition for work accomplishments might be instituted. For example, transponders might be moved to the new work limits after each day's activity and the new locations automatically computed and compared with project plans. These measurements of actual progress should be stored in a central database and then processed for updating the project schedule. The use of database management systems in this fashion is described in Chapter 14.

Example 12-3: Estimated Total Cost to Complete an Activity

Suppose that we wish to estimate the total cost to complete piping construction activities on a project. The piping construction involves 1,000 linear feet of piping which has been divided into 50 sections for management convenience. At this time, 400 linear feet of piping has been installed at a cost of $40,000 and 500 man-hours of labour. The original budget estimate was $90,000 with a productivity of one foot per man-hour, a unit cost of $60 per man hour and a total material cost of $ 30,000. Firm commitments of material delivery for the $30,000 estimated cost have been received.



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The first task is to estimate the proportion of work completed. Two estimates are readily available. First, 400 linear feet of pipe is in place out of a total of 1000 linear feet, so the proportion of work completed is 400/1000 = 0.4 or 40%. This is the "units of work completed" estimation method. Second, the cost ratio method would estimate the work complete as the cost-to-date divided by the cost estimate or $40,000/$ 90,000 = 0.44 or 44%. Third, the "incremental milestones" method would be applied by examining each pipe section and estimating a percentage complete and then aggregating to determine the total percentage complete. For example, suppose the following quantities of piping fell into four categories of completeness:

complete (100%) hangars and trim complete (90%) ends welded (60%) spool in place (20%)

380 ft 20 ft 5 ft 0 ft

Then using the incremental milestones shown above, the estimate of completed work would be 380 + (20)(0.9) + (5)(0.6) + 0 = 401 ft and the proportion complete would be 401 ft/1,000 ft = 0.401 or 40% after rounding.

Once an estimate of work completed is available, then the estimated cost to complete the activity can be calculated. First, a simple linear extrapolation of cost results in an estimate of $40,000/0.4 = $100,000. for the piping construction using the 40% estimate of work completed. This estimate projects a cost overrun of 100,000 - 90,000 = $10,000.

Second, a linear extrapolation of productivity results in an estimate of (1000 ft.)(500 hrs/400 ft.)($60/hr) + 30,000 = $105,000. for completion of the piping construction. This estimate suggests a variance of 105,000 - 90,000 = $15,000 above the activity estimate. In making this estimate, labour and material costs entered separately, whereas the two were implicitly combined in the simple linear cost forecast above. The source of the variance can also be identified in this calculation: compared to the original estimate, the labour productivity is 1.25 hours per foot or 25% higher than the original estimate.

Example 12-4: Estimated Total Cost for Completion

The forecasting procedures described above assumed linear extrapolations of future costs, based either on the complete experience on the activity or the recent experience. For activities with good historical records, it can be the case that a typically non-linear profile of cost expenditures and completion proportions can be estimated. Figure 12-1 illustrates one possible non-linear relationships derived from experience in some particular activity. The progress on a new job can be compared to this historical record. For example, point A in Figure 12-1 suggests a higher expenditure than is normal for the completion proportion. This point



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represents 40% of work completed with an expenditure of 60% of the budget. Since the historical record suggests only 50% of the budget should be expended at time of 40% completion, a 60 - 50 = 10% overrun in cost is expected even if work efficiency can be increased to historical averages. If comparable cost overruns continue to accumulate, then the cost-to-complete will be even higher.

Figure 12-1 Illustration of Proportion Completion versus Expenditure for an Activity

12.4 Financial Accounting Systems and Cost Accounts

The cost accounts described in the previous sections provide only one of the various components in a financial accounting system. Before further discussing the use of cost accounts in project control, the relationship of project and financial accounting deserves mention. Accounting information is generally used for three distinct purposes:

Internal reporting to project managers for day-to-day planning, monitoring and control.

Internal reporting to managers for aiding strategic planning. External reporting to owners, government, regulators and other outside

parties.



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External reports are constrained to particular forms and procedures by contractual reporting requirements or by generally accepted accounting practices. Preparation of such external reports is referred to as financial accounting. In contrast, cost or managerial accounting is intended to aid internal managers in their responsibilities of planning, monitoring and control.

Project costs are always included in the system of financial accounts associated with an organization. At the heart of this system, all expense transactions are recorded in a general ledger. The general ledger of accounts forms the basis for management reports on particular projects as well as the financial accounts for an entire organization. Other components of a financial accounting system include:

The accounts payable journal is intended to provide records of bills received from vendors, material suppliers, subcontractors and other outside parties. Invoices of charges are recorded in this system as are checks issued in payment. Charges to individual cost accounts are relayed or posted to the General Ledger.

Accounts receivable journals provide the opposite function to that of accounts payable. In this journal, billings to clients are recorded as well as receipts. Revenues received are relayed to the general ledger.

Job cost ledgers summarize the charges associated with particular projects, arranged in the various cost accounts used for the project budget.

Inventory records are maintained to identify the amount of materials available at any time.

In traditional bookkeeping systems, day to day transactions are first recorded in journals. With double-entry bookkeeping, each transaction is recorded as both a debit and a credit to particular accounts in the ledger. For example, payment of a supplier's bill represents a debit or increase to a project cost account and a credit or reduction to the company's cash account. Periodically, the transaction information is summarized and transferred to ledger accounts. This process is called posting, and may be done instantaneously or daily in computerized systems.

In reviewing accounting information, the concepts of flows and stocks should be kept in mind. Daily transactions typically reflect flows of dollar amounts entering or leaving the organization. Similarly, use or receipt of particular materials represent flows from or to inventory. An account balance represents the stock or cumulative amount of funds resulting from these daily flows. Information on both flows and stocks are needed to give an accurate view of an organization's state. In addition, forecasts of future changes are needed for effective management.

Information from the general ledger is assembled for the organization's financial reports, including balance sheets and income statements for each period. These reports are the basic products of the financial accounting process and are often used to assess the performance of an organization. Table12-5 shows a typical



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income statement for a small construction firm, indicating a net profit of $ 330,000 after taxes. This statement summarizes the flows of transactions within a year. Table 12-6 shows the comparable balance sheet, indicated a net increase in retained earnings equal to the net profit. The balance sheet reflects the effects of income flows during the year on the overall worth of the organization.

TABLE 12-5 Illustration of an Accounting Statement of Income Income Statement

for the year ended December 31, 19xx Gross project revenues Direct project costs on contracts Depreciation of equipment Estimating Administrative and other expenses Subtotal of cost and expenses Operating Income Interest Expense, net Income before taxes Income tax Net income after tax Cash dividends Retained earnings, current year Retention at beginning of year Retained earnings at end of year

$7,200,000

5,500,000 200,000 150,000

650,000 6,500,000

700,000

150,000 550,000

220,000 330,000

100,000 230,000

650,000 $880,000.

TABLE 12-6 Illustration of an Accounting Balance Sheet Balance Sheet

December 31, 19xx Assets Amount

Cash Payments Receivable Work in progress, not claimed Work in progress, retention Equipment at cost less accumulated depreciation Total assets

$150,000 750,000 700,000 200,000

1,400,000 $3,200,000

Liabilities and Equity Liabilities Accounts payable Other items payable (taxes, wages, etc.) Long term debts Subtotal Shareholders' funds

$950,000

50,000 500,000 1,500,000



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40,000 shares of common stock (Including paid-in capital) Retained Earnings Subtotal Total Liabilities and Equity

820,000

880,000 1,700,000

$3,200,000

In the context of private construction firms, particular problems arise in the treatment of uncompleted contracts in financial reports. Under the "completed-contract" method, income is only reported for completed projects. Work on projects underway is only reported on the balance sheet, representing an asset if contract billings exceed costs or a liability if costs exceed billings. When a project is completed, the total net profit (or loss) is reported in the final period as income. Under the "percentage-of-completion" method, actual costs are reported on the income statement plus a proportion of all project revenues (or billings) equal to the proportion of work completed during the period. The proportion of work completed is computed as the ratio of costs incurred to date and the total estimated cost of the project. Thus, if twenty percent of a project was completed in a particular period at a direct cost of $180,000 and on a project with expected revenues of $1,000,000, then the contract revenues earned would be calculated as $1,000,000(0.2) = $200,000. This figure represents a profit and contribution to overhead of $200,000 - $180,000 = $20,000 for the period. Note that billings and actual receipts might be in excess or less than the calculated revenues of $200,000. On the balance sheet of an organization using the percentage-of-completion method, an asset is usually reported to reflect billings and the estimated or calculated earnings in excess of actual billings.

As another example of the difference in the "percentage-of-completion" and the "completed-contract" methods, consider a three year project to construct a plant with the following cash flow for a contractor:

Year Contract Expenses Payments Received 1 2 3

Total

$700,000 180,000

320,000 $1,200,000

$900,000 250,000

150,000 $1,300,000

The supervising architect determines that 60% of the facility is complete in year 1 and 75% in year 2. Under the "percentage-of-completion" method, the net income in year 1 is $780,000 (60% of $1,300,000) less the $700,000 in expenses or



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$80,000. Under the "completed-contract" method, the entire profit of $100,000 would be reported in year 3.

The "percentage-of-completion" method of reporting period earnings has the advantage of representing the actual estimated earnings in each period. As a result, the income stream and resulting profits are less susceptible to precipitate swings on the completion of a project as can occur with the "completed contract method" of calculating income. However, the "percentage-of-completion" has the disadvantage of relying upon estimates which can be manipulated to obscure the actual position of a company or which are difficult to reproduce by outside observers. There are also subtleties such as the deferral of all calculated income from a project until a minimum threshold of the project is completed. As a result, interpretation of the income statement and balance sheet of a private organization is not always straightforward. Finally, there are tax disadvantages from using the "percentage-of-completion" method since corporate taxes on expected profits may become due during the project rather than being deferred until the project completion. As an example of tax implications of the two reporting methods, a study of forty-seven construction firms conducted by the General Accounting Office found that $280 million in taxes were deferred from 1980 to 1984 through use of the "completed-contract" method.

It should be apparent that the "percentage-of-completion" accounting provides only a rough estimate of the actual profit or status of a project. Also, the "completed contract" method of accounting is entirely retrospective and provides no guidance for management. This is only one example of the types of allocations that are introduced to correspond to generally accepted accounting practices, yet may not further the cause of good project management. Another common example is the use of equipment depreciation schedules to allocate equipment purchase costs. Allocations of costs or revenues to particular periods within a project may cause severe changes in particular indicators, but have no real meaning for good management or profit over the entire course of a project. As Johnson and Kaplan argue:

Today's management accounting information, driven by the procedures and cycle of the organization's financial reporting system, is too late, too aggregated and too distorted to be relevant for managers' planning and control decisions....

Management accounting reports are of little help to operating managers as they attempt to reduce costs and improve productivity. Frequently, the reports decrease productivity because they require operating managers to spend time attempting to understand and explain reported variances that have little to do with the economic and technological reality of their operations...

The management accounting system also fails to provide accurate product costs. Cost are distributed to products by simplistic and arbitrary measures, usually direct



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labour based, that do not represent the demands made by each product on the firm's resources.

As a result, complementary procedures to those used in traditional financial accounting are required to accomplish effective project control, as described in the preceding and following sections. While financial statements provide consistent and essential information on the condition of an entire organization, they need considerable interpretation and supplementation to be useful for project management.

Example 12-5: Calculating net profit

As an example of the calculation of net profit, suppose that a company began six jobs in a year, completing three jobs and having three jobs still underway at the end of the year. Details of the six jobs are shown in Table 12-7. What would be the company's net profit under, first, the "percentage-of-completion" and, second, the "completed contract method" accounting conventions?

TABLE 12-7 Example of Financial Records of Projects Net Profit on Completed Contracts (Amounts in thousands of dollars) Job 1 Job 2 Job 3 Total Net Profit on Completed Jobs

$1,436 356

- 738 $1,054

Status of Jobs Underway Job 4 Job 5 Job 6 Original Contract Price Contract Changes (Change Orders, etc.) Total Cost to Date Payments Received or Due to Date Estimated Cost to Complete

$4,200 400

3,600 3,520

500

$3,800 600

1,710 1,830 2,300

$5,630 - 300

620 340

5,000

As shown in Table 12-7, a net profit of $1,054,000 was earned on the three completed jobs. Under the "completed contract" method, this total would be total profit. Under the percentage-of completion method, the year's expected profit on the projects underway would be added to this amount. For job 4, the expected profits are calculated as follows:

Current contract price = Original contract price + Contract Changes = 4,200 + 400 + 4,600

Credit or debit to date = Total costs to date - Payments received or due to date = 3,600 - 3,520 = - 80

Contract value of uncompleted work

= Current contract price - Payments received or due = 4,600 - 3,520 = 1,080

Credit or debit to come = Contract value of uncompleted work - Estimated Cost to



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Complete = 1,080 - 500 = 580

Estimated final gross profit = Credit or debit to date + Credit or debit to come = - 80. + 580. = 500

Estimated total project costs = Contract price - Gross profit = 4,600 - 500 = 4,100

Estimated Profit to date = Estimated final gross profit x Proportion of work complete = 500. (3600/4100)) = 439

Similar calculations for the other jobs underway indicate estimated profits to date of $166,000 for Job 5 and -$32,000 for Job 6. As a result, the net profit using the "percentage-of-completion" method would be $1,627,000 for the year. Note that this figure would be altered in the event of multi-year projects in which net profits on projects completed or underway in this year were claimed in earlier periods.

12.5 Control of Project Cash Flows

Section 12.3 described the development of information for the control of project costs with respect to the various functional activities appearing in the project budget. Project managers also are involved with assessment of the overall status of the project, including the status of activities, fina

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