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 com-

9 compressor Invoice

Place P.O.

Commitment $120,000

Pay invoice

Cash outflow 5120,000

Expense 5120,000

0 1 2 3 4 5 6 7 Time (months) Figure 1 : Three perceptions of project cost.

ply 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.

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 it level of expense to arrive at an acceptable period gross margin. At the end of each accounting year and |jS at the end of the project, adjustments are made to the 4f recorded expenses to account for the differences be- ft. tween actual expenses incurred and the theoretical ex-penses 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 by erroneously misrepresenting the projects P&L status; and the rare unscrupulous project man-ager can use an arbitrary assessment of the project s percentage of completion to manipulate the firms a P&L statement.

There are several ways by which the project's [ centage of completion can be assessed to avoid thesi risks. A typical method, which removes subject^ judgments and the potential for manipulation by rely-"" ing on strict accounting procedures is to be described. In this process a theoretical period expense is deter-} -mined, which is divided by the total estimated proiect... expense budget to compute the percentage of total; budget expense for the period. This becomes the Pr0'jL ject's percentage of completion which is then used t8Tr, determine the revenue to be "taken down" for the pe'jjK riod. In this process, long delivery purchased itemi-are not expensed on receipt of an invoice, but havi the value of their purchase order prorated over tfo term of order execution. Figure 2 shows the $120,C compressor in the example being expensed over tb six-month delivery period at the rate of $20,000 pet*! month.

Place P.O.

Pay Invoice Ship compressor i

Invoice

Commitment j

$120,000 Spenge Expense Expense i $20,000 $20,000 $20,000

Cash outflow $120,000

Expense , Expense i $20,000 i $20,000

Expense $20,000

012345678 Time (months)

Figure 2: Percentage of completion expensing.

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.

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 : protect 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 ^he monthly invoice for the work is paid. Expenses are "¡¿rea,;ed in a slightly different manner. Instead of prorating the subcontract sum over the performance period, the individual invoices for the actual work per-,°rme<l are used to determine the expense for the period covered by each invoice.

Thus the three different perceptions of cost can ¡suit in three different time-based cost curves for a Siven project budget. Figure 3 shows a typical rela-pnship between commitments, expenses, and cash utflow. The commitment curve leads and the cash

Months

Figure 3: Three perceptions of cost.

Months

Figure 3: Three perceptions of cost.

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.

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 of 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?

Project Management Made Easy

Project Management Made Easy

What you need to know about… Project Management Made Easy! Project management consists of more than just a large building project and can encompass small projects as well. No matter what the size of your project, you need to have some sort of project management. How you manage your project has everything to do with its outcome.

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