Sunday, May 16, 2004

Financial Management & Project Cost Management


Financial management is instrumental in identifying the need, determining the timing, and negotiating with potential sources of outside capital. Decisions to whether to engage in short-term or long-term borrowing are dependent on cash flow expectations, capital structure determination, and the cost of capital employed. To discharge this function effectively, managers must maintain close contact with financial markets and be sensitive to macroeconomic development that may influence the availability and cost of capital to be acquired.

Finance is also the focal point for information requested by creditors, lenders, and stockholders regarding the financial posture of the organization. Accuracy, timeliness, and tactfulness are the primary characteristics required for these activities.

The role of finance, particularly in the areas of scorekeeping and capital utilization are all-pervasive and impacts on the managerial discretion of non-finance activities. Therefore, all managers must develop an understanding of the objectives, tools, and functions of finance.

A matter of immediate concern for all managers is an appreciation of the purpose, underlying assumptions, and interpretation of the budgeting process. The ability to present a case for a budget and to discuss it, and to provide the data required for top management’s approval is a prerequisite for organizational survival. Any major allocation or request for funds will require forecast of benefits.

Effective financial management must take into account the needs and concerns of those who supply capital to the organization – lenders and stockholders. The observe is also true: effective lending and investment requires a thorough understanding of the tools and practices of financial management. In assessing the desirability of a loan to a potential borrower, or the injection of capital by stockholders, the funders must assure themselves of the viability and financial potential of the enterprise or a project. Analysis of past financial statements, prevailing financial plans, and control procedures will provide the much relevant information. By understanding the financial language, tools and procedures, investors can place themselves in the decision and information framework of corporate management, thereby gaining a better appreciation of the risks their capital is exposed to and the returns they may realize.

Financial Planning

Financial planning is a reasoned approach to allocating economic resources to maximize the satisfaction one gets from life. A financial plan or budget is a convenient decision-making tool, which is based on the fundamental economic principles of scarcity, choice and opportunity cost. In the absence of a financial plan, impulse buying may make it difficult to "make ends meet" no matter the level of income.

It is important to realize that every purchase involves cost (opportunity cost). Maximizing satisfaction depends on an analysis of the costs and benefits of purchases. Equipped with an understanding of the financial planning process, students are better able to adapt to ever-changing economic conditions.

One of the key functions of financial management is the allocation of existing resources with the expectation of reaping benefits in the future. The relationships between investment and returns are asymmetrical. While the costs of existing resources are expended with certainty, the benefits anticipated from the investment are not guaranteed. Thus returns may deviate from expectations and such deviation serves as the definition of uncertainty or risk.

The most carefully planned programs face great uncertainties as to the potential outcome of the course of events envisioned during the investment phase. Each of the events would have implications on the cash flow and profit. Planned benefits are uncertain and may deviate either direction from those assumed initially. Since risk cannot be avoided, it must be treated explicitly in the financial planning process. This can be accomplished by stipulating a range of likely outcomes, varying these stipulations, and observing the changes that occur in expected benefits as the assumptions are altered.

With the development of mathematical programming techniques and the availability of computers, econometric forecasting techniques have gained considerable acceptance. These forecast predict the stability of certain economic relationships and the ability to capture these relationships in mathematical terms. Before the forecast can be generated, certain assumptions regarding political events, tax legislature, demographic factors, technological developments, and consumer behaviors must be incorporated into the forecast, explicitly or implicitly. The cost of developing an econometric forecast is relatively high which preclude most small businesses from developing their own capability in this area. Alternatively, small corporations may procure these programmes from external source, but the reliability and accuracy, and the assumptions incorporated into the system may be improper and unrealistic. another less sophisticated technique, which can be used for forecasting, is the judgmental forecast, displaying in quantitative terms (such as GDP, interest rate, employment data).

Once a sales forecast is presented, company support plans can then be developed. The financial plan will then translates all these support plans into monetary terms, identify the source of fundings, and present an approach for the raising of capital from external source, if so required.

Project Cost Management

Project Cost Management includes the processes required to ensure that the project is completed within the approved budget (PMBOK, PMI, 2000). The major processes are: Resource Planning, Cost Estimating, Cost Budgeting and Cost Control. Project Cost Management is primarily concerned with the cost of the resources needed to complete project activities.

The principle objectives of which profit-oriented business organization tend to pursue are wealth enhancement, maximization of profit, maximization of return on investment of shareholders and satisfying stakeholders. Though wealth enhancement may not be a perfect description of what businesses seek to achieve, it is almost certain that wealth is something which business cannot ignore. A particular business only has a certain amount of wealth (capital) and it will take only a limited number of “wrong” decisions to see the business collapse. Therefore, business needs decisions such that it would be worth more as a result of the decision. When valuing businesses, managers need to take into account future profitability, both long-term and short-term, and the risk attached with the investment

The important issue for the success of an organization is not to whom specific responsibilities have been assigned, but rather that these functions are addressed in a timely fashion and are handled effectively. The functions of finance should be handled in accordance with the goal and objectives of the organization. In a profit-oriented enterprise, this goal should be maximization of the wealth of the shareholders.

Cost is often measured in monetary terms. The success of projects is judged by the efficiency with which we achieve the project objectives and that efficiency is assessed by measuring against two constraints – Cost & Time. In assessing the project duration, the duration of individual activities and resource usage have been optimized and further reduction of project duration must increase the direct cost of the project due to overtime and uneconomic use of the plants and machineries.


Cost Estimates

Estimating is never simple. Project managers must recognize that time, cost and resource estimates must be accurate if project planning, scheduling, and controlling are to be effective. At the work package level, the person most familiar with the task should make estimates. The line supervisors who are responsible for getting the job done and who are experienced and familiar with the work should be asked to develop the estimates at this level. The advantage is that the line supervisors will be responsible to ensure that the work activities as estimated by them would be achievable.

There are two practical problems in estimating. First, you are simply too optimistic. It is human nature at the beginning of a new project to ignore the difficulties and assume best-case scenario - in producing your estimates (and using those of others) you must inject a little realism. In practice, you should also build-in a little slack to allow yourself some tolerance against mistakes. This is known as defensive scheduling.

Second, you will be under pressure from senior management to deliver quickly, especially if the project is being sold competitively or the project is fast track as specified within the terms and conditions of contract.

Historical estimates has some inherent danger because they assume the past represents the future and may miss uncertainties that are associated with the new task. Any time estimates should reflect efficient methods for the resources normally available. Estimating of time must consider if normal time is calendar days, working days, weekends, mandays and hours. Many schedules developed by project managers are over optimistic (or faulty) because they do not take into considerations public holidays and other non-working days. Therefore, in developing the schedule, project managers are advise to formulate the project calendar to take into consideration the possible non-working days and other risks associated with schedule (workers can be sick, take leave, or raining days). Unfortunately, padding carries a price. While increasing the allowed time will reduce schedule risk, we will also increase the possibility of an increase in the budgeted cost – this is the time/cost trade-off. The objective of all planning should be to develop a “realistic plan” and if padding is required, it must be done on a “task-by task” basis. There will always be some variation in working times, caused by external factors outside the control of the project team.

Several types of estimates are required as a project evolves. They are:
 Conceptual Estimates,
 Detailed Estimates and
 Definitive estimates.

Conceptual Estimates (preliminary estimates) are generally made in the early phases of a project, during the pre-tender stage. The estimates tell an owner whether a project is economically feasible.

Detailed Estimates, commonly called “quantity take-off” where quantities are then multiplied by selected unit costs, and the resulting sum represents the estimated direct cost of the facility. The addition of indirect costs – plant & equipments, overheads, profit, escalation costs and contingencies will develop the total estimated project cost. The contractor’s bid estimate is his foundation for a successful project. He must bid competitively to win a tender and yet make a profit.

Definitive Estimates are prepared after the project has achieved substantial progress and the major works has been more or less confirmed, and is unlikely to have further changes. These estimates will forecast the final project cost with little margin for error.

Cost Budgeting

Project Cost Budgeting involves allocating the project cost estimate to individual work items. A properly constructed budget must be capable of being baselined and used as the basis for performance measurement and control. It must reflect the way that resources are applied to achieve planned objectives over time. It must be structured in relation to the build-up of estimates, and to the collection of actuals. In converting an estimate to a control budget, two important differences should be considered. First, the organization and the categorization of costs suitable for preparing an estimate are often not compatible with realistic field cost control. Second, estimates must deal in averages, whereas tighter standards are sometimes desirable for control purpose.

In building the project budget we should consider providing certain buffer of extra money. Padding is a standard procedure in managing any project. There is no way that every risk can be fully calculated or anticipated. By assuming that the project might run over budget, we could have a cushion against unexpected incidents or cost overruns. As a project manager, you must have as much direct control of your budget as possible if you are going to be held accountable for the project outcome.

A properly constructed budget must be capable of being baselined and used as the basis for performance measurement and control. It must reflect the way that resources are applied to achieve planned objectives over time. It must be structured in relation to the build-up of estimates, and to the collection of actuals. The budget assumes special importance in project environments as the only basis against which to measure achievement.

Project operating budget is developed initially from the original project budget approved at the conceptual stage. Once the key stages of the project have been identified and the logic developed, the budget can be divided and apportioned to each stage. Operating budget is derived from the work breakdown structure, initially focused on the key stages of the plan. Cost for each key stages are assessed based on the level of details developed and identified at the time. As we layer the plan progressively, the operating budget for each key stage is developed. As the detailed budget for each key stage is derived, we must compare the total with the project budget and analyze the variance. Any negative deviations must be subject to close scrutiny and action planning to determine what action, if any, be taken to contain the situation. Operating budget may include costs divided into the following types: -

1. Capital Costs

 Usually associated with purchased items that can be depreciated.
 Capital costs can be determined with reasonable accuracy from tender and quotations and allowances made for inflationary effects.


2. Revenue Costs

Written off as running costs of the project, i.e. all except the people cost and contract.
The revenue costs are often derived by a rule of thumb based on factors such as length of the project and the number of people involved.

3. People Costs

Measured as time and converted to a charge rate for costing, often with normal working hour and overtime working rates. The people costs are attributed to the project in a variety of ways from zero through to accurate analysis; based on an individual’s actual cost plus an overhead charge to cover fixed costs of the organization.

4. Contract Costs

Costs derived from valid tenders and quotations that form the basis of an official order or contract. The contract costs are derived from tenders and quotations called for all external supplies. We must check the validity of all prices quoted and preferably request such prices to be given with sufficient validity to avoid having to rebid.

5. Contingencies or Reserve

Additional funding held separate to the main budget for unforeseen events and to cover the uncertainties in the original estimates. Project contingencies is a reserve set aside by management with strict controls to ensure additional monies can be injected into the budget when problem occurs.

Cost Control

Effective control of cost gives the opportunity to forestall inevitable cost escalation, foresee potential problems and take advantage of possible savings. Cost is best controlled at source and designed into the project, not inspected in after the event. This allows us to resolve problems before they occur and to respond quickly to those that do occur.

Project Cost Control includes monitoring cost performance, ensuring that only appropriate project changes are included in a revised cost baseline, and informing project stakeholders of authorized changes to the project that will affect costs. It must be remembered that cost, time and specification are inextricably linked. Most massive overspends on projects are caused by over-runs in time or unclear and ever changing specifications. Effective control of specification and time can make the cost control task much simpler.

Several tools and techniques assist in project cost control. There must be some change control system to define procedures for changing the cost baseline. Another tool for cost control is performance measurement. The Earned Value analysis is especially useful for cost control as it helps to determine what is causing the variance and to decide if the variance requires corrective action. Computerized tools such as project management software and spreadsheets are often used to track planned cost vs. actual costs and to forecast the effects of cost changes.

Pitfalls in Costing

Trevor L. Young listed some of the common pitfalls in costing the work, which include: -

1. Misrepresentation of the scope of work statement;
2. Poorly defined scope;
3. Lack of standards and specifications;
4. Poorly defined work schedules;
5. Omissions in the WBS;
6. Poor assessment of individual skills and work rates;
7. Ignoring cost escalations and inflation effects;
8. Avoidance – especially bought-out services leading to guessing.

2 comments:

Kenley William said...

PMP Certification is highly respected within both IT & non-IT communities where strong project management skills are required. If you plan on a long term career as a project manager, then yes, even with your level of experience, I would suggest getting your PMP. You can prepare yourself for the exam in one of the PMP trainingproviders like http://www.pmstudy.com/. You can do minimal prep-work to get 40 PMI® Contact Hours and apply to PMI for PMP Exam before the class begins.

karl said...

Tax planning is the art of implementing strategies that help you reach your financial goals, be more productive and helping you pay taxes on time. Approved project budget can be followed completely if cost control is enabled and this is possible through finance planning. this article is interesting and informative.