Thus the three different perceptions of cost can result in three different time-based cost curves for a given project budget.

Three Perceptions of Project Cost

Read the Directed Reading entitled “Three Perceptions of Project Cost.”

Based on your research and reading, answer the following questions:

1. What are the differences in the ways project managers, accountants, and financial comptrollers perceive the expenses of a project?
2. How are indirect costs involved in the preparation of the budget for a project?
3. Using the typical profit and loss statement included in the Directed Reading, does it surprise you that a $1,000,000 project will generate only the Net profit shown on the bottom line of that statement? Why or why not?

You are going to be the project manager for the construction of a large warehouse for a major international company. Of course, there are many elements involved in constructing such a large facility, but this assignment will consider only one, the laying of the facility’s foundation (which is obviously preceded by site preparation and followed by the actual construction of the building).

In preparation for completing of this element of the project—laying the facility foundation—complete the following:

1. Locate a source of data for the hourly wages that will need to be paid to those who will pour and finish the concrete foundation (the Bureau of Labor Statistics of the United States government is a good source for such information). Be sure to document the source of your hourly wage data for such concrete workers.
2. Locate a source of data for the cost of a cubic yard of reinforced concrete. Be sure to document the source of your reinforced concrete cost data.
3. Assuming that eight workers will be needed for the completion of the project, that they will work five days per week for 10 hours per day, and that it will take them three full weeks to complete the pouring of the foundation, what is your estimate (based on the hourly wage data that you located) of the labor expense of pouring the foundation?
4. Assuming that the foundation will require 400 cubic yards of concrete, what is your estimate (based on the hourly wage data that you located) of the cost of the materials needed for pouring the foundation?
5. How would “Overhead charges” (review the Budgeting chapter if you do not remember learning about this term) impact the two estimates that you have calculated?
6. How would an increase in the cost of steel (one of the components of reinforced concrete) impact the budget that you had developed?
7. If the construction site was impacted by a hurricane during the preparation of the foundation (meaning that work had to be temporarily stopped), how would the overall schedule of the construction project be impacted?
Three Perceptions of Project Cost

Project cost seems to be a relatively simple expression, but “cost” is more than a four letter word. Different elements of the organization perceive cost differently, as the timing of project cost identification affects their particular organizational function. The project manager charged with on-time, on-cost, on-spec execution of a project views the “on cost” component of his responsibility as a requirement to stay within the allocated budget, while satisfying a given set of specified conditions (scope of work), within a required time frame (schedule). To most project managers this simply means a commitment to project funds inaccordance with a prescribed plan (time-based budget). Others in the organization are less concerned with the commitment of funds. The accounting department addresses expense recognition related to a project or an organizational profit and loss statement. The accountant’s ultimate goal is reporting profitability, while positively influencing the firm’s tax liability. The comptroller (finance department) is primarily concerned with the organization’s cash flow. It is that person’s responsibility to provide the funds for paying the bills, and putting the unused or available money to work for the company.
To be an effective project manager, one must understand each cost, and also realize that the timing of cost identification can affect both project and corporate financial performance. The project manager must be aware of the different cost perceptions and the manner in which they are reported. With this knowledge, the project manager can control more than the project’s cost of goods sold (a function often viewed as the project manager’s sole financial responsibility). The project manager can also influence the timing of cost to improve cash flow and the cost of financing the work, in addition to affecting revenue and expense reporting in the P&L statement.
Three Perceptions of Cost
To understand the three perceptions of cost—commitments, expenses, and cash flow—consider the purchase of a major project component. Assume that a $120,000 compressor with delivery quoted at six months was purchased. Figure 1 depicts the order execution cycle. At time 0 an order is placed. Six months later the vendor makes two shipments, a large box containing the compressor and a small envelope containing an invoice. The received invoice is processed immediately, but payment is usually delayed to comply with corporate payment policy (30, 60, 90, or more days may pass before a check is actually mailed to the vendor). In this example, payment was made 60 days after receipt of the invoice or 8 months after the order for the compressor was given to the vendor.
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 projectexpenses. In most conventional accounting systems, expenses for financial reporting purposes are recognized upon receipt of an invoice for a purchased item (not when the payment is made—a common misconception). Thus, the compressor would be treated as an expense in the sixth month.
In a conventional accounting system, revenue is recorded when the project is completed. This can create serious problems in a long-term project in which expenses are accrued during each reporting period with no attendant revenue, and the revenue is reported in the final period with little or no associated expenses shown. The project runs at an apparent loss in each of the early periods and records an inordinately large profit at the time revenue is ultimately reported—the final reporting period. This can be seriously misleading in a long-term project which runs over a multi-year period.
To avoid such confusion, most long-term project P&L statements report revenue and expenses based on a “percentage of completion” formulation. The general intent is to “take down” an equitable percentage of the total project revenue (approximately equal to the proportion of the project work completed) during each accounting period, assigning an appropriate level of expense to arrive at an acceptable period gross margin. At the end of each accounting year and at the end of the project, adjustments are made to the recorded expenses to account for the differences between actual expenses incurred and the theoretical expenses recorded in the P&L statement. This can be a complex procedure. The misinformed or uninformed project manager can place the firm in an untenable position 329330by erroneously misrepresenting the project’s P&L status; and the rare unscrupulous project manager can use an arbitrary assessment of the project’s percentage of completion to manipulate the firm’s P&L statement.
There are several ways by which the project’s percentage of completion can be assessed to avoid these risks. A typical method, which removes subjective judgments and the potential for manipulation by relying on strict accounting procedures, is to be described. In this process a theoretical period expense is determined, which is divided by the total estimated project expense budget to compute the percentage of total budget expense for the period. This becomes the project’s percentage of completion which is then used to determine the revenue to be “taken down” for the period. In this process, long delivery purchased items are not expensed on receipt of an invoice, but have the value of their purchase order prorated over the term of order execution. Figure 2 shows the $120,000 compressor in the example being expensed over the six-month delivery period at the rate of $20,000 per month.

Cash Flow—The Comptroller’s Concern
The comptroller and the finance department are responsible for managing the organization’s funds, and also assuring the availability of the appropriate amount of cash for payment of the project’s bills. Unused funds are put to work for the organization in interest-bearing accounts or in other ventures. The finance department’s primary concern is in knowing when funds will be needed for invoice payment in order to minimize the time that these funds are not being used productively. Therefore, the comptroller really views project cost as a cash outflow. Placement of a purchase order merely identifies a future cash outflow to the comptroller, requiring no action on his part. Receipt of the invoice generates a little more interest, as the comptroller now knows that a finite amount of cash will be required for a particular payment at the end of a fixed period. Once a payment becomes due, the comptroller provides the funds, payment is made, and the actual cash outflow is recorded.
It should be noted that the compressor example is a simplistic representation of an actual procurement cycle, as vendor progress payments for portions of the work (i.e., engineering, material, and delivery) may be included in the purchase order. In this case, commitment timing will not change, but the timing of the expenses and cash outflow will be consistent with the agreed-upon terms of payment.
The example describes the procurement aspect of project cost, but other project cost types are treated similarly. In the case of project labor, little time elapses between actual work execution (a commitment), the recording of the labor hours on a time sheet (an expense), and the payment of wages (cash outflow). Therefore, the three perceptions of cost are treated as if they each occur simultaneously. Subcontracts are treated in a manner similar to equipment purchases. A commitment is recorded when the subcontract is placed and cash outflow occurs when the monthly invoice for the work is paid. Expenses are treated in a slightly different manner. Instead of prorating the subcontract sum over the performance period, the individual invoices for the actual work performed are used to determine the expense for the period covered by each invoice.
Thus the three different perceptions of cost can result in three different time-based cost curves for a given project budget. Figure 3 shows a typical relationship between commitments, expenses, and cash outflow. The commitment curve leads and the cash outflow curve lags, with the expense curve falling in the middle. The actual shape and the degree of lag/lead between the curves are a function of several factors, including: the project’s labor, material, and subcontract mix; the firm’s invoice payment policy; the delivery period for major equipment items; subcontract performance period and the schedule of its work; and the effect of the project schedule on when and how labor will be expended in relation to equipment procurement.
The conscientious project manager must understand these different perceptions of cost and should be prepared to plan and report on any and all approaches required by management. The project manager should also be aware 330331of the manner in which the accounting department collects and reports “costs.” Since the project manager’s primary concern is in the commitments, he or she should insist on an accounting system which is compatible with the project’s reporting needs. Why must a project manager resort to a manual control system when the appropriate data can be made available through an adjustment in the accounting department’s data processing system?

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