Integration of Income Management and Cost Management: A Complementary for Financial Analysis of Projects. Abstract. Introduction

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1 Integration of Income Management and Cost Management: A Complementary for Financial Analysis of Projects Puian Masudifar, Deputy CEO, VIRA Consulting Engineers Fereydoun Fardad, Aryana Project Management Institute Abstract Many project-based companies earn their profit out of their invoices, which can be named as their income of project execution. Generally, this income is earned during the execution of project parallel to project expenditures and costs. These companies are required to analyze their financial situation based on cost and income factors. Based on professional experiences of the authors, it is essential that income management processes be integrated with those in cost management. This paper proposes some specific methods to define income management processes in planning and controlling stages align with those in cost management. By this process definition and integration, the authors introduce various analyses, which the most important of them are funding requirements and profitability of project through the project life cycle, profitability of project work packages to take risk response strategies, performance measurement indexes of income factors, as well as forecasting indexes similar to Earned Value indexes. Introduction Generally, scope, time, cost, and quality are considered as project objectives. Among these items is the one that is related to money and financial issues cost. Many projects especially those that are executing for an external customer, the income factor will be so critical in managing the project. In these types of projects the project management team is in charge of managing the process of earning the income of project. Obtaining customers approval on project deliverables, preparing invoices and communicating with them about financial issues of the project is the responsibility of the project management team. The difference between income and costs determines the profit of accomplishment of the project for the performing organization (generally a contractor). A desired profit can be achieved if they can maximize their income while they are trying to reduce their costs. Thus, income management is an integral part of the project s financial resource management, and the processes of both cost and income management should be able to be integrated with each other. Due to this, successful management of project cash flows and financial issues depends on successful management of both income and cost factors alongside each other. This paper, which is prepared based on professional experiences of the authors, introduces income management processes align with cost management processes as well as the analysis and benefits that can be gained from integrated management of them. What is Cost Management? Cost Management Cost can be considered as the money that should be paid to accomplish a project and cost management is the effort needed to appropriately manage the financial resources required in a project. The PMBOK Guide (PMI, 2008) defines cost management as estimating, budgeting, and controlling costs so that the project can be completed within the approved budget. This standard introduces three processes for cost management: Estimate Costs, Determine Budget, and Control Costs. By the concept of process groups in this standard, two steps for cost management can be defined: Cost planning and Cost control. One of the most important outputs of cost planning is Cost Baseline (see Exhibit 1). 1

2 In this illustration, cost is committed money that should be expended during the project. The time a cost occurs is the time when the related work should be performed not the time that should be paid for that work. This concept is also applicable in the controlling step in which the actual cost is not the amount of money really paid for the work performed but the money committed to expend for the work actually performed. Exhibit 1 Cost baseline, expenditures, and funding requirements. Again based on the Exhibit 1, required funds should be available for project expenditures (the time that money should be paid). The amount of funds that a performing organization (e.g., a contractor) has to prepare strictly is dependent to its earnings, which can be named the organizations income. Cost Planning Cost planning is the first step of cost management in which the amount of financial resources needed for project accomplishment is determined. The most important outputs of this step are the estimated costs for each activity (or work package) and the total budget of a project (also known as Budget At Completion [BAC]). When the estimated cost is merged with the project schedule, a time-phased diagram is achieved, which is named the Cost Baseline. The cost baseline is developed as a summation of the approved budgets by time period and is typically displayed in the form of an S-curve, as is illustrated in Exhibit 1. There are three common approaches to estimate cost of a project: Top-Down Approach: This approach generally is based on an analogy with similar previous projects. In a professional manner this approach is not reliable enough and can be utilized as a cross-control method, which compares the determined budget with the desirable budget in the mind of management or the customer. Quantity-Based Approach: This approach uses a bill of quantity, price list, etc., in the organization or industry as the basis of prediction. Commonly, estimators use this kind of list separately with no specific relation to project Work Breakdown Structure (WBS). In a well-developed project management system, a WBS can be mentioned as the center of project integration. Because the quantity base approach generally breaks down the final product of the project based on the provided list or items and doesn t cover the project WBS, it can t be take into account as a good practice of systematic project management. Bottom-Up Approach: This is the solely acceptable cost estimating approach in an integrated system. This approach can utilize various techniques such as expert analysis, parametric estimating, pert estimating, etc., but should maintain a bottom-up approach based on project WBS. (See Exhibit 2.) 2

3 Exhibit 2 Levels of a project. A bottom-up approach based on project WBS can be integrated into the total project management system and enable the project management team to analyze financial situation of the project further. Cost Control Earned Value Management (EVM) techniques are well-known and valid techniques for cost control. EVM is a suitable method for integrating the project management system of a project and is a powerful method to analyze project as well. To establish an EVM system in a project it is necessary to have: A strong, reliable and appropriate WBS; A sound definition of control accounts. Control accounts are simply the cross point of WBS and OBS in a specific management selected level of the WBS. Exhibit 3 Control accounts. EVM has three basic parameters that should be determined properly: Planned Value (PV), Actual Cost (AC) and Earned Value (EV). By means of just these three items, a project can be analyzed from two viewpoints. One viewpoint looks to the past performance of the project and another viewpoint gives the project management team a sense of the project future situation by forecasting. Each of these viewpoints has specific indexes. Past performance measurement indexes are: Schedule Variance (SV), Schedule Performance Index (SPI), Cost Variance (CV) and Cost Performance Index (CPI). Forecasting indexes are: Estimate At Completion (EAC), To Complete Performance Index (TCPI), Estimate To Complete (ETC) and Variance At Completion (VAC). Exhibit 4 shows these indexes. 3

4 (VAC) Exhibit 4 EVM indexes. Income Management What is Income Management? Income is the monetary revenue belongs to performing organization (Contractor) because of accomplishing the project that can determine the organization s profit. Profit of project can be calculated by subtracting project costs from project incomes. Primarily providing the required funds of project is the responsibility of the project sponsor, although the sponsor uses the project management team s efforts for that. Since many times the required funds should be provided from the project income, the sponsor needs to put in place the appropriate process for income management of the project. (See Exhibit 1.) In a systematic approach it is necessary to integrate income management processes with the total project management system, especially cost management processes. Thus, income management processes must follow cost management processes. Similar to cost management, two specific processes (steps) are definable for income management: Income Planning and Income Control. Income Planning Income planning is the first step of income management in which the amount of monetary resources can be gained from the customer is determined. The most important outputs of this step are the estimated income for each activity/work package (or control account or project phase) and the total income of project accomplishment (total income). When the estimated income is merged with the project schedule, a time-phased diagram is achieved, which can be named the Income Baseline. The income baseline is developed as a summation of the expected incomes by time period. Planning the income is tightly related to project contract. It is the contract that can determine when invoices can be issued and project earnings can be achieved. Normally, baselines have two distinct types: Continues Type: This type is typically displayed in the form of an S-curve, as is illustrated in Exhibit 5(a). Generally, cost reimbursable contracts and contracts with time-phased invoices can be put into this category. Discrete Type: In this type, there are specific times (weighted milestones/ phases) in the project lifecycle for invoicing. Generally, fixed price contracts take place in this category. See Exhibit 5(b). 4

5 Exhibit 5 (a) Income baseline continues, (b) income baseline discrete. Similar to cost estimating, income estimating has to follow a bottom-up approach. Even if there is a price list attached to the contract, income should be calculated in as much detail as possible regarding to WBS (in the level of activities, work packages, control accounts or at least specific phases of the contract). Integrating income management processes with cost management processes can give the project management team directions to determine control accounts appropriately. Contract constraints are determinant in this issue. Sometimes in the calculations, it is needed to adjust cost and/or income with the current situation of prices because of some issues like inflation. The project management team is responsible for taking appropriate solutions to make such an adjustment. Income Control For income control an effective method can be benchmarked from EVM. This benchmarked method can be named Earned Income Management (EIM). Similarly EIM has three basic parameters that should be determined properly: Planned Income (PI), Actual Income (AI), and Earned Income (EI). EIM has its own controlling indexes like EVM from two viewpoints as well: Past performance measurement indexes are Income Variance (IV) and Income Performance Index (IPI) as well as Schedule Variance based on Income and its relevant performance indexes (SVi & SPIi); Exhibit 6 Past performance measurement indexes for income. Forecasting indexes are Income Estimate At Completion (EACi), Income Estimate To Complete (ETCi), and Income Variance At Completion (VACi). 5

6 Exhibit 7 Forecasting indexes for income. Benefits and Analysis Gained From this System Many benefits are achievable via analyzing cost status (EVM analysis) or income status (EIM analysis) of the project individually. In addition, by analyzing the situation of the project, based on cost and income factors simultaneously, especially by comparing relevant factors, many benefits and analysis will be achieved as well. Below some of these analyses are introduced. Calculating the Profitability of Activities (or Work Packages) In a project there are many work packages. Some of these work packages can be profitable and some can be nonprofitable. It is the total profitability of whole work that determines project profit. Awareness of profitable and non-profitable works helps the project management team in better management of a project; for example, in reducing costs, having the staffs trained in weak areas, etc. Helping to Decide Whether to Outsource a Work Package or Not If a work package is not profitable it may means that the organization doesn t have enough facilities or resources to do that specific job. Typically, organizations prefer to outsource their non-profitable work packages. By taking this strategy they can turn non-profitable items to profitable items or at least complete them with minimum loss. Integrated cost and income management processes can be helpful on this issue. Defining Profitable Activity Groups In many projects, different activities (or work packages) belong to a specific activity group (e.g., concrete works, installation, etc.). The major share of project activities can be grouped into a bunch of determined groups. A Functional Work Breakdown Structure (FWBS) is a good technique to define project activity groups. Grouping project activities makes this obvious to the project management team, and helps determine which activity groups are profitable and which are non-profitable. Generally, profitable activity groups of a project belong to the core business of the organization and others are just an unrejectable part of the project (contract). With non-profitable activity groups, an organization can put an outsourcing strategy in place or try to empower itself by trainings or hiring better resources. Assisting on Defining Risk Response Strategies Based on obtained analyses and an organization s risk threshold, financial risks of the project can be better identified and relevant response strategies can be better adjusted. Avoiding, mitigating, or transferring a risk would be decided based on profitability of work packages, and contingency plans for accepted risks will be 6

7 devised accordingly. As an instance, risks that can menace profitable work packages can be avoided or mitigated while the threat that a work package becomes non-profitable can be transferred. Assisting on Deciding About Change Requests If a change request (especially a scope change) arises, it can be analyzed by considering the profitability factor in an integrated change control process. Determining Customer s Financial Obligation Although the income baseline is useful within the project management team, it can shows the project customer his/her own time phased funding obligations. As there is a difference between the cost baseline and project expenditures (see Exhibit 1), there is also a difference between the income baseline and invoice payment. Based on income baseline and contract provisions, a time phased invoice payment diagram (the customer s obligation) will be determinable. Clearing customer s financial obligations can help to maintain a better interaction between two parties and can avoid later changes in the project by a better planning in advance. Determining Project Profitability Areas Through the Time Comparing a cost baseline and an income baseline of a project can gives the project management team a vision of profitability periods of the project and determination of where the breakeven point of the project stands. The breakeven point is the point in which profit and loss of project are equal. At this point the profitability condition of project turns. A project can have more than one breakeven point or even no breakeven point. The variance between total income (IAC) and total cost (BAC) defines the final desired profit of project. Exhibit 8 shows some possible conditions of a project, regarding to its profit and loss periods. Exhibit 8 Some examples of possible breakeven points in a project. Deciding on Whether to Participate in a Project or Not Income of a project is the commitment of the customer. When a project is in its loss area, it needs to be funded by the project sponsor internally. The funded monetary resources will be returned later when the project falls into its profit area. By this analysis, contractors would be able to adjust the project, based on their financial potential and if they don t have enough financial capacity, accepting the project is a mistake that leads the organization towards failure. Determining Actual Profitability of the Project Actual profitability of the project is the result of comparison of the project s actual cost and actual income. With this comparison, the actual breakeven point of project will be determinable. Exhibit 9 illustrates this concept. 7

8 Helping on Schedule Compression and Leveling Exhibit 9 Actual profitability of the project. The analyses assist the project management team on optimizing project schedule by using activities floats. Nonprofitable activities can be postponed to maintain the balance of profitability of the whole project or until the time when financial resources become available to the project. On the contrary, high profitable activities can be considered as the financially critical activities that shouldn t be delayed so that their income can be gained earlier. Also in a schedule compression, profitable activities are first nominated activities for crashing or fast tracking rather than non-profitable activities. Helping on Contractual Claims Analyses based on cost and income baselines can help on better management of claims. Non-profit areas can be triggers and motives lead the contractor to contractual claims. As well, making a delay (a schedule change) in the project by the customer may change profitability diagrams and cause the contractor s resistance unless a compensation solution is put into place. Lessons Learned By implementing such integrated cost and income processes in various projects, the authors have obtained valuable lessons learned. The authors recommend project management teams to follow the following guidelines for implementing an integrated financial system in projects. Tactical Lessons Learned Training is a key success factor. Project management teams need to be trained about the system. Obtaining senior management support on developing a new system is another key success factor for this system. Implementing the system in all projects and sharing the lessons learned should be directed by organization s PMO. Sharing project profit with project team can be an effective incentive to reduce project costs. Technical Lessons Learned The WBS is the most important part of project planning, which is able to integrate other planning parts, so it is necessary to spend enough time to create a sound and well-structured WBS. Planning should be done in the lowest possible level of WBS, but if it isn t applicable, try upper levels. Determining control accounts (CAs) appropriately is very important. Project requirements, contracts, and an established payment system can be good guidelines to determine correct CAs. Note that each CA has to have only one responsible party. To have more reliable outcomes and analyses (especially about project profit), including indirect costs in cost estimating. To have more detailed and more useful reports to help improve the accounting and warehousing systems. 8

9 Record costs and incomes what is done today but will be paid tomorrow should be recorded as today s cost or income. Similarly, the money spent yesterday for the work supposed to be done today, should be recorded as today s costs. To analyze project data, try to develop beneficial databases and computer programs. Schedule indexes (SV, SPI, and even Earned Schedule) in EVM and also in EIM are not sufficiently reliable indexes to analyze project schedule. The Critical Path Method definitely gives more accurate analyses about schedule status. References Project Management Institute. (2008). A guide to the project management body of knowledge (PMBOK guide) (4 th ed.). Newtown Square, PA: Project Management Institute. Callahan, K. R., Stetz, G. S., & Brooks, L. M. (2011). Project management accounting: Budgeting, tracking and reporting cost and profitability (second edition). New Jersey: John Wiley & Sons, Inc. International Project Management Association (IPMA). (2006). ICB- IPMA competence baseline. (Version 3.0), Netherlands: IPMA. Project Management Institute. (2005). Practice standard for earned value management. Newtown Square, PA: Project Management Institute Inc. Project Management Institute. (2006). Practice standard for work breakdown structures (second edition). Newtown Square, PA: Project Management Institute Inc. Project Management Institute. (2011). Practice standard for project estimating. Newtown Square, PA: Project Management Institute Inc. Stockman,W. K., Kammerer, J. T., & King, D. R. (2002). The relationship between cost analysis and program management. The Journal of Cost Analysis & Management, Special Edition, (pp. 1-7). 9