MA CONSTRUCTION MANAGEMENT

TOPIC:BUDGETING AND CASH FLOW PLANNING AND

CONTROL, FINANCING OF CONSTRUCTION

BUDGETING

• Defining � a budget• � Establishing the project budget, including

elements thereof• Executing the budget�• Controlling the budget� (including approaches

to budgetary control)• Updating the budget � (including causes and

reasons)

Definition• A project budget is the total sum of money allocated for the

particular purpose of the project for a specific period of time. • It’s one thing to understand the total amount of funding that

will be available for the project, but it’s another to understand how much must be dedicated to the Different categories of project costs

• The goal of budget management is to control project costs within the approved budget and deliver the expected project goals.

• A successful project is one that meets four success criteria: that the project’s scope is delivered on schedule, it is delivered within budget and, once delivered, it meets the quality expectations of the client and users.

Definition (cont’d)• Project Budgeting is performed at the initial stages of project

planning and usually in parallel with the development of the project schedule.

• The steps associated with budgeting are highly dependent on both the estimated duration of tasks and the resources assigned to the project.

• Budgeting serves as a control mechanism where actual costs can be compared with and measured against the budget.

• When a schedule begins to slip, cost is proportionally affected. When project costs begin to escalate, the project manager should revisit the Project Plan to determine whether scope, budget, or schedule needs adjusting.

Why have a budget for a Project?The budget is an essential management tool. Without a budget, you are like a pilot navigating in the dark without instruments.

• The budget tells you how much money you need to carry out your activities.

• The budget forces you to be rigorous in thinking through the implications of your activity planning.

• Used properly, the budget tells you when you will need certain amounts of money to carry out certain activities.

• The budget enables you to monitor your income and expenditure and identify any problems.

• The budget is a basis for financial accountability and transparency. • You cannot raise money from donors or financiers unless you have a

budget. Donors use the budget as a basis for deciding whether what you are asking for is reasonable and well-planned.

Establishing the Project Budget• The project manager is responsible to estimate the budget required to

complete project activities. • The Project Manager should allocate costs to project activities, and all

aspects of the project, including the cost of internal and external human resources, equipment, travel, materials and supplies.

• The budget should become more detailed and more accurate as it project progresses to implementation stage.

• The first step involve determining what resources (people, equipment, services, and material) and the quantities of those resources are required to complete the project.

• The projects’ WBS, scope statement, historical information, resource information, and policies are inputs used to determine the resources for the project.

• The main output is a list of resources requirements that provides the basis for budget estimating and budget controls

Establishing the Budget (cont’d)• Once all project requirements have been documented, the

next step is to determine the costs of each requirement which will result in the creation of the project budget.

• As with developing a project schedule, documenting assumptions made while developing the project budget is critical to the success of the project. Without clear documentation, tracking the budget is difficult and risky.

• Project budgeting typically requires more than one person. A good process is to have the same people who reviewed the WBS activity list and schedule review the budget.

• There are three types of budget estimates that occur during the project cycle, these estimates – rough order of estimate, contract and definitive, vary primarily on when they are done, how they are used and how accurate they are.

Establishing the Budget (cont’d)

• The required levels of accuracy of construction cost estimates vary at different stages of project development, ranging from ball park figures in the early stage to fairly reliable figures for budget control prior to construction.

• Generally, the accuracy of a cost estimate will reflect the information available at the time of estimation.

• In spite of the many types of cost estimates used at different stages of a project, cost estimates can best be classified into three major categories according to their functions. A construction cost estimate serves one of the three basic functions: design, bid and control.

Establishing the Budget (cont’d)

• Design Estimates. For the owner or its designated design professionals, the types of cost estimates encountered run parallel with the planning and design as follows: – Screening estimates (or order of magnitude estimates) – Preliminary estimates (or conceptual estimates) – Detailed estimates (or definitive estimates) – Engineer's estimates based on plans and specifications

• For each of these different estimates, the amount of design information available typically increases.

Establishing the Budget (cont’d)

• Bid Estimates. For the contractor, a bid estimate submitted to the owner either for competitive bidding or negotiation consists of direct construction cost including field supervision, plus a markup to cover general overhead and profits. The direct cost of construction for bid estimates is usually derived from a combination of the following approaches. – Subcontractor quotations – Quantity takeoffs – Construction procedures.

Establishing the Budget (cont’d)

• Control Estimates. For monitoring the project during construction, a control estimate is derived from available information to establish: – Budget estimate for financing – Budgeted cost after contracting but prior to construction – Estimated cost to completion during the progress of

construction.

Elements of Project Budget

The capital cost for a construction project includes the expenses related to the initial establishment of the facility:

• Land acquisition, including assembly, holding and improvement • Planning and feasibility studies • Architectural and engineering design • Construction, including materials, equipment and labor, contractor’s overhead

and profit, insurance and bonds• Field supervision of construction • Construction financing and legal Fees• Statutory fees and taxes • Contingencies for project’s unknowns or risks, cost estimation, design, bid,

construction, cost escalation.• Equipment and furnishings not included in construction • Commissioning, inspection and testing

Elements (cont’d)• The magnitude of each of these cost components depends on the

nature, size and location of the project as well as the management organization, among many considerations.

• The owner is interested in achieving the lowest possible overall project cost that is consistent with its investment objectives.

• It is important for design professionals and project managers to note that while the construction cost may be the single largest component of the capital cost, other cost components are not insignificant. For example, land acquisition costs are a major expenditure for building construction in high-density urban areas.

• From the owner's perspective, it is equally important to estimate the corresponding operation and maintenance cost of each alternative for a proposed facility in order to analyze the life cycle costs.

Approval of a Budget

• The final steps in estimating the budget is to get approval. The completed project budget should be reviewed by the project team and be reviewed by the representative from the finance department.

• Approval of the project budget can result in negotiations between the client and the donor, depending on the size of the budget these negotiations can take some time before the budget is approved and a contract is signed.

EXECUTING THE BUDGET• Budget Baseline - Once the project budget has been reviewed and

approved, a budget baseline is created . The baseline is a time-phased budget that project managers use to measure and monitor budget performance.

• The baseline will be used to compare with the actual costs incurred by the project as it makes progress.

• Publish Budget - The approved budget needs to be communicated to all people that will use it to monitor, control and make decisions based on the information of the budget.

• Budget Execution – this is the action of authorizing the expenses approved on the project budget. This step occurs after the budget has been approved and the project authorized to start its activities according to the project plan.

• At this moment the finance department of the client’s organization and the donor has established the disbursement schedule that will put financial resources on a bank account available for the project.

BUDGET CONTROL• Controlling the budget is a critical responsibility of the project

manager.• Monitoring and controlling the project budget ensures that only

the appropriate project changes are included in the budget baseline, that information about authorized changes are communicated and corrective actions are taken by those in charge.

• The following are some of the approaches to budget control:

1) Budget Reporting• Reports from the finance unit, request for purchase approval from

the procurement unit, and reports from the project team are used to track the project budget and provide a picture of how the project spending is tracking with the budget.

• Typical budget report shall contain the following:

Budget Control (cont’d)

• Expense Reports - provide the expenses to date by account, project number and funding code.

• �Variance Reports - show the difference between what has been expensed and the approved budget, the balance for each account.

• Burn Ratio Reports - shows the rate at which the project is using the budget according to the original plan, a quick method to see if the project budget is on track.

• Project reports contain direct project expenses, administrative or overhead expenses and personnel costs including benefits.

Budget Control (cont’d)2) Budget Performance• Budget performance is the activity to see if the project expenses are being

executed according to the budget plan and helps identify deviations and develop corrective actions.

• The project manager needs to track actual expenditures in addition to accounting reports, and all monetary commitments made to vendors or consultant in the form of contracts or purchase orders that will only be recorded on the accounting system once the invoices are paid.

3) Earned Value Management• Earned Value Management (EVM) is a project management technique that

measures project progress objectively. EVM combines measurements of scope performance, schedule performance, and cost performance, within a single integrated methodology. EVM provides an early warning of performance problems while there is time for corrective action.

Budget Control (cont’d) EVM improves the definition of project scope, prevents scope creep,

communicates objective progress to stakeholders, and keeps the project team focused on achieving progress. EVM involves calculating three values for each activity or objective from the project’s WBS

• Planned Value (PV), is the total budget for an activity or the planned budget to be spent on an activity during a give period.

• Actual Cost (AC), is the total direct and indirect costs incurred in accomplishing work on an activity during a given period.

• Earned Value (EV), is the percentage of work actually completed multiplied by the planned value.

• Cost Variance (CV) = EV – AC, it shows the difference between the estimated cost of an activity and the actual costs of the activity. A negative value means that the work done cost more than planned .

• Schedule Variance (SV) = EV – PV, shows the difference between the schedule completion of an activity and the actual completion of that activity. A negative schedule means it took longer than planned to perform the work of an activity, and vice versa.

Budget Control (cont’d)• Cost Performance Index (CPI), is the ratio of EV to AC and is used to estimate

the projected cost of completing the project. A CPI equal to one or 100% means the planned and actual costs are equal or the costs equal the budget. A value of less than 1 or less than 100% means the project is over budget, if the CPI is greater than one or more than 100% then the project is under budget, a valuable indicator to know if the project budget is being used as planned and helps the project manager avoid surprises at the end of the project.

• � Schedule Performance Index (SPI), is similar to the CPI, is used to estimate the projected time to complete the project. A schedule performance index of one or 100% means the project is on schedule, a value greater than one or higher than 100% means the project is ahead of schedule, a value of less than one or less than 100% means the project is behind schedule.

• Negative values on the performance indices means the project is either running out of money faster than planned or will take longer than planned, these are the value a project manager needs to monitor.

BUDGET UPDATE Budget Changes• Updates to the budget come from approved changes to the

budget.• For most projects changes to the budget need to be approved

by the donor, in some instances the donor can give the project a small percentage that the project can use to cover small budget modifications.

• In other instances the donor may have strict limitations to allow budget changes.

• Other type of changes comes from causes external to the project that may limit the activities or work it needs to perform. Civil unrest or another critical event may cause the cancellation of project activities.

Budget Update (cont’d)• Other changes come from the donor who may reduce the original project

budget or changes caused by currency fluctuations that impact the funding available to the project.

• Approved changes to the budget will need to be reflected in the accounting system and new project budget reports will need to reflect this change.Corrective Actions

• Some project may include a predefined limit by which a project may be under or over budget during the project implementation phase, it is usually set as a small percentage of the total, if the project is above the defined limit then the project manager needs to take corrective actions to bring the budget back on track, these actions may include reducing the scope or lowering the quality.

• Corrective actions may include the use of alternative options to produce the similar output using different inputs, the project manager will implement them and monitor their performance to see if they are effective in reducing the project expenses and help bring the project back on track.

• Capture Lessons Learned• The lessons can apply to the remainder of the project activities or

to future projects. • The lesson captured need to be written as action steps that the

project will monitor and evaluate in the next reporting period. It makes no sense for a project to capture lessons if the lessons are not used.

• Communicate Changes• Changes to the budget need to be communicated and incorporated

on the system that track cost performance. Communicating the changes of the budget to the people that will use the information helps reduce the chances that work will be done on activities that have been either cancelled or postponed

PROJECT CASH FLOWS

• Elements of cash flow• � Characteristics of project cashflow• Cash flow planning�• Cash flow tracking and control�

ELEMENTS OF CASH FLOW

• A project’s cash flows are composed of

– Cash flow from operations

– Cash flow from investments in NWC

– Cash flow from investments in plant and equipment

Cash Flow Projection

• Projection of Income and expenses during the life of the project

• Several time scheduling aids used by contractor

Project S-Curve

• Duration

• SR

• Owner requires contractor to provide an S curve of estimated progress and costs

• Cumulative costs across the duration of the project

• A graphical portrayal of the outflow of monies (both direct & indirect)

Activity Days Cost ($) Cost/dayA 2 200 100B 5 500 100C 2 200 100D 7 500 71.4E 1 100 100F 2 100 50

Cash Flow

Source: Dr. L. K. Gaafar

Cash Flow (cont’d)

Day Activity Cost of day Total cost1 A 100 1002 A 100 2003 B 100 3004 B 100 4005 B 100 5006 B 100 6007 B 100 7008 C,D 171.4 8719 C,D 171.4 104310 D,E 171.4 121411 D 71.4 128612 D 71.4 135713 D 71.4 142814 D 71.4 150015 F 50 155016 F 50 1600

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Cumulative Expenses

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Cash Flow to the Contractor

• Progress Payments - Flow of money from owner to the contractor

• Estimates of work completed by the contractor periodically and (usually monthly) and verified by owner’s reps

• Evaluation based on type of contract– Lump Sum: Percentage of total contract

completion– Unit Price: Actual field measurements of

work completed

Progress Payments

• Contractor prepares a monthly progress claim (bill) usually at the end of each month

• The Owner evaluates the bill and pay contractor within the time period stipulated in the contract (usually within 30 days)

• Owner keeps a Retention of 10% from each payment (usually until cumulative progress bills reach 50% of the total contract sum)

Sample S Curve

Contractor’s Income Profile

• $

• Duration

Stair-step appearance since the progress payments are paid in discrete amounts

$

Duration

• Clear indication of expenses and income

• The difference between Expenses and revenue makes it necessary for the contractor to obtain temporary financing

Contractor’s Expenses and Income Profile

Expenses and Income Profiles

Contractor’s Financing

• Usually a bank extends a line of credit against which the contractor can buy materials, make payments and pay other expenses while waiting for reimbursement from owner.

• Bank charges interest on the outstanding balance (overdraft) • Good policy to try to minimize overdraft

Overdraft depends on

• Amount of markup (or profit) applied to contractor’s bid• Amount of Retention withheld by the owner• Delay between billing and payment by the owner

Overdraft Requirement

• The contractor needs to know what is the maximum overdraft during the construction project

• Uses Income and expenses profiles to asses the overdraft

• Tabulate the expenses and revenues and find the maximum overdraft

Banks evaluation of construction contractors

• High risky borrowers• If the contractor defaults, the loan is

secured only by some materials inventories and partially completed construction

• Charges very high interest rates on borrowings

• Some contractors offset the overdraft borrowing requirement by requesting mobilization, money from owner

• Influence of mobilization on payment and income profiles• Some owners issue 20% of the advance payment at the

inception against a bank guarantee submitted by the contractor

• The advance payment recovered in each progress payment at a rate of 20%.

• Since the owners are less risky than the contractors, they can borrow short-term money at a lower interest rates

• Transfer the interim financing requirement from contractor to the owner

• Overall cost savings to owner and the contractor

Mobilization Advance Payment

Expenses and Income Profiles (with mobilization advance)

Contractor's Expenses and Owner's Payments

Cash flows - Conclusion• Projection of Income and expenses during

the life of the project is very critical.

• The difference between Expenses and revenue makes it necessary for the contractor to obtain temporary financing

• Usually a bank extends a line of credit against which the contractor can buy materials, make payments and pay other expenses while waiting for reimbursement from owner

FINANCING OF CONSTRUCTION

• Sources of funds (including financier requirements/ qualification requirements)

• Different financing options or arrangements�• Evaluation of alternative financing plans�

SOURCES OF FUNDS• Investment in a constructed facility represents a cost in the short term

that returns benefits only over the long term use of the facility. Thus, costs occur earlier than the benefits, and owners of facilities must obtain the capital resources to finance the costs of construction.

• Finance is also a concern to the other organizations involved in a project such as the general contractor and material suppliers. Unless an owner immediately and completely covers the costs incurred by each participant, these organizations face financing problems of their own.

• The project finance problem is to obtain funds to bridge the time between making expenditures and obtaining revenues.

• A contractor would receive periodic payments from the owner as construction proceeds. However, a contractor also may have a negative cash balance due to delays in payment and retention of profits or cost reimbursements on the part of the owner.

Sources for the Client• Plans considered by owners for facility financing typically have both

long and short term aspects. • In the long term, especially for public institutions or clients, sources of

revenue include sales, grants, and tax revenues. Borrowed funds must be eventually paid back from these other sources.

• In the short term, a wider variety of financing options exist, including borrowing, grants, corporate investment funds, payment delays and others. Many of these financing options involve the participation of third parties such as banks or bond underwriters.

• For private facilities such as office buildings, it is customary to have completely different financing arrangements during the construction period and during the period of facility use. During the latter period, mortgage or loan funds can be secured by the value of the facility itself.

Sources for the Client (cont’d)

• The main sources of long-term finance are retained profits, share issues and debentures.

• Others include: Commercial finance companies; Balance Sheet Financing; Pure Project Financing; Syndicate Loans;

Sources for Contractor• The options for borrowing by contractors to bridge their expenditures and receipts

during construction are relatively limited. • A contractor’s principal physical asset, equipment which also moves from site to site,

is subject to rough treatment and has a useful life of just a few years. As a result these assets provide a very narrow collateral base.

• For small or medium size projects, overdrafts from bank accounts are the most common form of construction financing.

• Usually, a maximum limit is imposed on an overdraft account by the bank on the basis of expected expenditures and receipts for the duration of construction. Contractors who are engaged in large projects often own substantial assets and can make use of other forms of financing which have lower interest charges than overdrafting.

• Apart from overdraft, the contractor can also use trade credits offered by suppliers. Trade credit arises when a business receives goods and services from a supplier without the requirement of an immediate cash payment.

• The amount of trade credit provided to a company depends on the company’s creditworthiness and how important the supplier considers the company to be.

Sources for Contractor (cont’d)• The main characteristics that make trade credit an attractive option to

construction companies are as follows: it is readily accessible and does not jeopardize the firm’s line of credit with the bank; it can be used to smooth out short-term cash-flow problems experienced by many small and medium-sized companies; and it is relatively inexpensive.

• Bills of exchange are effectively time drafts drawn on one company or trader by another to finance the import or export, or sale of goods.

• Bills are short-term debt instruments and are initially issued for a period of one to six months.

• Commercial papers are another form of short-term borrowing facility with maturities from seven to 364 days. Companies can thus obtain unsecured finance directly from investors, bypassing banks and bond markets, although banks are often used as agents to place the paper.

• Others are bank loans, finance houses (asset financing).

Sources (cont’d)

• In recent years, there has been growing interest in design-build-operate projects in which owners prescribe functional requirements and a contractor handles financing.

• Contractors are repaid over a period of time from project revenues or government payments. Eventually, ownership of the facilities is transferred to a government entity.

Different financing arrangements• Financing arrangements differ sharply by type of owner and by the type of

facility construction. Different institutional arrangements have evolved for specific types of facilities and organizations.

• A private corporation which plans to undertake large capital projects may use its retained earnings, seek equity partners in the project, issue bonds, offer new stocks in the financial markets, or seek borrowed funds in another fashion. Potential sources of funds would include pension funds, insurance companies, investment trusts, commercial banks and others.

• Developers who invest in real estate properties for rental purposes have similar sources, plus quasi-governmental corporations such as Housing Finance Corporation.

• Syndicators for investment such as real estate investment trusts as well as domestic and foreign pension funds represent relatively new entries to the financial market for building mortgage money.

Financing arrangements (cont’d)• Public projects may be funded by tax receipts, general revenue bonds, or special bonds

with income dedicated to the specified facilities. General revenue bonds would be repaid from general taxes or other revenue sources, while special bonds would be redeemed either by special taxes or user fees collected for the project. Grants from higher levels of government are also an important source of funds for state, county, city or other local agencies.

• Despite the different sources of borrowed funds, there is a rough equivalence in the actual cost of borrowing money for particular types of projects. Because lenders can participate in many different financial markets, they tend to switch towards loans that return the highest yield for a particular level of risk. As a result, borrowed funds that can be obtained from different sources tend to have very similar costs, including interest charges and issuing costs.

• As a general principle, however, the costs of funds for construction will vary inversely with the risk of a loan. Lenders usually require security for a loan represented by a tangible asset.

• Loans made for projects under construction represent considerable risk to a financial institution.

Financing arrangements (cont’d)

• As a result of these uncertainties, construction lending for unfinished facilities commands a premium interest charge of several percent compared to mortgage lending for completed facilities.

• Financing plans will typically include a reserve amount to cover unforeseen expenses, cost increases or cash flow problems. This reserve can be represented by a special reserve or a contingency amount in the project budget.

Evaluation of financing plans• Since there are numerous different sources and arrangements for obtaining the

funds necessary for facility construction, owners and other project participants require some mechanism for evaluating the different potential sources.

• The relative costs of different financing plans are certainly important in this regard. • In addition, the flexibility of the plan and availability of reserves may be critical. • As a project manager, it is important to assure adequate financing to complete a

project. • Alternative financing plans can be evaluated using the same techniques that are

employed for the evaluation of investment alternatives. • The availability of different financing plans can affect the selection of alternative

projects. • A general approach for obtaining the combined effects of operating and financing

cash flows of a project is to determine the adjusted net present value (APV) which is the sum of the net present value of the operating cash flow (NPV) and the net present value of the financial cash flow (FPV), discounted at their respective minimum attractive rates of return (MARR),

END

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