Financial life cycles

March 2008 » Feature Articles
Develop best practices for estimating and managing project costs.
Robert J. Maxman, P.E.

Develop best practices for estimating and managing project costs.

When a consulting engineer or planner begins a planning or design project, the project’s finances take on a life of their own. This financial life cycle starts at or before the proposal stage and lasts until the last invoice is paid. By examining the finances of a project on their own and identifying the sequence of events, decisions, and impacts on the project’s financial life, a project manager or project principal can avoid common problems and develop their own best practices for successful financial project management.

Proposal stage
When a potential project is identified, the issue of cost and the ability to earn a fair profit is usually a key element in the decision process whether to pursue the assignment. What is the client’s budget? Does one exist? Does the client have reasonable expectations for budget versus desired scope of services? Is there ample time to reasonably complete the tasks? Does the proposed form of contract allow for reasonable recovery of project costs?

At this stage, the discussions should focus on scope of service first and cost second. The cost of a project is a result not a cause. That is, the cost of a planning or design endeavor is based on the scope required or desired by the client. Schedule issues should also be defined and analyzed prior to completion of the cost estimate. If a client has a fixed budget, then the scope must be developed based on those cost restrictions, but ultimately, it is the scope that will generate the resulting cost. The client, therefore, can dictate the scope or the cost, but not both. (I know that in reality, clients seek to define both the scope and the budget, but your calculations must be based on what you estimate the assignment will cost).

At this stage, the key issue is to determine what the proposed assignment will actually cost, using the following steps:

1) Identify client expectations, needs, and issues. Make sure that you understand any political, social, or schedule issues that may affect scope or schedule.

2) Define the deliverables that the client will receive from this project. Remember, it is your task to make the client successful in the eyes of their constituents.

3) Identify the tasks that must be accomplished to generate these deliverables (work breakdown structure).

4) Estimate the effort required to accomplish each task (both in-house team effort and sub consultants, if required). Include project management and quality assurance efforts in these estimates. Internal effort is based on estimated labor cost. External effort (subs) is based on proposed contract amount with the sub.

5) Estimate the direct project costs required to support the effort (subs, travel expenses, other direct expenses).

This method of project cost estimating is called "bottom up" and requires that the project be carefully thought out and all aspects considered. A contingency (for risks known and unknown) should be added to the estimate to come up with a reasonable budget number. A series of limitations and clarifications should also be articulated to support the estimate. This estimate can be only as accurate as the scope description and your ability to estimate the effort.

How can we be reasonably sure of the effort required? The key issue is: Have we done a similar project or projects like this before? If so, do we have accurate budget and effort information for these past projects? While this may seem elementary, the issue of accurate historical information is critical and seldom realized. The factors that affect this are the following:

  • Does staff put all hours worked on their time sheets?
  • Do project managers move budgets and effort to make individual phases or tasks look good?
  • Are all direct project costs religiously charged to the correct project?

If staff—this is especially true of salaried staff—do not record all time spent on a project, you have no real record of what it costs to perform the project. If, as the project progresses, budgets are modified to make a task look good, you have no indication of how well you performed as compared with the original budget. If effort is moved from phase to phase or task to task, you have no idea how much effort it took to complete the phase or task. If travel or other direct costs were not charged to the project (regardless of whether these costs can be invoiced to the client), then you really don’t know what this project cost the firm and whether it was financially successful.

Once the cost estimate is developed based on the effort required to complete the work breakdown structure, prepare another estimate (to verify your budget) based on known benchmarks for your firm. These can include the following:

  • design fee as a percent of construction cost;
  • dollars per mile (or foot, or square feet, etc,); and
  • hours or dollars per sheet.

Remember that these benchmarks are also influenced by the accuracy of your historical information, as well as unusual schedule requirements.

Initiation stage
At the point of selection and contract negotiation, the financial life cycle takes on a new and critical role. Is the scope that is finally included in the contract identical (or at least similar) to the scope that was developed for the proposal? The contracted scope now needs to be used as the basis for a refined budget estimate. At this stage, the accuracy and risk of the budget number is based on the kind of contract that the client is willing to sign. This should be known in the proposal stage so that your costs and fee reflect the contract terms.

If the contract is such that you will be reimbursed on a time and materials (T&M) basis with a negotiated multiplier or rate schedule, and if the contract has an estimated fee, then the budget can and should also be an estimate. However, if you negotiate a lump sum agreement or a T&M contract with a "not to exceed," then the budget should be taken as a fixed amount (or maximum) for the agreed-upon scope.

This may appear to be basic and overly simplistic, but these conditions require that the terms in the contract for "out-of-scope work" or additional services be clear and well defined in terms of how the effort is identified and how the approvals are given to perform this extra work. The most pervasive reason for cost overruns on projects is scope creep. This must be dealt with at the contract stage first, and then implemented as the project proceeds. Even when dealing with an estimated fee, you must track and monitor costs and scope and inform the client of out-of-scope items before they are performed. Approval must still be obtained to ensure your ability to collect.

Execution stage
The best method to ensure that projects are proceeding in an acceptable manner financially is to have a reasonable budget breakdown based on how the project will be executed and managed. That is, a reasonable breakdown of budget by phase or task, and an effective project accounting system that gives actual versus budget progress on a regular basis.

Whether you budget based on cost or fee or earned value, the process is the same—project managers must have timely information that they review and act on that shows actual financial results versus budget.

This is the point in the project that the concept of "cost to complete" becomes critical. At project milestones (for larger projects) or at the 50-percent point (based on actual versus budget for the project as a whole), the project manager should review the contract scope, identify progress on all phases or tasks, and clearly define the work remaining. The cost of the remaining work should be estimated and added to the cost to date. The result is the new budget, which can then be compared to the original. This comparison allows for modifications in work plans, team membership, and scope negotiation with the client to ensure that the project is completed in a financially acceptable manner.

Remember: During project execution, cost is the result of the scope. If scope begins to "creep," so will the cost. The best method for ensuring that additional scope is compensated for is to communicate consistently with the client—weekly is not too often. After out-of-scope work has been performed is too late.

Communication within the project team is also a critical element in reducing scope creep. Your ability to lead and delegate is key in keeping the team on track.

It is at this stage (project execution) that the key elements of project invoicing and payment are realized. The contract should provide for at least monthly invoicing, with payment terms within 30 days and the right to stop work if payments are in arrears. A system of invoice follow-up and accounts receivable tracking and collection needs to be in place. There is no such thing a successful project that you have not been paid for.

Project close out
It has been said all too often, "The last 10 percent of a project always seems to take 25 percent of the budget." This is, of course, a lie; the last 10 percent of the project was really the last 25 percent. This idea results from underestimating the effort required to finish the project, answer questions, archive material, and finalize deliverables. These efforts need to be identified by the project manager and accounted for in the budgeting process. The final payment here is also critical. Make sure that the final invoice is not held hostage in return for extra or out-of-scope services.

Financial Indicators
Many firms use "multiplier" or "net effective multiplier" to monitor the financial aspects of a project. This term is defined as gross fee minus other direct costs divided by direct labor, where gross fee is the total fee received from the client for the project; other direct costs are all non-labor costs (no overhead) such as sub consultants, travel expense, etc. that are directly charged to the project; and direct labor is raw labor (no fringes, no overhead) that are charged to the project.

In our industry today, the target multipliers usually range from 2.9 to 3.2. ZweigWhite’s survey of high-profit firms indicates that the median target multiplier for high-profit firms is 3.2; the actual median multiplier for these firms is 3.31. This indicator allows for the target multiplier to be computed for each project based on all contractual, scope, and financial factors. The actual multiplier can be calculated at project milestones and at project completion and compared with the target.

Many firms use "desired fee" or "standard fee" as the benchmark and compare actual invoices or fee to assess financial success. While this is more effective than no budget at all, it obscures many factors and sets a firm-wide target whether or not the target is appropriate for the particular project being assessed. The concept of "project cost" must be separated from "project fee." Many firms with a time and materials culture equate the ability to invoice a cost with the actual cost itself. If a client will not pay for travel, the cost of the project-related travel is still a cost that should be assessed to the project and included in the calculation of the actual multiplier to see how the project fared financially.

Financial success
Many factors affect the financial success of a project. The following questions can all be answered by examining the finances from a life-cycle perspective: How did this get started? Where and how did it change? How did we monitor? Did we make any money?

Accurate financial records lead to accurate historical information on which to base current and future decisions. Without it, we reinvent the wheel every time we propose on a project, contract for a project, and execute a project. While that may be a challenging academic exercise, it’s no way to run a business. After all, without financial success on our projects, we have no hope of financial success as a company.

Robert J. Maxman, P.E., is senior vice president with Wade Trim Group, Inc., and serves as director of strategic growth. He has offices in Tampa, Fla., and Taylor, Mich. He can be contacted at rmaxman@wadetrim.com.


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