Project cash forecasting in the client organization

Project cash forcasting is a major problem faced by client organization, due largely to inaccurate project estimates at the outset. Inadequate project definition and risk analysis at the approval stage and, in some cases, a tendency of the project manager to overestimate are major contributors to the inaccuracy of project esti- mates. In addition, some organizations expect project managers to develop project-approval estimates to within 10% accuracy~ having completed less than 5% of the total project design. The reasons for failure of project cash forecasting are discussed, and the need for develop- ing a forecasting strategy is established. Some solutions to the problems are suggested.

Keyword: project management, forecasting, financial management, estimates

Project cash forecasting is a problem faced by both the contractor and the client. Whereas the problems faced by the contractor in this area have been researched and discussed at length, and indeed several software systems have been created to overcome some of the problems, the difficulties faced by the client in this area have not been given the recognition they deserve. It is therefore proposed to deal with this topic by discussing why clients have a specific problem. The reasons for failure in the area of project cash forecasting are discussed, and the need for developing a forecasting strategy is established. Some solutions to the problem are suggested.

WHY CLIENTS HAVE A SPECIFIC PROBLEM

project and programme level. They begin at the programme level, where a particular department or division is required to meet certain constraints on capital spending in a particular financial year. These constraints finally filter down to the project level where the initial requirements for departmental or divisional spending have been derived. For example, each project in a department having its own financial profile (S- curve) submits its forecast of expenditure over the life of the project. These S-curves may then be consolid- ated to develop a programme expenditure profile. It is usually this programme expenditure profile which acts as the limiting factor in the client organization. In public sector projects, government departments have to submit forecasts on capital spending to the Treasury up to four years ahead. This process is referred to as the programme expenditure survey (PES), and, in some cases, it puts unrealistic constraints on the project organization. Project forecasting on some of the most well-defined projects is difficult when considering a duration in excess of 12 months. Project managers in this environment are therefore faced with a most unenviable problem.

The PES imposes a further constraint of requiring a statement of the levels of actual cash spent by each project. Clearly, the rate at which invoices are paid depends on a variety of circumstances. Not only is it dependent on the anticipated value of work done by the contractor, but it is also a function of the speed with which a contractor submits invoices for payment, and the speed with which a client organization clears those invoices for payment. It is not unusual for payment to be made several months, and in some cases even years, after the physical completion of work.

The major problem faced by client organizations is in meeting cashflow constraints imposed on them by top management. These constraints occur at both the

Large client organizations also have several inhouse functions to take on the various specialist tasks within a project. For example, a specialist contracts department will be responsible for the issuing and vetting of all

Price Waterhouse Associates, Southwark Towers, London Bridge, contracts, Legal specialists may also be concerned with London SE1 9SY, UK the legal implications of changes to standard condi-

148 0263-~863/84/03014%05 $03.00 0 1984 Butterworth & Co (Publishers) Ltd Project Management

Glen Peters

tions. Finance, planning and a plethora of other functions may also be required to give their consent at several times during the life of the project. Clearly, such constraints make project reaction times far slower, and often it is quite difficult to estimate the rate at which the various functions involved may complete the tasks assigned to them. So, for example, the project manager may estimate the letting of a contract that demands a 10% payment on the placing of the contract, to begin before the end of a financial year. The various in-house processes may respond at a slower rate than anticipated by the project manager. Obviously, this will affect the placing of the contract and subsequently delay the actual cash expenditure for the project.

Large projects handled directly by a client require a substantial effort for the coordination of the various contractors, suppliers and other agencies involved in the project. This can put a substantial workload on the project team.

Clients engaged in large collaborative ventures can also encounter problems in arriving at accurate cash- flow forecasts. This is usually the result of the cumbersome nature of these collaborative ventures. For example, several countries may decide to colla- borate in a project and remit funds to an agreed bank deposit at prearranged intervals throughout the project life. The rate at which these funds flow from the member countries to the bank deposits may be assessed by examining the expected requirements for cash by the project. These funds may be invested in short-, medium- or long-term cash deposits. As Figure 1 illustrates, the project accountant requests cash calls from short-term deposits for payment to contractors.

It is apparent that the long chain of financial accountability from member country to contractor can make project reaction times unacceptably slow to develop adequate mechanisms for project cash fore- casting. The problem is further complicated by the flow of funds being in several currencies. Obviously, for effective project cash control, all project cash must be reduced to a base currency, or a basket of currencies.

The need for clients to develop accurate cashflow forecasts is of the utmost importance in situations where several projects compete for resources. Fre- quently, client organizations operate in environments of a limited capital funding on projects. In the private sector, usually projects with the highest internal rate of return qualify for approval. In the public sector, priorities resulting from certain statutory obligations may be set. Underspending therefore can cause acute

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Figure 1. Cash flows on a major collaborative project

Vol 2 No 3 August 1984

embarrassment to a project or programme director. For example, ten projects may have qualified to meet an annual cash ceiling of f100M. An underspend of 20% in any one financial year may imply that a further two projects could have qualified for approval.

WHERE PROJECTS GO WRONG

Having discussed some of the reasons why client organizations have a specific problem, it is worth examining some of the reasons why projects are unable to meet cashflow forecasts.

Probably the biggest cause of poor cash forecasts is the accuracy of the original project estimate. The main contributors to inaccurate project estimates are an inadequate project definition at the approval stage, inadequate risk analysis on highly-innovated projects and, in some cases, a tendency to overestimate.

Several client organizations expect project managers to develop project-approval estimates to within 10% accuracy, having completed, in some cases, less than 5% of the total project design. Clearly, this level of accuracy may only be met by chance and defies the abilities of even the most skillful cost engineer.

Highly-innovated projects are often not accom- panied by an adequate risk analysis to determine appropriate levels of contingency for high-risk areas of work. Client organizations are becoming increasingly aware of the need to perform adequate risk analysis to determine the accuracy of the approval estimates.

There is a tendency among project managers to provide an estimate that is above the anticipated figure in order to make allowance for possible cost overruns. The cumbersome nature of the approvals process for the authorization of cost overruns causes substantial delays, and project managers therefore allow them- selves two types of contingencies: one officially de- clared, and the second concealed in the actual project estimate. Quantity surveyors acting on the client’s behalf may also indulge in this practice by over- specifying measured quantities or provisional sums to allow for such eventualities.

As a result of project managers tending to over- estimate, however, other departments involved in the project (e.g. the finance department) may operate a curious practice of automatically reducing project estimates. The process is exacerbated in that project managers expect their estimate to be reduced and make adjustments accordingly. The nature of this cyclical process is somewhat confused as the amounts by which estimates are increased or reduced is purely arbitrary, and may not coincide for a given project. Furthermore, if the project manager’s estimate is not reduced as anticipated, approval in excess of the funds actually required is then sought.

Another factor contributing to poor-quality cash forecasts is the quality and the reality of the project programme. In large client organizations it is important to be realistic about dates by which contracts could be let. Realism therefore begins early in the project plan and continues after a contract for work has been awarded. Obviously, a programme that assumes a contractor’s rate of working to be faster than is actually achievable will affect the rate of expenditure.

Uncontrollable factors, such as major breakdowns in industrial relations, inclement weather and political

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intervention, can affect the progress of a project and eventually its projected cashflows.

FORECASTING STRATEGY

Before examining any solutions, the client organization must clearly establish a forecasting strategy.

l How important is cash forecasting to the organiza- tion?

l What accuracy is acceptable? l What resources can be committed to establishing

cash forecasts? l Which projects qualify? l Which methods should be employed?

Unless a strategy such as this is clearly laid out, the effective application of project cash forecasting will not be achievable. The organization may find itself ap- plying oversophisticated techniques for relatively simple projects and gaining little benefit from doing so. It may also discover that it does not have adequate administrative or technical resources to be able to achieve an ambitious forecasting strategy.

SOLUTIONS

Cost and schedule integration is perhaps the most obvious choice when seeking solutions to establishing project cash forecasts. In its simplest form, cost and schedule integration is practised by most project managers seeking to proportion project expenditure into required financial years or suitable accounting periods. This may be done by an assumed rate of working. Integration at this high level is seldom effective, and it is often necessary to develop lower- level links between activities on a programme of work and their associated costs. Cost and schedule integra- tion is hailed by many, particularly the software suppliers, as being the project manager’s only hope of achieving project cash forecasting. However, several practising project managers are of the opinion that true integration is impossible to achieve and is rather an academic solution to the problem. Some of the problems associated with cost and schedule integration should therefore be examined, and the means by which these can be overcome discussed.

A common problem encountered in achieving cost and schedule integration arises when an inappropriate work-breakdown structure (WBS) is used. The choice of a work-breakdown structure early in the project’s life may often be determined by the way in which work is estimated. Hierarchical or tree-like structures are perhaps the most commonly used WBSs. Problems arise when a method of working is not compatible with the manner in which the project has been estimated. This is particularly acute with building and civil engineering-orientated projects, which must comply with certain predefined estimating criteria.

The conditions of estimating of the Federation of Civil Engineering Contractors are a good example of this problem. Quantities of steel required for reinforce- ment on a civil engineering project will be estimated in terms of its overall tonnage. During the construction phase, in order to be able to associate cost with, say, a particular foundation, it will be necessary to estimate the quantity and cost of steel required for that particular foundation. This is not easy. However, with

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computer-assisted estimating techniques, the problem is becoming less difficult to overcome.

In the author’s experience, the most appropriate WBS to overcome this problem of incompatibility is the phase-by-phase work-breakdown approach. Figure 2 shows such a WBS concerned with the development of a project. Each project phase shares the same com- ponent of design, software development, weaponry and the vehicle itself.

Assuming it is possible to adopt an appropriate work- breakdown structure that assigns costs for each activity, it is then necessary to specify the anticipated rate at which those costs will be expended for the duration of the activity. Most computer systems will allow the user to specify either a linear or nonlinear relationship. The linear approach should not be disregarded completely. Figure 3 shows how a profile has been developed from simple linear relationships of small work elements on the construction of an access road. In this example, the actual project S-curve varied by no more than 3%.

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Figure 3. Project costs through time (contract for the construction of an access road)

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Whereas a simple linear relationship succeeds on activities bearing relatively small amounts of cost, larger cost items may require an assumed expenditure profile that may not be linear.

Not all payments to contractors occur in this smooth, regular manner. Several contracts, particularly in fixed lump-sum situations, are tied to either payment- or delivery-related milestone dates. True cost and schedule integration can therefore only be achieved by associating milestone payments with appropriate events in the project network. Figure 4 shows how integration can be achieved by a combination of simple linear relationships in the progress-related environment, and for milestone-related payments. Obviously, with mile- stone payments, the accuracy in cash forecasting is largely dependent on the accuracy with which the achievement of a particular milestone date can be assessed. It is for this reason that the client requires an appropriate level of project status information on the activities leading up to a significant payment milestone date.

Indeed, the overall success of cost and schedule integration depends essentially on a meaningful and up- to-date project plan. The relevance of this plan frequently depends largely on the quality of the information on project status supplied by contractors and their subcontractors on the project, It is therefore essential for a client to specify these requirements clearly during the tender period, and insist that these requirements are implemented during the execution of the contract. There is a move to use S-curves generated in this manner as a basis for contract valuations. Provided the client can have enough confidence in the ability of the contractor to report progress accurately, contractors and clients may find these arrangements to their mutual advantage. The benefits are that valua- tions can be quickly assessed with the minimum of specialist resources and, having realized these benefits, contractors may strive to ensure that the quality of information provided to update project status is ade- quate. Gough-Palmer has described such a system

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Figure 4. Financial plan of milestone and progress- related payments

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during the construction of the Hong Kong to Kowloon underground railway system’. It is obvious that, at present, there is some resistance to the evolution of this method of assessing interim payments. Nevertheless, clients need to take a positive attitude in this direction.

Effective cost and schedule integration can only be achieved provided it is possible to obtain the appro- priate level of information required. In several in- stances, the level of detail required is not available from contractors. In these situations, the client should look to the possibility of getting such contractors to agree to a contractually binding financial plan. The percentage of variation from an agreed financial plan will depend on the conditions that the contractor is prepared to accept. It is not unknown in the USA, for example, for large contracts to have financial plans with deviation clauses imposing a + 3% variation on the profiles agreed at the contract stage. Obviously, safeguards regarding actual progress compared to the values invoiced must be included with any such contract. Clients have found these arrangements satis- factory as part of an overall cash-forecasting strategy. The key to success of this approach lies in insisting on such a financial plan at the tender stage, using this plan as part of the tender evaluation process, and finally agreeing it with the contractor before the placing of a contract.

No forecasting strategy would be complete without due allowance having been made for project risks. A wholly deterministic approach to cash forecasting can only be recommended on very rare occasions. Most client organizations are becoming aware of the need to recognize and quantify risks occurring in a project and their impact on cashflows. It is necessary to separate work packages having high risk from other work packages with low risk. Often, it is quite acceptable to adopt a deterministic approach on the packages with low risk and a probabilistic assessment of the packages with an associated high risk. Large projects warrant the use of an overall project probabilistic model to gener- ate cash curves at varying levels of risk. High-risk packages obviously require more frequent monitoring and updating than low-risk packages.

Major reappraisals, both of project costs and their subsequent impact on cashflow, should be undertaken before each major phase in a project. The phases nearer completion will obviously have the benefit of more accurate project information, thereby resulting in the ability to develop more accurate cash forecasts. At the end of each phase, the need for contingencies, previously identified as the result of risk, should be assessed and either reconfirmed or transferred out of the project. Invariably, contingencies associated with the project in its early stages tend to remain with the project until completion, unless used as part of a common pool to fund other project areas where cost overruns might occur.

The problem of the delay between the actual value of work done and the payment to contractors (see Figure 5) is difficult to resolve simply. Its solution lies partly in the use of financial modelling techniques to predict actual payment dates on the basis of the average historical delay and the rate at which work is to be done in the future. Another solution lies in carefully ex- amining contractual clauses to ensure the presentation of invoices and their subsequent clearance within a pre- agreed period.

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Value of work done

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Figure 5. Cost curves

The currency of data, as previously discussed in cost and schedule integration, is by far the most important feature of achieving accurate cash forecasts. The currency of project data depends largely on the need to keep responsive and current change-control document- ation (see Figure 6) and to minimize the time between project status being assessed and Loaded onto the project model. With large contracts involving main contractors with other subcontractors reporting to these main contractors, delays in the currency of data can run to several months. This makes cash forecasting ineffective. The lag between the request for changes to

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Figure 6. Change-control process

the project and its final approval and updating of the work package estimate can also create errors in the cash forecasts. Clearly, both these factors need to be given first consideration, and the time lag in both instances reduced to a minimum.

Finally, in seeking solutions to achieve adequate forecasts for project cashflows, it is necessary to create an environment to avoid overestimation by project managers and project estimators. Frequently, the problem lies in a lack of adequate responsibility being assigned to these individuals. The instances cited earlier, where project estimates submitted by the project manager are automatically subject to a per- centage reduction, are not conducive to producing accurate cash forecasts.

REFERENCES

1 Pugh-Palmer, D H ‘Integration of time and cost in the planning and monitoring of the Hong Kong mass transit railway project’ Int. J. Proj. Manage. Vol 1 No 2 (May 1983) pp 95-100

BIBLIOGRAPHY

Peters, G Project management and construction control Construction Press, UK (1981)

Peters, G Construction management on small computers Architectural Press, UK (1984)

Peters, G ‘Project management in the client organiza- tion’ Proc. 7th Meeting of Cost Engineers London, UK (1982)

Glen Peter.s is a senior consultant at Price Waterhouse, London, UK. He was previously n project manager at British Gas, managing high-pressure gar tra~s~l~ssion projects. Since joining Price Water- house in 1982, he has advised on project manpgement systems in the UK central government, NATO and various areas of manu- facturing industry. He has written two books on project management and has presented several pnper.s on the topic at international symposia.

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