Project managers are expected to complete a project within budget, and to do this they monitor actual cost reports against planned budget spend. However, there is a great deal of confusion over the language of what is included within a cost report, and without some clarity, the project manager may be aiming for the wrong outcome.
There are two key sources of confusion over cost: the timeliness of the cost reports and how an organisation will handle the allocation of indirect costs to a project. As these issues vary from organisation to organisation, they must be uniquely defined for each.
Consider the first key variance: timeliness. The accounting department in most organisations is built around reporting to shareholders and the tax office. These parties demand accurate reports, but they are willing to wait several months after the fact to receive those reports. This drives the accounting departments to emphasise financial accuracy over timeliness.
To control costs, however, project managers need an understanding of the current actual costs against their planned cost at any given moment. This requires timely information. In a 10-month project, if there is a one-month delay in finances, this is likely to produce a report that understates the current financial situation by 10% or more.
While some financial systems will provide daily reports, the content of these reports needs to be clear. For example, delays in time sheets or subcontractor invoicing can see financial cost reports substantially understate the current reality.
Budget spend may mean that budget has been allocated to cover a purchase order, or committed to cover a received invoice, or actually paid as a payment to a subcontractor. These are three separate points in the financial payment process, and while project managers tend to think in terms of the first two, the accounting practices tend to report the last two.
Project managers need to understand the language of the financial reports before they attempt to rely on the data contained within them, and they need a detailed explanation of the financial reporting process to understand the extent of errors due to delays in posting costs.
Where project managers wish to track their costs on a timelier basis, they often prepare spreadsheets that draw down budget and apply it to purchase orders, subcontractors, and labour. These spreadsheets can be maintained daily by either the project manager or the project office, but they require reconciliation with the final reports from finance. The key difference between the two reports, apart from the time to post costs, will be the handling of indirect costs.
Now the second key source of confusion over cost: how an organisation handles the allocation of indirect costs to a project. The direct costs applied to a project will include the cost of supplies, the cost of subcontractor payments, and the wages paid to employees.
The total costs for an organisation include these costs that are directly associated with revenue, and also the non-revenue related costs such as office accommodation, transport, marketing, sales and administration. That is, the indirect costs or overheads. Taking the simplest example of an organisation that solely undertakes projects for others, then at the end of the financial year:
- Yearly sum of prices
Yearly Revenue = Profit + Yearly Direct Project Costs + Yearly Indirect Costs
Broadly speaking though, the organisation may decide to manage the projects to the direct costs only and fund the indirect costs from the yearly profits; or it may decide to allocate a proportion of the indirect costs to each project based upon some factor such as revenue; or it may decide to allocate the indirect costs against the labour and costs within the project. These approaches each result in different project cost definitions:
- Allocation at Yearly level
Project Price = Gross Profit + Project Cost [Sum of Direct Costs]
- Allocation at Project level
Project Price = Net Profit + Project Cost [Indirect Cost allocation + Sum of Direct Costs]
- Allocation at Cost Level
Project Price = Net Profit + Project Cost [Sum of Direct + allocation for Indirect Costs]