Mega Project in Ethiopia

GERD

Sheger park
Condiminium
 Rifty Valley University
Harar Campus
Course
❖ Code: PMgt 651

❖ Title: Project Accounting and Financial Management in Projects

❖ Credit hrs: 3 hrs

 This course focuses on the important aspects of project accounting and financial management. More
specifically, it elucidates on cost management, cash flows estimations, cost estimations, financial
planning, and variance analysis.

Objectives
 The aim of this course is to help students open up new horizons so that they can harness their full
potential in managing financial aspects of a personal project or that of the organization they work for.
More specifically, upon successful completion of this course, students will be able to:

• Use the different cost management tools and techniques

• Analyze sources of cash flows and their impact on project performance

• Apply techniques of cost estimations

• Prepare a financial plan

• Exploit the varieties of variance analysis techniques

 Chapter 1. Introduction to Cost Management

1.1 Meaning and need for cost management

 Cost management is the process of planning and controlling the costs associated with
running a business.
 It includes collecting, analyzing and reporting cost information to more effectively
budget, forecast and monitor costs.

We need it to set the baseline for project cost.

 Cost management practices can be applied to specific projects or to the company's

overall operating model.
 Cost management typically focuses on savings and maximizing profits in the longer
term.
Governs the actions to keep budget on track.
 Cont’d
 In absence of cost management :

➢ Company might lose money.

➢ Cost exceed profit.

➢ Customers invoiced incorrectly.

➢ Socio-economic and political chaos when project is unfinished.

Figure 1
 Cont...

 Project cost management is the process of estimating, budgeting and controlling costs
throughout the project life cycle, with the objective of keeping expenditures within the
approved budget.

 For a project to be considered a success,

➢ it delivers on the requirements and scope
➢ its execution quality is of a high standard
➢ it’s completed within schedule and
➢ it’s completed within budget.
Figure 2
 Hence, project cost management is one of the key pillars of project management and is
relevant regardless of the domain, be it manufacturing, retail, technology, construction and
so on.

 It helps to create a financial baseline against which project managers can benchmark the
current status of their project costs and realign the direction if needed.
 1.2 Project cost management process
A. Plan project cost management
 It is the process of that defines how project costs will be estimated, budgeted,
managed, monitored, and controlled.
 Provides guidance and direction on how the project costs will be managed
throughout the project.
 The process that establishes the policies, procedures, and documentation for
planning, managing, expending, and controlling project costs.

Figure 3
 Cont’d

B. Estimate project cost management

 It is the process of developing an approximation of cost of resources needed to
complete project work.
 It determines the monetary resources required for project.

 The process of developing an approximation of the monetary resources needed to Figure 1.4
complete project activities.
 Cont’d
C. Determine Budget
 It is the process of combining the estimated costs of individual activities to establish cost
baseline.
 It determines the cost baseline against which project performance can be monitored and
controlled.

 The process of aggregating the estimated costs of individual activities or work packages
to establish an authorized cost baseline.
Figure 1.5
 Cont’d

D. Control costs
 It is the process of monitoring the status of the project to update the project costs and managing changes to
the cost baseline.

 Cost baseline is maintained throughout the project.

 Ensuring that all changes requests are done in a timely manner.

 Ensuring that cost expenditures do not exceed the authorized funding limit.

 Monitoring costs to isolate and understand variability from the cost base line.

 Preventing unapproved changes from being included in the reported cost.

 Informing relevant stakeholders of all approved changes and associated cost.

 Bringing expected cos overruns with in acceptable limits.

Cont’d

Figure 1.6
Figure 1.7: PCM
overview
 1.3 Classification of project costs
The most common methods to categorize project costs :

1. Direct Costs: (DM and DL)

 Direct expenses are entailed by everything you do to produce a particular output. Let’s
take a hardware development project as an example. In its case, direct costs will include:
 Raw materials for the creation of finished goods (e.g., steel, plastic, etc.),
 Direct labor (i.e., human resources and hours necessary to manufacture the product),
and production equipment.

 Overall, any cost that directly influences your output volume belongs to the category of
direct expenses.
 Any change in the magnitude of production will lead to either an increase or decrease in
the number of specific things needed to meet the set output goal.
 These things will be your direct expenses.
 Classification of project continued
2. Indirect expenses
 Indirect expenses comprise the cost of everything that isn’t directly linked to primary project
operations but is required to support them.

 Let’s consider the above example again. To create hardware, you need to:
 Rent a facility,
 Pay wages to administrative employees,

 Use technology for communication between business units,

 And travel to different cities to sign contracts with suppliers.

 All these activities fall under the category of indirect costs.

 They are essential for the sustainability of the business as a whole but are not associated with
the production process itself.
 Classification of project continued
 When categorizing expenses based on the production capacity, business practitioners
divide them into fixed and variable costs.

3. Fixed costs
 Fixed costs are those expenses that never vary in their amount regardless of possible
changes in output volumes.

 One of the best examples of a fixed cost is rent payment. For instance, the
abovementioned hardware development company may have to pay $15,000 for a
production facility monthly.

 This price remains the same, invariably of how many items the business has
manufactured during the rent period – 15 or 500.
 Classification of project continued
4. Variable costs

 Variable costs constantly change as the company increases or decreases its production

outputs.

 If the same hardware development company decides to manufacture 300 USB flash

drives for the cost of $15 (i.e., the sum of all relevant direct expenses), the total variable

cost for that project will be $4,500.

 At the same time, if this company will choose to produce 800 USB drives instead, the

variable cost will go up to $12,000.

 2.4 Cost Measurement
 Cost measurement is an important subject, because no cost forecast can be better
than its measurement. It introduces the subject from an engineer’s point of view,
not from an accountant one.

 Cost measurement is not a standard term. Accountants, who are the experts in this
domain, call it “cost accounting”.

 Cost accounting is the technical process by which expenses are allocated to

products.

 Starting from the expenditures, it goes to the definition of the expenses and briefly
describes the different ways of cost measurement which are found in the industry,
with the advantages and limitations, always from a cost estimator’s point of view.
 Cost Measurement Cont…

This is two important for reasons on the way costs are “measured” :

 1. The cost analyst must know there are various ways to measure cost; when he/she receives figures,
he/she must be sure that the figures were computed about the same way. Of course, if these figures are
prices, he/she will assume that the figures are “full cost margin” (the margin can be positive, negative
or zero).

 2. Understanding the process of cost measurement allows the cost analyst to understand the
limitations of the process. One of these limitations is the accuracy he/she might expect from the costs
figures he/she gets from his/her own organization.
 The General Framework of Cost Measurement
 We already mentioned that there are several ways to measure costs.

The starting points:

 1. Everything starts from expenditures: an expenditure is an amount of money paid for acquiring an
asset or a service. An expenditure is always recorded on a piece of paper.

 2. A major constraint in cost measurement is the accounting period: the functions carried out by the
company must be accomplished during a given period, let us say for a year, generally starting on January
1st, finishing on December 31st (but other dates are sometimes used). This constraint is understandable:
external parties logically ask for periodic statements.

 3. Companies generally produce several (sometimes a lot of) different products: each product
consumes an amount of resources which may be different from the other one; the problem is then to put a
value on all the resources consumed by each product.
 The Frame Work

Figure 1.9: Different ways of measuring cost

 The Purposes of Cost Measurement

 ● External: for reporting to the outside world.

 ● Internal:

❖ determination of the cost of the goods produced

❖ determination of the rates (labor rates, machine rates, etc.)

End of Chapter One
 Chapter Two

Cost Estimation and Management

 2.1 Cost Estimation

 Is developing an approximation or estimate of the costs of the resources

needed to complete a project.

 An important output of project cost management is a cost estimate.

 The single most important task of a project: setting realistic

expectations.
Unrealistic expectations based on inaccurate estimates are
the single largest cause of many project failure.
 2.2 Difference between estimation and pricing
Estimating:
 Estimating, refers to ascertaining—in advance—the probable cost of manufacturing an
article, completing a contract, or executing a process in the near future.
 Estimating is based on past (recorded) experience.
 Estimating necessarily involves some guesswork, but guesses should be guided by facts to the
greatest possible extent.

Pricing:

 Pricing means fixing the selling price of an article.

 The pricing of an article already produced should be preceded by and based on costing, but
other factors are also taken into account (e.g., price of competitive articles, price trends, etc.).
 For example: A Software pricing factors
Market A development organisation may quote a low price because it
opportunity wishes to move into a new segment of the software market.
Accepting a low profit on one projec t may give the opportunity
of more profit later. The experience gained may allow new
products to be developed.
Cost estimate If an o rganisation is unsure of its cost estimate, it may increase
uncertainty its price by some contingency over and above its normal profit.
Contractual terms A c ustomer may be willing to allow the developer to retain
ownership of the source code and reuse it in other projects. The
price charged may then be less than if the software source code
is handed over to the customer.
Requirements If the requirements are likely to change, an organisation may
volatility lower its price to win a c ontract. After the contract is awarded,
high prices can be charged for changes to the requirements.
Financial healt h Developers in financial difficulty may lower their price to ga in
a c ontract. It is better to make a smaller than normal profit or
break even than to go out of business.
 Why estimation important?

➢ Program development of large software systems normally experience 200-

300% cost overruns and a 100% schedule slip

➢ 15% of large projects deliver…NOTHING!

➢ Key reasons…poor management and inaccurate estimations of

development cost and schedule

➢ If not meeting schedules, developers often pay the price!

 Fundamental estimation questions

❖ How much effort is required to complete an activity?

❖ How much calendar time is needed to complete an activity?

❖ What is the total cost of an activity?

❖ Project estimation and scheduling are interleaved management activities.

 1.3 Cost estimation tools and techniques

 Project managers must take cost estimates seriously if they want to complete

projects within budget constraints.

 It’s important to know the types of cost estimates, how to prepare cost

estimates, and typical problems associated with the cost estimates.

 1.4 Common (subjective) estimation models

❖ Expert Judgment

❖ Analogy

❖ Parkinson’s law

❖ Price to win
 Expert judgment

❖ One or more experts in both software development and the application domain
use their experience to predict software costs. Process repeats until some
consensus is reached.

❖ Advantages: Relatively cheap estimation method. Can be accurate if experts have

direct experience of similar systems

❖ Disadvantages: Very inaccurate if there are no experts!

 Estimation by analogy

 The cost of a project is computed by comparing the project to a similar project

in the same application domain.

 Advantages: May be accurate if project data available and people/tools the

same.

 Disadvantages: Impossible if no comparable project has been tackled. Needs

systematically maintained cost database.
 Parkinson's Law

❖ The project costs whatever resources are available

❖ Advantages: No overspend

❖ Disadvantages: System is usually unfinished

 Cost Pricing to Win

 The project costs whatever the customer has to spend on it

 Advantages: You get the contract

 Disadvantages: The probability that the customer gets the system he or she
wants is small. Costs do not accurately reflect the work required.

 How do you know what customer has?

 Only a good strategy if you are willing to take a serious loss to get a first
customer, or if Delivery of a radically reduced product is a real option.
 Top-down and bottom-up estimation

➢ Any of these approaches may be used top-down or bottom-up.

➢ Top-down

➢ Start at the system level and assess the overall system functionality and how
this is delivered through sub-systems.

➢ Bottom-up

➢ Start at the component level and estimate the effort required for each
component. Add these efforts to reach a final estimate.
 Top-down estimation

➢ Usable without knowledge of the system architecture and the components

that might be part of the system.

➢ Takes into account costs such as integration, configuration management

and documentation.

➢ Can underestimate the cost of solving difficult low-level technical

problems.
 Bottom-up estimation

➢ Usable when the architecture of the system is known and components identified.

➢ This can be an accurate method if the system has been designed in detail.

➢ It may underestimate the costs of system level activities such as integration and
documentation.
 Estimation methods

 Each method has strengths and weaknesses.

 Estimation should be based on several methods.

 If these do not return approximately the same result, then you have insufficient
information available to make an estimate.

 Some action should be taken to find out more in order to make more accurate
estimates.

 Pricing to win is sometimes the only applicable method.

 Pricing to win

 This approach may seem unethical and un-business like.

 However, when detailed information is lacking it may be the only appropriate

strategy.

 The project cost is agreed on the basis of an outline proposal and the development
is constrained by that cost.

 A detailed specification may be negotiated or an evolutionary approach used for

system development.
 Algorithmic cost modeling

 Cost is estimated as a mathematical function of product, project and process

attributes whose values are estimated by project managers

 The function is derived from a study of historical costing data

 Most commonly used product attribute for cost estimation is LOC (code size)

 Most models are basically similar but with different attribute values
 1.5 Earned Value Management (EVM)

 EVM is a project performance measurement technique that integrates scope,

time, and cost data.

 Given a baseline (original plan plus approved changes), you can determine how

well the project is meeting its goals.

 You must enter actual information periodically to use EVM.

 More and more organizations around the world are using EVM to help control

project costs.
 Earned Value Management Terms

❖ The planned value (PV), formerly called the budgeted cost of work scheduled (BCWS), also called the
budget, is that portion of the approved total cost estimate planned to be spent on an activity during a
given period.

❖ Actual cost (AC), formerly called actual cost of work performed (ACWP), is the total of direct and
indirect costs incurred in accomplishing work on an activity during a given period.

❖ The earned value (EV), formerly called the budgeted cost of work performed (BCWP), is an estimate of
the value of the physical work actually completed.

❖ EV is based on the original planned costs for the project or activity and the rate at which the team is
completing work on the project or activity to date.

❖ Rate of performance (RP) is the ratio of actual work completed to the percentage of work planned to
have been completed at any given time during the life of the project or activity
Earned Value Formulas
1.6 Profitability Ratios
 Definition: Profitability Ratios
 Profitability ratios are calculated to analyze the earning capacity of the business
which is the outcome of utilization of resources employed in the business.
 The various ratios which are commonly used to analyze the profitability of the
business are:
❖ Gross profit ratio
❖ Operating ratio
❖ Operating profit ratio
❖ Net profit ratio
❖ Return on Investment (ROI) or Return on Capital Employed (ROCE)
❖ Return on Net Worth (RONW)
❖ Earnings per share
❖ Book value per share
❖ Dividend payout ratio
❖ Price earning ratio.
 A. Gross Profit Ratio
 Gross profit ratio as a percentage of revenue from operations is computed to have an
idea about gross margin.
 It is computed as follows:
Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100

➢ Significance: It indicates gross margin on products sold. It also indicates the margin
available to cover operating expenses, non-operating expenses, etc.
➢ Change in gross profit ratio may be due to change in selling price or cost of revenue
from operations or a combination of both.
➢ A low ratio may indicate unfavorable purchase and sales policy.
➢ Higher gross profit ratio is always a good sign.
 B. Operating Ratio

 It is computed to analyze cost of operation in relation to revenue from operations. It is

calculated as follows:

Operating Ratio= (Cost of Revenue from Operations + Operating Expenses) × 100

Net Revenue from Operations

❖ Operating expenses include office expenses, administrative expenses, selling expenses,

distribution expenses, depreciation and employee benefit expenses etc.

❖ Cost of operation is determined by excluding non-operating incomes and expenses such

as loss on sale of assets, interest paid, dividend received, loss by fire, speculation gain
and so on.
 C. Operating Profit Ratio

 It is calculated to reveal operating margin. It may be computed directly or as a residual

of operating ratio.
 Operating Profit Ratio= 100 – Operating Ratio
 Alternatively, it is calculated as under:
 Operating Profit Ratio= Operating Profit/ Revenue from Operations × 100
Where
Operating Profit= Revenue from Operations – Operating Cost

 Significance: It helps to analyze the performance of business and throws light on the
operational efficiency of the business.

 It is very useful for inter-firm as well as intra-firm comparisons. Lower operating ratio
is a very healthy sign.
 D. Net Profit Ratio

 Net Profit Ratio = Net profit/Revenue from Operations × 100

 Generally, net profit refers to profit after tax (PAT).

 Significance: It is a measure of net profit margin in relation to revenue from

operations.

 It reflects the overall efficiency of the business, assumes great

significance from the point of view of investors
 E. Return on Capital Employed or Investment

 Capital employed means the long-term funds employed in the business and
includes shareholders’ funds, debentures and long-term loans.
 Return on Investment (or Capital Employed) =Profit before Interest and
Tax/Capital Employed × 100
 Significance: It measures return on capital employed in the business.
 It reveals the efficiency of the business in utilization of funds entrusted to it by
shareholders, debenture-holders and long-term loans.

 For inter-firm comparison, return on capital employed funds is considered

a good measure of profitability.
 It also helps in assessing whether the firm is earning a higher return on
capital employed as compared to the interest rate paid
 F. Return on Shareholders’ Funds

ratio is very important from shareholders’ point of view in assessing

 This
whether their investment in the firm generates a reasonable return or not.

A measure of profitability from shareholders point of view is obtained by

determining return on total shareholders’ funds, it is also termed as Return
on Net Worth (RONW).
 G. Earnings per Share

 The ratio is computed as:

EPS= Profit available for equity shareholders/Number of Equity Shares

 In this context, earnings refer to profit available for equity shareholders which is
worked out as Profit after Tax – Dividend on Preference Shares.

 This ratio is very important from equity shareholders point of view and also for the
share price in the stock market.

 This also helps comparison with other to ascertain its reasonableness and capacity to
pay dividend.
 H. Book Value per Share

 This ratio is calculated as :

Book Value per share = Equity shareholders’ funds/Number of Equity
Shares
 Equity shareholder fund refers to Shareholders’ Funds – Preference Share Capital.

 This ratio is again very important from equity shareholders point of view as it
gives an idea about the value of their holding and affects market price of the
shares.
 I. Dividend Payout Ratio

 This refers to the proportion of earning that are distributed to the shareholders. It is
calculated as :

Dividend Payout Ratio = Dividend per share /Earnings per share

 This reflects company’s dividend policy and growth in owner’s equity.

 J. Price / Earning Ratio

 The ratio is computed as –

P/E Ratio = Market Price of a share/earnings per share

For example, if the EPS of X Ltd. is Rs. $10 and market price is $ 100, the price
earning ratio will be 10 (100/10).

 It reflects investors expectation about the growth in the firm’s earnings and
reasonableness of the market price of its shares.

 P/E Ratio vary from industry to industry and company to company in the same
industry depending upon investors perception of their future.
1.7 Looking beyond the price: Life-cycle
costs of products
LCC = is the total cost of owner ship of an asset.

1. Purchase price
2. Cost of Operation and Maintenance
3. Renew = Refurbishment
4. Disposal
 Cont…

 The most common misconception about is that green products cost more. However, upon closer inspection, this
does not necessarily hold true.

 Although in many (but certainly not all) cases the greener alternative may have a higher purchase price, if we
analyse all the costs (throughout the working life of the product), overall the greener alternative may well prove
to be cheaper over time.

 If contracting authorities wish to ascertain, which products are most cost effective for them they need to apply
Life-Cycle Costing (LCC) approaches in their procurement decisions.

 This means comparing not just the initial purchase price of a product, but all future costs as well: • Usage
costs (energy/water consumption, consumables such as ink or paper) • Maintenance costs • Disposal
costs/resale value

 E.g Water pump: when we compare based on cost of installation, maintenance, power, repair and remove over
along period.
 = Lower energy >>>lower heat>>>longer life span = Big price at the beginning of purchase
Higher energy >>>higher heat>>>short life span = small price
End of chapter two