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Integration of income management and cost management

a complementary for financial analysis of projects

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CONFERENCE PAPER  Cost Management  24 April 2013
Masudifar, Puian | Fardad, Fereydoun
How to cite this article:
Masudifar, P. & Fardad, F. (2013). Integration of income management and cost management:
a complementary for financial analysis of projects. Paper presented at PMI® Global
Congress 2013—EMEA, Istanbul, Turkey. Newtown Square, PA: Project Management
Institute.

Fereydoun Fardad, Aryana Project Management Institute

Abstract
Many project-based companies earn their profit out of their invoices, which can
be named as their income of project execution. Generally, this income is earned
during the execution of project parallel to project expenditures and costs. These
companies are required to analyze their financial situation based on cost and
income factors. Based on professional experiences of the authors, it is essential
that income management processes be integrated with those in cost
management.
This paper proposes some specific methods to define income management
processes in planning and controlling stages align with those in cost
management.
By this process definition and integration, the authors introduce various analyses,
which the most important of them are funding requirements and profitability of
project through the project life cycle, profitability of project work packages to take
risk response strategies, performance measurement indexes of income factors,
as well as forecasting indexes similar to Earned Value indexes.

Introduction
Generally, scope, time, cost, and quality are considered as project objectives.
Among these items is the one that is related to money and financial issues—cost.
Many projects especially those that are executing for an external customer, the
income factor will be so critical in managing the project. In these types of projects
the project management team is in charge of managing the process of earning
the income of project. Obtaining customers’ approval on project deliverables,
preparing invoices and communicating with them about financial issues of the
project is the responsibility of the project management team. The difference
between income and costs determines the profit of accomplishment of the project
for the performing organization (generally a contractor). A desired profit can be
achieved if they can maximize their income while they are trying to reduce their
costs. Thus, income management is an integral part of the project's financial
resource management, and the processes of both cost and income management
should be able to be integrated with each other. Due to this, successful
management of project cash flows and financial issues depends on successful
management of both income and cost factors alongside each other.
This paper, which is prepared based on professional experiences of the authors,
introduces income management processes align with cost management
processes as well as the analysis and benefits that can be gained from
integrated management of them.

Cost Management
What is Cost Management?
Cost can be considered as the money that should be paid to accomplish a
project and cost management is the effort needed to appropriately manage the
financial resources required in a project.
®
The PMBOK  Guide (PMI, 2008) defines cost management as “estimating,
budgeting, and controlling costs so that the project can be completed within the
approved budget.” This standard introduces three processes for cost
management: “Estimate Costs,” “Determine Budget,” and “Control Costs.” By the
concept of process groups in this standard, two steps for cost management can
be defined: “Cost planning” and “Cost control.”
One of the most important outputs of cost planning is “Cost Baseline” (see
Exhibit 1).
In this illustration, cost is committed money that should be expended during the
project. The time a cost occurs is the time when the related work should be
performed not the time that should be paid for that work. This concept is also
applicable in the controlling step in which the actual cost is not the amount of
money really paid for the work performed but the money committed to expend for
the work actually performed.

Exhibit 1 – Cost baseline, expenditures, and funding requirements.

Again based on the Exhibit 1, required funds should be available for project
expenditures (the time that money should be paid). The amount of funds that a
performing organization (e.g., a contractor) has to prepare strictly is dependent to
its earnings, which can be named the organizations income.

Cost Planning

Cost planning is the first step of cost management in which the amount of
financial resources needed for project accomplishment is determined. The most
important outputs of this step are the estimated costs for each activity (or work
package) and the total budget of a project (also known as Budget At Completion
[BAC]). When the estimated cost is merged with the project schedule, a time-
phased diagram is achieved, which is named the “Cost Baseline.” The cost
baseline is developed as a summation of the approved budgets by time period
and is typically displayed in the form of an S-curve, as is illustrated in Exhibit 1.
There are three common approaches to estimate cost of a project:
Top-Down Approach:
This approach generally is based on an analogy with similar previous projects. In
a professional manner this approach is not reliable enough and can be utilized as
a cross-control method, which compares the determined budget with the
desirable budget in the mind of management or the customer.
Quantity-Based Approach:
This approach uses a bill of quantity, price list, etc., in the organization or
industry as the basis of prediction. Commonly, estimators use this kind of list
separately with no specific relation to project Work Breakdown Structure (WBS).
In a well-developed project management system, a WBS can be mentioned as
the center of project integration. Because the quantity base approach generally
breaks down the final product of the project based on the provided list or items
and doesn't cover the project WBS, it can't be take into account as a good
practice of systematic project management.
Bottom-Up Approach:
This is the solely acceptable cost estimating approach in an integrated system.
This approach can utilize various techniques such as expert analysis, parametric
estimating, pert estimating, etc., but should maintain a bottom-up approach
based on project WBS. (See Exhibit 2.)

Exhibit 2 – Levels of a project.

A bottom-up approach based on project WBS can be integrated into the total
project management system and enable the project management team to
analyze financial situation of the project further.

Cost Control

Earned Value Management (EVM) techniques are well-known and valid

techniques for cost control. EVM is a suitable method for integrating the project
management system of a project and is a powerful method to analyze project as
well. To establish an EVM system in a project it is necessary to have:
▪ A strong, reliable and appropriate WBS;
▪ A sound definition of control accounts.
Control accounts are simply the cross point of WBS and OBS in a specific
management selected level of the WBS.

Exhibit 3 – Control accounts.

EVM has three basic parameters that should be determined properly: Planned
Value (PV), Actual Cost (AC) and Earned Value (EV). By means of just these
three items, a project can be analyzed from two viewpoints. One viewpoint looks
to the past performance of the project and another viewpoint gives the project
management team a sense of the project future situation by forecasting.
Each of these viewpoints has specific indexes. Past performance measurement
indexes are: Schedule Variance (SV), Schedule Performance Index (SPI), Cost
Variance (CV) and Cost Performance Index (CPI). Forecasting indexes are:
Estimate At Completion (EAC), To Complete Performance Index (TCPI),
Estimate To Complete (ETC) and Variance At Completion (VAC). Exhibit 4
shows these indexes.
Exhibit 4 – EVM indexes.
 

Income Management
What is Income Management?

Income is the monetary revenue belongs to performing organization (Contractor)

because of accomplishing the project that can determine the organization's profit.
Profit of project can be calculated by subtracting project costs from project
incomes.
Primarily providing the required funds of project is the responsibility of the project
sponsor, although the sponsor uses the project management team's efforts for
that. Since many times the required funds should be provided from the project
income, the sponsor needs to put in place the appropriate process for income
management of the project. (See Exhibit 1.)
In a systematic approach it is necessary to integrate income management
processes with the total project management system, especially cost
management processes. Thus, income management processes must follow cost
management processes. Similar to cost management, two specific processes
(steps) are definable for income management: “Income Planning” and “Income
Control.”

Income Planning

Income planning is the first step of income management in which the amount of
monetary resources can be gained from the customer is determined. The most
important outputs of this step are the estimated income for each activity/work
package (or control account or project phase) and the total income of project
accomplishment (total income).
When the estimated income is merged with the project schedule, a time-phased
diagram is achieved, which can be named the “Income Baseline.” The income
baseline is developed as a summation of the expected incomes by time period.
Planning the income is tightly related to project contract. It is the contract that can
determine when invoices can be issued and project earnings can be achieved.
Normally, baselines have two distinct types: Continues Type: This type is
typically displayed in the form of an S-curve, as is illustrated in Exhibit 5(a).
Generally, cost reimbursable contracts and contracts with time-phased invoices
can be put into this category. Discrete Type: In this type, there are specific times
(weighted milestones/ phases) in the project lifecycle for invoicing. Generally,
fixed price contracts take place in this category. See Exhibit 5(b).

Exhibit 5 – (a) Income baseline—continues, (b) income baseline—discrete.

Similar to cost estimating, income estimating has to follow a bottom-up approach.
Even if there is a price list attached to the contract, income should be calculated
in as much detail as possible regarding to WBS (in the level of activities, work
packages, control accounts or at least specific phases of the contract).
Integrating income management processes with cost management processes
can give the project management team directions to determine control accounts
appropriately. Contract constraints are determinant in this issue.
Sometimes in the calculations, it is needed to adjust cost and/or income with the
current situation of prices because of some issues like inflation. The project
management team is responsible for taking appropriate solutions to make such
an adjustment.

Income Control
For income control an effective method can be benchmarked from EVM. This
benchmarked method can be named “Earned Income Management (EIM).”
Similarly EIM has three basic parameters that should be determined properly:
Planned Income (PI), Actual Income (AI), and Earned Income (EI). EIM has its
own controlling indexes like EVM from two viewpoints as well:
Past performance measurement indexes are Income Variance (IV) and Income
Performance Index (IPI) as well as Schedule Variance based on Income and its
relevant performance indexes (SVi & SPIi);

Exhibit 6 – Past performance measurement indexes for income.

 
Forecasting indexes are Income Estimate At Completion (EACi), Income
Estimate To Complete (ETCi), and Income Variance At Completion (VACi).

Exhibit 7 – Forecasting indexes for income.

 

Benefits and Analysis Gained From this System

Many benefits are achievable via analyzing cost status (EVM analysis) or income
status (EIM analysis) of the project individually. In addition, by analyzing the
situation of the project, based on cost and income factors simultaneously,
especially by comparing relevant factors, many benefits and analysis will be
achieved as well. Below some of these analyses are introduced.

Calculating the Profitability of Activities (or Work Packages)

In a project there are many work packages. Some of these work packages can
be profitable and some can be nonprofitable. It is the total profitability of whole
work that determines project profit. Awareness of profitable and non-profitable
works helps the project management team in better management of a project; for
example, in reducing costs, having the staffs trained in weak areas, etc.

Helping to Decide Whether to Outsource a Work Package or Not

If a work package is not profitable it may means that the organization doesn't
have enough facilities or resources to do that specific job. Typically,
organizations prefer to outsource their non-profitable work packages. By taking
this strategy they can turn non-profitable items to profitable items or at least
complete them with minimum loss. Integrated cost and income management
processes can be helpful on this issue.

Defining Profitable Activity Groups

In many projects, different activities (or work packages) belong to a specific

activity group (e.g., concrete works, installation, etc.). The major share of project
activities can be grouped into a bunch of determined groups. A Functional Work
Breakdown Structure (FWBS) is a good technique to define project activity
groups. Grouping project activities makes this obvious to the project
management team, and helps determine which activity groups are profitable and
which are non-profitable. Generally, profitable activity groups of a project belong
to the core business of the organization and others are just an unrejectable part
of the project (contract). With non-profitable activity groups, an organization can
put an outsourcing strategy in place or try to empower itself by trainings or hiring
better resources.

Assisting on Defining Risk Response Strategies

Based on obtained analyses and an organization's risk threshold, financial risks

of the project can be better identified and relevant response strategies can be
better adjusted. Avoiding, mitigating, or transferring a risk would be decided
based on profitability of work packages, and contingency plans for accepted risks
will be devised accordingly. As an instance, risks that can menace profitable
work packages can be avoided or mitigated while the threat that a work package
becomes non-profitable can be transferred.

Assisting on Deciding About Change Requests

If a change request (especially a scope change) arises, it can be analyzed by

considering the profitability factor in an integrated change control process.

Determining Customer's Financial Obligation

Although the income baseline is useful within the project management team, it
can shows the project customer his/her own time phased funding obligations. As
there is a difference between the cost baseline and project expenditures (see
Exhibit 1), there is also a difference between the income baseline and invoice
payment. Based on income baseline and contract provisions, a time phased
invoice payment diagram (the customer's obligation) will be determinable.
Clearing customer's financial obligations can help to maintain a better interaction
between two parties and can avoid later changes in the project by a better
planning in advance.

Determining Project Profitability Areas Through the Time

Comparing a cost baseline and an income baseline of a project can gives the
project management team a vision of profitability periods of the project and
determination of where the breakeven point of the project stands. The breakeven
point is the point in which profit and loss of project are equal. At this point the
profitability condition of project turns. A project can have more than one
breakeven point or even no breakeven point. The variance between total income
(IAC) and total cost (BAC) defines the final desired profit of project.
Exhibit 8 shows some possible conditions of a project, regarding to its profit and
loss periods.
Exhibit 8 – Some examples of possible breakeven points in a project.

Deciding on Whether to Participate in a Project or Not

Income of a project is the commitment of the customer. When a project is in its

loss area, it needs to be funded by the project sponsor internally. The funded
monetary resources will be returned later when the project falls into its profit
area. By this analysis, contractors would be able to adjust the project, based on
their financial potential and if they don't have enough financial capacity,
accepting the project is a mistake that leads the organization towards failure.

Determining Actual Profitability of the Project

Actual profitability of the project is the result of comparison of the project's actual
cost and actual income. With this comparison, the actual breakeven point of
project will be determinable. Exhibit 9 illustrates this concept.
Exhibit 9 – Actual profitability of the project.

Helping on Schedule Compression and Leveling

The analyses assist the project management team on optimizing project

schedule by using activities’ floats. Nonprofitable activities can be postponed to
maintain the balance of profitability of the whole project or until the time when
financial resources become available to the project. On the contrary, high
profitable activities can be considered as the “financially critical activities” that
shouldn't be delayed so that their income can be gained earlier.
Also in a schedule compression, profitable activities are first nominated activities
for crashing or fast tracking rather than non-profitable activities.

Helping on Contractual Claims

Analyses based on cost and income baselines can help on better management
of claims. Non-profit areas can be triggers and motives lead the contractor to
contractual claims. As well, making a delay (a schedule change) in the project by
the customer may change profitability diagrams and cause the contractor's
resistance unless a compensation solution is put into place.

Lessons Learned
 
By implementing such integrated cost and income processes in various projects,
the authors have obtained valuable lessons learned. The authors recommend
project management teams to follow the following guidelines for implementing an
integrated financial system in projects.

Tactical Lessons Learned

▪ Training is a key success factor. Project management teams need to be trained
about the system.
▪ Obtaining senior management support on developing a new system is another
key success factor for this system.
▪ Implementing the system in all projects and sharing the lessons learned should
be directed by organization's PMO.
▪ Sharing project profit with project team can be an effective incentive to reduce
project costs.

Technical Lessons Learned

▪ The WBS is the most important part of project planning, which is able to
integrate other planning parts, so it is necessary to spend enough time to create
a sound and well-structured WBS.
▪ Planning should be done in the lowest possible level of WBS, but if it isn't
applicable, try upper levels.
▪ Determining control accounts (CAs) appropriately is very important. Project
requirements, contracts, and an established payment system can be good
guidelines to determine correct CAs. Note that each CA has to have only one
responsible party.
▪ To have more reliable outcomes and analyses (especially about project profit),
including indirect costs in cost estimating.
▪ To have more detailed and more useful reports to help improve the accounting
and warehousing systems.
▪ Record costs and incomes—what is done today but will be paid tomorrow
should be recorded as today's cost or income.
▪ Similarly, the money spent yesterday for the work supposed to be done today,
should be recorded as today's costs.
▪ To analyze project data, try to develop beneficial databases and computer
programs.
▪ Schedule indexes (SV, SPI, and even Earned Schedule) in EVM and also in
EIM are not sufficiently reliable indexes to analyze project schedule. The Critical
Path Method definitely gives more accurate analyses about schedule status.
Project Management Institute. (2008). A guide to the project management body
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of knowledge (PMBOK  guide) (4  ed.). Newtown Square, PA: Project
Management Institute.
Callahan, K. R., Stetz, G. S., & Brooks, L. M. (2011). Project management
accounting: Budgeting, tracking and reporting cost and profitability (second
edition). New Jersey: John Wiley & Sons, Inc.
International Project Management Association (IPMA). (2006). ICB- IPMA
competence baseline. (Version 3.0), Netherlands: IPMA.
Project Management Institute. (2005). Practice standard for earned value
management. Newtown Square, PA: Project Management Institute Inc.
Project Management Institute. (2006). Practice standard for work breakdown
structures (second edition). Newtown Square, PA: Project Management Institute
Inc.
Project Management Institute. (2011). Practice standard for project
estimating. Newtown Square, PA: Project Management Institute Inc.
Stockman,W. K., Kammerer, J. T., & King, D. R. (2002). The relationship
between cost analysis and program management. The Journal of Cost Analysis
& Management, Special Edition, (pp. 1-7).
This material has been reproduced with the permission of the copyright owner.
Unauthorized reproduction of this material is strictly prohibited. For permission to
reproduce this material, please contact PMI or any listed author.
©2013 Puian Masudifar, Fereydoun Fardad
Originally published as a part of 2013 PMI Global Congress Proceedings –
Istanbul, Turkey
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