Project Forecast: Why it is Important Not to Confuse Actual Changes and Productivity Issues

We have found repeatedly in our consulting interventions that Project-driven organizations often confuse a number of causes for variances to the Project forecast. Astonishingly, this happens even in established and recognized organizations. This results in misunderstandings as to the reasons for deviations of the project forecast outcome. As a result, corrective actions taken by Project Management can be significantly delayed and have a very poor effectiveness. Our new White Paper 2014-13 ‘Understand Project Forecast Variances: Why it is Important Not to Confuse Actual Changes, Productivity Issues and Materialization of Risks‘ investigates this essential issue.

Natural Variation is part of any process. Think of this curve as representing the level of effort to produce a given deliverable. Variations happen naturally around some average. Yet nothing was changed!

When executing a Project, a number of situations can lead to changes of the project outcome – either in terms of cost or schedule:

• Changes – to the project scope or even simply to the project execution plan, due either to internal choice or to external request,
• Materialization of (external) opportunities or risks,
• Variances that are not due to either changes or risks, and that are simply the result of differences with the expected productivity of resources, bid estimation errors, the result
  of mistakes or unexpected rework, external market conditions, duplicate ordering of material etc.

Many organizations unfortunately confuse the causes of forecast variance by allocating all variances to Changes. This results in great confusion. In particular, the most critical issue we observe is late recognition of forecast variance due to requirements to treat them as changes and hence go through a lengthy approval process.

On one side, an effective Management of Change practice covering all internal Changes irrespective if their contractual status is critical for project teams to early identify the relevant potential variance enabling the teams to take proactive measures and efficiently manage the business.

On the other side, proper segregation of the causes of forecast variances is then essential to effective action-taking. Confusing all variances with Changes is deeply misleading and adds other issues in particular, frequent lag in the recognition of actual variances, or inability to fully apprehend productivity issues at a time where something can still be done about them.

Understand this essential issue in our new White Paper 2014-13 ‘Understand Project Forecast Variances: Why it is Important Not to Confuse Actual Changes, Productivity Issues and Materialization of Risks‘ released today!

Thanks to Kamlesh Narwani for the challenging exchanges on the draft of this White Paper.

How to Deal with the Complication of Cost Control for Multi-Entity, Multi-Currency International Projects

Most Large, Complex Projects are executed nowadays in an international environment. Sometimes the contract given to a Contractor is split into several contracts for several entities often located in different countries. At the same time, multiple currencies are often used both for revenue and expenditure. Being able to manage effectively this additional complexity and take advantage of it is a substantial competitive edge for international contractors, where maturity of processes and systems is essential for success. Our new White Paper 2014-12 on Multi-Currency, Multi-Entity Cost Control explains the basics that need to be followed.

The White Paper tackles in particular the following key issues:

• How overall Percentage of Completion accounting needs to be implemented, and not a Percentage of Completion accounting separate per entity; and how to deal with the accruals that result,
• How multi-currency issues have to be managed, and what are the different ways to protect oneself against currency fluctuations – natural hedging and contractual hedging, and what are the advantages and drawbacks of each method.

Mature international contractors distinguish themselves by being able to manage the complication of multicontract, multi-currency situations through adequate systems and processes.

Multiple contracting entities and multiple currencies are additional challenges that are often unavoidable in the performance of international contracts, in particular in certain countries. Specific control and accounting approaches must be used. If they are not implemented, profit might be recognized imprudently too early and significant impacts can happen from changes in currency exchange rates. This has led many upcoming project-driven organizations in difficult situations with respect to their investors or clients. Surprises created because of these issues denote poor control of project operations. Learn how to overcome these issues in our new White Paper 2014-12 on Multi-Currency, Multi-Entity Cost Control !

How to Manage Properly Project Cost Time-Phasing to Avoid Project Financial Reporting Surprises

Percentage-of-Completion (POC) accounting amplifies any change in the project forecast at completion when it comes to the short term financial results recognition (refer to our previous White Paper 2014-10). In this new White Paper 2014-11 we give Project Managers strategies to manage the time-phasing of their project costs in a way that will avoid as much as possible surprises at the end of the accounting year – thus preserving a trusting relationship with the organization’s executive management.

Your Percentage of Completion forecast at the end of the year is critical to the organization. Make sure your cost time phasing is relevant!

The project cost model must be time-phased month by month for each section of the Cost Breakdown Structure (often called Work Packages). This should be implemented in the Cost Control tool. Downloads from the Cost Control Tool will then feed the financial models.

It is important to review the time phasing on a monthly basis to make sure that costs that are known to slip to the next accounting period (fiscal quarter or year) have effectively been pushed as soon as this information is known. This is critical to ensure the quality of the time-phasing as seen from the financial function, and avoid any unpleasant surprises in the last few weeks of a Quarter the last few months of a Financial Year. The White Paper gives some useful strategies that can be used to minimize the surprise effect of project delays.

As a general observation it is important to be conservative (pessimistic) when it comes to the time-phasing of the cost that will be used as a basis for POC calculation and hence, profit recognition for the accounting period. While not the priority of the Project Manager, she needs to understand the importance of this issue for the organization’s senior management and check that a proper process is in place, together with the relevant awareness of her Cost Control team.

Advice for Project Managers: a good Project Manager is a Project Manager that retains responsibility of projects because she knows how to manage senior management expectations. Don’t give senior management unrealistic expectations as to the profit that could be recognized for your project in this particular year or quarter! Read our new White Paper 2014-11 “How to Manage Properly Project Cost Time-Phasing to Avoid Project Financial Reporting Surprises at the End of the Accounting Year!

Understand the Surprising Effects of Percentage-of-Completion Accounting on Project Financial Results

While Project Managers are rightfully focused on the end result of their projects (forecast at completion), they need to be aware that changes in their forecast will be amplified by the accounting methods when it comes to the short term profit recognition for large projects spanning over multiple years. Accounting principles sometimes lead to counter-intuitive results, and great opportunities from the Project Manager point of view could even turn into a short term loss that needs to be recognized by the organization! Our new White Paper 2014-10 explains in detail what are these effects and how to manage them from the perspective of the project manager.

Percentage-of-Completion (POC) accounting is the most used accounting method when it comes to lump-sum construction projects profit & loss (P&L) accounting. The Project Manager must be aware that POC accounting introduces a double whammy effect when it comes to the amplification of variances in EAC forecast. This is of course, particularly applicable to multi-year projects.

In the White Paper we describe the main effects: amplification of project forecast variance between accounting periods, effect of changes in the time phasing of costs (without change in the project forecast). The case of an unsigned change order introduces a double whammy situation where the two previous effects add up.

It should be clear that the main focus of Project Managers should be their EAC profit at the end of the project, on which they are accountable.
However, Project Managers must be sensitive to the fact that changes to the forecast and cost time-phasing changes will have a very significant impact on the company’s performance, as these changes will be dramatically amplified by the POC accounting method. Project Managers need to understand these effects: read our new White Paper 2014-10 “Understand the Surprising Effects of Percentage-of-Completion Accounting on Project Financial Results”!

How to Manage Properly Your Project Contingency Throughout Project Execution

Setting up a contingency element as part of the project cost is nowadays a common practice in project management. It can be derived by various methods including advanced statistical (Monte Carlo) methods. However, because it is so intrinsically linked to profit recognition, the contingency element is not always properly managed throughout project execution, leading to unpleasant surprises for the organization. Our new White Paper 2014-09 exposes good practices and some typical shortcomings that are commonly observed.

Contingency is a very particular cost element. Contingency is reforecast using the relevant project risk management process. This tricky cost element attracts a lot of attention from management, so that the contingency update needs to be supported by a clear and shared risk management process. Notwithstanding the process chosen to determine contingency, it should generally decrease as the project progresses, because it addresses future risks.

Managing project contingency throughout project execution: discretionary contingency and calculated contingency

It is not a recommended practice to release contingency to compensate for higher costs compared to the budget. Contingency should only be used to compensate for exceptional events that are external and beyond the normal control of the Project Manager. Beyond those exceptional events, release of contingency by senior management should only be the result of an appreciation on the residual risk of the project moving forward, not on the poor estimate of costs that have already been spent.

Understand what are the proper practices of contingency management in our new White Paper 2014-09 “How to Manage Properly Your Project Contingency Throughout Project Execution” !

Why the ‘Achievable’ project forecast is as Important as the Prudent ‘Estimate At Completion’

When it comes to forecasting the final outcome of a project in terms of cost and profit result, two different forecasts need to be established: a prudent ‘Estimate at Completion’ used for short term accounting reporting, as well as an ‘Achievable/ Likely’ forecast derived from a sensitivity analysis, that is used to anticipate the organization’s longer term financial performance. Both are equally important to the project-driven organization and should call for the same level of attention from the Project Manager. In our new White Paper 2014-08 we investigate why they are both important and how they should be derived and considered.

Manage your management expectations using properly the ‘Achievable’ Forecast

The EAC is a prudent estimate of the project outcome. It contains a significant element of contingency (which has been calculated using a specific process that can involve advanced statistical methods). It is also often conservative because it recognizes costs immediately but revenue only when a Change Order has been formally signed by the Client. Hence the EAC is supposed to be a relatively pessimistic – or prudent – view of project outcome; some organizations describe it as something like a P80 (only 20% chances to be worse).
The ‘Achievable’/ ‘Likely’ forecast, contained in a sensitivity table, on the other hand, reflects what the project believes it can achieve. It reflects a reasonable amount of additional revenue from unsigned Change Orders and the P50 (achievable) contribution from the contingency calculation. It also reflects risks and opportunities that have not yet materialized but that the project manager reasonably believes will happen.

At the company financial level which aggregates several projects, the ‘Achievable’ value or some part thereof is considered for the company financial forecast, which is why it is so important to the organization.

Project Managers should thus focus their attention as much on the Estimate at Completion (EAC) as on the ‘Achievable’ or ‘Likely’ forecast, because of the implications for the organization. It is also a way to go beyond the necessarily prudent (accounting-driven) EAC to really understand the potential of the project. Understand how that principle works in reality in our new White Paper 2014-08 “Why the ‘Achievable’ project forecast is as important as the Prudent ‘Estimate At Completion’”!

What the Two Approaches for Cost Forecasting are, and When to Use Them

Depending on the type of cost, there are two different fundamental approaches to Cost Forecasting. The differences between those two approaches, where they do apply and where they cannot apply, need to be fully understood by Project Managers and Cost Controllers. In our new White Paper 2014-07 we expose what are these two approaches, what are they main characteristics, and how best to use them.

The principles of the progress based forecast: there needs to be independent cost and progress measurements!

The two fundamental forecasting approaches that are applicable to different types of costs are:

• An approach based on Commitment / Yet-to-Commit for external costs related to numerous small purchases of standard equipment such as bulk piping, steelwork, electrical equipment, etc.;
• An approach based on Estimate to Complete derivation from productivity data (Earned Value) for internal costs (engineering) or external costs such as services, subcontracts, fabrication, complex procurement, etc.

Unfortunately depending on their history, organizations sometimes tend to use a single approach for all types of costs, which does not work. It is essential to be able to use both methods depending on the type of activity or costs that is involved.

In any case, it is important to understand that the final cost does depend in part on the underlying quantities, but also on softer issues related to contractual issues and other considerations.

Read our new White Paper 2014-07 “What the Two Approaches for Cost Forecasting are, and When to Use Them” to understand in detail these two types of forecasting and what are the main traps to avoid!