The financing area of the project is, in the case of many projects, considered to be within the stakeholder area of influence and, because of that, is not directly addressed by the project manager. But without project management tools and techniques and without studying correctly the cost of the project, it’s impossible to know exactly the amount of money that the project needs and the cost baseline that influences the finance needs of the project.
This paper looks at the best practices in finance and project management areas, and works with them to get to the debt, equity, and return of the project, considering it in the enterprise environment.
“Project finance” is a well-known and frequently addressed topic that can be easily researched in any good library. At amazon.com you can find somewhere in the neighborhood of 3,774 results if you search for textbooks on the topic, and, if you “google” it, you will find around 1,710,000 results. However, when you search “financing the project” instead, you will find only around 1,768 results at amazon.com and 159,000 results using Google’s search engine. Considering that www.amazon.com searches backwards also, there is a huge difference between the information available when you want to investigate “project finances” versus “financing the project.”
The importance of the topic is prominent. Being one of the primary questions that the sponsor asks, it is not a question that is answered well most of the time. The Project Management Institute’s A Guide to the Project Management Body of Knowledge (PMBOK® Guide)—Fourth edition defines sponsor as “the person or group that provides the financial resources—in cash or in kind—for the project” (Project Management Institute [PMI], 2008a, p. 441). And financing the project is, by definition, the most important action that the sponsor has, after having championed the development of the project charter.
Being within the responsibility of the project sponsor, there is no doubt, however, of the importance that financing has to the project. Without proper funding, projects will strive to get the right resources and will be very hard to find the money needed.
Because there are so many things that depend on the decisions made in the finance management of the project, this must be considered a key area for portfolio and program projects managers.
The project charter is the process of developing a document that formally authorizes a project or a phase and of documenting initial requirements that satisfy the stakeholder’s needs and expectations. The project charter provides the project manager with the authority to apply resources to project activities (PMI, 2008a).
Key inputs to the project charter are:
- The “project statement of work” that addresses the business need, the product scope description, and the organization strategic plan (especially the way that the project helps fulfill the strategic vision).
- The “business case” that provides the necessary information that is needed from a business standpoint. The business case is a consequence of (or a combination of) a market demand, an organizational need, a costumer request, a technological advance, a legal requirement, an ecological impact, or a social need. Typically, it includes the business need and the cost-benefit analysis.
Project charter is developed using, as a tool and technique, the “expert judgement”—from other units, consultants, stakeholders (like costumers or sponsors), professional and technical associations, industry groups, subject matter experts, and project management offices (PMO).
Project charter documents the business needs, and it should contain the project purpose or justification, the measurable objectives and success criteria, the high-level requirements, high-level project description, high-level risks, summary milestone schedule, the summary budget, project approval requirements (what is project success, who decides it and who signs off), assigned project manager (responsibility, authority level), and name and authority of the project sponsor or other individual(s) authorizing the project.
Project charter is the key deliverable in making the decision to invest in this or other projects.
Program charter provides authorization to the program management team to use organizational resources to execute the program and it links the program to the business case or the organization’s strategic priorities, according to the Project Management Institute’s The Standard for Program Management—Second edition (PMI, 2008c). When it comes to the way that the financing is treated, projects and programs seem to share the same concepts. Even the treatment given to the components within the program management explains that the business case developed for each of the projects that addresses the investment is a responsibility of the program setup phase. Program funding is required to support the program through the initiating and planning phases, until cost and budgeting are researched later.
Project Cost Management is one of the nine areas of knowledge in the project management framework. It includes the processes involved in estimating, budgeting, and controlling costs so that the project can be completed within the approved budget (PMI, 2008a). Cost, besides objectives and time, is one of the three main constraints that exist in any project. Cost concept is well spread all over the PMBOK® Guide. Every Knowledge Area refers to cost, as most of the decisions made in the Knowledge Areas affect the cost, implying its rise (or decrease)..
Cost is fundamental to determining the budget, the cost baseline, and the earned value management (EVM), since it compares the planned value on the budget with the real cost on the accountancy.
Estimate Costs is the process of developing an approximation of the monetary resources needed to complete project activities, and Determine Budget is the process of aggregating the estimated costs of individual activities or work packages to establish an authorized cost baseline. Control Costs is the process of monitoring the status of the project.
These processes are the most important contributions that the PMBOK® Guide—Fourth edition gives to the profession. To rightly estimate the cost of the project is fundamental to be able to know very important things, such as the expenditure level or the funding requirements. It is the best way to be able to understand and handle the investment that the project requires.
Cash flow analysis is also well addressed in the The Standard for Program Management—Second edition (PMI, 2008c). It is considered as examining the schedule for the program’s revenues and expenses. It is stated to be the analysis of the funding needs, considering, for instance, that in the construction industry funds are usually released when milestones are met.
Other PMI standards, such as The Standard for Portfolio Management—Second Edition (PMI, 2008b), address this question considering that cash flow analysis is necessary for portfolio balancing, considering it to be a tool and technique with that propose. Cost benefit analysis, such as net present value (NPV), discounted cash flow (DCF), internal rate of return (IRR), cost benefit ratio, payback, and options analysis are presented. Quantitative analysis is presented as a tool to examine resource loading requirements or cash flow. Scenario and probability analysis and graphical analytical methods are stated also as tools and techniques to understand better the balancing of the projects.
The main deliverable of the Project Cost Management discussed in the PMBOK® Guide—Fourth edition (PMI, 2008a) is the cost baseline. Cost baseline, although it should incorporate all the work that is produced for planning in all the other knowledge areas, is one of the most important sources of information for control purposes.
PMI’s Construction Extension to the PMBOK® Guide–2000 Edition states “Commonly, the owner determines the need for a new facility or improvement and then performs, or has performed, a further study (often called a feasibility study) to more clearly define the viability and form of the project that will produce the best or most profitable result. The study usually involves a review of alternates that may satisfy the need (value management) and the desired form of financing (financial management)” (PMI, 2003, p.14). This extension goes on to state that the owner usually employs the service of an engineer to do most of the work.
The Construction Extension to the PMBOK® Guide–2000 Edition is an industry-based supplement to the PMBOK® Guide. It utilizes the PMBOK® Guide processes and areas of knowledge by adapting them to the industry that is being considered. The processes used by the general intended guide are adapted, as well as the inputs, tools, techniques, and outputs to the industry that is addressed.
The authors of the extension found that construction industry needs four more areas of knowledge than the nine Knowledge Areas of the PMBOK® Guide. They are Project Safety Management, Project Environment Management, Project Financial Management, and Project Claim Management.
Because the purpose of this section is to introduce the financial management viewed as a strong complement to the Cost Management, other key contributions that this extension has provided to the project management profession are not going to be considered for the purpose of this paper.
Financial management is presented in Chapter 15 of the Construction Extension to the PMBOK® Guide–2000 Edition (PMI, 2003). It is defined as the processes to acquire and manage the financial resources for the project, and it is more concerned with revenue source and analyzing and updating net cash flows for the construction project than is Cost Management. Cost Management is stated to be related more to the management of the day-to-day costs of the project for labor and materials, while financial management is more oriented towards the analyses of the net cash flow.
Major processes are: (1) Financial Planning, (2) Financial Control, and (3) Administration and Records.
Planning is the phase in which all requirements of a financial nature are identified and provided for. Tasks must be identified, requirements placed on a timescale and quantified, and necessary resources to the financial management must be considered.
This process, as stated in the Construction Extension to the PMBOK® Guide–2000 Edition is considered to have the following as inputs (PMI, 2003, p 160):
- Source of funds
- Contract requirements
- Economic environments
- Estimated construction cost
- Project duration
- Tax benefits
- Financial advisor
- Risk factors
Source of funds for the project are often from the company’s central financing system, which may be a combination of borrowing from financial institutions, retained profits, financial reserves and progress, or down payments expected to be made by the client. Source of funds may also be based on direct funding of the project; thus this can be done by the issue of commercial paper, bank loans, public debt offerings, private placements in the market, syndicated commercial long-terms loans, and government entity loans, to name just a few.
Contract requirements are important because they address the client ability to provide the expected cash flow for the project and legal implications that may have arisen. Economic environment is to make sure that the project manager takes into account the market risks.
Estimated construction cost is based on the projected cost for the project. Project duration and time projection of the investment is a critical input. Both are established according to the PMBOK® Guide—Fourth edition (PMI 2008a).
Tax benefits, financial advisor, and risk factors are key issues for the financing activities of the project. Some risk factors that should be taken into account are completion risk, cost overrun, regulatory and political risk, and technology risk.
The process proposes the use of the following tools and techniques:
- Feasibility study
- Financial advisor
- Sensitivity analysis
- Provision for added financing
- Test the financial plan
The feasibility study is a study made to determine if the project can be profitable or whether the proposed payments will be enough to provide for the cost and a reasonable profit. Cash flow measurement is a prime way to determine the viability. Money outflow is determined as being the schedule payments for subcontractors, vendors, fees, insurance, taxes, direct labor, and support staff. By analyzing revenue and expenditure, the net cash flow (inflow minus outflow), and basic finance requirements are determined.
The finance advisor assumes the responsibility of developing a comprehensive marketing strategy that will implement the financing plan in an optimal manner. A sensitive analysis should be performed, varying several parameters to determine the effect of the changed variables in the projected cash flow and preliminary finance plan. Unexpected delays, scope revision, and other risks should be verified, in order to add predicted financial needs to the provision for additional financing. Testing the financial plan and contacting potential lenders to assure the acceptability of the unique features it has are good practices.
The outputs are the project financial plan, the legal entity and the expenditure authority. The project financial plan consists of a clear identification of the financial requirements and of the means to finance them. With this comprehensive document, all parties must understand by whom and when all of the necessary equity, debt, and insurance are to be supplied. Legal entity is the definition of the legal form that the project will take; it may be a partnership, a corporation, trust, joint venture. or a combination thereof. The expenditure authority is usually determined by organizational policies. That must also take into account the fact that dual signatories and levels of spending and approval should be considered.
This process assures that financial control and cost control are executed in the most effective way to ensure that all items are within budget and the financial cash forecast.
Inputs are contract requirements, project financial plan (both as described in the previous section), cost and revenue benefits (the forecasts developed for the financial plan), and change requests (the impact of change requests either in cost or revenues streams must be analyzed and incorporated into the financial plan and their effect in borrowing and other features considered).
Tools and techniques are the project accounting systems, the internal and external audits, and the financial reports.
Project accounting systems structure should be similar to the work breakdown structure (WBS), showing the breakdown of the total project in more controllable modules. The objective is to closely monitor the actual spending and revenue against budget and cash flow forecasts, adjusting either the work methods or problem areas where this mechanism shows deviations.
Internal or external audits consist in assuring that correct accounting methods and financial practices are being maintained. Often they are mandatory.
Financial reports are a requisite for management and for any lenders who may be involved in the project. Status of the project and forecast of the finance health of the project must be on the report.
Output of control is corrective action. Based on the information collected, it may be necessary to develop an action plan to correct deviations.
Financial Administration and Records
This process assures that financial information is administrated and that records are well made. Inputs are the previously presented financial status reports, contract requirements (attention to contract clauses), and project financial plan. Tools and techniques are cost, accounting, and financial systems. The outputs are the traceability of the financial systems and lessons learned. Traceability consists of storing the financial records in a well-defined and standardized way, preferably using a computer-aided financial information storage. Lessons learned should report on the problem areas encountered and the corrective action taken.
With small and minor adjustments, the Construction Extension to the PMBOK® Guide–2000 Edition (PMI, 2003) could be considered for most projects, since it provides an excellent starting point for the questions that we have when we try to make the mind set change from cost to finance.
Good Practice in Project Financial Management
The natural state for a subject that operates at the confluence of numerous disciplines and real world contexts (Urli & Urli, 2000) is considered to be the main reason why it is a very demanding task to identify good practices. Assumptions made from most of the researches and practicing elements that projects are related to the development of new products or processes (WEFO, 2007) to be incorporated into an organization core activity, are not useful to the clear understanding of the project financing needs, since they do not take into account the return of the investment and the cost of operating the product of the project when it is completed. Even cost management is viewed as the way in which the cost is considered from an engineering point of view, and it is rare that the document includes finance or account perspectives.
The construction of a feasibility study is a method primarily used by the sponsor with the objective of establishing three key variables:
- Cost of operation
- Benefits of operation
The problem of calculating these three values is much studied. Every one of the finance methods of analyzing cash flows, such as the NPV, the internal rate of return, and payback period depends substantially on the correct calculation of these. Every beginner knows how to do the math after having those established. And to correctly project these on the timeline is one of the most difficult tasks that we may have to address.
Being able to calculate the return over investment (ROI) is a long-term problem, and it also has long-term solutions. Although the formulas are quite easy, the truth is that to correctly sustain them is not such an easy task. Projected monetary benefits must be compared to project costs. We commonly call this ratio the benefit/cost ratio.
When we investigate benefits, one of the problems is that they are not always directly tangible. And to transform intangibles into measurable elements is not only difficult; it is also subject to several biases and errors. Another key problem when studying benefits is that it’s easy to expect them, but it’s not so easy to make them available. Another is that we only get the money from the benefits after they occurred.
But, when we study the costs, a great deal of other issues also need to be considered. One, common to benefits, is that cost and investment are not in one specific moment in time. In other words, when we analyze a project, we need to take into account the fact that the cash flow projected for the year x is not going to occur on the 31st of December of the year x, since the cash flow comes from several inputs that have occurred throughout the year. On the other hand, it may even happen that predicted cash flows for a particular year only actually entered into the bank account in another time frame, sooner or later than the cash flow directly extracted from accountancy.
Cost and investment projections are very difficult to project. Operational costs of the project may be influenced by future events, and something that is projected today may not be able to occur in the way it is intended. Investment, using project management tools and techniques, is becoming more and more correctly projected, but operational costs are not.
If we proceed in selecting projects without taking into account the way in which the project is organized for benefits and cost, we will end up choosing not the better projects, the ones that bring value to the organization, but instead those that are more easily projected for future benefits and costs.
Identifying and transforming intangibles into tangibles is a key problem for project management to solve. Projects that will bring more satisfying work conditions, improve the organizational involvement, produce better teamwork, produce more or better costumer services, or diminish the number of complaints or conflicts must be comparable with those that bring more invoice volume or new direct profitability.
And, calculating the ROI is also fundamental, because it is the way to measure the contribution each project makes to the organizational performance. ROI makes a sense of priority between projects and improves the selection processes, because it focuses on results. It also raises management sensibility into project management.
Calculating the investment consists of calculating the planned value (PV) of the project, as it is considered in the earned value methodology (EVM). The only adjustments that may be necessary are:
- Those that have to do with the fact that we may need to have the money before (for a subcontractor guarantee fee, for instance) or after (we only pay an invoice several days after it is received and confirmed) the actual cost has occurred
- Those that have to do with the fact that we may need to pay for the total asset investment when, in cost management system, we will only charge the project with the depreciation value
Cost and Benefits
Projecting the operational costs implies the ability to anticipate the direct, indirect, financing, and ownership costs that the project may originate, either to operate itself or to be able to produce the expected results.
This means that it is necessary to develop a cost perception very early. Cost is the total amount of subcontractor invoices, all of the utilities necessary, rent, and other property costs, personnel costs, management costs, taxes, financing costs, and others that may require the expenditure of money to make the product of the project operate.
Benefits are the revenues, either tangible or intangible, that the operation of the product of the project will generate.
Cash Flow Projection
After successfully having projected the investment, cost, and benefit, the projection of the cash flow of the project and of the product of the project is very easy. It is only to add investment to projected cost and project benefits, and considering the time value of the money, that is naturally different and less as time goes by.
Financing the project is to guarantee that the amount of money needed is available. This means that the project management sponsor, in order to know how much money is needed, needs to be able to calculate the amount of the cost, benefits and investment. He or she then needs to adapt the time scale of the money needed, to finally know how much and when the money is required.
Once it is known how much money is needed for the project, it is the sponsor’s responsibility to assure that the money is ready when it’s needed. The sponsor may have direct funding or may establish debt or get other sponsors to fund the project, but it’s indispensable that he or she have full knowledge of the project money implications.
Conclusion and Future Work
Cost (investment) is a very well-studied area in the project management field. But to properly understand product benefits and operating costs, transforming them into expected money and being able to compare them to the Investment is much more difficult and requires the development of Knowledge Areas beyond those addressed by the PMBOK® Guide—Fourth edition (PMI, 2008a). This work is considered as a preliminary approach to help the development of more deep studies into each of the general parts it contains.
On the other side, further investigation is also necessary to improve project measurement systems, especially the measurement of the way in which projects serve business strategy and the global organizations objectives. This can only be done if we first clearly define and understand what we are referring to when we use the word “value.”