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4-5 2008, Karachi, Pakistan
Financial Management of Construction Contracts (Constructability and its Relation with TQM, Cost Shifting Risk And Cost/Benefit)
Tauqir Haider Consultant & Faculty Member, LUMS.UCP.UMT & PU, Lahore, Punjab, Pakistan email@example.com
Financial Management, Book Keeping and Recognition of Construction contracts is now considered as a unique professional job due to its recognition by IASB (International Accounting Standard Board) through IAS (International Accounting Standard) 11. IAS 11 specifically deals with Construction Contracts. This very standard has provided the basis for Constructability. Constructability has received considerable attention from researchers and practicing engineers and other professionals. This is a fact that Constructability has been associated with Total Quality Management (TQM) and Value Engineering. This paper attempts to conceptually describe Cost shifting Risk, Cost/Benefit analysis as well as the evolution of constructability in relation to IAS 11.In addition, the paper presents a framework to measure recognition of Cost and revenues related to Construction Contracts.By providing professionals with this framework, the parameters will be visible and defined, thus removing skepticism as to the financial management as well as enable more consistent and uniform results to be obtained. Additionally, this paper will provide Framework for the Preparation and Presentation of Financial Statements to determine when contract revenue and expenses in the income statement.
Financial Management, Construction Contracts, Constructibility
A Construction Contract is a contract specifically negotiated for the construction of an asset or a combination of Assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use (“Construction Contract: IAS 11” 19951) . Managing the activities of Construction contract in a productive way produces the concept of Constructability. Constructability has been defined as the optimum use of construction knowledge and experience in planning, design, procurement, and field operations to achieve overall project objectives ("Constructability: A Primer" 1986). As a result of constructability, the quality of a constructed facility can be improved by better communication among major project participants such as design engineers and construction professionals. Communication among these participants reduces the chance of project failure and other related performance problems.
IAS 11 specifically deals with the management, Accounting and recognition of Construction contracts. Construction contracts are given a specific identification through IAS 11.
4 A cost plus contract is a construction contract in which the contractor is reimbursed for allowable or otherwise defined costs. A group of contracts whether with a single customer or with several customers. The contracts are performed concurrently or in a continuous sequence. “Total Quality Management in Construction Contracts”: By James. c. “ Audit of Contract”: A Practical Guide 2005. Each asset has been subject to separate negotiation and the contractor and customer have been able to accept or reject that part of the contract relating to each asset. Significant attention has been given to the topic of Construction Contract (IAS-11). “Value Engineering and Cost Benefit: Costing Techniques” By Houston & jordeen 2003. It also presents a framework to measure costs and benefits related to constructability. and contracts for the destruction or restoration of assets. shall be treated as a single contract when: a. There is considerable discussion among industry professionals as to how constructability is related to Total Quality Management (TQM) and value engineering. Evolution of Construction Contract Management Construction contract may be negotiated for the construction of a single asset such as a bridge. examples of such contracts include those for the construction of refineries and other complex pieces of plant or equipment. A fixed price contract is a construction contract in which the contractor agrees to a fixed contract price. A construction contract may also deal with the construction of a number of assets which are closely interrelated or interdependent in terms of their design. 3 2 416 . Construction Contracts – Financial Management When a contract covers a number of assets. Both contractors and their auditors should be aware of the potential impact of shifts in job costs from one contract to another. plus a percentage of these costs or a fixed fee. ship or tunnel. the construction of each asset shall be treated as a separate construction contract when: a. pipeline. dam. or fixed rate per unit of output. The contracts are so closely interrelated that they are. The Construction Management 1991. Separate proposals have been submitted for each asset. in effect. Construction contract include contracts for the rendering of services which are directly related to the construction of the asset. The cost and revenue of each asset can be identified. those for the service of project managers and architects. for example. The contractor should have a reliable job cost system in place to record contract costs accurately.Cost shifting2 is an accidental or deliberate misstatement in a contractor’s job cost system that can have a substantial impact on the contractor’s balance sheet and income statement. and the restoration of the environment following the demolition of assets. part of a single project with an overall profit margin c. Cost shifting is an illegal practice that can change results and outcomes seriously. This paper attempts to conceptually describe these interrelations. technology and function or their ultimate purpose or use. "Constructability: A Primer" 1986. The group of projects are negotiated as a single package b. building. which in some cases is subject to cost escalation clauses. Constructability: An Article of Tauqir Haider in The NEWS” . Santee 2006. road. b. Construction contracts are formulated in various ways such as fixed price contracts3 and Cost plus contracts4. The auditor should always test contract costs and look for unusual contract costing trends.
The price of the asset is negotiated without regard to the original contract price. contract revenue increases as the number of units is increased. A variation may lead to an increase or decrease in the contract revenue. Cost & Revenue Recognition Contract Revenue5 is measured at a fair value of the consideration received or receivable. b. The asset differs significantly in design. Contract Cost 6 include site labor costs inclusive of supervision costs. As per PC-1 cost of the total construction contract is phased along with its targeted completion stages. cost of material used in contract. cost of moving plant. A contractor and a customer may agree variations or claims that increase or decrease contract revenue in a period subsequent to that in which the contract was initially agreed. equipment and material to and from the contract site. costs are attributable to the contract activity in general and other costs specifically chargeable to the customer under the terms of the contract. The measurement of the contract revenue is effected by a variety of uncertainties that depend on the outcome of the future events. When a fixed price contract involves a fixed price per unit of output. technology or function from the asset or assets covered by the original contract. d. When the outcome of the construction contract can be estimated reliably. Practically in Financial Management of Construction contracts PC7-I is devised as a measure which works as a base for all estimations and variations. Therefore. 6 Contract cost directly relates to the specific contract. Attributable costs may include insurance. estimated cost of rectification and claims from third party. b. contract revenue and contract costs associated with the construction contract shall be recognized as revenue and expenses respectively by the reference to the stage of completion of the contract activity at the Balance Sheet. c.A contract may provide for the construction of an additional asset at the option of the customer or may be amended to include the construction of an additional asset. Contract cost however can be reduced by the incidental income. The amount of revenue agreed in a fixed price contract may increase as a result of cost escalation clauses. A variation is an instruction by the customer for a change in the scope of the work to be performed under the contract. The construction of the additional asset shall be treated as a separate construction contract when: a. The amount of contract revenue may decrease a result of penalties arising from delays caused by the contractor in the completion of the contract. Non attributable costs are general admin costs for which reimbursement is not specified in the contract or selling costs. Contract revenue is the initial amount of revenue agreed or variation in contract and claim or reliable measurement. cost of design and technical assistance. For example: a. In addition to incentive payments are additional amounts paid to the contractor if the specified performance standards are met or exceeded. cost of hiring plant & equipment. 7 5 417 . The estimates often need to be revised as events occur and uncertainties are resolved. cost of design and technical assistance and construction overheads. the amount of contract revenue may increase or decrease from one period to the next. depreciation of plant & equipment used on the contract.
it seems improbable that a qualified auditor could simply overlook the improper capitalization of significant assets.000) Estimated Profit ($ 100. It seems improbable that a substantial misstatement of profits could occur without affecting any expense accounts. It also seems improbable that profits could swing without booking any additional billings. 1.000 $1.000) ( 1.Out of the total Construction cost there is a division for direct cost and indirect cost. 9 Running Bill is a periodic basis Bill which is submitted along with stage of completion for payment. many contractors and their auditors have discovered the dramatic impact that cost shifting can have on a company’s financial statement. In the Final Bill all adjustments are done to close the matter however Bank guarantee remains in custody up till the end of the specified period of satisfactory work.1 What is the Effect of Cost Shifting? At first glance.200. In many cases.000 ( 1.300. Some advance payment cans also be availed on the availability of material stock which is again adjusted in future. The example below shows the substantial gross profit impact of a $200.000 1. Significant cost shifting can quickly cause a material misstatement to a contractor’s financial statement and leave the contractor and the auditor open to serious charges. Cost Shifting It is now a day in routine to find out many corporations improperly booking assets related to uncompleted construction contracts. however. Mobilization advance8 is paid at the start of the project to the contractor so that he can mobilize the job to be done in future and this is subject to adjustment in the Running Bills9.200.000) 500.200.200. Cash and accounts payable balances are unaffected. Through these Bills a certain position is calculated along with its financial impact and the payment is made on the work which is certified by the concerned professionals.000) $ 600.000 Billings to date Overbilling (Liability) Revenue to date Costs to date $1. the movement of costs from one contract to another would seem to have little or no overall financial statement impact. traditional audit procedures designed without construction accounting in mind can fail to detect the improper booking of assets related to uncompleted construction contracts. However. Cost shifting is an accidental or deliberate misstatement in a contractor’s job cost system that can have a substantial impact on the contractor’s balance sheet and income statement. Civil works and phase wise cost associated with it. 1. However.000 ( 400. 418 . To the public.000 cost shifting entry: Contract A Contract B Completed Uncompleted Contract Contract Before Cost Shifting Contract Amount $1. cost shifting can have a balance sheet and income statement impact larger than the amount of the costs that have been shifted. Accounts receivable and expense account balances are also unaffected.500.000 100.300.000 Estimated Job Costs ( 1.000) $ 300. The most dangerous type of cost shifting involves moving or misdirecting job costs from an unprofitable job to a profitable job.000) ( 8 Mobilization advance is normally a certain percentage (usually 10%) of the total contract that is paid as advance to start work on it against bank guarantee.
000) $ 100. most cost shifting does not occur when a corporation tries to manipulate its balance sheet. Because Contract B is incomplete.000) $ 100.200.000 over budget or another cost shifting entry will occur.200.000 of costs which did not belong to that job. Auditors and other users of contractors’ financial statements should look at under billings skeptically and investigate each under billing carefully.000) $ 150.000 750. Contractors often pay bonuses to their field managers and estimators based on the profitability of completed contracts. it will either finish $200. Or. gross profit is recognized on the percentage of completion basis.200.000 $1. Uncompleted Contract B received $200. the superintendent of Contracts A and B might deliberately miscode invoices from one job to another to hide losses that occurred under his supervision.000 $ 600.000 of costs are shifted from Contract A to Contract B) Contract Amount Estimated Job Costs Estimated Profit Billings to date Underbilling (Asset) Revenue to date Costs to date Gross Profit to date Job percentage complete Increase in gross profit $1.000 ( 600.Gross Profit to date Job percentage complete ($ 100.000 150. Therefore.3 How to Spot Cost Shifting The only way the contractor’s balance sheet changes when cost shifting occurs is that under billings (an asset) increase and over billings (a liability) decrease. The $200. When Contract B is completed.100.000 ( 1. Completed Contract A improves by $200.200.000 In this example.000) $ 300.2 Who Benefits from Cost Shifting? Although the big corporate cases grab the headlines. the estimator of Contract A might receive a bonus based on the false assumption that the contract was profitable.000) 100% $ 100. In the above example. However.000 cost shifting entry improved the books of the contractor by a total of $250.000.500. 1.000 1.000). Cost shifting can also happen accidentally although the consequences usually are not as severe. Cost shifting occurs most frequently when field level managers attempt to manipulate contract profitability. Contract B recognizes 50% of the estimated gross profit for the entire job ($150. Under billings should be rare. 419 .000 100% $ 200. especially in contracts over 50% complete.000 $ $1. In this example.000 33% After Cost Shifting ($200.000 50% 50.000) rather than 33% of the gross profit for the entire job ($100. 1.000 ( 1. Uncompleted Contract B also improves because the contract is now 50% complete rather than 33% complete.100.000 due to the costs shifted off the job.000 ( 1.
8 420 .5 1.4. shop costs. every audit of a contractor must include random testing of contract costs and the related cost coding.4. At worst. and labor burden.6 1.4 Controls and Audit Steps Designed to Detect Cost Shifting Intentional cost shifting constitutes fraud by some member of a contractor’s management.2 Strong internal controls for job cost coding – Project managers should not have free reign to code job cost invoices without accounting review.1 1. Tests designed to find improperly booked billings or receivables will find no exceptions. the 1.4. Comparison of subcontract costs on particular line items versus the original bid amount can help spot this type of cost shifting. The first measures each job’s prior period profitability forecasts against current forecasts or actual results.7 1. Compare job costs against bid documents – Every contractor should estimate contracts in the same manner in which they record job costs. Two fade schedules should be prepared.3 1. An auditor should test job costs for significant contracts by comparing each line item of job cost against the original forecast. An auditor should test revised profitability estimates against original bid estimates in the same manner in which job costs are compared against bid documents. 1.4. Cost shifting by field personnel can also involve directing a subcontractor to invoice the wrong contract. The auditor should compare the contractor’s bid price versus the second place bidder and versus the average bid price of all the contractor’s competitors bidding for each job.4. Examine bid spreads – Examining bid results can help an auditor determine whether a contractor has been awarded a job at an unusually low price.4. an auditor must test contract costs and internal control systems. A fade schedule measures a contractor’s job profit forecasts versus the final profit on a job. contract fades can indicate cost shifting has occurred. The second schedule should restate prior period uncompleted contract schedules using revised profitability figures. documented with a change order. Any overruns should be explained and. Review allocations of indirect job costs – Cost shifting is often hidden in the allocation of indirect costs such as internally-owned equipment costs. a grading contractor whose overall direct costs are 40% equipment related should have about the same percentage of equipment costs on each job. Audit test work for cost shifting must focus on the accuracy of job costing procedures. preferably.4. The following steps are designed to prevent or detect cost shifting: 1. If a contractor is more than 5% to 10% low on a job.Many users of contractors’ financial statements prepare fade schedules. While audits are not specifically designed to detect fraud.4 1. Perform a fade analysis – The best contractors tend to finish jobs at the same profit levels at which they were forecast.4. Traditional audit procedures designed for non-contractors will not detect cost shifting. The most significant components of the contractor’s job costs should receive the heaviest scrutiny. This actually makes the financial impact of the cost shift even more drastic. significant contract fades can indicate poor job profitability forecasting. At a minimum. For instance. Test revised profitability estimates against bid documents – Very often. Periodic tests should be performed to ensure that each job is being charged its fair share of indirect costs. Test Job costs for accuracy – At a minimum. Tests designed to search for unrecorded liabilities or to detect improper cutoff of expenses will only reflect that all costs have been reported in the proper period. Analytically test job cost components – Contractors who perform similar types of work should have comparable costs from job to job. insurance. cost shifting is accompanied by an upward revision in contract profitability. Each of these schedules helps an auditor determine which contracts have had unusual fluctuations in profits.
constructability has been an evolving work process.1. Another test for this would be to compare uncompleted contract gross profit percentages with completed contract percentages. and designer. The contractor should have a reliable job cost system in place to record contract costs accurately. Compare profitability estimates against historical results – A contractor may attempt to hide cost shifting by increasing profit estimates on uncompleted jobs. The auditor should be careful always to test contract costs and look for unusual contract costing trends. Years ago. A principal focus of TQM is for each supplier of services to identify and satisfy or exceed their customer's needs in terms of cost. quality. the master builder focused on the entire project and considered the impact early decisions had on the construction process. the level of design and construction integration achieved within these organizations serves today as the model for modern constructability programs. TQM has two principal objectives: (1) customer satisfaction and (2) continuous improvement. including the owner. and churches. constructor. The owner supplies the requirements to the designer. including schools. Such a job is a prime target for cost shifting.5 An Ongoing Process Both contractors and their auditors should be aware of the potential impact of shifts in job costs from one contract to another. and time. Total Quality Management (TQM) is a comprehensive and structured approach to organizational management that seeks to improve the quality of products and services through ongoing refinements in response to continuous feedback 10 421 . 1. Constructability Since the formalization of constructability. and construct a facility. During recent years. During the planning and design phases. each party involved on a project. the use of TQM has spread beyond the manufacturing industry to construction. the gross profit percentages on uncompleted jobs will often exceed the contractor’s historical results. In a sense.4. Organizations embracing TQM are adopting a management philosophy that makes quality a strategic objective for the organization.9 contractor will likely make little or no profit on that job. Total Quality Management & Constructability TQM10 requirements may be defined separately for a particular organization or may be in adherence to established standards. design. Master builders were responsible for all project activities required to plan. TQM can be applied to any type of organization. the designer supplies the plans and specifications to the constructor. When this occurs. Successful application of TQM to constructor has increased its recognition as an effective method to improve quality and productivity. it originated in the manufacturing sector and has since been adapted for use in almost every type of organization imaginable. such as the International Organization for Standardization's ISO 9000 series. highway maintenance. plays the role of customer and supplier of services. Within the construction industry. construction and design activities were integrated within the master builder's organization. and the constructor supplies the built facility to the owner. hotel management.
and fire resistance" ( Kavanagh ) 422 . e. and supplies for the purpose of achieving the essential function at the lowest total (life-cycle) cost. facilities. safety. recognition of the need for education regarding the program. these steps must be accompanied by a method of measuring the progress and cost effectiveness of the TQM program. reliability. This includes tabulating quantitative costs and benefits stemming from constructability and TQM such as dollar and schedule savings. this means making a formal effort to recognize problems during the planning and design phases instead of discovering problems during construction. and f. In the construction industry. planning/proposal. improvements and innovations can be implemented in future designs. This commitment must be established from the executive level to the construction craftsmen on the site. implementation/follow-up 11 Value Engineering (VE) has been defined as "the systematic effort directed at analyzing the functional requirements of systems. aesthetics. The second step in continuous improvement is identifying methods that increase productivity including technological innovations. consistent with meeting needed performance. Value Engineering Implementation of value engineering11 involves six steps: a. as well as recognizing qualitative effects such as higher quality and increased customer satisfaction. and constructor representatives as early as the planning phase of a project.Continuous improvement not only involves problem solving on projects but also a proactive search for methods of completing a task more efficiently. d. construction personnel may be more aware of innovations in equipment or construction techniques that may play a key role in improving designs. and a self-assessment regarding capabilities and resources available to achieve the desired goals. The first step of the process is problem avoidance. including construction knowledge and experience. Constructability is a means of continuous improvement in several respects. By so doing. Maintaining a lessons-learned database allows communication of positive and negative activities and experiences from one project to future projects. evaluation. information. However. b. functional analysis. This assures that quality and productivity are not only increased but also maintained. This is a proactive process requiring teamwork. looking and accounting for areas that may later cause problems. Thus. A constructability system can enhance customer satisfaction by facilitating teamwork among owner. it provides more resources. Both steps towards continuous improvement create progress toward more productive and higher quality construction. That is. Measurement of cost effectiveness may also be used to increase corporate awareness and commitment by showing the financial benefits accrued as a result of the TQM process. Measurement of program effectiveness is also a key aspect of both a TQM and constructability program. maintainability. c. Also. procedures. quality. TQM and constructability both stress commitment from all personnel. for planning and designing a quality project that maximizes construction productivity. equipment. designer. creative.
a need exists for standardized cost effective parameters so that constructability performance may be documented and compared among projects and organizations. this does not mean that they are mutually exclusive. constructability consultant. Constructability implementation can act as a precursor to value engineering. as an attack on their design. Personnel from many organizations including the owner. Value engineering may be performed in two ways: (1) proactively or (2) reactively. is synonymous with "The project is over budget and we need to cut X Rupees from the project's scope. A reactive approach gathers cost effective alternatives through design reviews by other project personnel such as constructors and other designer engineers. at the same time. However. Cost Factors To quantify the costs of implementing constructability at the project-level. In the building sector. achieving lowest life-cycle cost. A common concern among parties that procure construction input is the difficulty of accurately estimating its value or benefit. multiple design alternatives are considered and the most cost effective selected on a continual basis throughout the design phase. and materials used to 423 . constructor. Thus. They are typically measured through documented benefits from constructability ideas implemented. Rather.The creative step involves a brainstorming session where life-cycle cost alternatives for design components are considered. providing information through constructor input and lessons learned from past projects such that value engineering may be more effective. often the term V. Cost parameters primarily consist of personnel and miscellaneous cost items. The primary objective of value engineering is to reduce the total life-cycle cost of a facility. and when appropriate vendors and major subcontractors. whereas constructability focuses upon optimization of the entire construction process. This section describes a simplified framework for identifying and quantifying the costs and benefits stemming from implementing constructability at the project-level.E. It is relatively simple to track the cost of design. Thus. Benefits accrued through implementing constructability are often difficult to quantify. value engineering is normally performed during the design phase of the facility delivery process. construction labor. Constructability and value engineering differ in terms of the criteria discussed above. A proactive approach uses value engineering to collect ideas starting at the beginning of design." Some designers view V. suggestions for improvement require design rework. Inconsistent means of cost/benefit measurement may incorrectly reflect the effectiveness of constructability on a project in comparison to other projects or programs in industry. An effective formal constructability program ideally begins during the conceptual planning phase and continues through construction.E. Cost Effectiveness As with TQM. improvements of a constructability program depend upon accurate and consistent measurements of its effectiveness. This is performed after the entire design or specific component of design is complete. activities within the two work processes may complement each other in achieving their goals. a cost estimation framework is necessary. In most cases of industry implementation. Thus. This may result in construction optimization while. design engineer.
R. Inc. ASCE." Journal of Construction Engineering and Management.S & J. Univ. "Total Quality Management: The Competitive Edge. and Gugel. value engineering." accepted for publication in the ASCE Journal of Construction Engineering and Management. the question. J.wikipidea. O'Brien. The Department of Engineering Professional Development. Rowings.J e.E. www." Journal of Construction Engineering and Management. Snodgrass.T. "Total Quality Management: The Competitive Edge. "A Comparison of Two Corporate Constructability Programs." (1990). and constructability are not mutually exclusive. J. Constructability." Journal of Construction Engineering and Management.J. "Management of Construction Productivity. O'Connor. however. (1986)." James. "Constructability for drilled shafts. J. J. in partial fulfillment of the requirements for the degree of Master of Science in Civil and Environmental Engineering. Wisconsin. "Constructability for drilled shafts. TX. Value Analysis in Design and Construction. "A model for design/construction integration during the initial phases of design for building construction projects.complete a given design alternative. "Benefits and Costs of Constructability: Four Case Studies. 118(1)." (1990). "Industrial project constructability improvement. Thus. Summing up Total Quality Management. S. 69-82. 112(1). involves generating ideas that optimize the construction process. ASCE. pp. of Texas at Austin." Journal of Management in Engineering. J.G.com www. T. M. 259-278. Function Analysis: The Stepping Stones to Good Value. and Kasi. A coordinated effort with the application of available standards the Financial Management Aspect as well as cost shifting can be evaluated. Turner.G . ASCE.comanag." James. "Model Constructability Implementation Procedures. A practical approach towards implementation of standards can yield desired results References “Cost Shifting Analysis by Norton Cannons” (2007) International Accounting Standard –IAS(11) Published in 2005 J. (1986). WI. "Constructability of cable-stayed bridges.ocmi.J. Madison. 148-156. Tucker. J." (2006).L.L. J. Construction Industry Institute. McGraw Hill.W.L. "A Comparison of Two Corporate Constructability Programs. R. Radtke.S.com 424 . how do you estimate the value of such ideas? Conclusion In Developing Countries there is an immense need of actual application of COST & MANAGEMENT Accountants to find out the ways to improve the construction quality and its financial impacts so that we can handle the natural disasters and other problems leading to causalities and loss of precious lives. at Madison. Instead. (1986). (1991)." J. University of Wisconsin. (1992). Value Analysis in Design and Construction. M.com www.G.Brown (2007).S & J. ASCE. Austin. 13.P." thesis presented to University of Wisconsin. NY.. New York. and Kaspar. Russell.wisegeek. value engineering and constructability are complementary work processes that may be used as key elements in achieving total quality. (1976). Publication 10-4. 117(2). and Tucker." "Manual for special project management. (1992). 77-93.com www. 2(3). (1992).
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