Description
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).
415
First International Conference on Construction in Developing Countries (ICCIDC-1)
“Advancing and Integrating Costruction Education, Research & Practice”
August 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 protected]
Abstract
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.
Key Words
Financial Management, Construction Contracts, Constructibility
Introduction
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.
1
IAS 11 specifically deals with the management, Accounting and recognition of Construction contracts.
Construction contracts are given a specific identification through IAS 11.
416
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. Both contractors and their
auditors should be aware of the potential impact of shifts in job costs from one contract to another. The
contractor should have a reliable job cost system in place to record contract costs accurately. The auditor
should always test contract costs and look for unusual contract costing trends.
There is considerable discussion among industry professionals as to how constructability is related to
Total Quality Management (TQM) and value engineering. This paper attempts to conceptually describe
these interrelations. It also presents a framework to measure costs and benefits related to constructability.
Significant attention has been given to the topic of Construction Contract (IAS-11), The Construction
Management 1991, "Constructability: A Primer" 1986, “ Audit of Contract”: A Practical Guide 2005,
Constructability: An Article of Tauqir Haider in The NEWS” , “Total Quality Management in
Construction Contracts”: By J ames. Santee 2006, “Value Engineering and Cost Benefit: Costing
Techniques” By Houston & jordeen 2003.
Evolution of Construction Contract Management
Construction contract may be negotiated for the construction of a single asset such as a bridge, building,
dam, pipeline, road, ship or tunnel. 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, technology and
function or their ultimate purpose or use; examples of such contracts include those for the construction of
refineries and other complex pieces of plant or equipment.
Construction contract include contracts for the rendering of services which are directly related to the
construction of the asset, for example, those for the service of project managers and architects; and
contracts for the destruction or restoration of assets, and the restoration of the environment following the
demolition of assets. Construction contracts are formulated in various ways such as fixed price
contracts3 and Cost plus contracts4.
Construction Contracts – Financial Management
When a contract covers a number of assets, the construction of each asset shall be treated as a separate
construction contract when:
a. Separate proposals have been submitted for each asset.
b. 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.
c. The cost and revenue of each asset can be identified.
A group of contracts whether with a single customer or with several customers, shall be treated as a single
contract when:
a. The group of projects are negotiated as a single package
b. The contracts are so closely interrelated that they are, in effect, part of a single project with an
overall profit margin
c. The contracts are performed concurrently or in a continuous sequence.
2
Cost shifting is an illegal practice that can change results and outcomes seriously.
3
A fixed price contract is a construction contract in which the contractor agrees to a fixed contract price, or fixed
rate per unit of output, which in some cases is subject to cost escalation clauses.
4
A cost plus contract is a construction contract in which the contractor is reimbursed for allowable or otherwise
defined costs, plus a percentage of these costs or a fixed fee.
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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. The construction of the additional asset shall
be treated as a separate construction contract when:
a. The asset differs significantly in design, technology or function from the asset or assets
covered by the original contract.
b. The price of the asset is negotiated without regard to the original contract price.
Cost & Revenue Recognition
Contract Revenue5 is measured at a fair value of the consideration received or receivable. The
measurement of the contract revenue is effected by a variety of uncertainties that depend on the outcome
of the future events. The estimates often need to be revised as events occur and uncertainties are resolved.
Therefore, the amount of contract revenue may increase or decrease from one period to the next. For
example:
a. 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.
b. The amount of revenue agreed in a fixed price contract may increase as a result of cost
escalation clauses.
c. The amount of contract revenue may decrease a result of penalties arising from delays caused by
the contractor in the completion of the contract.
d. When a fixed price contract involves a fixed price per unit of output, contract revenue increases
as the number of units is increased.
A variation is an instruction by the customer for a change in the scope of the work to be performed under
the contract. A variation may lead to an increase or decrease in the contract revenue. In addition to
incentive payments are additional amounts paid to the contractor if the specified performance standards
are met or exceeded.
Contract Cost 6 include site labor costs inclusive of supervision costs, cost of material used in contract,
depreciation of plant & equipment used on the contract, cost of moving plant, equipment and material to
and from the contract site, cost of hiring plant & equipment, cost of design and technical assistance,
estimated cost of rectification and claims from third party. Contract cost however can be reduced by the
incidental income. Attributable costs may include insurance, cost of design and technical assistance and
construction overheads. Non attributable costs are general admin costs for which reimbursement is not
specified in the contract or selling costs.
When the outcome of the construction contract can be estimated reliably, 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.
Practically in Financial Management of Construction contracts PC
7
-I is devised as a measure which
works as a base for all estimations and variations. As per PC-1 cost of the total construction contract is
phased along with its targeted completion stages.
5
Contract revenue is the initial amount of revenue agreed or variation in contract and claim or reliable
measurement.
6
Contract cost directly relates to the specific contract, costs are attributable to the contract activity in general and
other costs specifically chargeable to the customer under the terms of the contract.
7
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Out of the total Construction cost there is a division for direct cost and indirect cost, Civil works and
phase wise cost associated with it. 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. 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. Some advance payment
cans also be availed on the availability of material stock which is again adjusted in future. 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. Cost Shifting
It is now a day in routine to find out many corporations improperly booking assets related to uncompleted
construction contracts. To the public, it seems improbable that a qualified auditor could simply overlook
the improper capitalization of significant assets. However, traditional audit procedures designed without
construction accounting in mind can fail to detect the improper booking of assets related to uncompleted
construction contracts. 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 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. The most dangerous type of
cost shifting involves moving or misdirecting job costs from an unprofitable job to a profitable job. Cash
and accounts payable balances are unaffected. Accounts receivable and expense account balances are
also unaffected. In many cases, however, cost shifting can have a balance sheet and income statement
impact larger than the amount of the costs that have been shifted.
1.1 What is the Effect of Cost Shifting?
At first glance, the movement of costs from one contract to another would seem to have little or no overall
financial statement impact. 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. However, many contractors and their auditors have discovered the
dramatic impact that cost shifting can have on a company’s financial statement. The example below
shows the substantial gross profit impact of a $200,000 cost shifting entry:
Contract A Contract B
Completed Uncompleted
Contract Contract
Before Cost Shifting
Contract Amount $1,200,000 $1,500,000
Estimated J ob Costs ( 1,300,000) ( 1,200,000)
Estimated Profit ($ 100,000) $ 300,000
Billings to date $1,200,000 $ 600,000
Overbilling (Liability) - ( 100,000)
Revenue to date 1,200,000 500,000
Costs to date ( 1,300,000) ( 400,000)
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.
9
Running Bill is a periodic basis Bill which is submitted along with stage of completion for payment.
419
Gross Profit to date ($ 100,000) $ 100,000
J ob percentage complete 100% 33%
After Cost Shifting
($200,000 of costs are shifted from Contract A to Contract B)
Contract Amount $1,200,000 $1,500,000
Estimated J ob Costs ( 1,100,000) ( 1,200,000)
Estimated Profit $ 100,000 $ 300,000
Billings to date $1,200,000 $ 600,000
Underbilling (Asset) - 150,000
Revenue to date 1,200,000 750,000
Costs to date ( 1,100,000) ( 600,000)
Gross Profit to date $ 100,000 $ 150,000
J ob percentage complete 100% 50%
Increase in gross profit $ 200,000 $ 50,000
In this example, Completed Contract A improves by $200,000 due to the costs shifted off the job.
However, Uncompleted Contract B also improves because the contract is now 50% complete rather than
33% complete. Because Contract B is incomplete, gross profit is recognized on the percentage of
completion basis. Therefore, Contract B recognizes 50% of the estimated gross profit for the entire job
($150,000) rather than 33% of the gross profit for the entire job ($100,000). The $200,000 cost shifting
entry improved the books of the contractor by a total of $250,000.
In this example, Uncompleted Contract B received $200,000 of costs which did not belong to that job.
When Contract B is completed, it will either finish $200,000 over budget or another cost shifting entry
will occur.
1.2 Who Benefits from Cost Shifting?
Although the big corporate cases grab the headlines, most cost shifting does not occur when a corporation
tries to manipulate its balance sheet. Cost shifting occurs most frequently when field level managers
attempt to manipulate contract profitability. Cost shifting can also happen accidentally although the
consequences usually are not as severe.
Contractors often pay bonuses to their field managers and estimators based on the profitability of
completed contracts. In the above example, the estimator of Contract A might receive a bonus based on
the false assumption that the contract was profitable. Or, the superintendent of Contracts A and B might
deliberately miscode invoices from one job to another to hide losses that occurred under his supervision.
1.3 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. Under billings should be rare, especially in
contracts over 50% complete. Auditors and other users of contractors’ financial statements should look at
under billings skeptically and investigate each under billing carefully.
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Many users of contractors’ financial statements prepare fade schedules. A fade schedule measures a
contractor’s job profit forecasts versus the final profit on a job. At a minimum, significant contract fades
can indicate poor job profitability forecasting. At worst, contract fades can indicate cost shifting has
occurred.
Traditional audit procedures designed for non-contractors will not detect cost shifting. 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. Tests designed to find improperly booked billings or receivables
will find no exceptions. Audit test work for cost shifting must focus on the accuracy of job costing
procedures.
1.4 Controls and Audit Steps Designed to Detect Cost Shifting
Intentional cost shifting constitutes fraud by some member of a contractor’s management. While audits
are not specifically designed to detect fraud, an auditor must test contract costs and internal control
systems. The following steps are designed to prevent or detect cost shifting:
1.4.1 Strong internal controls for job cost coding – Project managers should not have free reign to code
job cost invoices without accounting review.
1.4.2 Test J ob costs for accuracy – At a minimum, every audit of a contractor must include random
testing of contract costs and the related cost coding. The most significant components of the
contractor’s job costs should receive the heaviest scrutiny.
1.4.3 Compare job costs against bid documents – Every contractor should estimate contracts in the
same manner in which they record job costs. An auditor should test job costs for significant
contracts by comparing each line item of job cost against the original forecast. Any overruns
should be explained and, preferably, documented with a change order.
1.4.4 Test revised profitability estimates against bid documents – Very often, cost shifting is
accompanied by an upward revision in contract profitability. This actually makes the financial
impact of the cost shift even more drastic. An auditor should test revised profitability estimates
against original bid estimates in the same manner in which job costs are compared against bid
documents. Cost shifting by field personnel can also involve directing a subcontractor to invoice
the wrong contract. Comparison of subcontract costs on particular line items versus the original
bid amount can help spot this type of cost shifting.
1.4.5 Analytically test job cost components – Contractors who perform similar types of work should
have comparable costs from job to job. For instance, a grading contractor whose overall direct
costs are 40% equipment related should have about the same percentage of equipment costs on
each job.
1.4.6 Review allocations of indirect job costs – Cost shifting is often hidden in the allocation of indirect
costs such as internally-owned equipment costs, shop costs, insurance, and labor burden.
Periodic tests should be performed to ensure that each job is being charged its fair share of
indirect costs.
1.4.7 Perform a fade analysis – The best contractors tend to finish jobs at the same profit levels at
which they were forecast. Two fade schedules should be prepared. The first measures each job’s
prior period profitability forecasts against current forecasts or actual results. The second schedule
should restate prior period uncompleted contract schedules using revised profitability figures.
Each of these schedules helps an auditor determine which contracts have had unusual fluctuations
in profits.
1.4.8 Examine bid spreads – Examining bid results can help an auditor determine whether a contractor
has been awarded a job at an unusually low price. 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. If a contractor is more than 5% to 10% low on a job, the
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contractor will likely make little or no profit on that job. Such a job is a prime target for cost
shifting.
1.4.9 Compare profitability estimates against historical results – A contractor may attempt to hide cost
shifting by increasing profit estimates on uncompleted jobs. When this occurs, the gross profit
percentages on uncompleted jobs will often exceed the contractor’s historical results. Another
test for this would be to compare uncompleted contract gross profit percentages with completed
contract percentages.
1.5 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. The contractor should have a reliable job cost system in place to record contract costs
accurately. The auditor should be careful always to test contract costs and look for unusual contract
costing trends.
Constructability
Since the formalization of constructability, constructability has been an evolving work process. Years
ago, construction and design activities were integrated within the master builder's organization. Master
builders were responsible for all project activities required to plan, design, and construct a facility.
During the planning and design phases, the master builder focused on the entire project and considered
the impact early decisions had on the construction process. In a sense, the level of design and
construction integration achieved within these organizations serves today as the model for modern
constructability programs.
Total Quality Management & Constructability
TQM
10
requirements may be defined separately for a particular organization or may be in adherence to
established standards, such as the International Organization for Standardization's ISO 9000 series. TQM
can be applied to any type of organization; it originated in the manufacturing sector and has since been
adapted for use in almost every type of organization imaginable, including schools, highway maintenance,
hotel management, and churches.
During recent years, the use of TQM has spread beyond the manufacturing industry to construction.
Organizations embracing TQM are adopting a management philosophy that makes quality a strategic
objective for the organization. Successful application of TQM to constructor has increased its recognition
as an effective method to improve quality and productivity.
TQM has two principal objectives: (1) customer satisfaction and (2) continuous improvement. Within the
construction industry, each party involved on a project, including the owner, constructor, and designer,
plays the role of customer and supplier of services. The owner supplies the requirements to the designer,
the designer supplies the plans and specifications to the constructor, and the constructor supplies the built
facility to the owner. 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, and time.
10
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
422
Continuous improvement not only involves problem solving on projects but also a proactive search for
methods of completing a task more efficiently. The first step of the process is problem avoidance. That
is, looking and accounting for areas that may later cause problems. In the construction industry, this
means making a formal effort to recognize problems during the planning and design phases instead of
discovering problems during construction. The second step in continuous improvement is identifying
methods that increase productivity including technological innovations.
Both steps towards continuous improvement create progress toward more productive and higher quality
construction. However, these steps must be accompanied by a method of measuring the progress and cost
effectiveness of the TQM program. This assures that quality and productivity are not only increased but
also maintained. 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.
A constructability system can enhance customer satisfaction by facilitating teamwork among owner,
designer, and constructor representatives as early as the planning phase of a project. By so doing, it
provides more resources, including construction knowledge and experience, for planning and designing a
quality project that maximizes construction productivity.
Constructability is a means of continuous improvement in several respects. Maintaining a lessons-learned
database allows communication of positive and negative activities and experiences from one project to
future projects. Thus, improvements and innovations can be implemented in future designs. Also,
construction personnel may be more aware of innovations in equipment or construction techniques that
may play a key role in improving designs.
Measurement of program effectiveness is also a key aspect of both a TQM and constructability program.
This includes tabulating quantitative costs and benefits stemming from constructability and TQM such as
dollar and schedule savings, as well as recognizing qualitative effects such as higher quality and increased
customer satisfaction.
TQM and constructability both stress commitment from all personnel. This commitment must be
established from the executive level to the construction craftsmen on the site. This is a proactive process
requiring teamwork, recognition of the need for education regarding the program, and a self-assessment
regarding capabilities and resources available to achieve the desired goals.
Value Engineering
Implementation of value engineering11 involves six steps:
a. information,
b. functional analysis,
c. creative,
d. evaluation,
e. planning/proposal, and
f. implementation/follow-up
11
Value Engineering (VE) has been defined as "the systematic effort directed at analyzing the functional
requirements of systems, equipment, facilities, procedures, and supplies for the purpose of achieving the
essential function at the lowest total (life-cycle) cost, consistent with meeting needed performance,
reliability, quality, maintainability, aesthetics, safety, and fire resistance" ( Kavanagh )
423
The creative step involves a brainstorming session where life-cycle cost alternatives for design
components are considered.
Value engineering may be performed in two ways:
(1) proactively or
(2) reactively.
A proactive approach uses value engineering to collect ideas starting at the beginning of design. Thus,
multiple design alternatives are considered and the most cost effective selected on a continual basis
throughout the design phase. A reactive approach gathers cost effective alternatives through design
reviews by other project personnel such as constructors and other designer engineers. This is performed
after the entire design or specific component of design is complete. Thus, suggestions for improvement
require design rework.
In the building sector, often the term V.E. is synonymous with "The project is over budget and we need to
cut X Rupees from the project's scope." Some designers view V.E. as an attack on their design.
The primary objective of value engineering is to reduce the total life-cycle cost of a facility, whereas
constructability focuses upon optimization of the entire construction process. In most cases of industry
implementation, value engineering is normally performed during the design phase of the facility delivery
process. An effective formal constructability program ideally begins during the conceptual planning
phase and continues through construction.
Constructability and value engineering differ in terms of the criteria discussed above. However, this does
not mean that they are mutually exclusive. Rather, activities within the two work processes may
complement each other in achieving their goals. This may result in construction optimization while, at
the same time, achieving lowest life-cycle cost. Constructability implementation can act as a precursor to
value engineering, providing information through constructor input and lessons learned from past projects
such that value engineering may be more effective.
Cost Effectiveness
As with TQM, improvements of a constructability program depend upon accurate and consistent
measurements of its effectiveness. 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. Thus, a need exists for standardized cost effective parameters so that constructability
performance may be documented and compared among projects and organizations. This section describes
a simplified framework for identifying and quantifying the costs and benefits stemming from
implementing constructability at the project-level.
Cost Factors
To quantify the costs of implementing constructability at the project-level, a cost estimation framework is
necessary. Cost parameters primarily consist of personnel and miscellaneous cost items. Personnel from
many organizations including the owner, constructability consultant, constructor, design engineer, and
when appropriate vendors and major subcontractors.
A common concern among parties that procure construction input is the difficulty of accurately estimating
its value or benefit. Benefits accrued through implementing constructability are often difficult to
quantify. They are typically measured through documented benefits from constructability ideas
implemented. It is relatively simple to track the cost of design, construction labor, and materials used to
424
complete a given design alternative. Constructability, however, involves generating ideas that optimize
the construction process. Thus, the question, 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.
Summing up Total Quality Management, value engineering, and constructability are not mutually
exclusive. Instead, value engineering and constructability are complementary work processes that may be
used as key elements in achieving total quality. A coordinated effort with the application of available
standards the Financial Management Aspect as well as cost shifting can be evaluated. 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 .J e- Brown (2007), Value Analysis in Design and Construction,
J .S & J .G, "Benefits and Costs of Constructability: Four Case Studies,"
J .S & J .G , "A Comparison of Two Corporate Constructability Programs,"
J ames, "Constructability for drilled shafts,"
J ames, "A model for design/construction integration during the initial phases of design for building
construction projects,"
"Manual for special project management." (2006).
O'Brien, J .J . (1976). Value Analysis in Design and Construction, McGraw Hill, Inc., New York, NY.
O'Connor, J .T. and Tucker, R.L. (1986). "Industrial project constructability improvement," J ournal of
Construction Engineering and Management, ASCE, 112(1), 69-82.
Radtke, M.W. (1992). "Model Constructability Implementation Procedures," thesis presented to
University of Wisconsin, at Madison, Wisconsin, in partial fulfillment of the requirements for the
degree of Master of Science in Civil and Environmental Engineering.
Rowings, J .E. and Kaspar, S.L. (1991). "Constructability of cable-stayed bridges," J ournal of
Construction Engineering and Management, ASCE, 117(2), 259-278.
Russell, J .S. and Gugel, J .G. (1992). "A Comparison of Two Corporate Constructability Programs,"
accepted for publication in the ASCE J ournal of Construction Engineering and Management.
Snodgrass, T.J . and Kasi, M. (1986). Function Analysis: The Stepping Stones to Good Value, The
Department of Engineering Professional Development, University of Wisconsin, Madison, WI, pp. 1-
3.
"Total Quality Management: The Competitive Edge." (1990).
"Total Quality Management: The Competitive Edge." (1990). Publication 10-4, Construction
Industry Institute, Univ. of Texas at Austin, Austin, TX.
Tucker, R.L. (1986). "Management of Construction Productivity," J ournal of Management in
Engineering, ASCE, 2(3), 148-156.
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Management, ASCE, 118(1), 77-93.
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doc_393057125.pdf
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).
415
First International Conference on Construction in Developing Countries (ICCIDC-1)
“Advancing and Integrating Costruction Education, Research & Practice”
August 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 protected]
Abstract
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.
Key Words
Financial Management, Construction Contracts, Constructibility
Introduction
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.
1
IAS 11 specifically deals with the management, Accounting and recognition of Construction contracts.
Construction contracts are given a specific identification through IAS 11.
416
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. Both contractors and their
auditors should be aware of the potential impact of shifts in job costs from one contract to another. The
contractor should have a reliable job cost system in place to record contract costs accurately. The auditor
should always test contract costs and look for unusual contract costing trends.
There is considerable discussion among industry professionals as to how constructability is related to
Total Quality Management (TQM) and value engineering. This paper attempts to conceptually describe
these interrelations. It also presents a framework to measure costs and benefits related to constructability.
Significant attention has been given to the topic of Construction Contract (IAS-11), The Construction
Management 1991, "Constructability: A Primer" 1986, “ Audit of Contract”: A Practical Guide 2005,
Constructability: An Article of Tauqir Haider in The NEWS” , “Total Quality Management in
Construction Contracts”: By J ames. Santee 2006, “Value Engineering and Cost Benefit: Costing
Techniques” By Houston & jordeen 2003.
Evolution of Construction Contract Management
Construction contract may be negotiated for the construction of a single asset such as a bridge, building,
dam, pipeline, road, ship or tunnel. 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, technology and
function or their ultimate purpose or use; examples of such contracts include those for the construction of
refineries and other complex pieces of plant or equipment.
Construction contract include contracts for the rendering of services which are directly related to the
construction of the asset, for example, those for the service of project managers and architects; and
contracts for the destruction or restoration of assets, and the restoration of the environment following the
demolition of assets. Construction contracts are formulated in various ways such as fixed price
contracts3 and Cost plus contracts4.
Construction Contracts – Financial Management
When a contract covers a number of assets, the construction of each asset shall be treated as a separate
construction contract when:
a. Separate proposals have been submitted for each asset.
b. 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.
c. The cost and revenue of each asset can be identified.
A group of contracts whether with a single customer or with several customers, shall be treated as a single
contract when:
a. The group of projects are negotiated as a single package
b. The contracts are so closely interrelated that they are, in effect, part of a single project with an
overall profit margin
c. The contracts are performed concurrently or in a continuous sequence.
2
Cost shifting is an illegal practice that can change results and outcomes seriously.
3
A fixed price contract is a construction contract in which the contractor agrees to a fixed contract price, or fixed
rate per unit of output, which in some cases is subject to cost escalation clauses.
4
A cost plus contract is a construction contract in which the contractor is reimbursed for allowable or otherwise
defined costs, plus a percentage of these costs or a fixed fee.
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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. The construction of the additional asset shall
be treated as a separate construction contract when:
a. The asset differs significantly in design, technology or function from the asset or assets
covered by the original contract.
b. The price of the asset is negotiated without regard to the original contract price.
Cost & Revenue Recognition
Contract Revenue5 is measured at a fair value of the consideration received or receivable. The
measurement of the contract revenue is effected by a variety of uncertainties that depend on the outcome
of the future events. The estimates often need to be revised as events occur and uncertainties are resolved.
Therefore, the amount of contract revenue may increase or decrease from one period to the next. For
example:
a. 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.
b. The amount of revenue agreed in a fixed price contract may increase as a result of cost
escalation clauses.
c. The amount of contract revenue may decrease a result of penalties arising from delays caused by
the contractor in the completion of the contract.
d. When a fixed price contract involves a fixed price per unit of output, contract revenue increases
as the number of units is increased.
A variation is an instruction by the customer for a change in the scope of the work to be performed under
the contract. A variation may lead to an increase or decrease in the contract revenue. In addition to
incentive payments are additional amounts paid to the contractor if the specified performance standards
are met or exceeded.
Contract Cost 6 include site labor costs inclusive of supervision costs, cost of material used in contract,
depreciation of plant & equipment used on the contract, cost of moving plant, equipment and material to
and from the contract site, cost of hiring plant & equipment, cost of design and technical assistance,
estimated cost of rectification and claims from third party. Contract cost however can be reduced by the
incidental income. Attributable costs may include insurance, cost of design and technical assistance and
construction overheads. Non attributable costs are general admin costs for which reimbursement is not
specified in the contract or selling costs.
When the outcome of the construction contract can be estimated reliably, 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.
Practically in Financial Management of Construction contracts PC
7
-I is devised as a measure which
works as a base for all estimations and variations. As per PC-1 cost of the total construction contract is
phased along with its targeted completion stages.
5
Contract revenue is the initial amount of revenue agreed or variation in contract and claim or reliable
measurement.
6
Contract cost directly relates to the specific contract, costs are attributable to the contract activity in general and
other costs specifically chargeable to the customer under the terms of the contract.
7
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Out of the total Construction cost there is a division for direct cost and indirect cost, Civil works and
phase wise cost associated with it. 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. 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. Some advance payment
cans also be availed on the availability of material stock which is again adjusted in future. 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. Cost Shifting
It is now a day in routine to find out many corporations improperly booking assets related to uncompleted
construction contracts. To the public, it seems improbable that a qualified auditor could simply overlook
the improper capitalization of significant assets. However, traditional audit procedures designed without
construction accounting in mind can fail to detect the improper booking of assets related to uncompleted
construction contracts. 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 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. The most dangerous type of
cost shifting involves moving or misdirecting job costs from an unprofitable job to a profitable job. Cash
and accounts payable balances are unaffected. Accounts receivable and expense account balances are
also unaffected. In many cases, however, cost shifting can have a balance sheet and income statement
impact larger than the amount of the costs that have been shifted.
1.1 What is the Effect of Cost Shifting?
At first glance, the movement of costs from one contract to another would seem to have little or no overall
financial statement impact. 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. However, many contractors and their auditors have discovered the
dramatic impact that cost shifting can have on a company’s financial statement. The example below
shows the substantial gross profit impact of a $200,000 cost shifting entry:
Contract A Contract B
Completed Uncompleted
Contract Contract
Before Cost Shifting
Contract Amount $1,200,000 $1,500,000
Estimated J ob Costs ( 1,300,000) ( 1,200,000)
Estimated Profit ($ 100,000) $ 300,000
Billings to date $1,200,000 $ 600,000
Overbilling (Liability) - ( 100,000)
Revenue to date 1,200,000 500,000
Costs to date ( 1,300,000) ( 400,000)
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.
9
Running Bill is a periodic basis Bill which is submitted along with stage of completion for payment.
419
Gross Profit to date ($ 100,000) $ 100,000
J ob percentage complete 100% 33%
After Cost Shifting
($200,000 of costs are shifted from Contract A to Contract B)
Contract Amount $1,200,000 $1,500,000
Estimated J ob Costs ( 1,100,000) ( 1,200,000)
Estimated Profit $ 100,000 $ 300,000
Billings to date $1,200,000 $ 600,000
Underbilling (Asset) - 150,000
Revenue to date 1,200,000 750,000
Costs to date ( 1,100,000) ( 600,000)
Gross Profit to date $ 100,000 $ 150,000
J ob percentage complete 100% 50%
Increase in gross profit $ 200,000 $ 50,000
In this example, Completed Contract A improves by $200,000 due to the costs shifted off the job.
However, Uncompleted Contract B also improves because the contract is now 50% complete rather than
33% complete. Because Contract B is incomplete, gross profit is recognized on the percentage of
completion basis. Therefore, Contract B recognizes 50% of the estimated gross profit for the entire job
($150,000) rather than 33% of the gross profit for the entire job ($100,000). The $200,000 cost shifting
entry improved the books of the contractor by a total of $250,000.
In this example, Uncompleted Contract B received $200,000 of costs which did not belong to that job.
When Contract B is completed, it will either finish $200,000 over budget or another cost shifting entry
will occur.
1.2 Who Benefits from Cost Shifting?
Although the big corporate cases grab the headlines, most cost shifting does not occur when a corporation
tries to manipulate its balance sheet. Cost shifting occurs most frequently when field level managers
attempt to manipulate contract profitability. Cost shifting can also happen accidentally although the
consequences usually are not as severe.
Contractors often pay bonuses to their field managers and estimators based on the profitability of
completed contracts. In the above example, the estimator of Contract A might receive a bonus based on
the false assumption that the contract was profitable. Or, the superintendent of Contracts A and B might
deliberately miscode invoices from one job to another to hide losses that occurred under his supervision.
1.3 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. Under billings should be rare, especially in
contracts over 50% complete. Auditors and other users of contractors’ financial statements should look at
under billings skeptically and investigate each under billing carefully.
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Many users of contractors’ financial statements prepare fade schedules. A fade schedule measures a
contractor’s job profit forecasts versus the final profit on a job. At a minimum, significant contract fades
can indicate poor job profitability forecasting. At worst, contract fades can indicate cost shifting has
occurred.
Traditional audit procedures designed for non-contractors will not detect cost shifting. 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. Tests designed to find improperly booked billings or receivables
will find no exceptions. Audit test work for cost shifting must focus on the accuracy of job costing
procedures.
1.4 Controls and Audit Steps Designed to Detect Cost Shifting
Intentional cost shifting constitutes fraud by some member of a contractor’s management. While audits
are not specifically designed to detect fraud, an auditor must test contract costs and internal control
systems. The following steps are designed to prevent or detect cost shifting:
1.4.1 Strong internal controls for job cost coding – Project managers should not have free reign to code
job cost invoices without accounting review.
1.4.2 Test J ob costs for accuracy – At a minimum, every audit of a contractor must include random
testing of contract costs and the related cost coding. The most significant components of the
contractor’s job costs should receive the heaviest scrutiny.
1.4.3 Compare job costs against bid documents – Every contractor should estimate contracts in the
same manner in which they record job costs. An auditor should test job costs for significant
contracts by comparing each line item of job cost against the original forecast. Any overruns
should be explained and, preferably, documented with a change order.
1.4.4 Test revised profitability estimates against bid documents – Very often, cost shifting is
accompanied by an upward revision in contract profitability. This actually makes the financial
impact of the cost shift even more drastic. An auditor should test revised profitability estimates
against original bid estimates in the same manner in which job costs are compared against bid
documents. Cost shifting by field personnel can also involve directing a subcontractor to invoice
the wrong contract. Comparison of subcontract costs on particular line items versus the original
bid amount can help spot this type of cost shifting.
1.4.5 Analytically test job cost components – Contractors who perform similar types of work should
have comparable costs from job to job. For instance, a grading contractor whose overall direct
costs are 40% equipment related should have about the same percentage of equipment costs on
each job.
1.4.6 Review allocations of indirect job costs – Cost shifting is often hidden in the allocation of indirect
costs such as internally-owned equipment costs, shop costs, insurance, and labor burden.
Periodic tests should be performed to ensure that each job is being charged its fair share of
indirect costs.
1.4.7 Perform a fade analysis – The best contractors tend to finish jobs at the same profit levels at
which they were forecast. Two fade schedules should be prepared. The first measures each job’s
prior period profitability forecasts against current forecasts or actual results. The second schedule
should restate prior period uncompleted contract schedules using revised profitability figures.
Each of these schedules helps an auditor determine which contracts have had unusual fluctuations
in profits.
1.4.8 Examine bid spreads – Examining bid results can help an auditor determine whether a contractor
has been awarded a job at an unusually low price. 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. If a contractor is more than 5% to 10% low on a job, the
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contractor will likely make little or no profit on that job. Such a job is a prime target for cost
shifting.
1.4.9 Compare profitability estimates against historical results – A contractor may attempt to hide cost
shifting by increasing profit estimates on uncompleted jobs. When this occurs, the gross profit
percentages on uncompleted jobs will often exceed the contractor’s historical results. Another
test for this would be to compare uncompleted contract gross profit percentages with completed
contract percentages.
1.5 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. The contractor should have a reliable job cost system in place to record contract costs
accurately. The auditor should be careful always to test contract costs and look for unusual contract
costing trends.
Constructability
Since the formalization of constructability, constructability has been an evolving work process. Years
ago, construction and design activities were integrated within the master builder's organization. Master
builders were responsible for all project activities required to plan, design, and construct a facility.
During the planning and design phases, the master builder focused on the entire project and considered
the impact early decisions had on the construction process. In a sense, the level of design and
construction integration achieved within these organizations serves today as the model for modern
constructability programs.
Total Quality Management & Constructability
TQM
10
requirements may be defined separately for a particular organization or may be in adherence to
established standards, such as the International Organization for Standardization's ISO 9000 series. TQM
can be applied to any type of organization; it originated in the manufacturing sector and has since been
adapted for use in almost every type of organization imaginable, including schools, highway maintenance,
hotel management, and churches.
During recent years, the use of TQM has spread beyond the manufacturing industry to construction.
Organizations embracing TQM are adopting a management philosophy that makes quality a strategic
objective for the organization. Successful application of TQM to constructor has increased its recognition
as an effective method to improve quality and productivity.
TQM has two principal objectives: (1) customer satisfaction and (2) continuous improvement. Within the
construction industry, each party involved on a project, including the owner, constructor, and designer,
plays the role of customer and supplier of services. The owner supplies the requirements to the designer,
the designer supplies the plans and specifications to the constructor, and the constructor supplies the built
facility to the owner. 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, and time.
10
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
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Continuous improvement not only involves problem solving on projects but also a proactive search for
methods of completing a task more efficiently. The first step of the process is problem avoidance. That
is, looking and accounting for areas that may later cause problems. In the construction industry, this
means making a formal effort to recognize problems during the planning and design phases instead of
discovering problems during construction. The second step in continuous improvement is identifying
methods that increase productivity including technological innovations.
Both steps towards continuous improvement create progress toward more productive and higher quality
construction. However, these steps must be accompanied by a method of measuring the progress and cost
effectiveness of the TQM program. This assures that quality and productivity are not only increased but
also maintained. 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.
A constructability system can enhance customer satisfaction by facilitating teamwork among owner,
designer, and constructor representatives as early as the planning phase of a project. By so doing, it
provides more resources, including construction knowledge and experience, for planning and designing a
quality project that maximizes construction productivity.
Constructability is a means of continuous improvement in several respects. Maintaining a lessons-learned
database allows communication of positive and negative activities and experiences from one project to
future projects. Thus, improvements and innovations can be implemented in future designs. Also,
construction personnel may be more aware of innovations in equipment or construction techniques that
may play a key role in improving designs.
Measurement of program effectiveness is also a key aspect of both a TQM and constructability program.
This includes tabulating quantitative costs and benefits stemming from constructability and TQM such as
dollar and schedule savings, as well as recognizing qualitative effects such as higher quality and increased
customer satisfaction.
TQM and constructability both stress commitment from all personnel. This commitment must be
established from the executive level to the construction craftsmen on the site. This is a proactive process
requiring teamwork, recognition of the need for education regarding the program, and a self-assessment
regarding capabilities and resources available to achieve the desired goals.
Value Engineering
Implementation of value engineering11 involves six steps:
a. information,
b. functional analysis,
c. creative,
d. evaluation,
e. planning/proposal, and
f. implementation/follow-up
11
Value Engineering (VE) has been defined as "the systematic effort directed at analyzing the functional
requirements of systems, equipment, facilities, procedures, and supplies for the purpose of achieving the
essential function at the lowest total (life-cycle) cost, consistent with meeting needed performance,
reliability, quality, maintainability, aesthetics, safety, and fire resistance" ( Kavanagh )
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The creative step involves a brainstorming session where life-cycle cost alternatives for design
components are considered.
Value engineering may be performed in two ways:
(1) proactively or
(2) reactively.
A proactive approach uses value engineering to collect ideas starting at the beginning of design. Thus,
multiple design alternatives are considered and the most cost effective selected on a continual basis
throughout the design phase. A reactive approach gathers cost effective alternatives through design
reviews by other project personnel such as constructors and other designer engineers. This is performed
after the entire design or specific component of design is complete. Thus, suggestions for improvement
require design rework.
In the building sector, often the term V.E. is synonymous with "The project is over budget and we need to
cut X Rupees from the project's scope." Some designers view V.E. as an attack on their design.
The primary objective of value engineering is to reduce the total life-cycle cost of a facility, whereas
constructability focuses upon optimization of the entire construction process. In most cases of industry
implementation, value engineering is normally performed during the design phase of the facility delivery
process. An effective formal constructability program ideally begins during the conceptual planning
phase and continues through construction.
Constructability and value engineering differ in terms of the criteria discussed above. However, this does
not mean that they are mutually exclusive. Rather, activities within the two work processes may
complement each other in achieving their goals. This may result in construction optimization while, at
the same time, achieving lowest life-cycle cost. Constructability implementation can act as a precursor to
value engineering, providing information through constructor input and lessons learned from past projects
such that value engineering may be more effective.
Cost Effectiveness
As with TQM, improvements of a constructability program depend upon accurate and consistent
measurements of its effectiveness. 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. Thus, a need exists for standardized cost effective parameters so that constructability
performance may be documented and compared among projects and organizations. This section describes
a simplified framework for identifying and quantifying the costs and benefits stemming from
implementing constructability at the project-level.
Cost Factors
To quantify the costs of implementing constructability at the project-level, a cost estimation framework is
necessary. Cost parameters primarily consist of personnel and miscellaneous cost items. Personnel from
many organizations including the owner, constructability consultant, constructor, design engineer, and
when appropriate vendors and major subcontractors.
A common concern among parties that procure construction input is the difficulty of accurately estimating
its value or benefit. Benefits accrued through implementing constructability are often difficult to
quantify. They are typically measured through documented benefits from constructability ideas
implemented. It is relatively simple to track the cost of design, construction labor, and materials used to
424
complete a given design alternative. Constructability, however, involves generating ideas that optimize
the construction process. Thus, the question, 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.
Summing up Total Quality Management, value engineering, and constructability are not mutually
exclusive. Instead, value engineering and constructability are complementary work processes that may be
used as key elements in achieving total quality. A coordinated effort with the application of available
standards the Financial Management Aspect as well as cost shifting can be evaluated. A practical
approach towards implementation of standards can yield desired results
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