The Purposes of Project Accounting
In other blogs we have already demonstrated how traditional accounting, with product costing based on full costing, sets constraints to management from making right decisions for maximizing profit's growth.
Project Accounting is a branch of accounting focused at controlling revenues and costs in Engineered-to-Order manufacturing environments where the work-flow is aimed at producing unique and highly customoized product or service.
Project work manufacturing environment is often chosen in the following industries:
Consulting services
Construction
Shipyards
Architecture & Engineering
Etc
Project accounting is the method adopted to track costs related to each project and to recognize its revenues. The most common approaches to recognize revenues are:
Time and Materials project: the customer pays the supplier according to the actual time and materials it takes to complete the project.
Fixed-price project: the customer pays the supplier a fixed amount for the project, with the supplier taking the risk if the project will cost more than initial estimation.
Value-Based project: customer and supplier decide to link a portion of the fees owed to supplier to the results the customer will get by using the deliverables of the project.
Let's look at option 2, as one of the most commonly adopted for pricing. With fixed-price projects, the most common schemas for revenue recognition are:
Percentage of completion
Milestone-based
Both mechanisms applies the matching principle, aiming to match cost with revenues.
We said at the beginning that project accounting can be a constraint to enable management decisions to increase profit growth. Now let's see why.
Both with Percentage of Completion and Milestone-based, revenues flow depends on the speed of delivery. The faster to complete the project, the faster the revenues can be recognized in the Profit and Loss statement.
The more resources are assigned to a project, the faster should be the delivery speed (with caution to productivity): productivity for each resource is expected to increase, stabilize and then to decrease as far more resources are dedicated to a project.
In a milestone-based, because of productivity behavior, speed of the revenue flow is expected to increase very quickly at the initial injection of resources, then it should grow with decreasing rate as additional resources are added to the project.
In a PoC with straight line recognition, revenues are recognized independently of the productivity of the resources, just as a mere % of costs vs total EAC costs.
The amount of resources (and the level of seniority as it drives the resources cost rates) impact and increase not only the revenue speed but also the delivery cost of the project itself.
Project managers are typically measured against the project margin: how much profit they get form the project, by subtracting the direct cost of the resources assigned to the project from its revenues. Because of such measurement system - that set the focus on local optimization (the project) rather than on the total system profit (the overall revenue throughput for the company) - project managers:
Are focused on keeping project costs under control, trying to meet the EAC cost estimated for their projects.
They are reluctant adding more resources to the project to increase the project speed to avoid incurring in additional costs.
Being focused on the local optima of balancing the project margin, the overall system profitability may not be fully exploited. Some common distortions provoked by Project Accounting measures are:
The system may have available spare capacity, that may remain not fully used to avoid additional cost to projects. This spare capacity, in reality, will generate costs in any case (used or not used) because the company will still have to pay payroll to its employees: these costs will not hurt the project margin, but will hurt in any case the bottom line.
When short in revenues and adopting PoC, managers could be tempted to "boost revenue recognition" by pumping costs into the project accounting system, to accelerate consumption of the backlog.
When long on costs, managers can be tempted to assign delivery cost as “Business Development” to avoid impacting project margins.
When project budget is low, project managers can be tempted to use less experienced resources (that generally have lower cost rates), underrating risks for the overall quality of the delivery.
As the above behaviors are for the purpose of maximizing projects results, without right considerations to the global organization's goal, it is important to have in place global measures aiming to focus management attention not only on the project profitability. Measures that allow to pursue the overall company profitability in order to drive decisions fostering a global impact on the company performance.
Such global measures should incentive the overall contribution of resources to generate Throughput.
Theory of Constraints principles, focused on the Critical Chain Project Management provides room for improving. More about CCPM can be found here (https://www.pmi.org/learning/library/critical-chain-financial-reporting-work-together-9332)
We help companies implementing Theory of Constraints and Throughput Accounting principles to increase profitability and performance for our customers. Discover our new TOC Starter Kit
To learn more, please contact us via our website (www.weeond.com/contacts) or by email at info@weeond.com
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