1.1.1 Project

Performance of work by organisations may be said to involve either operations or projects, although there may be some overlap.

Operations and projects share a number of characteristics in that they are:

• Planned, executed, and controlled
• Constrained by resource limitations
• Performed by people

Projects are, however, different from operations (such as maintenance or repair work) in that they are temporary endeavours undertaken to create a. unique product or service. Table 1.1 shows the differences and similarities between operational and project activities.

The primary objectives of a project are commonly defined by reference to function, time, and cost. In every case there is risk attached to the achievement of the specified project objectives.

1.1.2 Program

A program is a grouping of individual, but inter-dependent, projects that are managed in an integrated manner to achieve benefits that would not arise if each project were managed on its own.

1.1.3 Project management

Project management is the application of specific knowledge, skills, tools, and techniques to plan, organise, initiate, and control the implementation of the project, in order to achieve the desired outcome(s) safely.

Note that ‘Project Management’ is also used as a term to describe an organisational approach known as ‘Management by Projects’, in which elements of ongoing operations are treated as projects, and project management techniques are applied to these elements.

1.2.1 Elements

Successful project management requires that planning and control for each project is properly integrated.

Planning for the project will include the setting of functional objectives, cost budgets and schedules, and define all other delivery strategies. Successful planning requires the proper identification of the desired outputs and outcomes.

Control means putting in place effective and timely monitoring, which allows deviations from the plan to be identified at an early stage. As a result they can be accommodated without prejudicing project objectives, and corrective action can be initiated as required.

A project organisation appropriate to the task must be set up, and the duties and responsibilities of the individuals and groups within the organisation must be clearly defined and documented. The lack of clear definition of structure and responsibilities leads to problems with authority, communication, co-ordination and management.

The project management procedures put in place for the project must ensure that monitoring is focused on the key factors that the results obtained by monitoring are timely as well as accurate, and that effective control systems are established and properly applied by the project team. Project management involves five basic processes:

• Initiating: Undertaking the necessary actions to commence the project or project phase
• Planning: Identifying objectives and devising effective means to achieve them
• Executing: Co-ordinating the required resources to implement the plan
• Controlling: Monitoring of the project and taking corrective action where necessary
• Closing: Formalising the acceptance of the project or phase deliverables (the ‘handover’), and terminating the project in a controlled manner

Within each of these processes there are a number of sub-process involved, all linked via their inputs and outputs. Each sub-process involves the application of skills and techniques to convert inputs to outputs. An example of this is the preparation of a project network diagram (output) by the application of the precedence method (technique) to the identified project activities (input).

1.2.2 The professional body of knowledge

Project management has developed as a professional discipline since the 1950s. It is claimed, reasonably, that the military was the first institution that adopted planning and control processes that could be characterized as formal project management – specifically for the Normandy invasion, and subsequently for the Manhattan Project. Since the 1970s there has been a sustained development of project management as a professional discipline.

There are professional project management bodies in most countries. In Australia the professional organisation is the Australian Institute for Project Management. In New Zealand it is the New Zealand Chapter of the Project Management Institute (PMI). The international body is the International Project Management Association.

In defining the knowledge base for project management it is useful to refer to the structures adopted by the PMI in the USA and the Association for Project Management (APM) in the UK. Their web addresses are www.pmi.org and www.apm.org.uk respectively.

1.3.1 Lifecycle elements

Projects proceed through a sequence of phases from concept to completion. Collectively, the separate phases comprise the project ‘life cycle’.

There are only a limited number of generic lifecycles, though the breakdown of the phases within can be at differing levels of detail. The generic types are usually considered to include capital works, pharmaceutical, petrochemical, defence procurement, research and development, and software development. Consequently the initial starting point for managing the project is to define the type, and select an appropriate life cycle model as the planning framework.

Figures 1.1 and 1.2 illustrate generic project life cycles for two project types.

1.3.2 Project phases

Different industries generally have specific standard definitions for each phase, but a generic description of each phase identified in Figure 1.1 for a capital works project is:

• Pre-feasibility: Identification of needs, and preliminary validation of concept options
• Feasibility: Detailed investigation of feasibility, including preliminary brief, project estimate and investment analysis
• Planning: Detailed definition of the project with respect to scope, organisation, budget, and schedule, together with definition of all control procedures
• Implementation: The execution of the scoped project. The components of this phase will depend upon the nature of the project
• Handover: Passing the facility into the control of the principal. This includes formal handover of the facilities, user training, operating and maintenance documentation etc.
• Close out: Archiving of the project records, establishing appropriate performance evaluations, capturing and transferring lessons learned, and dissolving the project organisation

Project phases share defined characteristics.

• In every instance project management processes undertaken with a specific phase comprise initiating, planning, executing, controlling, and closing.
• A project phase will have one or more tangible deliverables. Typical deliverables include work products such as feasibility studies, software functional specifications, product designs, completed structures, etc.
• Outputs from a phase are typically the inputs to the succeeding phase

Normally, deliverables from any phase require formal approval before the succeeding phase commences. This can be imposed through the scheduling of compulsory ‘milestones’ (e.g. design reviews) between phases.

1.4.1 General

Where projects are set up within existing organisations, the structure and culture of the parent organisation has great influence on the project, and will be a deciding factor in whether or not there is a successful outcome. Where the project team is outside the sponsoring or client organisation, that organisation may exert significant influence on the project.

The organisation of the project team also directly influences the probability of achieving a successful outcome. The benefits and disadvantages of the various options for project team organization need to be appreciated.

1.4.2 Projects within existing organizations

Organisational structures have traditionally been defined within the spectrum from fully functional to fully project oriented. Between those extremes lie a range of matrix structures.

The classic functional structure is a hierarchy, with staff grouped within specialist functions (e.g. mechanical engineering, accounting etc.), with each staff member reporting directly to one superior. Such organisations do manage projects that extend beyond the boundaries of a division, but within a division the scope of the project is considered only as it exists within the boundary of that division. Project issues and conflicts are resolved by the functional heads.

In a project management organization the staff are grouped by project, and each group headed by a project manager who operates with a high level of authority and independence. Where departments co-exist with the project groups, these generally provide support services to the project groups.

Matrix organisations may lie anywhere between the above. A matrix approach applies a project overlay to a functional structure. Characteristics of matrix organisations may be summarised as follows:

• Weak matrix organizations are those closely aligned to a functional organization, but with projects set up across the functional boundaries under the auspices of a project co-ordinator. The project co-ordinator does not have the authority that would be vested in a project manager
• A strong matrix organization would typically have a formal project group as one of the divisions. Project managers from within this group (often with the necessary support staff) manage projects where specialist input is provided from the various functional groups. The project managers have considerable authority, and the functional managers are more concerned with the technical standards achieved within their division than with the overall project execution
• In a balanced matrix the project management is exercised by personnel within functional divisions who have been given the appropriate authority necessary to manage specific projects effectively

The different organizational structures, and the corresponding project organization options, are identified in Figure 1.3. In many cases an organization may involve a mix of these structures at different levels within the hierarchy. For example, a functional organization will commonly set up a specific project team with a properly authorized project manager to handle a critical project.

The influence of the organisation structure on various project parameters is illustrated in Figure 1.3.

While a matrix approach may be seen as providing an inadequate compromise, in reality it is often the only realistic option to improve the performance of a functional organization. It does work, but there are some trade-offs. One factor critical to the effectiveness of the matrix structure is the authority vested in the person responsible for delivery of the project. A key predictor of project performance is the title of this person i.e. whether he/she is identified as a ‘project manager’, or something else.

Briefly, the benefits and disadvantages of the matrix approach include (see Table 1.3), also see Table 1.4:

1.4.3 Project organization

The organisation of the project team is characterised by:

• The principal or project sponsor. This is the beneficial owner of the project
• The Project Control Group (PCG). In some cases this will be the principal, but when the principal is a large company it is required to identify and make accountable certain nominated individuals. The function of this group is to exercise approvals required by the project manager from time to time, controlling the funding to the project manager, and maintaining an overview of the project through the reporting process
• The project manager. In a ‘perfect world’ the responsibilities, roles and authority of this person would be defined and documented
• A project control officer or group, if this function is not undertaken by the project manager. This group of people is responsible for the acquisition and analysis of data relating to time, cost and quality, and to compare actual figures with the planned figures
• The rest of the project team, which will vary in composition according to the project type, as well as specific project variables

The project organization may be vertical or horizontal in nature, depending on the span of control chosen by the project manager. That choice will be a balance between available time and the desired level of involvement. Typical project structures for a capital works project are illustrated in Figure 1.4. These illustrate the difference between horizontal, intermediate, and vertical organisation structures.

In general the horizontal structure is the best option, because the communication channels between those who execute the project work and the project manager are not subject to distortion. For instance, in the vertical organisation there is a far higher probability of the project manager receiving and acting upon inaccurate information. Such inaccuracies may arise unavoidably, by oversight, carelessly, or deliberately. The impacts can be severe. Reducing that opportunity, by shortening communication channels and removing the intermediate filters, improves the likelihood of achieving the desired project outcome.

On large projects the desire to maintain a horizontal structure can be largely achieved by increasing the size of the ‘project manager’. This is typically done by augmenting the project manager with support staff that have direct management responsibilities for a portion of the project. Their interests are aligned with those of the project managers, and a higher reliability of information may be expected.

1.5.1 General

Many projects qualify as successes, but we all have experience, anecdotal or otherwise, of projects that have gone severely wrong. Project failures exist within all industries. Even today, with the level of awareness for project management processes as well as advanced tools, there are spectacular failures. These occur even on very large projects where it is assumed that the investment in management is high. The consequences of failure can be significant to the sponsoring organisations as well as project personnel.

A 1992 study of some 90 data processing projects, completed in the previous 12 years, provides a common profile of experience. The study identified the primary factors affecting the project outcomes as set out in the Table 1.5. These are listed by frequency and severity (ranked in descending order of impact) in respect of their negative impact on project success. This analysis provides an instructive basis for any organisation operating, or setting up, a project management methodology. Note that most of these issues are project management issues.

1.5.2 Project success criteria

It is a vital step, yet one commonly omitted, to define the project success criteria before commencing planning and delivery. In other words, define what needs to be achieved if the project implementation is to be considered a success. The project stakeholders must identify and rank the project success criteria. The ‘client’s’ preferences are obviously paramount in this process, and will consider performance right through the life of the product under development as well as the factors present only during the project.

The objectives of cost, quality, and time are frequently identified as the definitive parameters of successful projects. These are a very useful measure in many capital works projects where they can be defined in advance, adopted as performance indicators during project implementation, provide a basis for evaluating trade-off decisions, and applied with relative simplicity.

However, this approach to measuring project success is necessarily only a partial assessment in almost every situation. Projects completed within the targets for such constraints may be successfully completed from the perspective of the project implementation team, but are not necessarily from alternative viewpoints such as those of the sponsors or users. In some instances projects that are not completed within some of the time/cost objectives may still be considered a success. Common project success criteria include safety, loss of service, reputation, and relationships.

The process of defining ranked success criteria provides surprising insights in many instances, and enhances project planning. During project implementation the project success criteria provide a meaningful basis for establishing project performance indicators to be incorporated within project progress reports. They are also helpful in making trade-offs, should that become necessary.

1.5.3 Critical success factors

The results of a study of the critical success factors in projects, published in the June 1996 issue of the International Journal of Project Management, proposes a framework for determining critical success factors in projects. This study classified critical success factors applicable to all project types within four interrelated groups. These are set out in Table 1.6 with examples.

In practice, this is a particularly important and useful framework within which critical success factors can be identified. Where necessary, these can be managed proactively in order to maximise the probability of project success.

A survey was conducted amongst members of the PM, seeking to correlate project success criteria (specified as time, cost, quality, client satisfaction, and other) against the above factors. Projects included in the survey covered construction, information services, utilities, environmental and manufacturing. The study concluded that the critical project success factors primarily arose from the factors related to the project management and project team. For each industry the project manager’s performance and the technical skills of the project team were found to be critical to project outcomes. This confirms the conclusions from the 1992 study noted earlier.

It is important to identify, within this framework, the specific critical success factors which may impact on the project. It is then the reponsibility of the project team to develop strategies to address these factors, either in the planning or in the implementation phase.

1.5.4 Critical project management issues

The skills, knowledge, and personal attributes of the selected project manager have a critical impact on the success of the project. These critical skills encompass more than just technical and project management parameters. A key element in the success of the project manager is the effective application of non-technical skills (the so-called ‘soft’ skills); including leadership, team building, motivation, communication, conflict management, personnel development and negotiation.

It is essential that the project manager, once appointed, has full control of the project within the limitations defined by the principal or project sponsor. All parties must be made aware of this single point of authority. The authority delegated to the project manager, and his/her effectiveness in exercising it, is critical. Project management structures, particularly if the project is one within an existing organisation and across functional boundaries, creates a complex web of formal and informal interactions. Lack of clarity in defining the authority of the project manager invariably leads to difficulties.

The appointment of the project manager should ideally be made sufficiently early in the project to include management of the feasibility studies. The project manager should be appointed in order to undertake the project definition. If the project manager is not involved in the project definition phase, the outputs of this phase (project plan, control procedures, etc.) must be specifically signed off by the project manager when subsequently appointed to that role.

1.6.1 The project quality plan

“PROJECTS BADLY PLANNED ARE PROJECTS PLANNED TO FAIL”

The project planning phase is critical to the effective implementation and control of the project and the basis for project success is established during this phase. The planning undertaken at this stage is the responsibility of the project manager. The primary output from this phase is the Project Quality Plan (PQP). The basic element required to properly define the PQP is the Work Breakdown Structure or WBS.

The PQP comprises the following:

• The PQP sign-off
• The statement of project objectives
• The project charter
• The project plan
• Project control procedures

Note: here lies an inconvenience of terminology. The PQP is much more than a plan for incorporating quality into the project. There is a comnponent within the PQP that deals exclusively with quality issues per se.

1.6.2 PQP sign off, project objectives, project charter

PQP sign-off

This is a formal record of the agreement, signed by the Project Manager as well as the PCG of the PQP. It is confirmation of approval of the plan (e.g. what is to be done, when, who, at what cost etc) and the processes involved if the desired outcomes are to be achieved.

Project objectives

This is a statement defining the project objectives. The confirmed Project Success Criteria should be included, together with quantified measures. Unquantified objectives introduce a high degree of risk to the process, by reducing the ability to measure divergences at an early stage.

Project charter

Management’s commitment to internal projects (and hence the willingness to make available the required resources), as well as formal delegation of authorities to the project manager, are recorded here.

1.6.3 The project plan

The Project Plan is the master plan for the execution of the project, and provides the framework from which the implementation will develop in a co-ordinated and controlled manner. The project scope definition, programme and budget are established at this time. These provide the baseline against which performance can be measured, and against which approved changes to the project baseline can be properly evaluated. The Project Plan comprises the following components:

Scope definition

A written scope statement that defines, in appropriate detail, the scope of every project component and identifies all significant project deliverables. In this context ‘scope’ includes features and functions of products and/or services, and work to be undertaken to deliver a conforming output

Work breakdown structure

A Work Breakdown Structure (WBS) is the breakdown of the project into the separate activities that can be considered entities for the purpose of task assignment and responsibilities. The WBS is generally presented in a product-oriented hierarchical breakdown. Successive levels include increasingly detailed descriptions of the project elements. The lowest level items are referred to as work packages and these are assignable to individuals within the project team, or to subcontractors.

Orgonization breakdown structure

The Organization Breakdown Structure (OBS) involves the definition of the project structure, setting out the parties and individuals involved in the execution of the project. It also formalizes the lines of communication and control that will be followed.

Task assignment

This is a list of the assignment tasks and responsibilities. All tasks and activities previously defined become the responsibility of specified parties. The WBS and OBS may be extended to define a ‘task assignment matrix’.

Project schedule

The preliminary master schedule for the project identifies the target milestones for the project, and the relative phasing of the components.

Project budget

In some cases a project budget is established during the feasibility study, without the benefit of adequate detail of the concepts evaluated. At that stage a maximum cost may have been established, because expenditure above that figure would cause the project not to be economically viable. Where such a constraint exists, and if the feasibility study has not reliably established the cost of the project, it will be necessary to further develop the design before committing to the project.

Miscellaneous plans

Additional plans may need to be documented here. These include, inter alia, consultations and risk management. Alternatively, a strategy for these can be defined in the section dealing with project controls.

Documentation

All of the above project elements must be documented in the Project Plan. Figure 1.5 shows the inter-relationships of all these entities.

1.6.4 Project control procedures

The ultimate success of the project will require that objectives for performance, budget and time, as defined within the Project Plan, are fulfilled. This will only be possible if the necessary monitoring and control systems are established prior to the commencement of project implementation.

Monitoring and reporting should include project performance indicators derived from the Project Success Criteria. Planning should take into account the critical success factors, i.e. it should address any potential difficulties that may arise from them.

Control procedures need to be established and documented for the management of the following parameters:

Administration

Procedures for the administration of the project should be defined. These should include issues such as:

• Filing
• Document management
• Correspondence controls
• Administrative requirements of the principal

Scope

The definition of scope change control systems which:

• Define circumstances under which scope changes can arise
• Control the process invoked when changes do arise
• Provide for integrated management of the consequences of the changes, i.e. time and cost implications

Quality

The definition of project-specific quality policies and standards, together with processes for ensuring that the required quality standards will be achieved. This is best achieved by reference to the application of, and responsibilities for, Inspection and Test Plans.

Cost

The definition of control procedures which should include:

• Budget and commitment approvals for design, procurement and construction functions
• The issue and control of delegated financial authority, to the project manager controlling consultants and contractors, as well as to consultants controlling contractors
• Variation control for changes arising during project implementation
• Value engineering
• Cost monitoring, reporting and control systems and procedures

Time

The definition of strategies and procedures for scheduling, monitoring and reporting, likely to include:

• Programming methods and strategies for master and detail programmes, i.e. definition of programming techniques as well as the frequency of review and updating
• Progress monitoring and reporting systems and procedures.

Risk

The definition of objectives and procedures for putting in place effective risk management. Note that there may be a Risk Management activity schedule in the PQP.

Communications

This specifies all requirements for communications within the project and to the client/sponsor, and is likely to include:

• Meetings – schedules and processes
• Reporting requirements
• Document distribution
• Handover
• Close out

Procurement

This defines strategies and procedures for tendering, as well as for the selection and management of consultants, suppliers and contractors.

Tendering

This covers documented standardized tendering procedures, tender documentation, and tender evaluation procedures for each contract type (i.e. service, procurement, construction etc).

The tendering process is often a very sensitive one, especially if public funds are involved. Appropriate attention must be paid to ensure that the legal aspects of the process are properly addressed, and that the process is applied with demonstrable fairness. Recent changes in the laws applying to tendering should be noted.

Consultants

This refers to a standardized document dealing with the use of consultants. It should cover issues such as consultants’ briefs and terms of engagement. Consultants’ briefs would typically include the following items:

• The scope of the work to be undertaken, and any limitations thereon
• The type of services to be provided and the deliverables required (this will be defined within the WBS for the specific work package)
• Approvals required from the client
• Approvals to be exercised on behalf of the client
• Special requirements of a management, technical or financial nature, for example quality assurance/quality control programmes, variation control procedures etc.
• Reporting requirements
• Project schedule requirements, for service delivery as well as implementation phases
• Budgets for the proposed implementation deliverables or capital items
• Basis of payment for services to be provided by the consultant

Contracts

The terms of engagement and conditions of contract should be based on standard documents where these exist. The level of documentation should be appropriate to the values of contracts let, and usually a number of options are required.

1.6.5 Work breakdown structures

Developing the WBS is fundamental to effective planning and control for the simple reason that the derived work packages are the primary logical blocks for developing the project time lines, cost plans and allocation of responsibilities.

Many people either miss out this key step in the project management process, or undertake the step informally without appreciating how important it is.

Definition and terminology

PMI PMBOK 1996 provides the following definition for a WBS:
A deliverable oriented grouping of project elements which organizes and defines the total scope of the project: work not in the WBS is outside the scope of the project. Each descending level represents an increasingly detailed description of the project elements.

The WBS is created by decomposition of the project, i.e. dividing the project into logical components, and subdividing those until the level of detail necessary to support the subsequent management processes (planning and controlling) is achieved.

Terminology varies in respect of defining project elements. The use of the terms ‘project’, ‘phase’, ‘stage’, ‘work package’, ‘activity’, ‘element’, ‘task’, ‘sub-task’, ‘cost account’, and ‘deliverable’ is common:

PMBOK terminology provides the following definitions:

• A work package is a deliverable at the lowest level of the WBS
• A work package can be divided into activities
• An activity is an element of work performed; with associated resource requirements, durations and costs
• An activity can be subdivided into tasks

A properly developed WBS provides a basis for:

• Defining and communicating the project scope
• Identifying all components of work within the project
• Identifying the necessary skills and resources required to undertake the project
• Effective planning of the project (scheduling, resource planning, cost estimating)

The WBS does not identify dependencies between the components, nor does it identify timing for the components. These are, for example shown in the PERT and Gantt charts (see next chapter).

Creating the WBS

There are many valid approaches for the decomposition of a project. In many cases there will be semi-standard WBS templates that can be used or adapted. The WBS should generally identify both the project management and project deliverables, and should always be defined to reflect the particular way in which the project is to be managed.

The appropriate level of detail will vary between projects, and at different times within the same project. Future project phases may need less definition than the current phases – so the WBS may be progressively developed as the project develops – but this requires a flexible WBS structure to be selected in the first instance.

In planning the WBS, criteria can be adopted to ensure that the level of detail is appropriate and consistent. Such criteria might include:

• Are the packages of work in the WBS sensible?
• Can any package be broken down further into sensible components?
• Is each package the responsibility of only one organizational group?
• Does every package represent a reasonable quantity of work?
• Does any package constitute more than, say, 5% (or 10%) of the project?
• Does any package constitute less than, say, 1% (or 2.5%) of the project?
• Does every package provide the basis for effective cost estimating and scheduling?

The following example shows the WBS of a project with geographical location at the second level (see Figure 1.6).

Alternatively, the various functions (design, build, etc) can be placed at the second level (see Figure 1.7).

A third alternative shows a subsystem orientation (see Figure 1.8).

A fourth alternative shows a logistics orientation as follows (see Figure 1.9):

The WBS could also be drawn to show a timing orientation (see Figure 1.10).

Note that ‘Design’ and ‘Execution’ in the WBS above are NOT work packages, they are just headings. ‘Start up’, however, is a work package since it is at the lowest level in its branch. The WBS could be broken down even further but the risk here is that the lowest-level packages could be too small. If ‘advertising’, for example, could be accomplished in 100 hours it might be a good idea to stop at that level. It could then be broken up into activities and tasks (and even sub-tasks); the duration and resource requirements would then be aggregated at the ‘advertising’ level, but not individually shown on the WBS.

It is, of course, not necessary to use a sophisticated WBS package; a spreadsheet will work just fine as the following example shows (see Figure 1.11).

2.2.1 Defining the activities

The first step in project planning is to break the defined work packages into component activities, and sometimes tasks. It is crucial that this breakdown be carefully considered if the subsequent output is to be an effective project control tool.

In establishing the activity list, the following principles may assist:

• For an initial analysis the number of activities should be kept to the minimum required to be useful. This allows for the framework to be developed and checked for consistency before too much effort has been spent. If found necessary, the activities can be broken down further at a later stage if that is appropriate
• For a definitive plan it is useful to include more detail so that the schedule in the PQP can be adopted as the baseline for schedule monitoring
• Who else will be using the schedule, and for what purpose?
• Is it an appropriate master plan, allowing elements to be defined in more detail as implementation continues?

It is important to note that the word ‘operation’ or ‘activity’ is used in its widest sense. It will not only include actual physical events, derived form the work packages, but anything that may exercise a restraint on the completion of the project should be included as an activity. This will include actions such as obtain finance, obtain approval, place order, and represent passages of time with no actual activity, e.g. delivery period.

2.2.2 Preparing the logic network

The arrow diagram

In CPM, each activity is represented by an arrow. The tail of an arrow marks the start of the activity it represents, and the head marks its finish. The start and finish of activities are called events or nodes. Circles are drawn at the tails and heads of arrows to denote the nodes. The arrow diagram, or network, is drawn by joining the nodes together to show the logically correct sequence of activities. The arrows are not drawn to scale; their lengths are unimportant at this stage. Their directions show the flow of work. Here are a few simple illustrations.

Figure 2.1 shows two sequential activities indicating that Activity B cannot be started until Activity A is completed.

Figure 2.2 shows that Activity E must await the completion of both Activities C and D before it can commence.

Figure 2.3 shows Activities G and H as concurrent activities that can start simultaneously once Activity F has been completed.

When developing the arrow diagram, three questions are asked of each activity in order to ensure its logical sequence:

• What must precede it?
• What has to follow it?
• What can take place concurrently with it?

The importance of these three questions cannot be overemphasized. Be aware of the ease of inadvertently introducing constraints by implication.

Numbering of events

All events are numbered to facilitate identification. This step is usually carried out after the whole arrow diagram has been drawn. Each activity is identified by two event numbers, e.g. as (i,j). The (i) number identifies the tail of the arrow, and the (j) number identifies the head of the arrow. The letters ‘i’ and ‘j’ are chosen at random and have no special significance, but it is advisable to use multiples of 5 or 10. The reason for this is the flexibility to introduce additional events into the network. For example, see Figure 2.4.

Activity C is identified by (15, 20), D by (20, 25) and E by (20, 30). Note that for sequential activities, such as C and D, the (j) number of the preceding activity is the same as the (i) number of the following activity.

Dummies

Each activity should have a unique identification. If two concurrent activities both start and finish at the same nodes they will be identified by the same (i, j) numbers, as shown in Figure 2.5 where both Activities M and N are (15, 30).

In order to keep the identification of activities unique, a dummy activity is introduced as shown in Figure 2.6. Activity M is still (15, 30) but Activity N is now (15, 25). Activity (25, 30) is a dummy. Dummy activities are always represented by a dotted arrow.

Another important use for dummies is to keep the sequence logic correct in a group of arrows where not all preceding and following activities are interdependent. Suppose we have a situation where starting Activity D depends on the completion of both Activities A and B, and starting Activity C depends only on completion of Activity A.

The logic shown in Figure 2.7 is incorrect. It introduces a non-existent restraint, namely that Activity C cannot start until Activity B is complete.

The correct logic requires the introduction of a dummy activity. Refer to Figure 2.8.

Overlapping activities

Unlike the conventional bar chart, no overlapping of activities is permitted in the arrow diagram. If overlapping exists between activities, then these activities must be broken down further to provide sequential activities that may subsequently be analyzed.

Figure 2.9 shows two sequential activities, indicating that Activity 2 starts after all of Activity 1 is complete.

For a small job, this is probably the case. For a large job, however, the two activities may overlap to some extent. This is shown by breaking both activities down into two activities, as shown in Figure 2.10.

2.2.3 Adding activity data

The way in which the necessary data is included on the network diagram is very simple. See Figure 2.11. The required information is added for each activity in the network. Once all necessary activities are included, the network can be analyzed.

2.2.4 Analyzing the network

This analysis comprises the following actions:

• adding durations for each of the activities
• adding resources for each of the activities (optional)
• analyzing the network to determine the critical path (based on the activity durations)

Adding activity durations

Durations will normally be fixed by the scheduler allocating a fixed resource for a given time. Note, however, that some computer programs calculate the duration by consideration the work content of the activity (for example, 45 man-days) and the available resources.

Time may be expressed in any convenient unit; for example, hours, calendar days, working days, weeks, months, etc.

Durations may be determined from calculations, experience, and advice. Estimates should be made on the basis of normal, reasonable, circumstances according to judgment. For a given quantity of physical work, the duration will depend on the resources allocated.

For physical activities the duration will depend on the quantity of work and the resource to be applied, the efficiency of the resource, location etc. For outside activities an allowance must be made for adverse weather.

Adding resources

Resources must be included where they are likely to be a limitation either within the project itself, or where the project competes with others for resources from a pool. See paragraph 6.0.

The critical path

The purpose of analyzing the network is to determine the critical path, and thus the total project duration. Once the network has been drawn there will, generally, be more than one path between the start and finish. The project duration for each path is calculated very simply. By adding the durations for all the activities that make up the path, various total durations will be determined. The longest of these is the time required for completion of the project. The path associated with it is, by definition, the critical path.

In many cases the critical path is obvious, or can be located by considering only a few paths, and this should be determined as a first step. If the total project duration is too long, review the planning (for example by reviewing the assumed sequencing, constraints, overlap opportunities, resources, etc) to reduce the critical path before carrying out the detailed calculations for the whole schedule.

Earliest start time and earliest finish time

The Earliest Start Time (EST) of any activity means the earliest possible start time of the activity as determined by the analysis. The EST of any activity is the Earliest Event Time (EET) of the preceding node, i.e.:
EST_ij = EET_i

The Earliest Finish Time of an activity is simply the sum of its earliest start time plus its duration, i.e.:
EFT_ij = EST_ij plus duration

But note that:
EFT_ij = EET_j

The EST of an activity is equal to the EFT of the activity directly preceding it – if there is only a single precedent activity. If an activity is preceded by more than one activity, its EST is then the latest of the EFTs of all preceding activities. The logic of this should be clear: an activity can only start when all preceding activities have been completed. The latest of these to finish must govern the start of the subject activity.

ESTs are calculated by a forward pass, working from the first to the last activities along all paths. This analysis determines the EFT for the last node, and this is the minimum time for completing all activities included in the network.

Latest finish time and latest start time

The Latest Finish Time (LFT) of any activity means the latest possible time it must be finished if the completion time of the whole project is not to be delayed. The LFT for an activity is the Latest Event Time (LET) of the succeeding node, i.e.:
LFT_ij = LET_j

The Latest Start Time of an activity is simply the sum of its latest finish time less its duration, i.e.:
LST_ij = LFT_ij minus duration

But also note that:
LST_ij = equals LET_i

The LFT for the final activity is taken to be the same as its EFT. The latest times for all other activities are computed by making a backwards pass from the final activity. The Latest Start Time (LST) for any activity is obtained by subtracting its duration from its LFT. For each activity, the LFT must be equal to the LET of the succeeding node. When an activity is, however, followed by more than one activity, its LFT is equal to the earliest of the LSTs of all following activities.

The results of the analysis are recorded directly on to the network. The information displayed is the EET and LET for each node, as shown in Figure 2.12.

Float

Along the critical path none of the activities will have any float; i.e. the EST for each activity will equal the LST. If any one of those activities is delayed, the completion of the whole project will be delayed.

In most projects there will be activities for which EST precedes LST, i.e. there is some float. There are distinct categories of float, of which the following two are the most relevant.

• Total float is the difference between the EFT and LFT of any activity. It is a measure of the time leeway available for that activity. It gives the time by which an activity’s finish time can be delayed beyond its earliest finish time without affecting the completion time of the project as a whole. However, using part or the entire total float of an activity will generally impact on the float available for other activities.
  Total Float = LFT-EFT = LFT – EST – duration
• The free float of an activity is the difference between its EFT time and the earliest of the ESTs of all its directly following activities. The significance of free float is that it gives the time by which the finish time of an activity can exceed the earliest finish time without affecting any subsequent activity.

2.3.1 General

The Precedence method (also known as the Activity on Node or AoN method) includes the same four steps as the Critical Path method. There are two fundamental differences between the Precedence and Critical Path methods of network analysis.

• For precedence analysis the data relating to each activity is contained on the node
• The arrows connecting the activities can show a variety of logical relationships between activities

The ability to overlap activities more easily using the Precedence method is a considerable advantage. This method gives the same results as the Critical Path method with respect to determining the critical path for the project, and the amount of float available for non-critical activities (those activities not on the critical path). It is often easier to use for people with no previous programming experience. The work breakdown is performed as per the Critical Path method.

2.3.3 Preparing the logic network

The precedence diagram

A precedence diagram is based on representing the activities. Activity data is shown within a box, and relates to the activity, as opposed to the node in the case of the CPM method. Consequently, time data is referred to as ‘earliest start date’, ‘latest start date’ etc, rather than ‘earliest event time’, ‘latest event time’ etc. Refer to Figure 2.13.

Dependencies

The logical links between activities are known as dependencies. These are generally one of the following three types as shown in Figure 2.14, i.e.

• Finish-to-start
• Start-to-finish
• Finish-to-finish

It is also possible, but rare, to have Start-to-finish dependencies.

The dependency may have a time component (shown in the following figure as ‘n’). This is known as ‘lag’. It is also be just a logical constraint.

Note that in all cases the logical relationships between A or B and other activities may well mean that other constraints control the actual start or finish of Activity B, not the dependency between A and B.

Activity constraints

The timing of activities may be constrained by factors unrelated to logical relationships between the activities. By default, analysis assumes that all activities start As Soon as Possible (ASAP type). However, the start or end date for each activity can be controlled by defining the constraint on it. If the activity constraint conflicts with the logical relationships between activities, the activity constraint overrides the logical relationship.

Activity constraints may of the following types:

• ASAP As Soon As Possible
• ALAP As Late As Possible
• FNET Finish No Earlier Than
• SNET Start No Earlier Than
• FNLT Finish No Later Than
• SNLT Start No Later Than
• MFO Must Finish On
• MSO Must Start On

Milestones

Milestones are notional activities introduced into the network to mark particular points, say, completion of each phase (e.g. completion of user definition), or achievement of a critical series of events (e.g. award of a major contract). Milestones are activities with a defined duration of ‘0’ time units. Milestones are typically used to enable higher level reporting and monitoring of the schedule.

Be aware of the fact that a milestone could involve a time-consuming design review that could take several days or weeks, in which case the milestone should be shown with an appropriate duration, or else the preceding design review must be incorporated in the project network diagram.

2.3.4 Analyzing the network

The method of determining ESD, LSD, EFD, and LFD is similar to that for the Critical Path method, although account must be taken of all defined dependency lags as well as activity constraints.

With this method it is necessary to create an artificial ‘Start’ and ‘Finish’ activity, both with zero duration. ESD and EFD are calculated by a forward pass. Calculate the ESD for each activity by consideration of preceding activities:

• • EFD_a plus n (dependency lag) equals ESD_b.

The latest ESD_b determined from all precedent paths is the ESD_b to be used.

• • EFD_b equals ESD_b plus duration.

Once the Finish task is reached, the LSDs and LFDs are calculated by a backward pass. Calculate the LSD for each activity by consideration of succeeding activities plus dependencies and durations.

• • LFD_a equals LSD_b minus n (dependency lag)

The earliest LFD_a determined is the LFD_a to be used.

• • LSD_a equals LFD_a minus duration

This is not as difficult as it sounds, but some practice is required to master the subtle aspects of more complex networks.

Example

Activity A has no predecessors, and a duration of 4 time periods (e.g. months). Activity B has no predecessors either, and a duration of 3 time periods. Activity C has a duration of 2 time periods and can only start when A is finished. Activity D is expected to take 4 time periods, and can only start when A and B is finished. The following figure shows the completed network. Note the following:

• Each activity is labeled in the middle, and the duration is shown at the top, in the centre field.
• The dummy activities ‘start’ and ‘finish’ have zero duration

Now the forward pass:

• The ‘start’ activity begins and ends at time zero (EST = EFT =0)
• Activity A can begin straight away (EST =0) and ends at time 4 (EFT =4)
• Activity B can also begin straight away (EST = 0) and ends at time 3 (EFT =0)
• C must wait for A. The earliest it can therefore start is at time 4, ending at 6 (EST = 4, EST = 6)
• D must wait for both A and B to finish and can therefore not start before 4, ending at 8 (EST = 4, EFT = 8)
• The project is only finished when D is completed, at time 8
• The ‘finish’ dummy task has zero duration, and therefore starts and finishes at 8 (EST = EFT =8)

Next follows the backward pass:

• The ‘finish’ task has zero duration, therefore its LST = LFT = 8
• Completion of C can now be delayed until time 8 (LFT = 8), so with a duration of 2 its LST is now 6
• There is no slack in C, so its latest times are the same as its earliest times
• Since the earliest D can start is 4, B need not finish before then
• A must finish by 4, otherwise it will delay D

The floats are now calculated as LST minus EFT, or LFT minus EFT, i.e. the bottom number minus the top number on either the left or the right side of each block. The critical path interconnects all those blocks with zero slack. Remember that it is possible to have more than one critical path, and that the critical path may change once the project is under way (see Figure 2.15).

2.5.1 Resource loading

A highly valuable feature of project network analysis is the ability to generate information regarding the project resources associated with the scheduled activities. In many cases a schedule produced without consideration of the resource implications is meaningless. When reviewing construction schedules for instance, the associated resource data is always required to ensure that the planned inputs are, in fact, practical.

Useful resource analysis requires that the demand for each category of resource be identified separately for each activity. This process can be performed manually, but this can be time consuming. Computer programs used for Critical Path analysis will generally produce charts showing resource loading versus time. These are called resource histograms.

2.5.2 Resource leveling

In some project situations the total level of projected resource demands may not be a major concern, because ample quantities of the required resources are available. It may, however, be that the pattern of resource usage has undesirable features, such as frequent changes in the amount of a particular manpower skill category required. Resource-leveling techniques are useful in such situations because they provide a means of distributing resource usage over time in order to minimize the variations in manpower, equipment or money expended. They can also be used to determine whether peak resource requirements can be reduced without increasing the project duration.

Those activities that have float are rescheduled within the available float to provide the resource profile that is the most appropriate. The available float is, of course, determined by the critical path analysis which has been performed with consideration of resource requirements. During the resource leveling process the project duration is not allowed to increase.

In the case of a single resource type the process of resource leveling can be conducted manually for sizeable networks with the aid of magnetic scheduling boards, strips of paper or other physical devices. However, in situations involving large networks with multiple resource types the process becomes complicated, since actions taken to level one resource may tend to produce imbalances for other resources. In such situations the process can really only be done using a computer.

2.5.3 Constrained resource leveling

The process of resource leveling by rescheduling non-critical activities within the original project duration may not be sufficient if the resource level for one or more resources is limited. Where it is not possible to obtain all resource requirements equal to or less than the available resource levels by this process, it is necessary to extend the project duration sufficiently to allow the required resources to balance the available resources.

This process is called constrained resource leveling. Again, the process can really only be done effectively using a computer, but generally all project scheduling software programs have this feature (see Figure 2.18).

2.6.1 Defining the plan

The effectiveness of monitoring depends on the skill with which the programmer has broken down the project into defined parcels of work. Progress is assessed by measuring the ‘percentage complete’ of individual activities during the project. If it is not possible to assess the true progress (percentage complete) of significant of significant activities, then reporting inaccuracies will be the norm and deviations will be difficult to detect. To reduce or avoid this uncertainty, each activity should be divided into stages, completion of which is both useful and measurable. This breakdown should be finer rather than coarser. Such ‘activity milestones’ must be agreed between the Project Manager and the person responsible for the specific activity at the start of the project.

The importance of this approach can be demonstrated by reference to the two scheduling scenarios shown in Figure 2.19. In each case progress can only be properly measured on completion of each activity.

Assume that in both scenarios Activity A is completed one month late, at which time the problem is identified for the first time. Under Scenario I the effective rate of improvement required to complete within the original project duration is 125% (i.e. 5 periods of work outstanding with 4 periods available to complete). By comparison, in Scenario II the effective rate of improvement required to complete within the original project duration is 150% (i.e. 3 periods of work outstanding with 2 periods available to complete).

The project manager has a much greater likelihood of achieving the project time objective in the first scenario.

2.6.3 Monitoring

The project manager must be aware at all times of the actual deviance of the project from the plan. Monitoring and reporting on progress must be regular and accurate. There is no justification for the project manager not to know the precise status of the project.

The objective of the progress monitoring system is to:

• Identify areas of the project where performance is below expectations
• Provide information on such deviations from the project plan in sufficient time for corrective actions to be usefully applied

Most of the available project scheduling computer software programs allow for progress to be ‘posted’, that is, for the current status of programmed activities to be updated on the computer schedule. The network is then re-analyzed to take into account the new data, and new completion dates for the remaining activities are computed. Generally the updated schedule can be compared against an earlier baseline schedule and progress variance, both historical and future, tabulated. This baseline facility is of extreme benefit when monitoring performance.

A typical graphic progress report can provide the information shown in Figure 2.20 for each activity in the schedule.

The effectiveness of the reporting is a crucial element of the project control function. A reporting format should be standardized for each project, and all progress reporting required conforming to the specified format. To provide effective control the reporting must be:

• Timely
• Accurate
• Easily interpreted

A formal report should include the following information:

• A summary of efforts and accomplishments during the reporting period
• A summary of planned efforts and accomplishments in the following period
• The status of project milestones (achieved and predicted)
• Any changes in milestones status since the previous report
• The consequences of any delays in milestones
• Desired changes in predicted performances
• Actions required/suggested/recommended to obtain desired changes, and their cost/resource implications
• In addition to the text, a graphic progress analysis clearly indicating actual versus planned progress should be included.

Progress monitoring and reporting must be a regular activity; at least monthly on projects over six months, but probably fortnightly or weekly for projects of shorter duration. Remember that the aim of monitoring progress includes the ability to take action that will allow any time lost to be regained. This may not be achievable if monitoring occurs at less frequent intervals than, say, 10 percent of the project duration.

Slippage is commonplace and should be a major concern of project managers. It occurs one day at a time and project managers need to be ever vigilant to keep it from accumulating to an unacceptable level. Slippage can be caused by complacency or lack of interest, lack of credibility, incorrect or missing information, lack of understanding, incompetence, and conditions beyond one’s control, such as too much work to do. Project managers need to be on the alert to detect the existence of any of these factors in order to take appropriate action before they result in slippage.

Project slippage is not inevitable. In fact, there is much project managers can do to limit it. The tools of progress control are the bar charts or critical path networks described above. The project manager should take the following steps:

• Establish targets or ‘milestones’ – times by which identifiable complete sections of work must be completed
• As each target event occurs, compare actual against targeted performance
• Assess the effect of performance to date on future progress
• If necessary, re-plan so as to achieve original targets or to come as near as possible to achieving them
• Request appropriate action from those directly responsible for the various activities

2.6.4 Change control

The project manager must implement a project change control procedure to provide for effective control of discretionary changes during the project, and to track non-discretionary changes. Thus, if a proposed change in scope is requested, the commitment of the change must require specific approval, given only when the cost and time impacts have been defined. In the case of unavoidable changes their impact on the project must be systematically incorporated into the project information system, especially with regard to time and cost changes.

3.1.1 Importance of estimates

Estimating costs is of fundamental importance to every project. Estimates are prepared to meet two different objectives:

• As the basis for determining the economic feasibility of a project
• As the basis for cost management of the project.

If the estimates are unnecessarily pessimistic, decisions on project scope are improperly constrained. In the worst case the project, or elements within it, may not receive approval to proceed. On the other hand, if the initial cost estimates are unrealistically optimistic, the resulting project cost objectives are unlikely to be achievable, irrespective of the quality of the project management applied.

3.1.2 Basis of estimates

A cost estimate is a calculation of the approximate cost of a specific project or project component. Contrary to the belief often held by those who approve the budget, the estimate has an inherent uncertainty. The accuracy of the estimate is directly related to the amount of information or detail available at the time the estimate is prepared, the method used to develop the costs, specific inclusions and exclusions, and various assumptions necessarily made. It follows that when the estimate is presented for approval, the basis upon which it has been prepared must be clearly stated. This should include:

Inclusions/Exclusions

It is necessary to specify all inclusions and exclusions; for example fees, contingencies, escalation, principal supplied plant, etc.

Order of accuracy

The order of accuracy must be stated in terms that have specific probabilities defined. For example, in capital works projects the following definitions are commonly employed:

Cost indices

Where it is appropriate to include for escalation, the cost index upon which the estimate has been prepared must be identified. If the estimate includes provision for escalation, the index calculated to apply at completion must also be stated. The dollar value of the escalation is most accurately determined from a forecast cash flow that determines the value of expenditure, and thus the related escalation, on a quarter-by-quarter basis.

Escalation can only be estimated on the basis of judgment. However, the particular judgment may only be that of the person doing the estimate, or a projection provided by a recognized and competent source.

Contingency

Contingency is an estimate of cost provided against expected, but currently undefined, costs associated with the particular risks of the component being estimated. Contingency levels may be assessed in any of the following ways:

• Judgment based on the cost impact of particular risks, and probabilities of each particular risk arising
• Historical experience of similar activities
• Organizational policies for risk management
• Probabilistic modeling, using appropriate software

3.8.1 Reporting requirements

The basic objective of the financial report must be to provide an accurate status report of forecast financial cost versus approved budget. To meet this objective, the financial report needs to include the following information:

• Initial budget
• Approved budget variances to date
• Current budget
• Current forecast final cost

Further useful information includes:

• A breakdown of the difference between the original estimate and the current forecast final cost by scope, estimate and escalation variance
• Trends in the forecast final cost.

Depending on the value to the project team, the following information could also be included:

• Commitments to date
• Accrued expenditure to date. Accrued expenditure arises when contract payments are subject to retentions
• Expenditure to date versus planned expenditure to date. This will be of value if cost and schedule variance are identified using earned value analysis
• Forecast expenditure

3.8.2 Monitoring forecast final cost

Recall that at the project definition stage, the estimate of final cost (i.e. total dollars spent) is forecast as:
FFC = Base estimate + Contingency + Escalation + Exchange fluctuations

With this original FFC identified as FFC₀, the revised FFC at subsequent stages of the project is defined as:

3.8.3 Variances defined

Estimate variance

An estimate variance is a change in the estimated cost of an element included in the original estimate. The calculation of estimate variances will include periodic recalculation of the contingency provision since, as work is completed during the execution of the project, the required allowance for contingency will decrease.

Scope variance

A scope variance is a change in the estimated final cost of the project due to the inclusion of a new element that is not within the scope of the defined project, or the deletion of an existing element within the scope of the defined project.

Escalation variance

An escalation variance is a change in the total calculated escalation for the project. As the project progresses, total final escalation costs will need to be updated to take into account the actual movement in cost indices.

3.9 Value management

The purpose of value management

The objective of the Value Management (VM) process is to achieve the lowest possible cost without prejudicing required functionality or necessary quality; i.e. to improve the value/cost relationship. The VM process provides an analysis, generally at a particular point in the design phase, which evaluates the cost effectiveness of the proposed solutions. On larger or more complex projects, a VM study during the brief finalization process is often justified. At a later stage in the project, separate VM studies can be undertaken on the design.

VM is more than a cost review; it is a structured process within which all elements of a design brief and design solutions are tested against a number of parameters, such as what the real functional requirements of each specific element is, and what solution most efficiently meets those requirements. VM has produced some excellent results in many instances. In general, savings and improvements achieved from the VM process will justify the costs involved.

Value management methodology

The VM process includes pre-study activities, the VM study itself, and post-study activities. Pre-study activities, generally undertaken by the VM study leader, include:

• Co-ordination of the study process
• Collection of relevant information and documentation
• Some pre-study review and modeling

The actual VM studies are conducted in the form of workshops. The specific objectives for each study are defined as an initial activity during the workshop.

The participants include the study leader, representatives of the client organization, the designers (this term is used generically), and representatives of the supply, installation and construction functions. At the option of the client, personnel not connected with the design team may be present to contribute a view which is entirely independent of the solutions being reviewed. The process undertaken during the workshop requires that the VM study leader operates as a facilitator. The process, which is both rational and creative, is structured to review operating criteria and assumptions, identify risks and opportunities, and create and analyze alternative solutions.

4.2.1 Definitions

The following definitions will be used throughout this chapter (see Table 4.1).

4.2.2 Elements

The main elements of the risk management process are:

• Establishing the context
• Risk identification
• Risk analysis
• Risk evaluation
• Risk treatment
• Monitoring and reviewing

4.2.3 Benefits and costs

The benefits from applying risk management accrue to both the project team and to the project sponsor. These benefits include:

• Providing a more informed basis for committing to the project financially
• An increased understanding of the project, leading to better planning
• Development of more suitable project processes (e.g. contracting arrangements)
• Facilitation of more rational risk taking
• Improving the distinction between good luck and good management

The cost of applying risk management to a project varies, as a function of the scope of the project and the depth to which the process is applied. Costs can be very low (say, a few hours) at one end of the scale, and ranging up to several percent of the total management costs if done in depth and as an ongoing process throughout all project phases.

4.2.4 Application of risk management

Risk management is applicable to all projects. While this may be obvious, it is the widespread experience of project managers that it is difficult to convince clients to adopt comprehensive risk management processes.

While it is clearly of great relevance on large or complex projects, it will provide benefits on all projects except on recurring projects being undertaken in an unchanging environment – if such a situation ever arises.

Risk management is a continuous process that can be initiated at any point in the project cycle, and continued until the costs of maintaining the process exceed the potential benefits. It has the greatest potential benefits if used early on in the project. The following points within a project should be specifically addressed within the risk management processes:

• During the feasibility study – to assist the selection of implementation strategies
• At the time of client commitment – to properly understand the real exposure to risk
• At time of tender – by contracting parties
• Post tender – by the project manager to assess the likely performance of the contractors
• During implementation – to monitor existing and emerging risks and amend and/or develop appropriate management strategies

4.2.5 Documentation

In order to maintain a record to facilitate ongoing reviews as well as an adequate audit trail, all components of the risk management process must be adequately documented.

Sample documentation, based on that recommended within AS/NZS 4360:2004, is appended.

4.3.1 General

This defines the external and internal parameters which need to be taken into account when managing risk, and setting the scope and risk criteria for the risk management policy.

The outputs from this step are:

• Definition of the elements within the project to define a structure for the identification and analysis of risks; and
• Definition of risk assessment criteria directly related to the policies, objectives and interests of stakeholders

This process reviews the external, internal and project contexts.

4.3.2 The external context

This analysis reviews the external environment in which the organization seeks to achieve its objectives The purpose is to identify factors that enhance or impair the ability of the organisation to manage risks. This includes the financial, operational, competitive, political, legal, social, and cultural aspects of the operating environment.

4.3.3 The internal context

This analysis is directed at the internal environment in which the organization seeks to achieve its objectives

4.3.4 The project context

This analysis is directed to the specific project objectives and its component technologies, activities, timing and physical environment.

4.4.1 General

The organization needs to identify sources of risk, areas of impacts, events (including changes in circumstances) and their causes and their potential consequences. The purpose of this step is to identify all the risks, including those not under the control of the organisation, which may impact on the framework defined above.

A systematic process is essential because a risk not identified during this step is removed from further consideration.

4.4.2 Procedure

The first step is to identify all the events that could affect all elements of the framework.

The second step is to consider possible causes and scenarios for each event.

The process of risk identification can be complex, and a planned approach is necessary to ensure that all sources of risk are identified. This process may involve:

• Identifying the key personnel associated with the project, i.e. those whose understanding of the project environment and the project processes enables them to properly appreciate the sources of risk
• Undertaking structured interviews with these personnel. Checklists should be used to ensure comprehensive coverage of all project elements. The objective is to determine, from each person; concerns, constraints and perceived risks within their area of expertise
• Organizing brainstorming sessions
• Engaging the services of specialist risk analysts
• Reviewing past experiences in this regard

4.5.1 General

The objectives of risk analysis are to comprehend the nature of risk and to determine the level of risk. This involves:

• Assigning a level of risk to each identified event
• Providing data to assist the assessment and treatment processes
• Separating minor, acceptable risks from other requiring further consideration

Risk is analysed by consideration of the likelihood and consequence of events occurring within the context of existing controls i.e. management procedures, technical systems and risk management procedures.

The analysis can be carried out to various levels of refinement by way of qualitative and quantitative analysis, or a hybrid of the two. It is necessary to avoid subjective biases when analysing the likelihood and consequences of individual risks.

4.5.2 Qualitative risk analysis

Once the risks associated with every area of the project have been identified, the impacts of these risks are assessed qualitatively. Where the impact that the risks within specific areas have on the overall project may be different, the resulting impacts need to be evaluated independently. All identified risks are categorised into low/high probability, and low/high impact classifications.

Initial responses for the significant risks should be developed at this stage. If risks requiring immediate response are identified, then the initial response should be implemented. A proposed response to an initial risk may result in consequential risks not initially present. These are known as ‘secondary risks’. Secondary risks need to be included in the risk assessment process as they may dictate that a proposed response to a primary risk is not acceptable.

This analysis can be performed with software such as ‘RiskTrak’. The advantage of using software is that it ensures that few questions are left un-asked, and also provides a database with all risks, their assessment and methods of addressing them that can be accessed by the entire project team.

Interviews are conducted in general or specific project. Figure 4.2 shows the interviewing in progress.

Once the project-related risks have been identified, their chance of occurring and the related severity of such an occurrence have to be ascertained, together with the method and costs of addressing the issue. This is done via a conventional possibility/consequence matrix as shown in Figure 4.3.

4.5.3 Quantitative risk analysis

A quantitative risk analysis enables the impacts of the risks to be quantified with respect to the three fundamental project success criteria: time, cost and functionality.

The techniques outlined below have been developed for analysing the effects of risks on the time and cost outcomes of projects, and are in common use. These techniques are well documented in the literature, and a detailed treatment is outside of the scope of this chapter. These techniques are often not applicable to analysing risk impacts on functionality objectives.

Sensitivity analysis

Generally considered to be the simplest analytical technique to apply, this analysis determines the effect on the desired dimension of the project – i.e. time, cost, functionality – from changing each one of the risk variables independently.

The resulting Sensitivity Diagrams – one for each project dimension modeled – identifies impact each variable has on project outcome, and what those impacts are. By inspection, the critical variables are apparent. This provides the opportunity to develop a risk management strategy that targets the most critical risks.

Probabilistic analysis

Probabilistic analysis is an analysis to identify the frequency distribution for a desired project outcome, e.g. total project cost, internal rate of return or total project duration.

The most common form of this analysis uses sampling techniques, normally referred to as Monte Carlo Simulation. This can only be practically undertaken using an appropriate software application package.

A mathematical model of the project is developed, incorporating all relevant variables. A probability distribution is then defined for each variable, and the project model is analyzed taking into account all risks in combination. This analysis is repeated a number of times, typically 100 to 1000 passes, and at each pass the value for each variable is randomly calculated within the assigned probability distribution. The results from each analysis provide a distribution frequency of the project outcome. This establishes a mean outcome, and the range of outcomes possible.

Probabilistic analysis can be performed on cost as well as project schedules. One of the better-known software packages in this regard is @RISK, although there are various alternatives on the market, some stand-alone and others as add-ons for scheduling packages such MS Project and Primavera. An example of an inexpensive software package for Monte Carlo analysis on project costs is Project Risk Analysis. The following figures show the statistical behavior of project costs for a given project (see Figure 4.4).

If the above bell curve distribution is integrated from left to right, it yields a so-called S curve that indicates the possibility that the cost will be less than a given value (see Figure 4.5).

From the S-curve (specific values on the X-axis are available via the ‘Statistics’ function) it can be seen that, despite a mean cost of $4978 being predicted, there is only a 50% chance of that happening. In order to guarantee the cost with 99% certainty, provision has to be made for a cost of up to $5395, i.e. a contingency of $417 or 8.79% is required.

An alternative to Monte Carlo Simulation is the Controlled Interval and Memory Method. On less complex analyses this technique offers great precision for less computer effort.

Decision trees

This method has been in use for a considerable time and provides for decision making based on a relatively crude risk assessment. Decision trees display the set of alternative values for each decision, and chance variable as branches coming out of each node. Figure 4.6 shows the decision tree for the R&D and commercialization of a new product.

Influence diagrams

This is a relatively new technique, used as an interface with computer based risk models to facilitate development of complex risk models (see Figure 4.7).

Decisions, shown as rectangles with sharp corners (i.e. ‘Fund R&D’ and ‘Launch Product’), are variables that the decision maker has the power to control. Chance variables, shown as oval shapes (‘Success of R&D’ and ‘Market success’), are uncertain and cannot be controlled directly. Objective variables, shown as hexagons (‘Market value’), are quantitative criteria that need to be maximized (or minimized). General variables (not shown here) appear as rectangles with rounded corners, and are deterministic functions of the quantities they depend on.

Arrows denote influence. If ‘Market success’ influences ‘Market value’ it means that knowing the extent of the ‘Market success’ would directly affect the beliefs or expectations about the ‘Market value’. An influence expresses knowledge about relevance and does not necessarily imply a causal relation, or a flow of material, data, or money.

Influence diagrams show the dependencies among the variables more clearly than decision trees would. Although decision trees show more details of possible paths or scenarios as sequences of branches from left to right, all variables have to be shown as discrete alternatives, even if they are actually continuous. In addition, the number of nodes in a decision tree increases exponentially with the number of decision and chance variables and, as a result, Figure 4.6 would need in excess of a hundred nodes to display the decision tree for Figure 4.7, even if we assume only three branches for each of the two decisions and two chance variables.

4.6.1 General

Risk evaluation is used to assist in making decisions based on the outcomes of risk analysis as to which risks need treatment and the priority for such treatment This involves comparing the levels of risks determined from the analysis process against the acceptance criteria previously established.

The output from the risk evaluation is a prioritised list of risks requiring further action.

4.6.2 Categories of risk

The assessment process will determine whether risks may be categorised as low or acceptable, or other.

Low or acceptable risks may be accepted as they are, or with minimal further treatment, subject only to ongoing monitoring.

Risks that fall into the other category are subject to a specific treatment option.

4.7.1 General

Risk treatment involves identifying the range of options available for modifying those risks identified as requiring action in the previous stage, evaluating those options in respect of each risk, and developing and implementing risk treatment plans.

Note that some risk response activities may have been undertaken during the qualitative analysis step, if the urgency of developing a response to specific risks warranted it.

4.7.2 Identifying treatment options

Risk treatment options include the following. These options may not necessarily be mutually exclusive, or appropriate in all circumstances.

• Risk avoidance means not proceeding with the activity or situation giving rise to the risk
• Risk taking means taking or increasing the risk to pursue an opportunity
• Risk removal eliminates either the likelihood or the consequences of the risk
• Risk reduction reduces either the likelihood (e.g. by training programmes, QA programmes, preventative maintenance, etc) or the consequences (e.g. by contingency planning, design features, isolation of activity, etc)
• Risk transfer transfers all or part of the risk to another party. Mechanisms include the use of contracts, insurance, and organisational structures (e.g. a joint venture)
• Risk retention can be adopted by informed decision.

There are two additional classifications for risk treatment responses, viz. immediate or contingency.

• An immediate response is one where the project plan is amended in order for the identified risk to be avoided, or its impact minimized
• A contingency response is one where provision is made within the project plan for a contingent course of action that will only be initiated if the risk occurs

4.7.3 Evaluating treatment options

Options generated for risk treatment should be evaluated on the basis of the extent of risk reduction versus the costs of doing so, taking into account the risk assessment criteria previously developed.

Clearly large reductions in risk where achieved for relatively low cost should be implemented. Other opportunities may be less easily justified on economic grounds, including the need to consider rare but severe risks that cannot be economically justified, but which could be fatal if they arose. Some risks provide benefits (e.g. adoption of new technology) that need to be factored into the evaluation.

4.7.4 Developing risk treatment plans

Treatment plans document how the selected treatment options will be implemented. They define responsibilities, time frames, expected outcomes, budgets, performance measures and planned reviews.

Effective implementation of the risk treatment plan, including undertaking the planned reviews, requires appropriate management input on an ongoing basis. This should be addressed within the project planning.

4.8.1 General

Monitoring and review of all elements of the risk management programme is essential.

The specific risks themselves, as well as the effectiveness of the control measures, need to be monitored. Few risks remain static and factors impacting on the likelihood or consequences may change.

Changing circumstances may alter earlier priorities, and factors impacting on the cost/benefit of management strategies may vary. If, following treatment for a specific risk, there is still a residual risk, then the management of that risk needs to be investigated.

5.1.1 General

Historically, quality was achieved entirely by reliance on quality control procedures in isolation; that is, by inspections of the product during manufacture, and/or on completion. Uncovered defects involved remedial work, often expensive in terms of time and cost. Not all defects were found before in-service failures occurred. With the increase in complexity of systems and manufacturing processes, the limitations of the historical approach have necessitated a different philosophy. Real evidence of quality in all processes and activities involved in the generation of the output (design, manufacturing, installation and commissioning) must now be demonstrated. Incorporating quality assurance into each of these processes using a systematic approach promotes the reliable achievement of quality objectives.

Quality management is a key issue for many businesses in today’s environment, and many clients rank demonstration of quality management competencies highly when evaluating potential suppliers. The benefits to the purchasers include better quality of services and products, cost benefits due to improved efficiencies within the suppliers’ processes, and lower whole-of-life costs. Suppliers derive competitive advantages from the lower costs as well as from attaining certification to recognized standards.

Achievement of quality is a management function for which responsibility cannot be delegated. If it is to be implemented successfully, the quality program must be seen to have the commitment of senior management.

5.1.2 Quality concepts

Degree of excellence

This refers to the grade of defined product or service, when all quality characteristics are considered as a whole. It is best illustrated by the difference between a luxury sedan and a small utility vehicle, both made to a high standard of conformance in terms of the specified criteria for quality characteristics.

Fitness for purpose

A product or service is fit for purpose if all necessary quality characteristics are present, and it adequately meets (but does not unnecessarily exceed) prescribed or required criteria for each characteristic.

Quality characteristics

Quality is defined or demonstrated with regard to the following criteria:

• Performance – the primary operating characteristics
• Features – secondary characteristics that supplement the primary functional operation characteristics
• Reliability – a measure of the frequency of breakdown
• Conformance – to pre-determined standards
• Durability – a measure of the life span of the product
• Serviceability
• Aesthetics (subjective)
• Perceived quality (subjective)

5.1.3 Quality definitions

The following section will clarify some of the quality-related concepts used in this section.

Inspection and test plan

This is a document that identifies inspection and test schedules (verification activities) and the acceptance criteria for every activity in the process.

Non-conformance

Non-conformance refers to the non-fulfillment of specified requirements (ISO 8402).

Quality

Quality refers to the totality of features and characteristics of a product or service that bear on its ability to satisfy stated or implied needs (ISO 8402). In a contractual situation quality requirements are generally specified. In other situations the needs that are implied rather than expressed must be identified. Needs are normally defined as criteria to be achieved with respect to defined characteristics. In some situations the needs may change over time.

Quality assurance

Quality Assurance refers to all those planned and systematic actions necessary to provide adequate confidence that a product or service will satisfy all requirements laid down by a given quality policy (ISO 8402).

Quality Assurance is not an add-on to a process. Instead, its success depends on commitment to the philosophy of total integration of quality planning and implementation throughout all component activities.

Quality audit

A Quality Audit is a systematic independent examination to determine whether quality activities and related results comply with planned arrangements, whether these arrangements are implemented effectively, and whether they are suitable to achieve the objective (ISO 8402).

Quality Control

Quality Control consists of the operational techniques and activities used to fulfill requirements for quality (ISO 8402).

Quality management

Quality Management is that aspect of the overall management function that determines and implements quality policy (ISO 8402).

Quality plan

A Quality Plan is a document setting out the specific quality practices, resources and sequences of activities relevant to a particular product, service, contract or project (ISO 8402).

Quality planning

Quality Planning, in general, identifies which quality standards are relevant to the project and determines how to satisfy them

Quality system

A Quality System is the organizational structure, responsibilities, procedures, processes and resources for implementing quality management (ISO 8402).

Total Quality Management (TQM)

TQM is an approach for continuously improving the quality of goods and services delivered through the participation of all levels and functions of the organization, in order that fitness for purpose is achieved in the most efficient and cost-effective manner. TQM systems provide company-wide operating structures, documented in effective and integrated technical and managerial procedures, which guide and co-ordinate company activities across administration, marketing, technical, sales, etc.

5.1.4 Quality management fundamentals

Customer focus

The ultimate purpose of the quality system is to ensure complete customer satisfaction with the goods or services provided. Focus on the requirements of the customer at every stage in the process is fundamental to ensuring satisfaction. The customer-supplier relationship is therefore of great significance; every quality system should involve the customer, either directly or indirectly. Customer feedback provides the best inputs from which to define required improvements. The focus on the customer has the following elements:

• Define customer needs
• Convert customer needs into products and/or services
• Determine how well the customer perceives performance of product(s) or service(s)
• Determine what new characteristics will better meet customers’ needs

Process focus versus output focus

Note the earlier definition for Quality Assurance. It is not an add-on to a process. Instead, its achievement results from commitment to the philosophy of the total integration of quality planning and implementation throughout all component activities. Quality is achieved by putting in place a quality system that is intended to ensure that all component processes are subject to appropriate planning and control, not by inspection of the end product to see if it is conforming. In other words, quality is planned into the process, not inspected into the output.

Continuous improvement

The process of ‘continuous improvement’ is an essential element of TQM. This process is one of continually involving all process participants in a team environment, reviewing and experimenting in order to make small changes and innovations in the process. The emphasis is on achieving improvements in effectiveness and efficiency from small-scale changes, as opposed to implementation of large-scale technological or capital investments. Note that continuous improvement is distinguished from radical innovations (as result from such investments.)

The effectiveness of the continuous improvement process is a function of:

• Management commitment to the process
• The skill, knowledge, expertise and creativity of the personnel involved
• The authority delegated to personnel as well as the resources available to them

Involvement of personnel

The contributions and alignment of all company personnel are essential to the viability and effectiveness of any quality program. The level of input from personnel will be directly related to the culture that has been instilled by management. Company personnel should be participants in decision-making processes, and should be considered as ‘expert advisors’ regarding the quality system and its application.

To carry out their assigned roles effectively, personnel need an appropriately documented quality system as the platform, relevant training, adequate resources, and the necessary authority.

Leadership

The successful implementation of effective quality management is directly linked to the actions of a champion, the vision of senior management, and strong leadership. Leadership is essential, and considered by many leading experts to be the most important factor.

Quality management will only be effectively implemented where the chief executive is committed to its success. That commitment is demonstrated by:

• Ownership of the ‘quality vision’
• Communication of the necessity to achieve customer satisfaction through quality management
• Developing a company culture that places importance on implementing that policy
• Implementation of an appropriate structure
• Commitment of necessary resources to the development and implementation of the quality program, including training of personnel
• Delegation of authority to those responsible to put the process in place; i.e. to all personnel

Structure

The ‘Quality Manager’ should report directly to the Chief Executive, i.e. ‘quality’ should not be considered to be a subsidiary grouping within a process or production department. It is reported that in most instances where the implementation of quality assurance has not been effective, a prime cause has been the organizational structure adopted by the company.

Data measurement and analysis

Measurement and analysis of data on an ongoing basis, i.e. quality control, is the process by which achievement of defined quality standards is evidenced, non-conforming products identified, and the requirement for system improvements made evident. The principle of effective quality control is based on the following:

• No manufacture without measurement
• No measurement without records
• No records without analysis (including statistical analysis as appropriate)
• No analysis without feedback and corrective action

Benchmarking

Benchmarking is the process of evaluating company practices against best industry practice. The path to competitive excellence requires that the company implements an evaluation program.

5.1.5 Supply chain relationships

The business process of an organization may be defined in terms of chains and interactions between different activities and parts of the company, whereby customer demands are converted into goods and services that meet those requirements. Each part of the organization has a dual role; that of receiver and supplier, adding value by the processes undertaken. The processes may be classified as internal or external, depending upon whether or not the specific chain is entirely internal to the company, or includes an external supplier or customer (see Figures 5.1 and 5.2).

There needs to be a positive interaction between the internal and external processes at all times; i.e. the customer should be involved throughout.

5.1.6 TQM models

TQM implementation commences with the definition of company objectives, based on an analysis of its strengths and weaknesses, and the desired competitive position. That analysis should include definition of role to be taken by TQM as a means to achieve the defined objectives.

The following models were developed to demonstrate the components of the TQM process (see Figures 5.3 and 5.4).

The elements in each model may be summarized as a component-based TQM model or an action-based TQM model. A component-based TQM model has the following attributes:

• The key: customer-supplier chains
• Systems: documented standards and procedures
• Tools: statistical process controls
• Teams: continuous improvement by teamwork

An action-based TQM model, on the other hand, has the following attributes:

• The key: continuous improvement
• Customer focus: the responsibility of all personnel
• Management commitment: setting goals, establishing systems, allocating resources
• Total participation: inputs of all personnel
• Statistical quality control
• Systematic problem solving: adopting the plan-do-check action cycle, using surveys and customer feedback

5.2.1 Procedures

Detailed procedures are developed for each system element identified in the systems outlines. These procedures should be appropriately detailed, and will generally include reference to quality documents (standard checklists, record sheets, etc) to be completed as part of the process in undertaking the defined procedure.

This hierarchy of a typical Quality System documentation is represented in Figure 5.5.

The Quality Manual is a document of intent, not detail. The detail is reserved for the procedures.

5.3.1 General

The International Organization for Standardization (ISO) has developed quality system guidelines that have gained international recognition as the benchmark for quality assurance systems.

The objectives of these standards are firstly to provide purchasers of products as well as services with independent evidence that the supplier has in place systems to ensure that the desired level of quality will be attained. In addition, they provide suppliers with defined guidelines that provide the basis for implementing a certified quality assurance system.

It may be argued that adherence to these standards will automatically lead to a quality output. This is, unfortunately, not so. While certification of quality system compliance with the relevant ISO standard does mean that an organization is properly applying documented quality systems, it does not mean that those quality systems are necessarily appropriate.

5.3.2 ISO 9000:2005, ISO 90001, ISO 9002, ISO 9003

The ISO 9000:2005 system guidelines recognize differing levels of quality assurance and are applicable in differing situations. There are three levels of quality assurance, defined respectively within ISO 9001, ISO 9002, and ISO 9003.

These standards define quality system requirements in decreasing levels of comprehensiveness.

• ISO 9001– For use where quality assurance is to comply with specified requirements during several stages, which may include design/development, production, installation and servicing
• ISO 9002- For use where quality assurance is to comply with specified requirements during production and installation
• ISO 9003- For use where quality assurance is to comply with specified requirements solely at final inspection and test

Guidance as to the selection of the appropriate standard to apply is set out in ISO 9000:2005.

5.3.3 ISO 9000:2005 quality system elements

ISO 9000:2005 quality systems have a common framework, although the specific requirements vary from ISO 9001 to ISO 9003 and may not be applicable at all levels for a particular organization because of the operations occurring within the organization. The defined quality system elements are set out in Table 5.1.

5.4.1 Project quality management

The generic elements of Quality Management were defined in 2.2 as including Quality Planning, Quality Control, and Quality Assurance. The application of appropriate controls to all elements of the project management processes is, in fact, quality assurance. In other words; project management methodology is a subset of the Quality Assurance Programmes.

The following section addresses the specifics of project quality management as a subsidiary control process directed at ensuring the fitness for purpose of the project deliverables.

5.4.2 Project quality planning

The following are inputs to the quality planning process for a project:

Quality policies

Quality policy refers to the formal policy of the sponsor organisation and/or the project management group. This might include, for example, requirements for using ISO 9000 accredited suppliers only.

Project scope statement

This defines the project objectives and major deliverables.

Project process descriptions

This involves the definition of the processes required to provide the project deliverables defined in the project scope statement.

Standards

This involves the definition of specific standards applying to the project. The outputs from the quality planning process are:

• Project quality procedures. These are defined process controls for each process within the project.
• Project inspection & test plans (ITPs). These define the required programme for applying quality controls.

5.4.3 Project quality control

Inputs to the Project Quality Control function are:

• Project Quality Procedures
• Project Inspection and Test Plans
• Inspection and measurement of product/service characteristics

Outputs from this function are:

• Acceptance/reject/rework decisions
• Test documentation
• Adjustments to the process

5.4.4 Project quality assurance

Inputs to the project quality assurance function are:

• Project Quality Procedures
• Project Quality Documentation

The output from this function is:

A Quality Improvement Program – i.e. a program to define and implement revisions to Project Quality Procedures and ITPs.

5.4.5 Project quality procedures

Typically the Project Quality Procedures are organised within three divisions:

Project management

These operate to control the activities of the project team itself, and will typically cover:

• Preparation of Project Quality Plans
• Project control procedures
• Project administration

Design services

These are issued to design consultants and define the requirements for quality systems and procedures to be applied by them. These will typically cover:

• Requirements to produce Project Quality Plans
• Requirements to submit quality system and procedure documentation for review
• Requirements to submit design validation and other test documentation for review
• Processes for ensuring design interfaces are integrated
• Design quality assurance

ITPs may be defined in the scopes of service, or submitted as part of the Project Quality Plan prepared by the consultants.

Supply, installation and construction services

These define the requirements for quality systems and procedures to be applied by suppliers, installers, and contractors. These will typically cover:

• Requirements to produce Project Quality Plans
• Requirement to submit quality system and procedure documentation for review
• Requirements to submit test documentation for review

ITPs may be defined in the contracts, or submitted as part of the Project Quality Plan prepared by the suppliers, installers, and contractors.

The procedures will be the relevant procedures, where they exist, selected from those defined within the Quality Assurance Program of each contributing organization, to be applied on the specific project. Where they do not exist the required procedures need to be specifically prepared.

6.1.1 General

A significant benefit of the EVM approach is that most of the data can be presented graphically, in one macroscopic view of the project progress. Because there is a common basis for these measurements, all individual measurements can be summarized (rolled up) to any level, up to the entire project. Each work item is given a weight factor equal to its planned dollar value or Budget At Completion (BAC) divided by the total of the BACs in any measured grouping.

Because all measurements are based on their dollar value, they can all be plotted on the same graph, with TIME on the x-axis and DOLLARS on the y-axis. Refer to Figure 6.1 for an illustration of the application of EVM.
Figure 6.1(a) depicts a traditional cost report comparing actual expenditure to budget. This does not assist the project manager in determining the status of the project. Superficially seen, expenditure is close to the budget and there would appear to be little cause for concern.

Figure 6.1(b) analyses the same data to provide information on the cost and schedule variances. In this case both variances are negative: the project is behind schedule, and the cost of the work completed is higher than budgeted. Thus the true position is that the project is poised for significant cost overruns as well as time delays.

6.1.2 EVM terminology

At first sight the simplicity of EVM is well-hidden behind the terminology that has been generated. Fortunately it very quickly makes sense to use the acronyms listed in Table 6.1. Note that these calculations can be done for a single item (on the WBS), or for a group of items, or for a rollup (summary) of the entire project. All measurements referred to must obviously be taken at the same time.

7.1.1 Management versus leadership

The role of the project manager is a synthesis of management and leadership.

There is a substantial difference between the two activities. Davis (Human Relations at Work, McGraw-Hill, 1967) defined the difference in the following terms:

“Leadership is part of management, but not all of it. A manager is required to plan and organize, but all we ask of the leader is that he gets others to follow. Leadership is the ability to persuade others to seek defined objectives enthusiastically. It is the human factor which binds a group together and motivates it towards goals.”

Bennis (Good Managers and Good Leaders, Across the Board, 1984) defined the difference as:
“A leader does the right thing (effectiveness), a manager does things right (efficiency)”

The quote above is ‘catchy’ but creates the impression that management and leadership are mutually exclusive activities, and that a good manager is not necessarily a good leader. This is not so. Leading is simply a part of management, along with directing, controlling, planning and coordinating; and therefore a good all-round manager is by necessity a good leader as well.

The opposite is not necessarily the case and history is riddled with examples of great leaders who were marginal or incompetent managers.

7.1.2 Management theories

Classical management theory defines the basic functions of management as planning, leading, organizing, directing and controlling (or planning, organizing leading and controlling). In addition to that, initiating and closing functions arise because of the specific nature of projects.

The basic elements of project management correlate closely to those defined in the classical model of management. The reality is, not surprisingly, that project management cannot be divorced from general management.

There are nevertheless significant differences between the two, and it is generally accepted that management of a project is more demanding than management of an operational environment since the situation tends to be more dynamic. In the final analysis the project manager is responsible for the achievement of defined, measurable project objectives. Project managers will focus their energies on the achievement of those objectives, in some instances with less regard for the sensitivities of the project team members than would be the case in a functional situation.

7.1.3 Leadership theories

Thousands of studies have been undertaken to review the characteristics and traits of successful leaders, and many definitions of the optimum blend of characteristics have been defined as a result. Handy (Understanding Organizations, Penguin, 1981) proposes three groups of leadership theories:

Trait theories

According to Handy, successful leaders tend to have the following learned or inherited characteristics:

• Intelligence. They have an above average intelligence without being geniuses, as well as the ability to identify common themes, solve complex problems and comprehend the work of team members
• Proactive. This refers to the ability to identify the need for action, and the strength of character to initiate the required action
• Self-assurance. They have sufficient confidence in themselves to believe that what they are doing is appropriate
• Helicopter mind. They have the ability to move within different levels, i.e. to understand the detail but without losing the global view

Style theories

Certain types of behavior are more effective for a leader than others:

• Autocratic. The autocratic manager dictates ‘what’, ‘how’ and ‘when’
• Democratic. The democratic manager respects the opinions of the team members, and pursues consultation before making decisions
• Laissez-faire. This type of manager behaves like any other team member, and all team members work on their own

Contingency theories

One of the better-known examples in this regard is the Situational Leadership model (Hersey and Blanchard- Centre for Leadership Studies). This model works very well in dynamically changing situations and is part of the training syllabus for US Army officers (see Figure 7.1).

In this model the follower can be categorized in one of four categories of ‘readiness’ viz. D1 through D4. Ideally the leader has to respond with the appropriate leader behavior, viz. S1 through S4. In the following discussions, ‘unable’ means technically incapable to perform the task at hand, and ‘unwilling’ means being hesitant or feeling insecure (e.g. because of a lack of relevant experience), or simply having an attitude (motivation) problem.

The behavior of the leader is shown on two axes. The horizontal axis shows the extent of the leader’s task behavior (i.e. directive behavior or degree of guidance to the follower). Towards the left the degree of the leader’s intervention diminishes, while it increases towards the right. The vertical axis represents the degree of supportive behavior (i.e. relationship behavior). It decreases towards the bottom and increases towards the top. The leader-follower relationship can now be summarized as follows:

• D1-S1. The follower is unable and unwilling (insecure/unmotivated), hence requires a leader-directed approach. This is typical of a young graduate joining an R&D team, for example. The leader adopts a ‘telling’ or directive style, making decisions for the follower and providing specific directions and close supervision. The leader is high on directive behavior, but low in supportive behavior. He basically tells the follower (albeit in a ‘nice’ way), what to do and how to do it.
• D2-S2. The follower has now developed and moved on to the quadrant where he/she is still considered technically unable, but willing (confident/motivated). The leader still directs the tasks, but adopts a ‘selling’ style, explaining decisions and soliciting suggestions. The leader is still being very directive (maybe a little less than in S1), but much higher on supportive behavior
• D3-S3. The follower is now able, but unwilling (insecure). This could be expected from a scenario where a member of the project team is, for the first time, appointed as project manager. The leader will adopt a participating style, making collaborative decisions with the follower or allowing the follower to make decisions and then supporting them. The leader is lower on directive behavior than in S1 and S2, and relatively high on supportive behavior
• D4-S4: The follower is now able and willing. The leader can turn over decisions and responsibilities for the task (i.e. delegate the task) to the follower. In this case the leader is low on both directive and supportive behavior as there is no need for either. There are, however, two very important points to consider.
  • Delegating a task to a person who is not able and willing to perform the required task is a surefire recipe for disaster
  • One can delegate responsibility but not accountability. The leader delegating the task still has to keep a watchful eye over it, as ‘the buck still stops’ with the leader if things go wrong

7.2.1 General

The culture of the organization within which the project is implemented, and the culture developed within the project team, have significant impacts on the success of the project management effort. Project managers need to be aware of these influences, how to react to them, and how to modify them.

The following discussion sets out a definition of culture within these environments, identifies the characteristics of organizational cultures, recommends strategies to be adopted by the project manager to operate effectively within those different cultures, and examines the cultural issues arising within the project team. Characteristics of an effective project team are listed.

7.2.2 Culture defined

Smirchich and Stubbart (Strategic Management in an Enacted World, Vol I, Monographs in Organizational Behavior and Industrial Relations, Jai Press, Greenwich CT, 1983) describe culture as:

“The degree to which a set of people share many beliefs, values and assumptions that encourage them to make mutually reinforcing interpretations of their own acts and the acts of others”.

As a result of the system of shared norms, the culture creates shared meanings for the individuals, thus providing bonds between them. The culture creates a social environment that influences the behavior of the individuals. The culture may generate commitment to management values, and will provide a perception of the organization to people within and outside of it.

Culture is transmitted directly, by the communication of beliefs and values, through both formal and informal mediums. It is also transmitted indirectly by way of the organization’s rituals, symbols and myths.

Project managers are normally involved with a number of different organizations, and therefore different cultures, within a single project. The differing organizations comprise the client organization, functional departments within an organization, and the project team itself. The project manager needs to be aware of the differing cultures, and the influence of those cultures, to avoid or minimize conflict and misunderstanding.

7.2.3 Organizational cultures

A useful model of organization cultures has been developed by Cameron (Cultural Congruence, Strength and Type: Relationships and Effectiveness; Working Paper No 401, Univ of Michigan Graduate School of Bus, Ann Arbour, MI, 1984). This model is based on the Jungian framework of psychological functions which states that decision making occurs within any individual on a continuum between thinking (rational, logic based) and feeling (based on whether the particular approach is pleasing or not pleasing), and that information gathering occurs on a continuum between sensing (based on measured or observed values and data) and intuiting (based on feeling). Jung postulated that individuals tend to combine an information gathering preference (sensing or intuiting) with a decision making preference (thinking or feeling) to understand and act on information. The Cameron model is represented in Table 7.1.

The key to Table 7.1 is as follows: [1] Leadership style, [2] Basis for bonding within the organization, [3] Strategic concerns and [4] Values emphasized.

The characteristics of each type of organization are:

• Hierarchical. The hierarchical culture is very bureaucratic. Individuals look internally for information, and make rationally based decisions. Typically, they build complex administrative systems to regulate their operations. Mining companies often have this type of culture
• Clan. The clan culture emphasizes flexibility in the decision making style, and an internally orientated approach to collecting information on which the decisions are based. An example is Intel
• Market. The market culture is orientated towards the external environment, and typically adopts highly analytical processes in the decision making processes. An example is the U.S. consumer commodities company Proctor & Gamble
• Adhocracy. The adhocracy cultures are flexible in the decision making processes, and are oriented towards the external environment, and are innovative and entrepreneurial. An example is the 3M Company

When interacting with a new organization, or component departments, it is important that project managers identify the type of culture operating. This is necessary in order for them to develop an ‘influence strategy’ that will maximize their ability to obtain the required cooperation and performance. Elmes & Wilemon (Organization Culture and Project Leader Effectiveness, Vol XIX, Project Management Journal, 1988) postulate the following strategies as guidelines.

• Hierarchical. Adopt the bureaucratic approach – i.e. work ‘within appropriate channels’, and adopt precise detailed communications. To gather the required support, look for ‘trades’. It may be useful to appeal to the sense of tradition within many long-lived bureaucracies. Innovation can create obstacles. Conflict resolution is typically avoidance, including postponement. The project manger will assist conflict resolution within this environment by providing a ‘face saving approach’, whereby issues and underlying feelings are expressed without the dispute becoming public. This requires sensitivity and a degree of private communications
• Clan. Focus on consensus building. Create a critical mass of support by involving many key players. Listening, expressing concerns and communicating trust are important if people are to make a commitment. Handle conflicts by collaborative methods
• Market. This culture is highly competitive, and the project manager may need to enable others to see benefits to themselves from project participation. It is useful to attract the support of ‘stars’ within the organization. Competition is a primary means of resolving conflict
• Adhocracy. Adhocracies have weak authority structures, and the project manager needs to be flexible and creative to gain support. Provide participants with freedom and intellectual challenge, and expose them to new problem-solving techniques. Focus on the task should be sensitive. Conflict should be solved by collaborative methods

7.2.4 Creating a team culture

Cultures within the project team are a reflection of the project manager’s preferences and style. The styles of the culture that can arise are similar to those described above. The project manager must ensure that the development of the team culture, and the nature of that culture, is deliberate and planned, not a situation that arises by default.

Mower and Wilemon (Team Building in a Technical Environment, Handbook of Technology, Wiley 1989) describe team building as a process aimed at the development of the team’s task competencies (meeting goals, objectives and targets), and interpersonal competencies (resolving conflicts, developing trust).

Project managers can assist the project teams to reach the desired level of performance in two ways. Firstly, they should protect the team from external conflicts and influences that will disrupt it, thereby interfering with progress towards the desired objectives. This is important where the culture of the dominant organization imposes values, rules or procedures which impede the ability of the team to complete their tasks. Secondly, project managers build up the effectiveness of the team by the values that they transmit to team members. Again, values are transmitted formally via such means as training manuals, meetings and structured discussion, and informally or symbolically.

Project managers need to specifically address the following:

• Clarifying roles, responsibilities and levels of authority for all team members
• Setting up effective channels of communication with all team members
• Setting realistic performance expectations for each team member
• Delegating effectively (instead of over-supervising)
• Publicly rewarding good performance
• Acknowledging legitimate concerns and conflicts within the team

Team building progresses through a series of defined phases to ultimately reach a high level of sustained performance. In the first stage, team members develop an understanding of the project objectives, their roles and responsibilities, and of each other. In the second stage, team members form a definitive view of their importance to the team and the project. During this stage conflicts between team members commonly arise. In the third stage the conflicts have been resolved and the members of the team are able to focus on execution of the project. In the final phase the team members evaluate what has been learned from completion of the task. At each stage the project manager can communicate values that move the team to the next stage.

The stages in team development are referred to as the processes of ‘forming’, ‘storming’, and ‘norming’.

7.2.5 The effective project team

The focus of the project manager is to develop an effective project team. Culture is an important component of this parameter, but it is not the sole issue.

Mower and Wilemon have identified the following characteristics of the effective project team (see Table 7.2):

7.2.6 Team motivation

There are certain issues that spur on individuals within the team to even greater achievements, and other issues that stifle performance. For a start, the project manager should ensure that his leadership style when dealing with a specific team member is in line with the degree of readiness of that individual. This will differ from individual to individual, and from task to task. It is not hard to imagine that inappropriate styles such as leaving a newcomer to sort out things for herself (S4 style with an R1 follower) or trying to prescribe to an individual to whom a task had been delegated (S1 style with an R4 follower) can lead to friction and loss of motivation within the team.

There are, however other issues that affect individual performance, sometimes within the ambit of the project manager’s control, and sometimes not. Herzberg has studied the topic and arrived at a list of so-called motivators and hygiene factors. A motivator is a cause for satisfaction, while a hygiene factor is a cause of dissatisfaction. An interesting observation from the results of his studies is that the lack of a motivator does not automatically make it a hygiene factor (de-motivator) and vice versa.

From the following figure it is evident that the major motivators are (in descending order of importance):

• Achievement
• Recognition
• Work itself
• Responsibility
• Advancement
• Personal growth

The absence of these factors, though, do not create an commensurate level of dissatisfaction.
On the other hand, the major hygiene factors are:

• Company policy and administration
• Supervision
• Relationship with supervisor
• Work conditions
• Salary
• Relationship with peers

As with the motivators, it is evident that the absence of a de-motivator does not automatically motivate the individual.

A few interesting observations are that a sense of achievement and recognition for work well done are by far the biggest motivators, while poor administration and unsatisfactory supervision are the greatest reasons for unhappiness. A lack of enough salary is, to a lesser extent, a de-motivator but sufficient salary is not much of a motivator (see Figure 7.2)!

7.3.1 Authority of the project manager

The authority of the project managers directly impact on their capability to perform the role effectively. That authority is derived from the following sources:

• Organizational. This refers to the authority vested in the individual by the corporate structure and policies, the individual’s position within the organization, and the formal delegation of authority from superiors
• Project. This is authority arising from the terms of reference for the specific project, and the manner in which the project organization has been structured and the control mechanisms defined
• de Facto. This is authority arising from the personal and political skills of the individual, and the influence those skills have on allowing the individual to obtain a significant role in the communication process and decisions paths within the project.

The level of authority required by the project manager is variable, and dependent upon the level of accountability that the project manager is held to. Generally the project managers should have more authority than their responsibilities dictate.
Common causes of problems within projects that arise from authority issues include:

• A lack of formal authority
• Incorrect perception of authority (often because of inadequate documentation)
• Dual accountability of individuals. This underlines the importance of having a single point of authority (the project manager) and defined assignment of responsibilities for all team members
• Inappropriate organization structures

7.3.2 Power of the project manager

Power comes from the credibility, expertise and decision making skills of the project manager. Power is granted to the project manager by the project team as a consequence of their respect for performance in those areas.

7.6.1 General

Given the consequences of the appointment, the project manager selection requires to be carefully considered, and must not be just an arbitrary action.

The primary issue in making a specific selection is what criteria should be applied to evaluate the suitability of a potential project manager. Technical project management skills and knowledge base requirements are covered elsewhere in this course. The preceding discussion defined specific skills and competencies required of the project manager as an effective leader.

There is a view that the definitions of a good project manager as outlined in this chapter are of limited application, given the reality that the choice of an individual must be made from a very limited group, amongst which there will not be one whose profile closely matches the desired ‘super person’. This view is not acceptable. While that reality may generally apply, it is still highly relevant for the potential employer to be well-informed as to the essential and desirable characteristics required of an appointee.

There are a number of approaches that can be adopted to procure a project manager. These include:

• In-house selection
• Recruitment
• External consultant

Each approach has specific issues, discussed below.

7.6.2 In-house selection

Selection of an in-house individual for the role of project manager has obvious advantages including:

• The appointee’s familiarity with the organization, its culture, procedures and personnel
• The relative ease with which the appointment can be organized
• The ability to make the position only part-time if dictated by the workload of the project management function

Whether or not this option is practical depends upon a number of factors:

• The capacity of the personnel within the organization to accept the additional workload created by the promotion of the incumbent
• The skills and experience of the potential incumbent to undertake the management of the particular project

It must be recognized that only a minority of people have the potential to be effective project managers. However, those individuals will only make good project managers if they have the opportunities to learn and develop the skills and techniques required.

7.6.3 Recruitment

Recruitment is an appropriate option where there is sufficient ongoing work to justify the additional increase in staffing. It has the benefit of allowing the necessary skills to be acquired at a lower cost than employing consultants, and widens the range of potential appointees to be considered for the position. It can have an advantage of providing the opportunity to transfer skills within the organization, but may be better achieved through formal training using external consultants or trainers.

7.6.4 External consultant

The use of external consultants allows specific expertise to be employed without increased establishment costs. The skill levels and experience retained in this way will normally be higher than by recruitment. The external consultant should have industry exposure, but may not have experience with the organization, although this may or may not be considered a critical factor. It is likely that the costs for undertaking the service will be higher than the other options, but on a true hourly rate cost the differential may easily justified. Where the management function is complex because of the nature of the project, or the project is a large one with significant consequences for non-achievement of objectives, this approach deserves serious consideration.

Selection of the consultant should focus on the nominated individual, rather than the company under consideration. Evaluation criteria for selection should include:

• Relevant experience with projects of a similar type and scope
• Previous performance in achieving project objectives
• Personal attributes of the consultant
• Adequacy of standard control procedures to be applied

Providing it is relevant and practical, the engagement of external consultants should provide for a transfer of knowledge to the client organization.

7.6.5 Project managers to avoid

The following personality types do not make effective project managers, and should be avoided.

• The technocrat. The individuals are so concerned and involved with the detail of the technology that they don’t have the time, ability, or desire, to manage the project effectively. They are unable to delegate the performance of the tasks, and commonly lack the interpersonal skills necessary to build an effective team
• The bureaucrat. This refers to an individual who is more concerned with the administration of the project than actually achieving the desired results. Ensuring that the way in which the work is done conforms to the prescribed procedures is seen as more important than the quality or effectiveness of the effort
• The salesman. This is the individual who accomplishes little, but directs his efforts to presenting the project as being successful

8.1.1 Basis of the legal system

Constitutional basis of law

In the Commonwealth legal system the Legislature makes the laws, the Executive administers the laws and the Judiciary decides in the case of disputes or transgressions of the laws.

Legislation is the body of rules that have been formally enacted or made. Many bodies have the power to lay down rules for limited purposes, for example, social clubs; but fundamentally the only way in which rules can be enacted so as to apply generally is by Act of Parliament. In constitutional theory, Parliament is said to have legislative sovereignty and provided that the proper procedure is followed, the statute passed must be obeyed and applied by the court. The judges have no power to hold an Act invalid or to ignore it, however unreasonable or ‘unconstitutional’ they may consider it to be.

Local government

Some of Parliament’s legislative functions are delegated to subordinate bodies who, within a limited field, are allowed to enact rules. Local authorities, for instance, are allowed to enact by-laws. However, local authorities can only do this because an Act of Parliament has given them the power to do so.

Civil law

The purpose of civil law is to be compensatory and not punitive as in criminal law. The principal divisions are contract and tort. Civil law is based on precedent, and has as the outcome financial award and sometimes mandatory order.

Actions under contract are based on breach of an agreement intended to be binding entered into by parties wherein an offer is made by one, accepted by another, accompanied by some valuable quid pro quo.

Actions under tort are based on breach of a legally recognized obligation owed by one party to another, or to persons generally.

8.1.2 Doctrine of precedent

Binding precedents

The decision in a previous case is binding under the following circumstances:

• It comes from a higher court in the same hierarchy
• There must be an essential statement in the legal decisions (ratio decidendi). The ratio decidendi (the reasoning vital to the decision) is the statement by the judge of the facts he regards as ‘material’, the legal principles which he is applying to these facts and why. The judge may at the same time discuss the law relating to this type of case generally, or perhaps discuss one or two hypothetical situations. These are known as obiter dicta (other comments) and while they may have persuasive force in future cases, they are not binding.
• Material facts must be the same. A material fact is one where it can be reasonably argued that the presence or absence of the fact affects the result.

Persuasive precedent

Precedents in the following cases exercise a varying degree of persuasion.

• Decision from a higher court in another hierarchy
• Court of similar or lower status in the same hierarchy
• Statement of law was beyond that necessary to decide the legal principle, that is, obiter dictum
• The ratio decidendi was distinguishable on the facts

8.1.3 Natural justice

Any breach of natural justice will set aside a decision of the court or the arbitrator.

The elements of natural justice are:

• He who alleges must have proof
• There must be no bias on the part of the judge/arbitrator
• The judge/arbitrator must have no interests in the case
• The other party must be present to argue the case unless he has given his (not his lawyer’s) express consent in writing

8.2.1 Types of contracts

Simple contracts

The contract may be oral, or written, or implied by conduct of the parties.

Formal contracts

Any simple contract put into writing with adequate particulars becomes a formal contract. It is then a formal simple contract.

When made by a company it is generally under seal. The period of limitation is 12 years for breach of contracts made under seal. In respect of building construction contracts, S91 of the Building Act 1991 sets the period of limitation at 10 years.

A contract made by deed must be under seal. If made by deed, no consideration is required, for example, a will or arbitration agreement.

Contract of record

Confined to the legal system, for example, to jail if fine not paid.

8.2.2 Essential requirements

The essential requirements for a contract to be legally enforceable are:

• The intention to create legal relations
• Agreement (offer and acceptance)
• Consideration
• Definite terms
• Legality
• Capacity of the parties

8.2.3 Intention to create legal relations

Unless the courts are satisfied that the parties intended this agreement to be legally binding, the courts will take no notice of it.

8.2.4 Agreement

The courts must be satisfied that the parties had reached a firm agreement and that they were not still negotiating. Agreement will usually be shown by the unconditional acceptance of an offer.

Offer

The offer must fully define the intended agreement. It can be accepted at any time unless:

• It is withdrawn, and the offeree advised
• It is rejected
  • A counter offer is made
  • There is a fluxion of time, i.e. the offer lapses unless accepted within a reasonable time

If the offer is not withdrawn by A, they are bound to take B’s acceptance. An offer can be made to another person, another party, a specific group, or the world at large. An example of an offer to a specific group is to people who send in coupons. The offer can be made to the world; contracts then exist with those who accept. A relevant case in this regard is Carlill v Carbolic Smoke Ball Co 1892.

It is necessary to distinguish between a genuine offer and ‘mere puff”, or boast, which no one would take too seriously. Note the difference between an offer and an invitation to treat. An advertisement for a tender is normally an invitation to treat. The tender itself is the offer. Refer to Pharmaceutical Soc v Boots 1953 as well as Fisher v Bell 1961.

A tender to supply as required is a standing offer to be converted to contracts upon placement of each order. It can be revoked at any time provided no order is currently unfulfilled.

It is held that advertisement of an auction is an invitation to treat only. Auctions can be called off after advertising. The auctioneer may withdraw the offer to sell up till the fall of the hammer if it is a reserve auction. If it is a no reserve auction, it is held to be an offer to sell to the highest bidder, and the highest bid must be accepted.

An estimate can be an offer. Revocation of the offer must be communicated to the offeree (Byrne v van Tienhoven 1880) and communication need not be by the offeror (Dickinson v Dodds 1876).

An offer may be conditional, and terms as such may be implied. For example, an offer to buy a car is implicitly conditional upon the car remaining in the same condition as when the offer is made.

In general, an offer can be revoked at any time before it is accepted. Note the position regarding tenders as discussed elsewhere in this chapter.

Acceptance

There must be some positive act of acceptance and mere silence will never be enough. Refer to Felthouse v Bidley 1863. Acceptance must be communicated to the offerer.

A contract is completed when the acceptance is posted. Note, however, that the courts accept that letters can be lost in the post.

A counter offer and a mere enquiry must be distinguished from each other. A counter offer destroys the original offer. A mere enquiry does not destroy the offer. Note that an acceptance relying upon a change in terms would be a counter offer. In this regard, refer to Hyde v Wrench 1840 and Stevenson v McLean 1880.

Acceptance should generally be in the same form as the offer, that is, a letter in response to a letter.

An offer must be accepted in the terms of the offer if such terms exist and if they are very precisely defined.

Conditional acceptance is not acceptance. For example, “… subject to a formal contract”, “… subject to solicitor’s approval”. Note, however, that “subject to finance” is held to be binding acceptance.
A provisional agreement pending a later contract is held to be binding.

8.2.5 Consideration

English law will only recognize a bargain, not a mere promise. A contract, therefore, must be a two-sided affair, each side providing or promising to provide some consideration in exchange for what the other is to provide. Consideration is defined as an act or forbearance of value, or the promise of such, for which the same is bought from another. Note that not all promises are deemed to constitute consideration.

Valid consideration includes:

• Executory consideration – when the consideration is a future act
• Executed consideration – when the consideration is the performance of the act (for example, return of dog for reward advertised).

Consideration need not be adequate, that is, the promises need not be of equivalent value. Consideration must exist and have some value otherwise there is no contract. The following have no value and cannot therefore constitute consideration so as to render a contract actionable:

• Past consideration (see Roscorla v Thomas 1842)
• A promise to perform an existing obligation to the promise (see D & C Builders Ltd v Rees 1966)
• A promise made to a third party

8.2.6 Terms of the contract

General

It must be possible for the courts to ascertain what the parties have agreed upon. If the terms are so vague as to be meaningless, the law will not recognize the agreement. There can be no contract at all if it is not possible to say what the parties have agreed upon because the terms are too uncertain. In particular, this will be the case where parties have still left essential terms to be settled between them: they are still at the stage of negotiation, and an agreement to agree in future is not a contract.

This rule is subject to some qualifications. The parties will be bound:

• If, although the agreement is not complete yet, the parties have made provision to render it complete without any further negotiations between themselves (for example, by reference to an independent arbitrator)
• If the parties have agreed criteria according to which the price can be calculated, or have had previous dealings similar to the present transaction, the courts can use these matters to ascertain the terms of the contract.
• If only a fairly minor term is meaningless, it may simply be ignored, and the rest of the contract treated as binding.

Establishing the terms of the contract

The terms of the contract are generally established by an analysis of the contract documents. Some terms may be implied. These simple statements can, in fact, give rise to complex issues.

Contract documents

The law is that the contract will consist only of those papers etc. forming the contract documents. It is therefore essential to include in the bound documents not only the conditions of contract, specifications, drawings and letters of offer and acceptance, but all correspondence between the parties that has a bearing on the bargain agreed to. All included documents must be listed. It is recommended that a conformed set of documents be prepared. All agreed changes to the tender documents should be incorporated directly into the contract conditions, specifications, etc. rather than relying upon an original document with an accompanying wad of correspondence.

Interpretation of contract documents

The court will always presume the parties have intended what they have, in fact, said. The words of the contract will be construed as they are written. A judge has said that “one must consider the meaning of the words used, not what one may guess to be the intention of the parties”. The law requires the parties to make their own bargain, and will not construct a contract from terms which are uncertain. In trying to ascertain the intention of the parties, the contract must be considered in its entirety. Where more than one meaning of a specific section is possible, the reliable interpretation is that which is consistent with the other sections of the contract. Despite any other interpretation the words or grammar may be able to support, if the intention is clear from the context of the document it is pointless to pursue an alternative construction.

In a construction document comprising general and special conditions, specification, schedule and drawings, it is important to define the priority of the documents within the special conditions. This avoids the situation where the Contractor claims to be entitled to rely upon the wording in the schedule only when preparing his/her tender.

The Contra Proferentum rule

This rule means that where a term of the contract is ambiguous, it will be interpreted more strongly against the party who prepared it. Application of this rule is subject to the general principle that a term will not be interpreted against the professed intention of the parties. It will only be applied when other methods of interpretation fail.

Implied terms

Where a term is not stated expressly, but is one which the court considers the parties must have intended to include in order giving the contract business efficacy, the term may be implied. For a term to be implied the following conditions must be satisfied:

• It must not contradict an express term of the contract
• It must be reasonable and equitable
• It must be necessary to give the contract business efficacy
• It must be so obvious “it goes without saying”
• It must be capable of clear expression

Pre contract negotiations

The law will not usually take into account pre-contract negotiations in interpreting the contract. It will not presume that the intentions of the parties prior to executing the contract were not altered by that time.

Representations

Representations are statements made by the parties which induce the formation of contract, but do not form a term of it. If a representation turns out to be false, the remedy lies in an action for misrepresentation.

8.2.7 Legality

Two classes of contracts not enforceable at law because of their content being distinguished [Reference Cheshire & Fifoot’s Law of Contract 6th Ed]. Examples of the first class, illegal contacts include:

• An agreement to commit a criminal offence or a tort
• A contract to defraud the revenue
• Immoral contracts
• Contracts to impede the course of justice

The second class includes contracts that are in breach of public policy (e.g. restraint of trade) or statute but do not involve reprehensible actions. These contracts are invalid and unenforceable, at least to the extent of the offending provisions.

8.2.8 Capacity

A contract will not be enforceable where one of the parties does not have the legal capacity to enter into it. This may arise as follows.

Minors

Capacity of minors to enter into contacts is limited, and subject to specific laws of the relevant country.

Corporations

The doctrine of ultra vires means that corporations, including trading and non-trading, can only exercise the powers provided for within their Articles of Association. In theory all else is ultra vires and contracts entered into in this manner are void. This doctrine is, however, subject to significant exceptions.

In theory contracts made by a corporation must be under seal to be enforceable. There are exceptions which provide for such things as routine minor contracts (e.g. for power etc).

Persons of unsound mind and drunkards

A registered mental patient may not enter into a contract. Contracts may be made on his/her behalf by the courts or receivers appointed for this purpose.

If a person makes a contract while temporarily insane, or drunk, the contract is avoidable if he can prove that he was so insane or drunk at the time as to be incapable of understanding what he did, and the other party knew this. The contract will be binding unless it is avoided within a reasonable time of regaining sanity or sobriety.

8.3.1 General

Consideration of the appropriate strategy should include the following factors:

• Risk preferences of the Principal
• The requirement to demonstrate a competitive process
• The need and/or ability to properly define scope of work prior to commencement
• The need or ability to exercise control over the operations of the Contractor
• The need to achieve early completion

There are a number of separate aspects to be considered when determining construction procurement strategy. These include:

• Tendering strategies
• Pricing strategies
• Timing strategies
• Contract types
• Delivery strategies

For the sake of clarity the following discussion treats each option as an independent component. However, the options may be interrelated in some instances such that not all can necessarily be combined: for example, a fast track contract cannot normally be let on a lump sum basis. The options can be subdivided: there are four recognized design build scenarios, and a similar number of cost plus contracts. Thus there are a very large number of different alternatives that may be potentially available when contemplating construction procurement strategies.

8.3.2 Tendering

Tenders may invited be by way of the following mechanisms:

• Public advertisement
• From parties who pre-qualify following public advertisement to do so
• By direct invitation to selected Contractors (including the option of only one)

Public advertisements generally attract all-comers, and while demonstrably ‘open’, create inefficiencies for both the party inviting the tenders, and Contractors.

If ‘public invitation’ is required, the preferred approach is to invite Registrations of Interest publicly, and then limit the tenderers to those clearly meeting pre-qualification criteria. In specialist areas, or where a high standard of performance is sought, tenders should be invited only from parties well-qualified by previous track record. In that case a direct invitation to tenderers known to meet the criteria is expedient.

The basis of evaluation of tenders has a significant impact on project outcomes. Tender evaluation criteria cover a range of issues, i.e. experience, track record, management systems, price – clearly the relative weighting given to each criteria should be given specific consideration in every instance.

8.3.3 Pricing

Pricing may be established either by competition or by negotiation. It is generally possible to get satisfactory tenders by the process of negotiation providing the type of work is well known to the party calling tenders, but competition is clearly the preferred option to arrive at the best tender.

8.3.4 Timing

For supply and services contracts, the contract for the supply or services may be:

• Once off , i.e. a defined output
• For a fixed period, e.g. for 12 months
• A standing order, i.e. for the supply as and when required over a fixed period, generally with a minimum quantity

Timing options for construction procurement contracts include:

• Sequential (i.e. conventional: documentation completed, tender, then supply /installation /construction)
• Concurrent (i.e. fast tracked: supply/installation/construction commencing prior to completion of full documentation)

Clearly the first option provides greatest certainty from the Principals’ perspective, i.e. it has the lowest risk. Fast tracking is necessary to reduce the total time frame for project implementation, and is justified in many cases. There are a number of options available to maintain a high degree of competitiveness in the pricing process on fast tracked projects, e.g. progressive tendering of sub-contract packages.

8.3.5 Contract type

Construction contracts may be one of the following three basic types, or a combination thereof. Contracts of each type may or may not be subject to cost escalation: if not, they are described as ‘fixed price’ contracts.

Lump sum

Under this form of contract, the Contractor/supplier undertakes to do all of the work required for the sum stated in its tender. This means that irrespective of the inputs actually necessary to properly complete the works defined in the contract document, the Contractor is entitled to be paid only the contract sum.

Measure and value

Under this form of contract, the Contractor/supplier undertakes to do all of the work required at the scheduled rates stated in its tender. On completion the amount of work actually done is measured, and payment is made at the scheduled rates for this quantum of work. This contract type is often referred to as a ‘schedule of rates’ contract.

Cost plus

Under this form of contract, the Contractor/supplier undertakes to do all of the work described in the contract, for which all costs are recovered, plus a fee. There are a number of options for the form of the fee, for example: the fee may be fixed, or a percentage of the cost, or subject to a formula based on the proximity of the final cost to a target cost.

8.3.6 Delivery strategies

The selection of the delivery strategy, as defined below, may have significant implications for the Principal. Therefore the implications of each option need to be properly understood, and selection based on consideration of the organization’s strategic operating policies, and in particular the risk management parameters. Selection of the preferred form will be, in part, based on the organization’s competencies and experience.

For service delivery contracts the principal delivery strategies are:

• Defining service requirements based on inputs to be provided. For example, maintenance services may be defined by specifying periods at which specified servicing of plant will be undertaken
• Defining service requirements based on performance and condition criteria for serviced units. For example, maintenance services may be defined by specifying plant operating reliability parameters (e.g. mean time between failures of 2000 hours, or 99% availability) and condition rating parameters on completion of the contract

For construction procurement, delivery options include:

• Conventional (i.e. separate designer and main Contractor)
• Design build. Options range from engaging of a design/build company in the first instance (to undertake all functions from brief finalization through concept development, design and construction), through the recent approach of novation of the design consultant. In this option the Principal engages a design consultant to finalize the brief and develop the concept design, at which point the design consultant’s contract is novated to the selected Contractor, for whom he is responsible to complete the detailed design.
• Management (either management contracting or construction management), defined as follows:
  • Management Contracting. The Principal enters into separate contracts with a designer and a management Contractor, who enters into sub-contracts with works Contractors
  • Construction Management. The Principal enters into separate contracts with a designer, a construction manager, and works Contractors

An option for all types of contract, i.e. services, supply, or construction, is partnering. There are two approaches.

• Single contract partnering. The partnering agreement is in addition to, but does not modify, the contractual agreement. This provides an enhanced communication framework with the objectives of improving relationships in general, and imposing a dispute resolution process. That process requires matters in dispute to either be settled at a particular level within a defined time frame or the matter is automatically taken up by the next level of management. It is yet to be demonstrated that the single contract partnering model will resolve substantial disputes with major commercial implications.
• Strategic partnering. It is not uncommon in the USA and UK for client and supplier organizations to form strategic partnering alliances. In that case the parties make a long term commitment to work together over many contracts. The contractual provisions become less important as parties seek to avoid disputes in order to maintain the longer term commercial benefits. It is claimed to provide significant benefits to both parties.

The particular delivery strategy adopted will reflect the particular project, the relevant expertise of the Principal and its advisors, and the abilities and prior performance of participating Contractors/vendors. There are many and varied opinions on the relative merits of each approach, often reflecting the interests of the particular party, but some of the innovative approaches are considered by experienced practitioners to have definite merit – e.g. design build by novation.

8.4.1 Compliance with tender procedures

The law relating to tendering practice is in a process of change as the result of recent case law developments, primarily in Canada. It may be assumed that in due course these cases will be followed throughout the Commonwealth. Previously it was generally regarded, at least by the practitioners, that no contractual obligations arose prior to acceptance of a tender.

In Blackpool & Fylde Aero Club v Blackpool Borough Council [1990], tenders were called to operate a concession. A condition of tender was that the Principal would not consider late tenders. The plaintiff’s tender was submitted in time, but the tender box was not emptied at the correct time. When the tender was found it was not considered on the basis that it was late, and another tender for a higher price was accepted. It was held that the Principal, because of the condition of tendering, was under an obligation to consider all conforming tenders submitted on time.

Canadian cases have established further the principle that the conditions of tender must be properly followed by the Principal.

In Ben Bruinsma v Chatham [1995], tenders were called for a civil works contract. After calling tenders it was decided to delete some of the works. This resulted in the tenderer whose price was initially the lowest no longer remaining so, and the contract was awarded to another. It was held that the Principal was bound to select the lowest price based on the documents as originally tendered, or to recall tenders for the varied scope of work.

In Megatech Contracting Ltd v Regional Municipality of Ottawa-Carleton [1989], the instructions to tenderers required that the names of proposed sub-Contractors be supplied. The lowest tender, which was accepted, did not include these details. This tender was significantly lower than the second lowest. The second lowest tenderer sued on the basis the Council had not complied with the instructions to tenderers. The court rejected this argument, relying upon further provisions of the instructions; that “the Corporation reserves the right to reject any or all tenders or to accept any tender should it be deemed in the interest of the Corporation to do so” and that tenders “which contain irregularities of any kind may be rejected as informal”. Note that a Principal is, in general, under no obligation to consider only conforming tenders.

In Chinnok Aggregates Ltd v District of Abbortsford [1990] the instructions to tenders included the provision that “the lowest or any tender will not necessarily be accepted”. The Council had a policy, not disclosed to the tenderers, of preferring local Contractors provided the price penalty was less than ten percent. A local Contractor was awarded the contract, and the lowest tenderer sued. It was held the Council was in breach of an obligation to treat all tenderers fairly.

8.4.2 Revocation of tender

In Canada at least, it is now established law that a tender may not be withdrawn where there is a condition of tendering that tenders shall remain irrevocable for a specified period. This is true even where there is a mistake in the tender.

This approach does protect a Contractor from the risk of sub-Contractors revoking their tender.

8.5.1 General

Contracts can be:

• Void: The contract is defective in law, a nullity; e.g. an immoral contract
• Avoidable: The contract is binding, but one party has the right, at his option, to set it aside

The following factors make contracts void or avoidable:

• Mistakes
• Misrepresentation
• Duress and undue influence

8.5.2 Mistake

Mistake as to facts, but not to general legal propositions, will prevent a contract being enforceable where the apparent agreement in fact lacks true consent between the parties. The general provisions relating to the effect of mistakes are set out below. Note, however, that in a number of Commonwealth countries specific Acts have been passed to address this issue, and the remedies available.

The general principle is that a mistake of fact may prevent the formation of a contract, providing the mistake has an element of mutuality that is the contract was entered into under the influence of:

• A unilateral mistake, i.e. one party influenced by a material mistake known, or ought to be known, to the other party
• An identical bilateral mistake (‘common’ mistake), i.e. the parties are influenced by the same mistake
• A mutual bilateral mistake (‘mutual’ mistake), i.e. the parties are influenced by different mistakes about the same matter of fact or law

A mistake on the part of one party only as to motive or purpose, or with respect to the real meaning of the provisions of the contract, is not sufficient grounds for the contract to be voided.

The mistake must exist at the time the contract is made. If third parties have acquired rights or possessions subsequently and lawfully, i.e. prior to the contract being found to be avoidable, those rights and possessions will generally be retained.

8.5.3 Misrepresentation

A representation is a statement of existing or past fact which does not form part of the contract. A misrepresentation is grounds for rendering a contract avoidable only if it was intended to, and did, induce a party to enter into the contract. The injured party must have been aware of the representation and taken it into account. It need not have been the only inducement.

Note that opinion must be distinguished from fact. If the opinion is not honestly held on the facts, then it becomes a misrepresentation. There are the following classes of misrepresentations.

• Innocent Misrepresentation. An innocent statement made by a party who believed it to be true when it was made and when the contract was entered into. If the representor subsequently finds his statement to be incorrect, or the facts change, he is under a duty to advise
• Negligent Misrepresentation. An incorrect statement made without dishonesty by a party with no reasonable grounds for believing it to be true (Hedley Byrne v Heller & Partners 1963)
• Fraudulent Misrepresentation. A statement made dishonestly, knowing it not to be true, or recklessly, not caring if it be true.
• Non-disclosure. Non-disclosure of a material fact, i.e. mere silence, is generally not misrepresentation. (Note that half-disclosure may be misrepresentation.) It does, however, constitute misrepresentation in three instances:
  • Where silence distorts a positive representation
  • Where the contract requires uberrima fides i.e. utmost good faith
  • Where a fiduciary relationship exists between the parties, i.e. a relationship of trust

The general remedy available to an innocent party where there has been a misrepresentation by the other parties include rescission (cancellation of the contract), or damages in the case of negligent or fraudulent misrepresentations.

8.5.4 Duress and undue influence

Duress refers to actual violence or a threat of same. The threat must be illegal. Undue influence generally, but not necessarily, involves parties in special relationships, and contracts of gifts obtained without free consent.

8.6.1 General

The contract is discharged when the obligation ceases to be binding on the promiser, who is then under no obligation to perform. This arises from:

• Performance
• Agreement
• Passage of time
• Frustration
• Repudiation
• Determination
• Operation of law

8.6.2 Performance

When all obligations under the contract have been fully performed by each party, all obligations are at an end; the contract is said to be terminated by performance. Note the following:

• For entire contracts, complete performance is required before any obligation to pay
• For divisible contracts, payment is required for partial performance
• If performance was prevented by one party, then the innocent party may recover under quantum meruit

Generally complete performance of the obligations created under a contract is required to bring the contract to an end. However, in order to allow the Principal to have timely possession of the works, it is general practice in the construction industry to provide for Practical Completion. That is the point at which the works are substantially complete apart from minor defects. A Certificate of Practical Completion must be issued for each separable portion. Certification should be conditional on the receipt of all maintenance documentation, as-built information and the like

In most installation contracts there is provision for a defects liability period to follow the date of Practical Completion. Where not provided for in the General Conditions of Contract, it is recommended that the Special Conditions should provide for the original defect liability period to recommence from the date of repair where significant faults are identified, in respect of the repaired elements only.

8.6.3 Agreement

This requires new consideration for the agreement, or for the agreement to be made under seal. In an executory contract where there has been no, or incomplete, performance, the mutual release of the parties is consideration, and is called bilateral discharge.

Where the contract has been wholly executed on one side but not the other, consideration is required for the agreement, unless under seal, and is called unilateral discharge. These situations are known as ‘accord and satisfaction’.

Where discharge by agreement takes the form of a new contract, this is called novation.

8.6.4 Time

In common law, time is held to be of the essence, even if it is not so stated, in the absence of contrary provisions. In equity, it is not necessarily of the essence if that view does not result in an injustice.

If time is of the essence, failure by one party to complete their obligations within the time specified allows the innocent party the right to rescind the contract. If time is not of the essence, the continuing failure of a defaulting party to complete within a reasonable time may be evidence of repudiation, and give the innocent party a basis to rescind the contract.

8.6.5 Frustration

A contract may be discharged under the doctrine of frustration if a later event renders its performance impossible or sterile. This event must arise externally and must make the intent of the contracting parties unobtainable, and does not include mere inconvenience or hardship. Reliance cannot be placed upon a self-induced frustration.

Note that the court may imply a continuing condition as a term of the contract (e.g. the health of a party), or the non-occurrence of some event.

The contract is discharged as to the future and both parties must fulfill their obligations as they are due.

Law is now governed by the Frustrated Contracts Act 1944. This Act makes advance payments less expenses incurred before the time of discharge recoverable.

8.6.6 Repudiation

Repudiation occurs when one party intimates by word or conduct that he does not intend to honor his obligations under the contract. Under the Commonwealth legal system, unless modified by specific laws, the common law position is that repudiation arises when one party is in breach of a ‘fundamental term’ of the contract, i.e. such a breach is by itself evidence of an intention not to be bound. Such terms are called ‘conditions’, and differentiated from other terms known as ‘warranties’ breach of which gives rise to a right of damages only as a remedy.

Where a party repudiates the contract does not necessarily come to an end. The defaulting party is in effect making an offer to the other to discharge the contract. In these circumstances the innocent party has the option of refusing or accepting the offer.

If the innocent party makes it clear that he refuses to discharge the contract, the contract stays in force with all future obligations intact. He is under no duty to mitigate his losses, but must not aggravate the damages. This principle is, however, subject to the limitation that it will not apply where the innocent party has no substantial interest in completing performance rather than claiming damages.
If the innocent party elects to treat the contract as discharged he must make this decision known to the defaulting party, and he may not then retract it. The defaulting party remains liable in damages for the breach that led to the default, and any earlier breaches, but is excused from all future obligations.

8.6.7 Determination

In general either party may be justified in determining the contract where the other party has repudiated the contract, i.e. demonstrated a clear intention not to perform the obligations arising under the contract.

Other grounds that justify the Principal determining the contract may be set out in the contract conditions. In these situations, this action should be considered with extreme reluctance, and never initiated without considered legal advice.

The law is particularly severe on Principals who determine a contract. If the basis for the determination is not absolutely in conformance with the contract provisions, or the procedures not followed absolutely without fault, the Principal is most likely to find himself/herself in a serious position that will translate into significant costs. It is necessary that, despite specific clauses in the contract to the contrary, the Contractor be given formal and specific warnings, and to the full extent practical be given the opportunity to rectify the default.

8.7.1 Time for completion

The date for completion of the contract should be defined in the contract. It is usual to be defined by a particular contract duration which, together with any extensions of time, is added to the date of possession of the site, thus determining the due date. It is not uncommon for construction contracts to provide for staged completion, that is the Contractor is required to hand over the defined separable portions at different times. Each separable portion may also have different dates for possession of site.

In a construction situation time is said to be of the essence if performance by the stated date is essential to the contract. In those instances, failure of one party to complete his/her obligations by the due date is a sufficient basis to release the other party from any obligations under the contract – e.g. payment. Reference within a normal construction contract to “time being of the essence” is almost certainly incorrect, and would not be sustained by the courts. It would only be applicable in the situation where the Principal was providing a facility, such as a temporary concert venue, that would be of no benefit if not complete before the date for the concert performance.

8.7.2 Provisions to extend the time for completion

In general, events will arise that delay the progress of the Contractor. The terms of the contract may define who takes the risk of delays arising from specific circumstances. For instance, the Principal generally accepts the risk of delays arising from industrial disruption, but may not accept the risk for bad weather unless it is extreme.

Contract conditions generally include provision for the Engineer to grant extensions of time for those circumstances where the risk is not to be assumed by the Contractor. Many believe that these provisions are provided for the benefit of the Contractor. This is correct to a limited extent, but the primary purpose of such clauses is to ensure that the Principal is able to retain his/her right to recover liquidated damages. In the absence of such clauses there could be sufficient justification to make time at large, thereby removing the Principal’s right to do so. When time is put at large the only obligation on the Contractor is to complete in a reasonable time. In the absence of flagrant non-performance the Principal could have difficulty to successfully recover damages for a significant delay.

If the Principal is in breach of the contract as a consequence of which the Contractor is delayed, the completion date is set at large, in the absence of express provisions in the contract providing for the Principal to extend time for such a breach. Therefore contracts should provide for the Principal to extend time for completion for such things as failure by him/her to give possession of site by the due date, and delays in providing information, materials and services. If the Principal is to be adequately protected, the wording must specifically define the particular breach that arises. The law will construe extension of time clauses very strictly against the Principal, because they are in effect penal provisions. So a generalized provision, for example “to extend time in the event of special circumstances arising which are beyond the control of the Contractor”, will not be allowed to protect against a breach on the part of the Principal.

8.7.3 Determination of extensions of time

In deciding if there is a justification for granting a particular time extension it is necessary to answer two questions:

• Has the Contractor been delayed by the particular circumstances, thereby becoming entitled to an extension of time?
• What is a ‘fair’ time extension?

To answer the first question it is necessary to determine whether or not the actual circumstances affected an operation on the Contractor’s critical path. This introduces the question of programs. It is not sufficient for the Contractor to show that delay arose on the critical path of some plan of work set out in a program – it must affect his/her actual critical path. The Contractor must be able to prove the progress he/she would have actually made had he/she not been delayed, not the progress he/she said he/she would make, or intended to make. A program is not conclusive evidence of the progress he/she would actually have made. To assist their case, some Contractors fail to supply updated programs, or supply programs that are over-optimistic. It is therefore necessary to exercise vigilance in requesting program updates, and to review the adequacy of the assumptions regarding resource levels and productivity.

To determine a ‘fair’ entitlement it is necessary to determine whether, in the circumstance, a delay could reasonably be minimized or avoided by either rescheduling affected operations, or by introducing additional resources. Although the introduction of additional resources is not a normal expectation, there will be some circumstances where that could reasonably be expected.

The question of concurrent causes of delay is a fertile area of debate. A useful direction is provided by Abrahamson: Engineering Law and ICE Contracts. 4th Edition at page 139:

“The situation where there are concurrent delays, only one of which is outside the Contractor’s control, is most difficult. The case may arise where the Contractor, due to his own deficiencies, is late in reaching a position to start some programmed activity, but in fact could not have started the activity earlier even if he had been ready because of delay by the engineer with some necessary drawings. It is suggested that in this sort of situation the net point is that the Contractor has not in fact been held up by “delay” outside his control, and it is immaterial that if his progress had been different he would have been so held up. The late drawings are not an actual “cause of delay” within this clause. The Contractor therefore is entitled to an extension of time only so far as the drawings are withheld past the date on which he in fact became ready for them.”

“Alternatively, the Contractor may say that if the employer’s concurrent delay had not occurred, he would have been able, for example, to increase his resources or bring pressure on a recalcitrant sub-Contractor so as to overcome the delay for which he is being held responsible. It does not seem that the mere existence of that abstract possibility is sufficient Unless the Contractor raises the issue at the time and gives evidence of readiness and ability in fact, a later argument that his delay would have been eliminated or shortened but for the employer’s concurrent delay is unlikely to be believed by the engineer or an arbitrator on a claim to extension.”

Commonly, clauses within the standard Conditions of Contract refer only to extensions of time. There is no provision for the Engineer to reduce the contract period, for instance if some element of the work is omitted from the contract. This also means that the Engineer cannot simply aggregate variations that include both additional work and deletion of work, to conclude no entitlement to a time extension arises. If any one or some of the variations give rise to an extension of time, that extension must be granted.

8.7.4 Notification of the time extension

The Contractor is, typically, required to apply for a time extension promptly, following the circumstance that causes the delay having arisen. While very late claims might be considered with some skepticism, it is recommended that the supervisor does not rely upon the lateness of claims to refuse an extension of time which is otherwise justifiable.

The law requires that, if the Contractor is to remain subject to the sanction that liquidated damages will be deducted for late completion, he/she must be advised as soon as possible of any extended date for completion. What this means is subject to the specific circumstances. The following references are a good guide.

• Smellie: Building Contracts & Practice 2nd Ed, page 219: “Furthermore, and depending on the construction of the contract, it may be that the extension of time must be made at the time the extra works are ordered, and if made later will be ineffective. And further, the person given power under the contract to extend the time will probably have no power to fix, as an extension of time, a date which has already passed.”
• Page 222 “Extensions of time may be granted even after the works have been completed if the cause of the delay operates until the completion. But if the cause of the delay has ceased to operate before completion, a purported extension made after completion is invalid.”
• Justice Roper in Fernbrook Trading Co Ltd v Taggart [1979] “In my opinion no one rule of construction to cover all circumstances can be postulated and the best that can be said on the present state of the authorities is that whether the completion date is set at large by a delay granting an extension must depend upon the particular circumstances pertaining. I think it must be implicit in the normal extension clause that the Contractor is to be informed of his new completion date as soon as is reasonably practicable. If the sole cause is the ordering of extra work then in the normal course the extension should be given at the time of the ordering so that the Contractor has a target for which to aim. Where the cause of the delay lies beyond the employer, and particularly where its duration is uncertain then the extension order may be delayed, although even there it would be a reasonable inference to draw from the ordinary extension clause that the extension should be given a reasonable time after the factors which will govern the exercise of the engineer’s discretion have been established. Where there are multiple causes of the delay there may be no alternative but to leave the final decision until just before the issue of the final certificate.”

Another consequence of a failure to extend the time for completion at or close to the time the cause of the delay occurs, is to run a serious risk that the Contractor will succeed with a claim for constructive acceleration.

8.7.5 Acceleration

In the absence of special conditions allowing it, the Supervisor has no power to request an acceleration. This provision should be included in the special conditions on significant contracts. Such clauses should allow for an acceleration to be ordered as a variation to the contract with the agreement of the supervisor and the Contractor. It is recommended that the basis of payment be agreed prior to the acceleration commencing in every case.

8.7.6 Payment arising from an extension of time

Where there is provision for additional payment to apply where there is an entitlement to an extension of time, there is often a lot of difficulty reaching agreement on the sum to be paid. Such difficulties can be avoided by the following approach. For the situation where the entitlement to a time extension arises, it can be appropriate to provide for additional sums to be paid on a per-day basis. Instances where this can usefully apply include delays arising from ordered variations, exceptional weather conditions, and delays caused by the Principal. The sum should be nominated in the tender, and be specified as the sole compensation for such delays, deemed to include all onsite and offsite overheads and profits.

8.8.1 Damages

Damages for breach of contract are governed by two considerations, namely the remoteness and the measure of damages.

Remoteness of damages

The test was established in Hadley v Baxendale 1854. The damages must be those either

• Arising naturally, in the normal course of actions, or
• To have been in the contemplation of the parties at the time they made the contract as being the consequence of the breach, that is, whether the special circumstances were within the actual or constructive knowledge of the defaulter at the time of the contract

This rule was developed in Victoria Laundry v Newman 1949 (abnormal profits not foreseeable). It is not the measure which must be foreseeable, but whether the probability of its occurrence was in the reasonable contemplation of the parties.

Measure of damages

The innocent party must be returned to the position it would have been in the absence of the breach, and the measure of the damages is assessed at the time of breach. The plaintiff must take all reasonable steps to mitigate loss caused by the breach. The burden of proving failure to mitigate rests with the defendant.

8.8.2 Liquidated damages

The contracting parties may agree as a term of the contract the amount to be paid in the event of a specific breach. This sum is either a liquidated damage or a penalty. Refer to Section 8.9. Liquidated damages must be a genuine pre-estimate of loss caused by the nominated breach. If the breach arises, the innocent party is entitled to recover the liquidated damages, without having to prove the actual loss.

8.8.3 Extinction of damages

The right to an action for damages may be released by:

• Release under seal
• Release by accord and satisfaction
• Fluxion of time, i.e. the right to claim damages is extinguished by the passage of time. The general law is that the right to seek action for breach of contract is limited to 6 years from the date of the breach, or 12 years if the contract is under seal

8.8.4 Specific performance

A decree of specific performance constrains a contracting party to perform that which it has contracted to do. The remedy is equitable in origin and is only decreed where the common law remedy of damages would be inadequate (for example, the sale of land). It is not a matter of right but is exercised at the discretion of the court (that is, it would not be applied if an injustice would result).

The plaintiff must not be in breach of his own undertakings. This remedy is not available for contracts of service. Damages may be (and, except in the cases involving property, generally will be) awarded instead of specific performance by the court.

8.9.1 Liquidated damages

Because of the difficulties that arise to establish the real damages or losses resulting to the Principal from late completion of a contract, it is common practice for the damages to be liquidated. That is, an agreed sum is provided for in the contract to be paid as damages for that specific breach. The sum is generally specified on a daily or weekly basis. It does not matter whether or not the actual loss suffered by the Principal turns out to be more or less than the specified damages, the sum specified is the amount of damages to be paid, provided it remains enforceable.

To be enforceable the sum set as the liquidated damages must be a genuine pre-estimate of the probable losses that the Principal will suffer, calculated at the time the tenders are called. In the event of arbitration or litigation it will become necessary to prove that the sum has been calculated properly on that basis. It is therefore essential to keep on file a signed and dated calculation setting out the basis of the calculation. The sum becomes unenforceable if found not to be a genuine estimate prepared prior to issuing the tender documents, or to incorporate a penalty.

Tenderers will normally make provision in their prices for the risk of delays, and costs thereof. Where the level set for liquidated damages is high, this will be reflected in the prices. For that reason liquidated damages are often graduated, with initial levels set at an amount significantly lower than the loss calculated. It is common to prescribe an upper limit on the liquidated damages, either as a nominated total sum, or as a percentage of the contract sum.

Where there are separable portions with differing completion dates, liquidated damages will normally be applied to each stage. It is important to ensure that the cumulative damages that arise in the event of concurrent delays do not exceed the estimate of maximum loss.

Take care where a pro forma schedule is used for the Special Conditions. If the space for the nominated figure for liquidated damages is left blank it is taken to mean that there is no provision for liquidated damages. If however the space contains “-” or “nil” it will be interpreted as meaning zero (specifically $0.00) damages apply in the event of late completion.

8.9.2 Application of liquidated damages

Liquidated damages apply to delays beyond the due date for completion. Therefore if the contract completion date can be demonstrated not to apply, which may be the case for any of the reasons discussed, then liquidated damages cease to be applicable. Where time is at large and the Contractor fails to complete in a reasonable time, the liquidated damages will apply from delays beyond the date fixed as ‘reasonable’.

If the contract provides for the Principal to deduct liquidated damages as and when they become due from payments otherwise due to the Contractor, then in the absence of some further undertaking by the Contractor the Principal will lose the right to recover the damages accrued if he/she fails to deduct them. This is not the case where the contract includes a provision for the Contractor to pay the damages in addition to the Principal’s right to deduct them.

8.10.1 Penalties

A penalty is a sum in the nature of a threat to secure performance. Courts will not enforce penalties.

Where the amount stated in the contract as liquidated damages is found to be a punitive sum, i.e. a sum not being a genuine pre-estimate of the probable damages or losses to be suffered by the Principal, but merely a sum fixed to ‘terrorize’ the other party to perform, the Principal will be unable to recover the stated amount as of right under the liquidated damages provisions.

Courts will compensate a party trying to enforce a penalty only to the extent of actual damages suffered. In the case where actual loss exceeds the nominated sum, the plaintiff may sue for breach of contract and receive full damages. This option does not exist where liquidated damages exist.

If the actual damages exceed the stated penalty the Principal can seek to recover the total costs by suing for breach of contract rather than enforcement of the penalty.

8.10.2 Bonuses

Building contracts may provide for a bonus to be paid, for example for early completion, or for completion below a defined price.

In this case, if there is a breach of the contract by the Principal that prevents the Contractor from achieving such completion, recovery of the bonus may be allowed as damages for the breach. So, again, the contract will need to be very carefully drafted.

The effect of variations ordered on the Contractor’s right to the bonus needs to be addressed. It need not be the case that an extension of time provision will necessarily extend the date for which the bonus is achieved.

9.1.1 Exercise 1

Objective: The objective of this exercise is to develop an understanding of the structure and purpose of Work Breakdown Structures.

Working in groups of two, develop a WBS for a project of your choice. Choose a project with which you have some experience or with which you can at least relate to. Define your project in such a way that it is not too complex, due to time limitations. The following examples might help:

• Building a small experimental aircraft
• Restoring a vintage car
• Building a prototype sailing dinghy for production purposes
• Adding a double garage or small barn to your property

HINT: Most technical people find this a challenge, but try to limit your work packages to about 8 to 10 for this exercise. It may look more impressive with 20 or 30 but you will need too much time for subsequent scheduling exercises built around your WBS.

9.2.1 Exercise 2

Run the spreadsheet ‘activity on node.xls’. You may have to enable macros on your computer. This exercise is self-explanatory and will guide you through the process of calculating start/finish times, calculating floats, and identifying the critical path(s).

9.2.2 Exercise 3

Using a project planning software package such as Plan Bee, create the PERT and Gantt charts for the following project. Also identify the critical path. Add START and FINISH activities and remember to save your project as you proceed.

The reason for using a simpler scheduling software package such as PlanBee, instead of (for example) MS Project or Primavera, is that this is an exercise to teach people the basic concepts of scheduling, and not the intricacies of ‘driving’ a specific piece of software. Due to the limited time available we need to use software that is relatively easy to master.

9.2.3 Exercise 4

For the preceding project, calculate the resource loading and the total cost, using the following information. Engineers are costed at $800 per day.

9.2.4 Exercise 5

Repeat exercises 2 and 3, but apply them to your case study project, for which you have developed the WBS in Exercise 1. Hopefully you have limited the number of work packages as suggested! You will have to specify your own cost structure.

9.3.1 Exercise 6

Objective: The objective of this exercise is to develop expertise in the analysis and reporting of project costs. Use the pro-forma cost report sheet attached, or the Excel spreadsheet ‘Cost Mgnt I’ supplied.Date 01/02/08

Maintenance of the gas extraction system on a geothermal power generation plant is proposed. The initial assessment indicates the following components require repair/replacement, with the associated indicated cost estimates:

Contingencies have been calculated as follows:

• Item 1: $2,000
• Item 2: $1,000
• Item 3: $500

It is anticipated the project will require a turbine shut down of 72 hours. Assume that the turbine is running at 30 MW, and the opportunity cost of generation is $40 per MW hour. The contingency for shutdown costs (i.e. loss of revenue or ‘cost of unsold energy’) is estimated at $11,100. Assume that this amount is allocated in equal portions to Items 1, 2 and 3.

Develop a realistic FFC for this project, including for the cost of lost generation.

Date 28/02/08

A detailed design for the project has been undertaken. It is found that a very useful additional modification is to increase the size of the condenser, at an estimated cost of $10,000, comprising labor $1,000 and components $9,000. This is expected to require a turbine shut down of an extra 12 hours.

Provide a current FFC for the project, with a variance analysis.

Date 31/03/08

A contract was called to do all of the previously defined work. The two tenders considered were:

• A: $40,000, with shutdown period of 88 hours.
• B: $45,000, with shutdown period of 80 hours.

Which tender was the best offer?
Provide a current FFC for the project, with a variance analysis.

Date 04/04/08

The contractor commenced work the previous day and immediately found that the existing fittings for attaching the nozzles were different to those shown in the drawings. It was decided to undertake appropriate extra work. The cost of this work was assessed at $2,000, and it extended the shutdown period by 4 hours. Work on the nozzles has been completed with no further problems. No work has yet been undertaken on the other two components.

Provide a current FFC for the project, with a variance analysis.

9.3.2 Cost Management Involving Escalation

Objective: The objective of the following three exercises is to develop expertise in the analysis and reporting of project costs involving escalation.

Exercise 7: Use the pro-forma cost report sheet or the excel spreadsheet ‘Cost Mgmt2 template.xls’ supplied. . The estimated costs for a specific work package, determined at 1 Jan 2004 is $1,000,000 (cost index as at Jan 04). It is planned to commence implementation on 1 January 2006, with an implementation period of 12 months. The S curve factor is 0.6, i.e. the weighted date for expenditure of the estimated cost is 60% through the duration.

Using the attached calculation tables, complete the FFC as at 1 Jan 2004, assuming the escalation data below, and a contingency sum of $75,000.

Exercise 8: As at 30 June 2004 the cost estimate is revised following further design definition. Including a new feature (required by the client to meet changed market conditions) with an estimated cost of $175,000, the revised cost is $1,300,000. (Cost index as at Jun 04). It is now anticipated that implementation start will be delayed 6 months to 1 July 2006. The forecast escalation noted above applies.

Using the same pro-forma or spreadsheet, complete the FFC as at 30 June 2004, assuming a revised contingency sum of $125,000.

Exercise 9: At 30 June 2006 a contract is let for the work package. The value of the awarded contract is $1,800,000. The estimated duration is now 18 months, with an S curve factor of 60% as before. The contract is on a fixed lump sum basis. The current cost index is 1250, and escalation over the following 18 months is assumed to increase the index to 1350 at the end of that time.

Using the same pro-forma or spreadsheet, complete the FFC as at 30 June 2006, assuming a revised contingency sum of $100,000 at the contract cost index.

Case Study: Cost Management with Escalation

9.4.1 Exercise 10

The objective of the following exercise is to develop expertise in the PMS technique of project performance review, which will provide the basis for applying the PMS features on project management software.

Use the planning sheet attached, or the excel spreadsheet ‘integr time cost template.xls’ supplied.

Resource availability is 10 hours per day at 100%
Activity 2 starts 10 days after Activity 1 starts
Activity 3 starts 20 days after Activity 2 starts
Activity 4 follows Activity 3
1 Week = 50 hours

Prepare a schedule, cost estimate, and forecast cash flow for the project.

9.4.2 Exercise 11

After 40 working days project progress and cost is reviewed. Activity 1 was completed in 25 days. Activity 2 started on time and is now 50% complete. Fixed cost was $25,000. Activity 3 is about to commence.

9.5.1 Exercise 12

With reference to the project for which you have developed a WBS, analyze the components of Quality Assurance for special processes quality required for a quality system complying with ISO 9000.

Identify specific processes to be subject to quality assurance processes. Develop an Inspection and Test plan for the process.

There is no specific answer to this case study. The required procedures will be process specific. An Inspection and Test Plan format is shown on the next page.

9.6.1 Exercise 13

For your own project (exercises 3 and 4), identify all the risks facing your project and define a plan of action for each. Use a matrix as on page 2 of the Risk Management chapter. It is important to identify risks to the PROJECT and not necessarily occupational safety (e.g. ‘Work Safe’) issues.

9.6.2 Exercise 14

Using the ProjRisk software, calculate the required contingency (in % and $) for the FIXED costs in exercises 3 and 4. According to historical data you can assume a triangular cost distribution of minus 10% to plus 15% for each element in the WBS. Also work on an 85% certainty factor as per the S-curve for your project.

9.7.1 Exercise 15

Joe and George are good friends. Joe is a Builder and George is in Underwear. George wants a house built so after a few drinks Joe says, “You get the materials and I will build it for you”. George accepts Joe’s offer, they shake hands and seal the offer with another round of drinks. When George buys the materials he cannot get Joe to build because Joe is too busy on another contract.
a) What is the legal position?
b) What advice do you give George?
c) If George sued what would be the likely result?

9.7.2 Exercise 16

George has plans prepared for a house. Joe offers to build the house for $50,000. George agrees to have Joe build, it if he can do it for $45,000. With no further communication Joe builds, and invoices the full $50,000 saying he had never agreed to any subsequent figure.
a) What is the legal position?
b) What advice do you give George?

9.7.3 Exercise 17

Party A advertises a car for sale for $10,000. Party B has a look at the car and says, “Looks OK but your asking price is too high for me, I’m offering you $8,000.” Party A says, “I’ll be in touch if I don’t get a better price.”

The next day Party A rings Party B and says, “Your price was the best, I’ll take it”. Party B says, “Sorry, I bought another car this morning.”

What is the legal position?

9.7.4 Exercise 18

XYZ Co, who manufactures industrial pump sets, wrote to Mogul Ltd, an oil company, offering to construct an item of plant for $100,000. The offer was made on a form containing XYZ’s standard terms of business. One of the terms contained in the document was that the initially agreed contract price might be varied according to the cost and availability of materials.

Mogul replied in a letter dated April 29 containing their standard terms of business, stating that they wished to order the plant. These terms did not include a price variation clause but contained a statement that the order was not valid unless confirmed by return of post. XYZ duly confirmed by a letter dated May 1. This letter was delayed in the post as it bore the wrong address, and did not arrive until May 14. Meanwhile on May 12 Mogul posted a letter to XYZ canceling the order. That letter arrived on May 13.

What is the legal position?

9.7.5 Exercise 19

Further to question 4. XYZ ignored the letter of May 12 and pressed on with the construction of the plant. It was completed at a price of $125,000. Mogul refused to take delivery.

What is the legal position?

9.7.6 Exercise 20

Millicent owns a factory manufacturing clothing. In January, the heating system of the factory broke down and she was forced to lay off the workforce. Millicent engaged Fixit Ltd to repair the system. They agreed to complete the necessary work within one week.

Owing to supply problems, the work was not completed within the week and Fixit offered to install a temporary system which would enable half day working at the factory. Millicent rejected this offer. In the event, the repair work took two months and as a result Millicent lost a highly remunerative contract to supply knitwear to the armed forces. Millicent is now claiming a total of $80,000 by way of lost profits.

Advise Fixit Ltd as to their liability in damages.

9.7.7 Exercise 21

Further, consider the position above if the contract between Millicent and Fixit referred to above had contained the following provision:

“If the repair work is not completed within one week, Fixit shall pay Millicent, by way of agreed damages, the sum of $10,000 plus $12,500 for every week during which the work is unfinished.”

9.8.1 Exercise 22

The objective of this exercise is to integrate the separate project planning and control techniques discussed over the last two days and produce a Project Quality Plan in outline form.

Work in the same groups and on the same project as for the WBS case study. Identify all the components of the project quality plan.

Develop in outline form (i.e. headings only) the components of the control procedures.

10.1.1 Exercise 1

Everyone’s answer will be different so this is just an example.

We will develop several work breakdown structures for the implementation of a new restaurant chain. This can be done with pen and paper, but we will use WBS Chart Pro, a work breakdown structure development tool. Although this package allows the user to enter a fair amount of information such as start dates, finish dates and interdependencies, we will only use it for its graphical capabilities at this point in time. The information entered here can be uploaded to MS Project if needed.

Break the project down to a point where the tasks can be administered and, if necessary, allocated to a subcontractor. DO NOT CONFUSE LOW-LEVEL ACTIVITIES WITH WORK PACKAGES ON THE WBS!!!! For example, in a building project, the foundation work could be a task on the WBS. However, if you start breaking up this task into its various activities, some of which can be performed by one person in an hour (e.g. knocking in the pegs to indicate the height of the concrete), then the WBS becomes ridiculously complicated.

Start the program by clicking on the desktop icon.

The following will appear.

Double-click on the ‘WBSchart1’ box and edit it to read ‘Restaurants project’. Alternatively, just type ‘Restaurants project’…the name of whichever box is highlighted (red border) will be updated.

The first level is now complete.

Now click on the ‘V’ arrow (see below)

and insert the first task at the second level

Click on the ‘Restaurants project’ rectangle again and add ‘Restaurant 2’. Continue until the WBS is complete.

There are several ways to do a WBS for the same project. Ultimately the lowest rectangles in any branch of the ‘tree’ must represent manageable work packages.

The following example shows the WBS of a project with geographical location at the second level.

Alternatively, the various functions (design, build, etc) can be placed at the second level.
Note that using the conventional inverted tree structure could often lead to a very wide drawing.
Use the  buttons to redraw the diagram.

The third alternative shows a subsystem orientation.

A fourth alternative shows a logistics orientation as follows:

The WBS could also be drawn to show a timing orientation.

Note that ‘Design’ and ‘Execution’ are NOT work packages, they are just headings. ‘Start up’, however, is a work package since it is at the lowest level in its branch. The WBS could be broken down even further but the risk here is that the lowest-level packages could be too small. If ‘advertising’, for example, could be accomplished in 100 hours it might be a good idea to stop at that level. It could then be broken up into activities and tasks (and even sub-tasks); the duration and resource requirements would then be aggregated at the ‘advertising’ level, but not individually shown on the WBS.

It is, of course, not necessary to use a sophisticated WBS package; Excel will work just fine as the following example shows. The work packages (except ‘Start up’) are shown at level 3.

10.2.1 Exercise 2

Run ‘activity on node.xls’. Macros should be enabled; else this demo will not run.
(Use Tools->Macro->Security and adjust settings if necessary)

Start the tutorial and the following will appear.

Click on ‘Start new analysis’. Note the ‘Start’ and ‘End’ nodes with zero duration.

First, the forward pass. Proceeding from left to right, click on each node and provide the ‘Earliest Start’ and ‘Earliest Finish’ times in the dialogue box. The program will alert you to any mistakes.

The start and finish times of the ‘start’ node is obviously 0 and 0. For all nodes with only one predecessor, the ‘Earliest Start’ time of that node equals the ‘Earliest Finish’ time of the previous node. For nodes with more than one predecessor, the ‘Earliest Start’ time obviously equals the biggest of the preceding ‘Earliest Finish’ times. The program will alert you to any mistakes.

Note that that the tasks may seem to overlap as each node starts on the same day that its predecessor finishes. This is, however, not the case. View each day as a 24-hour period starting, say, at 08h00 and finishing at 08h00 the next morning. A 1-day task could therefore start at 08h00 on Monday, day 7 of the project, and it will finish at 8h00 on Tuesday, day 8 of the project. Its successor could start at 08h00 on Tuesday, day 8.

Now the reverse pass. Start with the ‘End’ node and enter the same value as ‘Earliest Start’ and ‘Earliest Finish’ (15 in this case) for both ‘Latest Start’ and ‘Latest Finish’. For nodes with only one successor, the ‘Latest Finish’ equals the ‘Latest Start’ of its successor. In the case of multiple successors, take the smallest (earliest) value. The result looks like this:

The next step is to fill in the float, by subtracting either ‘Earliest Finish’ from ‘Latest Finish’ or ‘Earliest Start’ from ‘Earliest Finish’, i.e. top left from bottom left or top right from bottom right. Do this for all the nodes.

Finally, place the tip of the index finger (cursor) on each line that lies on the critical path (zero float) and click on the left mouse button.

The whole exercise can now be repeated. The duration of the nodes as well as their dependencies will be different for each pass.

10.2.2 Exercise 3

For this exercise we will use Plan Bee. The question might be asked why we do not use a more ‘industry standard’ software package such MS Project. The answer is very simple….the exercise is not about learning the operation of any software package…it is about mastering CONCEPTS. And so we need software that is easy to master within minutes (we do not have a lot of time!), even if it cannot handle large multimillion dollar projects.

Run Plan Bee by clicking on the desktop icon.

The following will appear.

Click file->new to start a new project.

Type in the project details and select a starting date. Click OK. Edit the first task so it reads ‘START’.

Now type in all the names of all the tasks, headings, etc. Normally you will only see around ten tasks, click on the ‘show more tasks’ button to obtain the following display. Click ‘show task options’ to return. Note that at this point all entries are tasks by default. We will change that later.

Enter the correct duration for tasks A to F.

The next step is to enter the precedence relationships. Highlight each task, and then click ‘add precedence’.

In the example shown here, the precedence for A is START. Do not forget to enter the precedence for FINISH, which is F.

If you have not done this yet, select the three entries that are simply headers, not tasks, (viz, PLANNING, INSTALLATION and COMMISSIONING) and change them to ‘header level 1’ by means of the radio buttons. Notice that they are now simply headings with no duration.

Now click on the Gantt chart icon.

Then do the same for the PERT chart. You will need to ‘auto align Pert nodes’ and also select ‘critical this color’ to show the critical path.

10.2.3 Exercise 4

Now we have to allocate some resources. Click on the resource button.

The resource window will appear.

Now click ‘Add a new resource’ and add ‘Engineer’ with the appropriate daily rate and the number of people available. This particular screenshot shows 3 engineers but this number eventually had to be increased to 4.

Now select task A and click ‘Add Engineer to A’. Do this for all the tasks and remember to allocate 2 engineers to task C.

Then check the required resources for each day. Note that we have just enough resources for some of the days. Had we been limited to, say, 3 engineers, we would have had to delay the start date of some tasks.

Finally, click on the ‘Admin details’ button.

Once again select tasks A-F and type in the fixed cost for each task, together with cost codes and notes as applicable.

When done, click ‘file->preview/print report’ to look at a cost summary for the project.

10.2.4 Exercise 5

The answer will depend on your specific example.

10.3.1 Exercise 6

* Assumes this element of work now complete so a nil contingency is correct.

** Assumes original allowance was divided evenly across the three elements.

10.3.2 Cost Management Involving Escalation

Exercises 7, 8 and 9

10.4.1 Exercise 10

Exercise 11

10.5.1 Exercise 12

The answer will depend on your specific example.

10.6.1 Exercise 13

The answer will depend on your specific example.

10.6.2 Exercise 14

Click Start->Run->Risk Analysis->ProjRisk

The data entry screen will appear.

Enter the likely cost for ‘A’, as well as the maximum and minimum values, either as Dollar amounts or as percentages. Also select the type of distribution. Note that in real life the type of distribution will have to be derived from historical data.

Work package ‘A’ will now appear as follows.

Enter the details for ‘B’ thru ‘F’ as well.

When done, click on the Analyze button. The software will perform a Monte Carlo simulation with 1,000 iterations (i.e. ‘rolling the dice’ 1,000 times.) The statistical distribution of the expected costs will be shown. Notice that it forms a normal distribution with a mean of $12,700 and a standard deviation of $331. It also appears highly unlikely that the cost will exceed $13,750 or that it will be less than $11,750.

Now click ‘swap graphs’ to show the cumulative probability or ‘S’ curve. This shows the probability of the cost being less than the indicated cost.

For example, the probability of the cost being less than $13,000 is 80%. To determine the amount for 85% certainty you will need to interpolate on the graph, or select the ‘statistics’ display.

Click on the ‘Cumulative Probabilities’ tab and find the value for 85%, which is $13,049.

Since the original estimate was ($1,000+$1,000+$5,000+$2,000+$3,000+$500) = $12,500, it means that the contingency allocation for 85% certainty needs to be $13,049 – $12,500 = $549

10.7.1 Exercise 15

Does a contract exist? Necessary factors present include offer, acceptance, consideration, legality and capacity. A necessary factor that is absent is definite terms, i.e. “what was the bargain”?

10.7.2 Exercise 16

What is the contract? The offer (i.e. $50,000) was extinguished by the counter offer. Joe’s commencement of work is constructive acceptance of the counter offer.

10.7.3 Exercise 17

The issue is whether or not the counter offer of $8,000 remains open for acceptance until the following day. If it does, it has not been revoked.

What is reasonable in these circumstances?

10.7.4 Exercise 18

Is there a binding contract between XYZ and Mogul? Mogul’s response to XYZ is a counter offer because of the change in terms. Has the counter offer been accepted? If the postal rule of acceptance applies here, XYZ’s confirmation of May 1 is effective. Two issues may affect this rule here:

i) It could be argued that “confirm by return of post” required the communication of acceptance within a short time to be effective.

ii) Incorrect address, if the fault of XYZ, may be sufficient to overturn the rule. If the fault lay with Mogul supplying the wrong address, this is not the case.

10.7.5 Exercise 19

If the contract is binding due to a valid postal acceptance, Mogul’s letter of May 12 could be regarded as a repudiatory breach of contract. XYZ are not bound to accept the repudiation and in the circumstances are under no duty to mitigate. XYZ may be entitled to complete performance and claim the contractual sum due, which would presumably be $100,000 as the price variation clause is excluded from the contract.

This depends upon the test of “substantial interest” in proceeding with the work, rather than claiming damages.

10.7.6 Exercise 20

Fixit are in breach of contract, thus liable for damages. The test for remoteness of damages laid down in Hadley v Baxendale applies, i.e. was the loss of profit from losing the armed forces contract within Fixit’s knowledge.

There is a duty on Millicent to mitigate her losses. An important issue will be whether or not it was reasonable for her to reject Fixit’s offer to install a temporary system.

10.7.7 Exercise 21

The fact that the provision is referred to as ‘agreed damages’ will not prevent the Court finding it to be a penalty if that is its true nature.

In this case damages claimed are $80,000. Applying the formula for 8 weeks’ delay gives $110,000 under this provision. Likely to be considered a penalty, and thus non-recoverable.

The $10,000 by itself appears to be a penalty. It arises if Fixit is half a day late or 20 days late, and therefore does not appear to be an assessment of losses in the normal course of the business.

A1.1 Introduction

For effective running of a business, management must know:

• Where it intends to go (organizational objective)
• How it intends to accomplish its objective (plans)
• Whether individual plans fit in the overall organizational objective (coordination)
• Whether operations conform to the plan of operations relating to that period (control).

Budgetary control is the device that an organization uses for all these purposes.

A1.2 Budget

A budget is a quantitative expression of a plan of action relating to the forthcoming budget period. It represents a written operational plan of management for the budgeted period. It is always expressed in terms of money and quantity. It is the policy to be followed during the specified period for attainment of specified organizational objectives.

In CIMA terminology, a budget is defined as follows:”A plan expressed in money. It is prepared and approved prior to the budget period and may show income, expenditure, and the capital to be employed. May be drawn up showing incremental effects on former budgeted or actual figures, or be compiled by zero-based budgeting.”

A1.3 Budgetary control and budgeting

The terms budgetary control and budgeting are often used interchangeably to refer to a system of managerial control. Budgetary control implies the use of a comprehensive system of budgeting to aid management in carrying out its functions such as planning, coordination and control.

In CIMA terminology: “Budgetary control is the establishment of budgets relating to responsibilities of executives to the requirement of a policy, and the continuous comparison of actual with budgeted results either to secure by individual action the objective of that policy or to provide a basis for revision.”

A1.4 Budgets and forecasts

A forecast is a prediction of what is going to happen as a result of a given set of circumstances. A forecast is a mere assessment of future events and the budget is a plan of action proposed to be adhered to during a specified period. Budgets start with forecasting and lead to a control process, which continues even after budget preparation. A forecast includes projection of variables either controllable or non-controllable that are used in development of budgets.

A1.5 Establishment of functional budgets and a master budget

A1.5.1 Sales budget

The sales budget is the most important functional budget and it primarily forecasts what the organization can reasonably expect to sell both in quantity and value during the budget period. A sales budget can be prepared showing sales under any one or combination of the headings: Product, Territory, Types of customers, Salespersons, Period (month, quarter or week).

Illustration -1:

AARK Associates manufactures three products X, Y and Z and sell them through three divisions, North, South and West. Sales budgets for the current year based on the estimates of Division Managers (Sales), were:

Actual sales for the current year were:

Sales prices are $12, $8 and $10 in all areas. It was found by the market research team that Product X finds favor with customers, but is under-priced. It is expected that if the price is increased by $1.00, its sales will not be affected. The price of product Y is to be reduced by $1.00 as it is overpriced. Product Z is properly priced, but extensive advertisement is required to increase its sales.

On the basis of the above information, the Divisional managers estimate that the increase in sales over the current budget will be

It is also expected that there will be a further rise in sales thanks to extensive advertising and the figures could be

We have to prepare a sales budget along with budgeted and actual sales for the current year.

AARK Associates

Presented By –
Checked By –
Submitted on –

A1.5.2 Production budget

This shows the quantities to be produced for achieving sales targets and for keeping sufficient inventory. Budgeted production is equal to projected sales plus closing inventory of finished goods minus opening stock of finished goods. It is a forecast of production for budgeted period and is prepared in physical units. It is necessary to coordinate the Production Budget with the Sales Budget to avoid imbalance in production. It is an important budget and forms the basis for preparation of material, labor and factory overhead budgets.

Illustration -2:

The SPG & Co. plans to sell 108,000 units of a certain product line in the first quarter, 120,000 units in the second quarter, 132,000 units in the third quarter, 156,000 units in the fourth quarter and 138,000 units in the first quarter of the following year. At the beginning of the first quarter of the current year, there are 18,000 units in stock. At the end of each quarter the company plans to have an inventory equal to one-sixth of the sale for the next quarter. We have to calculate the number of units that must be manufactured in each quarter of the current year.

Solution:

A1.5.5 Purchase budget

This budget sets out the ‘purchase’ plan of the company during the budget period. It is prepared considering factors like storage capacity and finance available so that capital tied up in stock is minimized while the production program continues smoothly.

Illustration -3:

VSAX Limited manufactures three products: A, B and C. It is required to prepare budgets for the month of January, 2004 for:

• Sales in quantity and value, including total value
• Production quantities
• Material usage in quantities
• Material purchases in quantity and value, including total value

Data available is tabulated below

Materials used in the company’s products are:

Solution:

1. Sales Quantity and Value Budget

2. Production Quantities Budget

3. Material Usage Budget (Quantities)

4. Material Purchases Budget (quantities and values)

A1.5.7 Overhead budget

Companies divide their overhead costs in two categories for the purpose of control – fixed overhead and variable overhead. Depreciation, insurance and taxes are the main items that fall within the fixed overhead category. Variable overheads include indirect material, indirect labor and indirect expenses, which are used according to production.

Illustration -4:

The following data is available in a manufacturing company for a yearly period:

Fixed Expenses:	$ Millions
Wages and salaries	9.5
Rent, rates and taxes	6.6
Depreciation	7.4
Sundry administration expenses	6.5
Semi-variable Expenses (At 50% of activity)
Maintenance and repairs	3.5
Indirect labor	7.9
Sales department salaries, etc.	3.8
Sundry administration expenses	2.8
Variable expenses (At 50% of activity)
Material	21.7
Labor	20.4
Other expenses	7.90
Total Cost	98.0

The fixed expenses remain constant for all levels of production; semi-variable expenses remain constant between 45% and 60% of capacity, increase by 10% between 65–80% and by 20% between 80–100% capacity.

Sales at various levels are:	$ Millions
50% Capacity	100
60% Capacity	120
75% Capacity	150
90% Capacity	180
100% Capacity	200

We have to prepare a flexible budget for the year and forecast the profit at 60%, 75%, 90% and 100% of capacity.

Solution:

Flexible Budget for the period

A1.6 Zero-base budgeting

Zero-base budgeting is a new technique of planning and decision making and reverses the working process of traditional budgeting. The concept of zero base budgeting has gained world-wide eminence after Peter Pyhr of Texas Instruments Inc. used it. Traditional budgeting starts with the previous year’s expenditure level as a base and then discussion is focused to determine the ‘cuts’ and ‘additions’ to be made. In zero-base budgeting no reference is made to previous levels of expenditure. A convincing case is made for each decision unit to justify the budget allotment for the unit during that period and each decision unit is subjected to thorough analysis to determine the relative priorities between different items included in it. Zero base budgeting is completely indifferent to whether the total budget is increasing or decreasing. It identifies the alternatives so that if more money is required in one department, it can be saved in another area. CIMA has defined it ‘as a method of budgeting whereby all activities are re-evaluated each time a budget is set. Discrete levels of each activity are valued and a combination chosen to match funds available.’ (see Figure A1.1)

A1.7 Program budgeting

Program Budgeting was introduced in the U.S. Department of Defense in 1961. Its utilization became extremely common by 1968, in federal as well as local government of the United States of America. Conventional budgeting works well in profit oriented organizations. Program budgeting came into existence for Government Departments and non-profit institutions. In program budgeting emphasis is laid on formulation of different budgets for different programs. It integrates all of the organization’s planning activities and budgeting into a total system. First programs for the mission of the organization are identified. Then each program is broken into elements, or each element’s resources i.e., material, manpower, facilities and capital are identified. Allocation of resources to various programs is taken into account. Great stress is continuously placed on analysis of alternatives and estimating cost of accomplishing objectives and fulfilling purposes and needs. The program budgeting format is illustrated here in Figure A1.2.

First resources over the period are identified for different elements and then the cost of these elements is aggregated to arrive at the cost of a program. For appraising public projects program budgeting uses micro-economies. The flow chart in Figure A1.3 illustrates the difference between the traditional budget format and the program budget format.

Program budgeting includes:-

• Identification of programs required to fulfill the mission
• Identification of program elements
• Allocating resources to programs
• Utilizing forecast studies analysis

Quantification of data in considerable detail is necessary because budgeting consequences of approved programs are anticipated and actual performance is compared with budget performance of programs. In non-profit organizations it is necessary to identify the output indicators because output cannot be measured in terms of money e.g., for an on-the-training program, output indicator may contain number of workers trained. Similarly for health program, output indicator may lower disease incidence. Program budget does not eliminate the need for traditional budget and very useful for multi-year forecasts. It adds new dimension to planning analysis and budgeting. Traditional budgeting emphasizes the method and means used, program budgeting emphasizes the purposes and the objectives of the program.

A1.8 Performance budget

The ‘Performance Budget’ was originally used in the United States by the First Hoover Commission in 1949, when it recommended the adoption of a budget based upon functions, programs and activities. It emphasizes work-cost measurement and managerial efficiency. Cost and production goals are established and then compared to actual performance. It provides output-oriented information with a long range perspective to allocate resources more effectively.

A performance budget is one which:

• Presents the purposes and objects for which funds are requested
• The costs of activities proposed for achieving these objectives
• Quantitative data measuring the accomplishments
• Work performance under each activity.

In program budgeting, the principal emphasis is on programs, identification of their elements and determination of cost for each program. In performance budgeting stress is on activities approved by the company and determination of cost of each activity.

A1.8.3 Stages of Performance Budgeting

Objectives

The objective of individual activities is clearly spelt out in quantitative and monetary terms as far as possible. These objectives are matched against the long term objectives of Government.

Analysis

The long-term strategy and short-term tactics for achieving the desired objectives are considered. In addition, possible alternative activities are identified and costs and their benefits are worked out. After detailed analysis, the activities are selected.

Classification

The activities taken for implementation are classified with reference to a prescribed classification system. This approach facilitates allocation of resources to selected activities.

Organization

The role of different implementing agencies in achieving the specified objectives are clearly demarcated and financial rules and accounting system are modified to implement the defined activities more effectively.

Evaluation

A proper system for evaluating the implementing of activities is predetermined. Desired information system and reporting system relating to financial, physical and economic data are also installed to monitor the desired activities during execution. The projects should be subject to thorough evaluation even after their completion (see Figure A1.4).

The five stages of performance budgeting are shown in Figure A1.4 where the clockwise arrows represent the activity flow of the system, while the anticlockwise broken arrows represent the feedback process. The tangential arrows represent the interface with the outside world.

A1.9 Participative budgeting

It is a commonly observed that lack of involvement in formulation of goals and objectives always leads to restricted efforts and output which is fatal for improvement of productivity. Optimum output requires greater participation of operating managers in budgeting process. Participative budgeting is the practice of allowing all individuals who are responsible for performance under a budget. It is the budgeting approach, which ensures that all concerned staff members and maximum coordination.

The advantages are summarized below:

• It provides operating manager with a sort of challenge for implementation of the budget
• Operating managers feel a sense of responsibility to implement the budget, when they have been a party to the decisions
• Operating staff consider the budget as their own goal and sense of achievement in completion

A1.10 Responsibility accounting

Responsibility accounting emphasizes the division of an organization among different sub-units in such a way that each sub-unit is the responsibility of an individual manager. The basis of this approach is that a manager should be held responsible for those activities, which are under his or her direct control. It recognizes cause and effect relationship between a Manager’s decisions and actions and its impact on cost and revenue results.

A1.10.2 Responsibility centers

There are five types of responsibility centers for the management control purpose and each center can be defined as a unit of function of an organization headed by a manager having direct responsibility for its performance.

Cost center

Responsibility in a cost center is restricted to cost alone. Cost center is a segment of the firm that provides tangible or intangible service to departments. In manufacturing environments, all production centers and service centers are termed as separate cost centers. CIMA defines ‘cost center’ as a production or service location, function, activity or item of equipment whose costs may be attributed to cost units.

Revenue center

The revenue center is the smallest segment of activity or an area of responsibility for which only revenues are accumulated. A revenue center is a part of that organization whose manager has the primary responsibility of generating sales revenues but has no control over the investment in assets or the cost of manufacturing a product. CIMA defines revenue center as a center devoted to raising revenue with no responsibility for production.

Profit center

CIMA defines profit center as a part business accountable for costs and revenues. It may be called a Business Center, Business Unit (BU), or Strategic Business Unit (SBU). A profit center is a segment of activity for which both revenues and costs are accumulated. Generally, most responsibility centers are viewed as profit centers, taking the difference between revenues and expenses.

Investment center

CIMA defines investment center as a profit center whose performance is measured by its return on capital employed. Investment center is a segment of activity for areas held responsible for both profits and investment. For planning purposes, the budget estimate is a measure of rate-of-return on investment and for control purposes, the performance evaluation is guided by a return on investment variance.

Contribution center

Contribution center is an area of responsibility for which both revenues and variable costs are accumulated. CIMA defines contribution center as a profit center whose expenditure is reported on a marginal or direct cost basis. The main objective of a contribution center manager is to maximize the center’s contribution

Illustration -5:

In a cotton textile mill, the spinning superintendent, weaving superintendent and the processing superintendent report to the Mill Manager who along with the Chief Engineer reports to Director (Technical).The sales manager along with publicity manager reports to the Director (Marketing) who along with the Director (Technical) reports to the Managing Director.

The following monetary transactions ($) have been extracted from the books for a particular period.

A = Adverse; F = Favorable

We have to prepare responsibility accounting reports for the Managing Director, Director (Marketing), Director (Technical) and Mill Manager.

Solution:

Responsibility Accounting Reports

	Budget	Actual	Variance
1. For Mill Manager
A. Spinning Superintendent
Raw Materials	2,800,000	2,920,000	120,000(A)
Labor	800,000	840,000	40,000(A)
Utilities	150,000	165,000	15,000(A)
Total A	3,750,000	3,925,000	175,000(A)
B. Weaving Superintendent
Materials	100,000	105,000	5,000(A)
Labor	600,000	620,000	20,000(A)
Utilities	200,000	190,000	10,000(A)
Total B	900,000	915,000	15,000(A)
C. Processing Superintendent
Raw Materials	7,00,000	6,40,000	60,000(F)
Labor	500,000	512,000	12,000(A)
Utilities	300,000	350,000	50,000(A)
Total C	1,500,000	1,502,000	2,000(A)
D. Mill Manager’s Salaries & Admin.	100,000	105,000	5,000(A)
Total of Mill Manager (A+B+C+D)	6,250,000	6,447,000	197,000(A)
2. For Chief Engineer
Maintenance Stores	200,000	190,000	10,000(F)
Maintenance Labor	260,000	255,000	5,000(F)
Maintenance Utilities	50,000	60,000	10,000(A)
Total for Chief Engineer	510,000	505,000	5,000(F)
3. For Director Technical
Mill Manager	6,250,000	6,447,000	197,000(A)
Chief Engineer	510,000	505,000	5,000(F)
Office Salary and Admn.	175,000	200,000	25,000(A)
Total for Director Technical	6,935,000	7,152,000	217,000(A)
4. For Director Marketing
A. Sales Manager
Income – Sales	10,000,000	8,800,000	1,200,000(A)
Expenditure – Traveling	40,000	42,000	2,000(A)
Sales Commission	2,50,000	240,000	10,000(F)
Salary and Admn.	100,000	95,000	5,000(F)
Total A	3,90,000	3,77,000	13,000(F)
B. Publicity Manager
Salary and Admn.	120,000	130,000	10,000(A)
Publicity Expenditure	200,000	198,000	2,000(F)
Total B	320,000	328,000	8,000(A)
C. Director Marketing
Sales manager Expenditure	390,000	377,000	13,000(F)
Publicity manager	320,000	328,000	8,000(A)
Salary and Admn.	200,000	190,000	10,000(F)
Total Expenses	910,000	895,000	15,000(F)
5. For Managing Director
Mg. Dir.’s office staff	250,000	270,000	20,000(A)
Director Marketing	910,000	895,000	15,000(F)
Director Technical	6,935,000	7,152,000	217,000(A)
Total Expenses	80,95,000	83,17,000	222,000(A)
Sales Manager (Income)	10,000,000	8,800,000	1,200,000(A)
Profit	1,905,000	483,000	1,422,000(A)

Case Study – A

I. Product X is produced from two materials: C and D. Data in respect of these materials is as follows:

During January there is to be an intensive sales campaign and to meet the expected demand, the production director requires the stocks of materials and product X to be at maximum level at 31^st December.

Data in respect of product X are as follows:

A) From the above data you are required to prepare for the month of December:

• Production budget
• Purchase budget

B) Calculate the optimal re-order quantities in respect of material C based on data given above and that:

• A 50 week – year is in operation.
• The cost of placing each order is Rs.5.
• The cost of storage is 25% per annum of the value of the stock held.

Hint:

• Maximum level = Re-order level/ (Re-order quantity – minimum consumption during the period required to obtain delivery).
• Re-order level = maximum usage × maximum re-order period.
• Minimum level = minimum usage × minimum lead time.

II. A company manufacturing two products using only one grade of direct labor is shown below from next year’s budget.

The stock of finished goods at the beginning of the first quarter is expected to be 3,000 units of product M and 1,000 units of product N. Stocks of work in progress are not carried.

Inspection is the final operation for product M and it is budgeted that 20% of production will be scrapped. Product N is not inspected and no rejects occur.

The company employs 210 direct operators working a basic 40-hour week for 12 weeks in each quarter and the maximum overtime permitted is 12 hours per week for each operator.

The standard direct labor hour content of product M is 5 hours per unit and for product N, 3 hours per unit. The budgeted productivity (efficiency) ratio for the direct operatives is 90%.It is assumed both M and N are profitable.

Calculate the budgeted direct labor hours required in each quarter of next year and to which the direct labor available can meet these budgeted requirements. Also suggest alternative action to minimize the shortfall or surplus of labor hours to achieve each quarter’s sales budget.

A2.1 Introduction

The comparison of actual performance with standard performance reveals the variances. A variance represents a deviation of the actual results from the standard results. There can be cost variances, profit variances, sales value and operational and planning variances.

Variance analysis is an exercise that tries to isolate the causes of variances in order to report to management those situations which can be corrected and controlled by timely action. Variance analysis is used for decision making e.g., an unfavorable price variance for raw materials may lead to looking for an alternative supplier and/or to increase the price of the product. It is also used for incentives/control. In accordance with the principal of controllability those factors a manager can control by means of variances are isolate.

Variance analysis should be a continuous process for the following reasons:

• Labor rates, salary levels etc., change due to union negotiations, policy decisions or changes in composition of the work force
• Selling price changes
• In a multi-product company, product mix changes and different lines have different margins; the overall profit position will change
• Improvement in systems can bring about reduction in costs
• Change in level of efforts of operators, supervisors etc. can affect existing cost levels
• Investment in new capital equipment and scrapping of old equipment/processes/methods can affect the operating cost levels
• The prices of bought-out material may vary
• Changes in product design may change cost-inputs
• Changes in organizational structure may affect cost levels
• The amount of idle time may change due to holdups, strikes, lockouts and power failure.

A2.2 Model steps

The ‘model steps’ approach has been adopted in computing variances. These model steps have been arranged in a logical sequence which should be necessarily adhered to for arriving at the correct inferences. Variance analysis is to measure performance, correct inefficiencies, and deal with accountability.

Variances can be favorable or adverse (unfavorable).

These are illustrated in Figure A2.1

Favorable variance = the actual amount < the standard amount. Favorable variances are credits; they reduce production costs.

Adverse variance = the actual amount > the standard. Adverse/Unfavorable variances are debits; they increase production costs. This works for each individual cost variance and when a total variance is computed.

A favorable variance does not necessarily mean it is desirable, nor does an unfavorable variance mean it is not desirable.

It is for the management to analyze all variances to determine the cause in the following manner

• Determine if standard is correct
• Consider costs vs benefits in reviewing standards

Whether a variance is favorable or unfavorable is ultimately determined with reference to its impact on profit. Each model step represents the existence of a particular variance. If the value of the step is zero then the value of the step immediately preceding the analyzed step should be considered for calculating variance.

A2.3 Cost variance

Cost Variance represents the difference between the costs actually incurred for production and the costs specified for the same. It is the sum total of following variances:

• Direct material cost variance
• Direct wage variance
• Variable overhead variance
• Fixed overhead variance

A2.3.1 Direct material cost variance

Direct material cost variance and its sub-divisions are illustrated in Figure A2.2

Model steps

Four model steps are given here for calculating the material cost variances

• M_{1 –} Actual cost of material used = Actual quantity of material used × Actual rate.
• M_{2 –} Standard cost of material used = Actual quantity of material used × Standard rate.
• M_{3 –} Standard cost of material used if it had been used in the standard proportion.
• M₄-Standard material cost output = Standard quantity of material required for the specified output × Standard rate.

Material cost variance

It is the difference between actual cost of material used and standard cost of material specified for output achieved. Material cost variance arises due to variation in price and usage of materials. Difference between M₁ and M₄ will be the material cost variance.

Material price variance

Material price variance is the difference between the actual price paid and standard price specified for the material. It represents the difference between the standard cost of actual quantity purchased and actual cost of these materials. Difference between M₁ and M₂ will be the material price variance. The material price variance is uncontrollable and provides management with information for planning and decision making purposes. It helps the management increase product price, use substitute materials or find other (offsetting) sources of cost reduction.

Material usage or volume variance

It indicates whether or not material was properly utilized and is also referred to as quantity variance. Material usage or volume variance is the difference between actual quantity used and standard quantity specified for output. A debit balance of material usage (variance) indicates that material used was in excess of standard requirements and credit balance indicates saving in the use of material. Difference between M₂ and M₄ will be material usage or volume variance.

Material usage variance consists of material mix variance and material yield variance. The favorable material usage variance is not always advantageous to the company as it may be related to an unfavorable labor efficiency variance, e.g. labor may have conserved material by operating more carefully at a lower output rate.

Material mix variance

It is the difference between the actual composition of the mix and the standard composition of mixing the different types of materials. Short supply of a particular material is often the common reason for material mix variance and it is the difference between M₂ and M₃.

Material yield variance

In certain cases, it is observed that output will be a particular percentage of total input of material e.g., 80% of the total input of material will be the expected output. If the actual yield obtained is different from that of the standard yield specified, there will be yield variance. Difference between M₃ and M₄ will be the material yield variance.

Illustration –6:

The standard cost of a certain chemical mixture is as under:

• 40% of material A at $20 per kg
• 60% of material B at $30 per kg

A standard loss of 10% is expected in production. The following actual cost data is given for the period.

• 180 kgs material A at a cost of $18 per kg
• 220 kgs material B at a cost of $34 per kg

The weight produced is 364 kgs.

We have to calculate the following:

• Material price variance
• Material mix variance
• Material yield variance
• Material cost variance
• Material usage variance

Solution:

M_{1 –} Actual cost of Material used:
Material A – 180 kgs × $18 = $3240
Material B – 220 kgs × $34 = $7480
M₁= $10,720

M_{2 –} Standard cost of Material used:
Material A – 180 kgs × $ 20 = $3600
Material B – 220 kgs × $ 30 = $6600
M₂= $10,200

M_{3 –} Standard cost of Material, if it had been in standard proportions.
Standard mix in kgs

Material A = (Weight in actual mix × standard rate of material A per kg × standard mix in kg)/ weight of standard mix = 400 kgs × $20 × 40 kgs/100 kgs = $3,200

Material B = (Weight in actual mix × standard Rate of material A per kg × standard mix in kg)/ weight of standard. mix = 400 kgs × $30 × 60 kgs/100 kgs = $7,200
M₃ = $3,200 + $7,200 = $10,400

M₄– Standard cost of output.

Standard Mix	Standard rate	Standard cost
40 Kgs.	$20	$800
60 Kgs.	$30	$1800

Standard cost for 100 kgs (Input) =$2600,
Less 10% i.e. for 90 kgs standard cost is $2600 and for 364 kgs standard cost is $10,516.

Variances

• Material Price Variance = M1 – M2 = $520 (A)
• Material Mix Variance = M2 – M3 = $200 (F)
• Material Yield Variance = M3 – M4 = $116 (F)
• Material Cost Variance = M1 – M4 = $204 (A)
• Material Usage Variance = M2 – M4 = $316 (F).

Note: Alternatively, Material Cost Variance = Material Price Variance + Material Mix Variance + Material Yield Variance.

And

Material Usage Variance = Material Mix Variance + Material Yield Variance.

A2.3.2 Direct wage variance

Model Steps for direct wage variances are as follows,

• L_{1 –} actual payment made to workers for actual hours worked = Actual hours worked × Actual hourly wage rate
• L_{2 –} estimated payment if the workers had been paid at standard rate = Actual hours worked × Standard hourly wage rate

L_{3 –} estimated payment if workers had been used according to the proportion of standard group, and payment had been made at standard rate. Example – in actual working, Grade-I and Grade-II workers might have been used in the ratio of 75:25 instead of standard ratio of 50:50.Hence, this step will involve determining the wage payment keeping in view the following points (see Figure A2.3).

• L_{4 –} Standard cost of labor hours utilized = Actual utilized hours × Standard hourly rate.
  Note: Strike, power failure etc. should be deducted from the available hours.
• L_{5 –} Standard labor cost of output achieved = Standard labor cost per unit × Actual production.

Direct Wage Variance represents the difference between actual wages paid and standard wages specified for the production and is expressed by the difference between (L₁) and (L₅ ).

It is due to the difference between actual wage rate paid and the standard wage rate specified. It represents the difference between actual payment to the worker for actual hours worked (L₁) and estimated payment if the worker had been paid at standard rate (L₂).

Direct wage efficiency variance

It represents the difference between (L₂) and (L₅). It arises due to the difference between actual hours paid and standard hours allowed for output achieved. It is the sum total of labor-gang variance, labor idle time variance and labor yield variance.

Direct wage group variance

It is the difference between actual composition of the group used and standard composition specified for the group. Suppose the composition of the group changes due to a shortage of a particular grade of labor. Changing the composition of labor mix will change the efficiency of that group. The difference between (L₂) and (L₃) will give rise to the direct wage group (gang) variance.

Labor idle time variance

The difference between labor hours applied and labor hours utilized is the labor idle time variance difference between (L₃) and (L₄). The idle time variance is to be calculated when there is a difference between labor hours applied and labor hours utilized.

Labor yield variance

It is the difference between the actual output of a worker and standard output of the worker. It is also termed as the labor efficiency variance. It can be divided into two parts:

1. When there is Idle Time variance

Yield variance = Standard cost of labor hours utilized (L₄ ) – standard labor cost of output achieved (L₅ ).

2. When there is no Idle Time variance

In that case (L₄ ) is to be considered as zero and the yield variance will be calculated from the difference between the value of (L₃) and (L₅ ).

Illustration – 7:

The standard composition and standard rates of a group of workers are as follows,

According to given specifications, a week consists of 40 hours and standard output for a week is 1000 units. It is observed in a particular week, a group of 13 skilled, 4 semi-skilled and 3 unskilled worked and they were paid as follows,

The production line supervisor’s report recorded that two hours were lost due to breakdown and actual production was 960 units in that week.

We have to find out –

Solution:

L_{1 –} actual payment made to workers for actual hours worked

Actual Composition of group	Hours worked	Rate $	Amount $
13 skilled	40	0.600	312
4 semi-skilled	40	0.425	68
3 unskilled	40	0.325	39
	Total	:	419

L_{2 –} payment involved if the workers had been paid at standard rate

Actual Composition of group	Hours worked	Std. Rate $	Amount $
13 skilled	40	0.625	325
4 semi-skilled	40	0.400	64
3 unskilled	40	0.350	42
	Total	:	431

L_{3 –} Payment involved if workers had been used according to the proportion of standard group, and payment had been made at standard rate.

Std. Composition of group	Hours worked	Std. Rate $	Amount $
10 skilled	40	0.625	250
5 semi-skilled	40	0.400	80
5 unskilled	40	0.350	70
	Total	:	400

L_{4 –} Standard cost of labor hours utilized

Std. Composition of group	Hours utilized	Std. Rate $	Amount $
10 skilled	40	0.625	237.50
5 semi-skilled	40	0.400	76.00
5 unskilled	40	0.350	66.50
	Total	:	380.00

L_{5 –} Standard labor cost of output achieved

Variances

Variable overhead variance

Variable overhead per unit remain same and varies with total output (see Figure A2.4).

Model steps are shown below,

VO₁ – Actual overhead incurred.

VO₂ – Actual hours worked at standard variable overhead rate

= Standard variable overhead rate per hour × Actual hours worked.

VO₃ – Standard variable overhead for the production

= Standard variable overhead per unit × Actual production.

Variable overhead variance

It is the difference between actual overhead incurred during the period and standard variable overhead for production i.e. VO₁ – VO₃. Variable overhead variance can also be determined by taking the aggregate of variable overhead expenditure and variable overhead efficiency variance.

Variable overhead expenditure variance

It is the difference between actual variable overhead and standard variable overhead appropriate to the level of activity attempted. Variable overhead expenditure variance is the difference between VO₁ and VO₂.

Variable overhead efficiency variance

Variable overhead efficiency variance is the difference between actual hours worked at standard variable overhead rate (VO₂) and standard variable overhead for the production (VO₃).

Illustration – 8:

Following information is obtained from a pre-cast concrete slab manufacturing company for the year 1999.

From the above data we have to find out the following variance.

• Variable overhead expenditure variance.
• Variable overhead efficiency variance.
• Variable overhead variance.

Solution

Variances

• Variable overhead expenditure variance = VO₁ – VO₂ = $2,300 (A).
• Variable overhead efficiency variance = VO₂ – VO₃ = $ 1,300 (F).
• Variable overhead variance = VO₁ – VO₃ = $ 1,000 (A).

A2.3.3 Fixed overhead variance

Fixed overhead variance arises when a company uses the absorption standard costing system. In this system, a standard rate is ascertained for fixed overheads by dividing the total fixed overhead by an appropriate base e.g. machine hours, units, labor etc. Fixed overheads incurred differ from standard allowance for fixed overheads or standard fixed overheads for production for various reasons. These give rise to different kinds of fixed overhead variances (see Figure A2.5).

FO₁ – Actual fixed overhead incurred.

FO₂ – Budgeted fixed overhead for the period or std. fixed overhead allowance. It represents the amount of fixed overhead which should be spent according to budget during the period. The amount of standard allowance for fixed overhead does not change due to change in volume.

FO_{3 –} Fixed overhead for the days/hours available at standard rate during the period. It is calculated by multiplying days/hours available and standard overhead rate.

FO_{4 –} Fixed overhead for actual hours worked at standard rate.

FO₅ – Standard fixed overhead for production. It is calculated by two ways,

• Unit Method-Multiplying the actual production and standard fixed overhead rate per unit.
• Hour Method-Multiplying the actual production in standard hours and standard fixed overhead rate per hour.

Fixed overhead variance is the difference between actual fixed overhead incurred and standard cost of fixed overhead absorbed and is calculated from the difference between FO₁ and FO_5.

Fixed overhead expenditure variance

It is also referred to as the budget variance and arises due to the difference between actual fixed overhead incurred and budgeted fixed overhead or the standard allowance for fixed overhead. The difference between FO₁ and FO₂ is the fixed overhead expenditure variance.

Fixed overhead volume variance

Fixed overhead volume variance arises due to the difference between budgeted fixed overhead for the period and standard fixed overhead for actual production. This variance indicates the degree of utilization of plant and facilities when compared to the budgeted level of operation.

Fixed overhead volume variance consists of:

Calendar variance or idle time variance

Calendar variance is the difference between budgeted fixed overhead and fixed overhead for days available during the period, at standard rate i.e. the difference between FO₂ and FO_3.

Idle time variance is determined almost in the same way as calendar variance. The difference between FO₂ and FO₃ is computed in hours as per budget and hours actually available during the period.

Capacity variance

It is the difference between capacity utilized and planned capacity or available capacity. Capacity variance is calculated from the difference between FO₃ and FO_4. An adverse capacity variance indicates under utilization. It will lead to unabsorbed balance of fixed overhead.

Efficiency variance

Efficiency variance reflects increased or reduced output arising due to the difference between budgeted or standard efficiency and actual efficiency in utilization of fixed common facilities. It is the barometer by which management comes to know how efficiently or inefficiently fixed indirect facilities or services are being used and is the difference between FO₄ and FO₅.

Illustration – 9:

We have to calculate fixed overhead variances from the following cost data of Naturextracts Ltd.

Solution

Calculation of variances

Variances

• Fixed Overhead Expenditure Variance = FO₁ – FO₂ = $8000 (A)
• Fixed Overhead calendar variance = FO₂ – FO₃= $16000 (F)
• Fixed Overhead Capacity Variance = FO₃ – FO₄ = $8800 (F)
• Fixed Overhead Efficiency Variance = FO₄ – FO₅ = $18480 (A)
• Fixed Overhead Variance= FO₁ – FO₅ = $1680 (A)
• Fixed Overhead Volume Variance = FO₂ – FO₅ = $6320 (F)

A2.3.5 Material Cost Variances and Two-Variance, Three-Variance and Four-Variance Approach

Two-variance

The term two-variance indicates that the analysis is restricted to two factors, i.e. price and quantity only. It can be graphically illustrated as shown in Figure A2.6.

Then, Actual cost	= PA QA
Standard Cost	= PS QS
Total variance	= Actual cost – Standard cost
	= PA QA – PS QS.

If the two-variance approach refers to material cost variance, then only material price variance and material quantity variance will be determined.

Three-variance

In this approach material cost variance, i.e. P_A Q_A – P_S Q_S is to be equal to A+ B + C and following variances are attempted.

a) Material price variance b) Material quantity variance c) Material mix variance.

Four-variance

The four variance approach takes the analysis still further and the area represented A+ B + C in the above figure will be divided as follows.

• Material price variance.
• Material sub-usage Variance
• Material Mix Variance.
• Material Efficiency Variance.

Overhead variance and two-variance, three-variance and four-variance approach

Overhead variance is the result of numerous contributory factors and its knowledge can be effective only when it is further analyzed according to the purposes.

Two-variance

Only expenditure variance or budget variance and volume variance are attempted under this approach.

Three-variance

The two-variance approach is viewed as inefficient for control purposes and the three-variance approach is recommended in which following three variances will be determined:

• Expenditure variance or budget variance
• Capacity variance
• Efficiency variance

Four-variance

Analysis of variances is further stretched in this approach in which calendar variance is also analyzed along with all the other three variances mentioned above.

Illustration – 10

The following figures are extracted from the books of a company:

We have to analyze the overhead variances and summarize those results according to the ‘Two-way’, ‘Three-way’ and ‘Four-way’ approach.

Solution:

Calculation of Fixed Overhead Variances

(Please refer Illustration-9 for details)

FO₁ – $2500, FO₂ – $2400, FO₃ – $2592, FO₄ – $2640 & FO₅ – $2600

Variances

• Fixed Overhead Expenditure Variance = FO₁ – FO₂ = $100 (A)
• Fixed Overhead calendar variance = FO₂ – FO₃= $192 (F)
• Fixed Overhead Capacity Variance = FO₃ – FO₄ = $48 (F)
• Fixed Overhead Efficiency Variance = FO₄ – FO₅ = $40 (A)
• Fixed Overhead Variance = FO₁ – FO₅ = $100 (F).
• Fixed Overhead Volume Variance = FO₂ – FO₅ = $200 (F)

Variable overhead variance

Variances

• Variable overhead expenditure variance = VO₁ – VO₂ = $ 100 (A).
• Variable overhead efficiency variance = VO₂ – VO₃ = $ 200 (A).
• Variable overhead variance = VO₁ – VO₃ = $ 300 (A).

The statement below shows the overhead variances under ‘Two-way’, ‘Three-way’ and ‘Four-way’ methods.

*In three-variance analysis, Fixed Overhead Capacity Variance will include Fixed Overhead Calendar Variance also.

A2.4 Non-conventional variance analysis

Internal factors, such as technological and organizational changes arise within the organization and these are controllable variances. These are normally known and planned for in advance. Extraneous factors such as inflation arise outside the organization and are uncontrollable, and require changes in a plan at short notice.

These factors invalidate the conventional variance analysis and necessitate the use of operating and planning variances.

Operating and planning variances are subsets of material total variance replacing traditional usage and price variances. These variances are used to isolate variances caused by unforeseen circumstances (planning variance) and operational variance, which reflects non-standard performance. This approach may also apply to labor and overhead.

A2.4.1 Operational/Planning variance

Operational price variance

{(Actual materials used or purchased × revised standard price) – (Actual materials used or purchased × Actual price)}.

Operational usage variance

{(Standard materials used × revised standard price) – (Actual materials used × revised standard price)}.

Planning price variance

(Standard material cost) – (Revised standard material cost).

Illustration – 11

PC & Co. has set the standard price of material at $2 per kg before the start of the period.

During the period:

• Standard quantity of material specified for the output in the period: 20,000 kg
• Actual material purchased and used: 21,000 kg
• Actual purchase price paid: $ 2.80 due to material shortage.
• At the end of the period, a price of $3 was agreed to have been an efficient buying price in the period. The standard costing system shows a direct material total variance of $18,800 made up of:
  • Material usage Variance $ 2,000 (A)
  • Material Price Variance $ 18,000 (A)

We need to distinguish between controllable and uncontrollable effects on performance.

Solution:

Actual cost of purchase (21,000 × $2.8)	= $ 58,800
Material actually purchased and used at revised standard cost (21,000 × $3) = $ 63,000
Revised standard cost (20,000 × $3)	= $ 60,000
Standard Price: (20,000 × $2)	= $ 40,000

• Operational Price variance (Controllable), (a-b) = $4,200 (F)
• Operational Usage variance (Controllable), (b-c) = $3,000 (A)
• Planning Price variance (Un-Controllable), (c-d) = $ 20,000 (A)

Direct material total Variance = Planning variance + Operational variance

= 3000 (A) + 20000 (A) + 4200 (F).

= $ 18,800 (A).

Causes of different variances are given here:

A2.5 Reporting of variances

The value of variances comes from an analysis of significant variances, the identification of their cause and the correction of these causes. The benefit of variance analysis lies in prompt communication to management and the delay may render the analysis useless. Cost control efforts are generally aided by using ratio analysis technique. The management prefers to compute a number of ratios pertaining to liquidity, profitability and capital structure etc. as opposed to absolute figures. Variance ratios Figure A2.7) help in comparing different periods and highlighting abnormalities.

The following variance ratios are commonly used:-

Illustration – 12

The following data is available in the books of GKW Ltd.

The related period of 4 weeks and there was a special one day holiday due to national event. We have to calculate the following ratios: Efficiency Ratio, Activity ratio, Calendar ratio, standard Capacity Usage Ratio, Actual Capacity Usage Ratio, Actual Usage of Budgeted Capacity Ratio.

Solution:

Efficiency Ratio = 7,000 hrs. × 100 / 6,000 hrs. = 116.7%.
Activity ratio = 7,000 hrs. × 100 / 6,400 hrs. = 109.4%.
Calendar ratio = {(5 days × 4 weeks) – 1} × 100 / (5 days × 4 weeks) = 95.0%.
Standard Capacity Usage Ratio = 6,400 hrs. × 100 / 8,000 hrs. = 80.0%.
Actual Capacity Usage Ratio = 6,000 hrs. × 100 / 8,000 hrs. = 75.0%.
Actual Usage of Budgeted Capacity Ratio = 6000 hrs. × 100 / 6,400 = 93.75%.

Case studies – B

I. PRAX Inc. manufactures a single product for which the following information is available:

The following extracts were taken from the actual results and reports for two consecutive accounting years.

We have to:

• Interpret and explain every variance of Period –I showing the underlying calculations.
• Calculate the sub-variances of the fixed overhead volume variance for Period-II assuming that an alternative suggestion is adopted that such a subdivision would aid management control.

II. A jewelry manufacturing company planned to manufacture 5,000 components in the month of September. Each component requires four standard hours to complete. For the 22 working days in the month 120 workers were allocated to the job. The factory operates an 8-hours day. The worker allocation included a margin for absenteeism and idle time.

Actual results were analyzed and it was revealed that absenteeism had averaged 5%, an average of 5 hours overtime had been worked by those present and 4,800 components had been completed at an average of 3.8 standard hours each.

During October, 120 of the completed components have been scrapped because of defective material. It is also planned to produce another 5,000 units plus the shortfall from September. From the information given, you are required to:

Calculate the following ratios for September,

• The production volume ratio,
• The capacity ratio, and
• The productivity (efficiency) ratio,

Give explanation of the above results.

• Estimate the manpower required for November production using 21 working days with one hour overtime per man per day, working at the budgeted efficiency level and the same percentage of absenteeism, idle time and rejects as occurred in the September production.
• Calculate the bonus for November, on a 50:50 profit sharing basis, which could be paid as an addition to the wage rate if the September production efficiency was achieved, idle time reduced to 5% but all other features were the same as in (c) above.

A3.1 Common forms of reports

Narrative reports– These are descriptive and verbal reports.
Statistical reports – These reports rely on tables, numbers, graphs, charts, etc.
Periodic reports – Reports may be issued on regular scheduled basis, e.g. daily, weekly, monthly, quarterly and annually.
Progress reports – Interim reports between the start and completion of a project and also called follow-up reports.
Special reports – Generally these reports are sent irregularly in response to a specific, non-routine request. In control reports, a subordinate summarizes the activities under the jurisdiction and accounts to his superiors for results, that he has previously committed himself to achieve. The practice of ‘reporting by results’ is primarily for management control purposes.

Tabular Presentation of Cost Reports for Different Levels of Management

Top management

Middle Management

Operating Management

A4.1 What is Value?

Value is a measure of how well the owner’s objectives are met. The term ‘Value’ is synonym for the term ‘worth’. Nothing can have value without being an object of utility.

A product or a service may have the following kinds of values for the customer:

• Use value – the monetary measure of the functional properties of the product or service which reliably accomplish a user’s needs.
• Esteem value – the monetary measure of the properties of a product or service which contribute to its desirability or salability. Commonly answers the ‘How much do I want something?’ question.
• Cost value – the monetary sum of labor, material, burden, and other elements of cost required to produce a product or service.
• Exchange Value – the monetary sum at which a product or service can be freely traded in the marketplace.

A4.2 Concept of value

The concept of Value relies on the relationship between the satisfaction of many differing needs and the resources used in doing so. Value increases when customer satisfaction increases and/or expenditure of resources diminish. Resource includes time, management, design costs, capital costs, cost in use etc. The fewer the resources used or the greater the satisfaction of needs, the greater the value (Figure A2.8). Value carries different meaning for different people. Value Management helps an organization to achieve its stated goals with the use of minimum resources.

The value can be improved by influencing the performance and resources variables in a number of ways:

Here P and R denote functional Performance and Life Cycle Cost/ NPV respectively.

It is important to realize that Value may be improved by increasing the satisfaction of need even if the resources used in doing so increase, provided that the satisfaction of need increases more than the increase in use of resources.

A4.3 Purpose

VM is the systematic application of recognized techniques used by a multi-disciplined team to: identify the function of a product or service, establish a worth for that function, generate alternatives through the use of creative thinking, and provide the needed functions to accomplish the original purpose of the project. This should be accomplished reliably and at the lowest life-cycle cost without sacrificing safety, necessary quality, and environmental attributes of the project.

A4.4 Value methodology

The systematic application of recognized techniques which identify the functions of the product or service, establish the worth of those functions, and provide the necessary functions to meet the required performance at the lowest overall cost. The Value Methodology is a professionally-applied, function-oriented, and systematic multi-disciplined team approach used to analyze and improve value in a product, facility design, system or service. It can be applied to any business or economic sector including industry, government, construction or service. By enhancing value characteristics, VM increases customer satisfaction, and adds value to the investment.

A4.5 Function oriented approach

It is the link between the need and the product and the need is expressed in terms of performances rather than the solutions. It is a powerful methodology used for solving problems and/or reducing costs while improving value, performance, and quality.

A4.6 Cross-disciplinary team

A key to the successful application of a value study is the skill and experience of those applying the methodology and it has been proven that a well organized team obtains the best value for significant projects. The Team Leader performs a key role and is a significant factor in the degree of success and should possess strong leadership, communication skills, and experience working with users/clients. The members should represent a diverse background and experience that incorporates all the knowledge required to fully cover the issues and objectives of the project. Participant selection and stakeholders involvement is the key to success. Typically these include a Facilitator, a Client Commercial Manager, a Client Representative, an End User, a Project Manager, a Cost Manager, a Planner, a Designer, a Contractor, a Risk Manager, and Other Stakeholders.

A4.7 Structured process

Value Methodology is a structured process and consists of the following analytical and creative thought processes,

• Analyze Information
• Brainstorm Function
• Organize Function
• Generate ideas for alternatives
• Evaluate alternatives and develop proposals
• Appraise options
• Recommend solutions

A4.8 The value methodology job plan

The Value Methodology uses a systematic Job Plan (Figure A2.9). The Job Plan outlines specific steps to effectively analyze a product or service in order to develop the maximum number of alternatives to achieve the product’s or service’s required functions. Adherence to the Job Plan will better assure maximum benefits while offering greater flexibility.

The VM Job Plan covers three major periods of activity: Pre-Study, the Value Study, and Post-Study. All phases and steps are performed sequentially.

Function analysis stage

Function definition and analysis is the heart of Value Methodology. It is the primary activity that separates Value Methodology from all other ‘improvement’ practices. The objective of this phase is to develop the most beneficial areas for continuing study where project functions or objectives are analyzed to improve value, by considering: ‘What should this do?’ rather ‘What is this?’ focus on functions rather than product.

The team performs the following steps:

• Identify and define both work and sell functions of the product, project, or process under study using active verbs and measurable nouns. This is often referred to as Random Function Definition.
• Classify the functions as basic or secondary
• Expand the functions identified in step 1 (optional)
• Build a function Model – Function Analysis System Technique (FAST) diagram. The function analysis captures requirements diagrammatically into a FAST diagram which is a logical method that identifies hierarchy.
• Assign cost and/or other measurement criteria to functions
• Establish worth of functions by assigning the previously established user/customer attitudes to the functions
• Compare cost to worth of functions to establish the best opportunities for improvement
• Assess functions for performance/schedule considerations
• Select functions for continued analysis
• Refine study scope (see Figure A2.10)

A4.9 Value methodology applicability

Value Methodology can be applied wherever cost and/or performance improvement is desired. This method is applicable to hardware, building or other construction projects, and to ‘soft’ areas such as manufacturing and construction processes, health care and environment services, programming, management systems and organization structures. For civil, commercial and military engineering works such as buildings, highways, factory construction, and water/sewage treatment plants, as these are one-time capital projects; VM is applied from the design phase to achieve maximum benefits and is applied on a project-to-project basis. It may also be applied during the build/manufacture cycle to assure that the latest materials and technology are utilized. VM can also be applied during planning stages and for project/program management control by developing function models with assigned cost and performance parameters.

A4.10 The benefits of value management

The most visible benefits arising out of the application of VM include:

• Better business decisions by providing decision makers a sounds basis for their choice
• Improved products and services to external customers by clearly understanding, and giving due priority to their real needs
• Enhanced competitiveness by facilitating technical and organizational innovation
• A common value culture, thus enhancing every member’s understanding of the organization’s goals
• Improved internal communication and common knowledge of the main success factors for the organization
• Simultaneously enhanced communication and efficiency by developing multidisciplinary and multitask teamwork
• Decisions which can be supported by the stakeholders.

A4.11 Function analysis system technique diagram

The Function Analysis System technique (FAST) is developed by Mr. Charles W. Bytheway in 1964, and first presented as a paper to the Society of American Value Engineers conference in 1965. FAST contributed significantly to perhaps the most important phase of Value Engineering – function analysis. It is not an end product or result, but rather a beginning. It lays open the subject matter under study, forming the basis for a wide variety of subsequent study approaches and analysis techniques.

Function Analysis is a common language, crossing all technologies. It allows multi-disciplined team members to contribute equally and communicate with each other while addressing the problem objectively without bias or preconceived conclusions. As an effective management tool, FAST can be used in any situation that can be described functionally. However, FAST is not a panacea; it is a tool that has limitations which must be understood if it is to be properly and effectively used.

FAST is a system without dimensions – that is, it will display functions in a logical sequence, prioritize them and test the dependency, but it will not tell how well a function should be performed (specification), when (not time oriented), by whom, or for how much. However, these dimensions can be added to the model. Which dimensions to use is dependent on the objectives of the project. There is no ‘correct’ FAST model, but there is a ‘valid’ FAST model. Its degree of validity is directly dependent on the talents of the participating team members, and the scope of the related disciplines they can bring to bear on the problem. The single most important output of the multi-disciplined team engaged in a FAST exercise is consensus. There can be no minority report. FAST is not complete until the model has the consensus of the participating team members and adequately reflects their inputs.

The mechanics of the process

To begin the process, a basic model is offered. Figure A2.11 showing the FAST components and its parts.

Standard symbols and graphics

These symbols and graphics have become the accepted standard over the past 20 years. The four primary directions in a FAST diagram are (see Figure A2.12):

The HOW and WHY directions are always along the critical path, whether it be a major or minor critical path. The WHEN direction indicates an independent or supporting function (up) or activity (down). At this point, the rule of always reading from the exit direction of a function in question should be adopted so that the three primary questions HOW, WHY and WHEN are answered in the blocks indicated below in Figure A2.13.

• HOW is (function) to be accomplished? By (B)
• WHY is it necessary to (function)? So you can (A)
• WHEN (function) occurs, what else happens? ( C ) or (D)

The answers to the three questions above are singular, but they can be multiple (AND), or optional (OR).

ALONG THE CRITICAL PATH – AND

‘AND’ is represented by a split or fork in the critical path. In both examples the fork is read as ‘AND’. In Example A, How do you ‘Build System’? By ‘Constructing Electronics) AND ‘Constructing Mechanicals.

In Example B, how do you ‘Determine Compliance Deviations?’? By ‘Analyzing Design’ AND ‘Reviewing Proposals’. However, the way the split is drawn, Example A shows ‘Constructing Electronics’ and ‘Constructing Mechanicals’ equally important; and in Example B, ‘Analyzing Designs’ is shown as being considered more important than ‘Review Proposals.’ (see Figure A2.14).

Along the critical path – ‘OR’

‘Or’ – represented is represented by multiple exit lines indicating a choice.

Using Example A, the answer to the question, how do you ‘convert bookings’, is by ‘Extending bookings’ OR ‘Forecast Orders’. When going in the ‘Why’ direction one path at a time is followed. Therefore: ‘Why’ do we ‘Extend Bookings’? So that you can ‘Convert Bookings’. Also, why do you ‘Forecast Orders’? So that you can ‘Convert Bookings to Delivery’. The same process applies to Example B, except as in the AND Example, ‘Evaluate Design’ is noted as being less important then ‘Monitor Performance’ (see Figure A2.15).

‘AND’ Along the WHEN Direction

WHEN functions, applicable to independent functions and activities, AND is indicated by connecting boxes above and/or below the critical path functions (see Figure A2.16).

The above example states ‘When you influence the customer’, you ‘Inform the customer’ AND ‘apply skills’. If it is necessary to rank or prioritize the AND functions, those closest to the critical path function should be the most important. It would appear that the same ‘fork’ symbol should be used to express AND in the WHEN as well as the HOW-WHY direction, giving example A this appearance (see Figure A2.17).

However, to do so would cause some graphic problems in multiple AND functions, in addition to building minor critical paths, such as (see Figure A2.18):

‘OR’ Along the WHEN Direction

OR is indicated by ‘flags’ facing right or left (see Figure A2.19).

Although Example B is an independent function (above the critical path) and Example C is activities (below the critical path), the WHEN, OR rules are equally applicable to both. Locating the ‘flags’ to the left or right of the vertical line bears on how we read back into the critical path function.

In Example C, working from below the critical path function, it reads: When you ‘request work’, you ‘order components’ OR ‘order collating’. Since the blocks are below the critical path, they are activities. In reading activities back, the flags face the HOW direction and the question reads: HOW do you ‘order Components’ OR ‘order collating’? By ‘requesting work’. Once again the graphic considerations modified the OR notations as seen on the critical path. Since OR is expressed in this form on the critical path:

It would appear that OR in the WHEN direction should follow this convention. However, the same problem in building minor critical paths from the support functions would occur. Also, the ‘flag’ OR, reading back into the critical path would be more difficult to express.

Other notations and symbols

Other notations and symbols used in expressing ideas and thoughts in the FAST Model are as follows: Indicates that the network continues, but is of no interest to the team, or does not contribute to the solution sought.

Indicates the Function (F) is further expanded on a lower level of abstraction.

Indicates that the line X connects elsewhere on the model, matching the same number.

A horizontal chart depicting functions within a project, with the following rules:

• The sequence of functions on the critical path proceeding from left to right answers the questions ‘How is the function to its immediate left performed?’
• The sequence of functions on the critical path proceeding from right to left answers the questions ‘Why is the next function performed?’
• Functions occurring at the same time or caused by functions on the critical path appear vertically below the critical path
• The basic function of the study is always farthest to the left of the diagram of all functions within the scope of the study.
• Two other functions are classified:
  • Highest Order – The reason or purpose that the basic function exists. It answers the ‘why’ question of the basic function and is depicted immediately outside the study scope to the left.
  • Lowest Order – The function that is required to initiate the project and is depicted farthest to the right, outside the study scope. For example, if the value study concerns an electrical device, the ‘supply power’ function at the electrical connection would be the lowest order function.

B1.1 Introduction

From the management’s point of view, ‘What a product should have cost’ is more important than ‘what it did cost’. Reasons for deviations are rigorously analyzed and responsibilities are promptly fixed. Therefore, ‘What a product should have cost’ is a question of great concern to management for improvement of cost performance. A scientific answer based on reasons and consequences is developed by use of standard costing. Standard costing is a managerial device to determine efficiency and effectiveness of cost performance.
Standard – It is a predetermined measurable quantity set in defined conditions.
Standard Cost – It is a scientifically pre-determined cost, which is arrived at assuming a particular level of efficiency in utilization of material, labor and indirect services.

CIMA defines standard cost as ‘a standard expressed in money. It is built up from an assessment of the value of cost elements. Its main uses are providing bases for performance measurement, control by exception reporting, valuing stock and establishing selling prices.’

Standard cost is like a model, which provides the basis for comparing actual cost. This comparison of actual cost with standard cost reveals very useful information for cost control.

Standard cost is primarily used for the following purposes:

• Establishing budgets
• Controlling costs and motivating and measuring efficiencies
• Promoting possible cost reduction
• Simplifying cost procedures and expediting cost reports
• Assigning cost to materials, work-in-process and finished goods inventories
• Forms the basis for establishing bids and contracts and for setting selling prices

Standard Costing: According to CIMA (London), ‘Standard costing is a control technique which compares standard costs and revenues with actual results to obtain variances which are used to stimulate improved performance.’ Use of standard costing is not confined to industries having repetitive processes and homogeneous products only. It can be used in non-repetitive processes like manufacture of automobiles, turbines, boilers and heavy electrical equipment.

B1.2 Limitation of historical costing

• Data does not provide yardstick of comparison for actual cost
• Data is made available too late to correct inefficiencies, that are causing costs to go out of limits
• It does not provide motivation to employees to strive for accomplishment of their objectives
• Data provides insufficiently for budgeting, planning, decision making and price quotation

These limitations of historical costing are primarily responsible for the advent and wide usage of standard costing.

B1.3 Advantage of standard costing

General advantages

• Use of standard costing leads to optimum utilization of men, materials and resources
• Its use provides a yardstick for comparison of actual cost performance
• Only distinct deviations are reported to management. It helps in the application of the principle of ‘management by exception’
• It is useful to management in discharging functions, like planning, control, decision making and price fixing
• It creates an atmosphere of cost consciousness
• It motivates workers to strive for accomplishment of defined targets
• It highlights areas, where a probe promises improvement
• Its introduction leads to simplification of procedures and standardization of products
• It reduces the time required for preparation of reports for pricing, control or quotation purposes
• It helps determine the cost of finished goods immediately after completion
• This eliminates much clerical effort in pricing, balancing and posting on store ledger cards and stock ledgers can be maintained in terms of quantities only
• Its use may encourage action for cost reduction.

Specific advantages

Specific uses of standard costing in an organization are summarized below:
Accounting department is benefited by:

• Planning and budgeting, valuation of inventories, cost control, pricing, sales and cost estimates, developing monthly operating results.

Production department is benefited by:

• Production planning, matching scheduled production with machine capacity and preparing reports of business logs in terms of time

Sales department is benefited by:

• Determining and checking selling prices, preparing quotations on special products and determining the profitability of specific product lines

B1.4 Preliminaries to establishment of standards

Before standard cost for different elements is determined, management should take a decision about the following:

• Length of period of use
• Types of standard to be used
• Review of existing procedures
• Classification of accounts
• Review of existing coding system

B2.1 Introduction

A cost item may have a direct or indirect relationship with the cost objective, i.e., the purpose or object for which the cost is being ascertained. Based on the direct and indirect relationship of the cost object, the total cost is supposed to be composed of the following two major categories: Prime and Overhead costs.

All direct costs are part of the prime cost, which is an aggregate of direct material cost and direct wages. All indirect costs form a part of the overhead, which is an aggregate of indirect material cost, indirect wages and costs of indirect services. Therefore overhead is a pool of indirect costs, i.e., the costs which cannot be identified or linked or attributed or allocated to the cost objective. CIMA defines overhead/indirect cost as expenditure on labor, materials or services which cannot be economically identified with a specific saleable cost per unit. The concept of overhead is shown in Figure B2.1.

When traceability is the basis of cost classification, the terms direct costs and indirect costs are used. On the other hand, if cost is classified based on elements, prime cost and overhead are used. Overhead may include some direct costs, which are so small in amount, that it will be inexpedient to trace them to specific units of production. Screws, bolts, glue etc., are a few examples. These items can be directly traced to cost units, but the cost involved may be so insignificant that it would be inexpedient to do so.

B2.2 Elements of overhead

Indirect material cost

Indirect material cost is that material cost which cannot be assigned to specific units of production; it is common to several units of production. A few examples of these are consumable stores, lubricating oil, cotton waste and small tools for general use. Sometimes indirect material cost includes direct material cost, which is so small or complex that direct tracing to specific units is inexpedient; for example, glue, thread, rivets, chalk etc.

Indirect labor cost

Indirect labor cost is that portion of labor cost, which cannot be assigned to any specific units of production; it is common to several units. Salaries of a foreman, supervisory staff and works manager, wages for maintenance workers, idle time, and workmen compensation are some of the examples of indirect labor cost. These, like some direct material cost, are not assigned to the specific units of production for the sake of expediency. Employees’ social security charge and unemployment payroll taxes are the two examples that fall under this category.

Indirect services cost

A few examples of indirect services are:

• Repair and maintenance of plant and machinery
• Factory rent
• Expenses of keeping and handling of stores
• First aid expenses

B2.3 Classification and collection of overhead

Classification is the process of grouping according to common characteristics. Overhead is classified on the basis of functions, behavior and elements.

B2.3.2 Behavior-wise classification

This classification is important for accounting and control. Based on behavioral patterns, overhead can be divided into the following categories: Fixed overhead, Variable overhead and semi-variable overhead.

Fixed overhead

Fixed overhead represents indirect cost, which remains constant in total within the current budget period regardless of changes in volume of activity. This concept of fixed overhead remains valid within certain output and turnover limits. Fixed overhead does not vary in total. The incidence of fixed overhead on unit cost decreases as production increases and vice versa (rent of building, depreciation of plant and machinery and building, cost of hospital and dispensary, pay and allowances of managers, secretary and accountants canteen expenses, legal, fee, audit fee etc). Fixed cost will be incurred even when no production activity takes place (see Figure B2.2).

Fixed overhead per unit is changing (decreasing with increase in volume), total fixed overhead is constant.

There are three types of fixed overhead:

• Long-run capacity fixed overhead – these are the expired cost of plant, machinery and other facilities used
• Operating fixed overhead – these overheads are incurred to maintain and operate the fixed assets; heat and light, insurance and property taxes are examples of fixed overhead of this category
• Programmed fixed overhead – these are cost of special programs approved by management. The cost of extensive advertising and cost of programs to improve the quality of the firm’s products are examples of programmed fixed overhead

Fixed overhead is fixed within specific limit relating to time and activity. Fixed overhead is dependent on the policy of management and the company’s activities. Policy of a particular management may be opposed to discharging supervisors during lean periods. Accordingly, supervision will be a fixed overhead.

Variable overhead

Variable overhead represents that part of indirect cost which varies with change in the volume of activity. It varies in total but its incidence on unit cost remains constant.

The examples of variable overhead are indirect material cost, indirect labor cost, power and fuel, internal transport, lubricants, tools and spares (see Figure B2.3).

Total variable overhead is increasing whereas variable overhead per unit is constant.

Semi-variable overhead

It is that part of overhead which is partly fixed and partly variable. These overheads show mixed relationship, when plotted against volume. Semi-variable overheads may remain fixed within a certain activity level, but once that level is exceeded, they vary without having direct relationship to volume changes. It does not fluctuate in direct proportion to volume. An example of semi-variable overhead cost is the earning of an employee, who is paid a salary of $500 per month (fixed) plus a bonus of $0.5 for each unit completed (variable). If he increases his output from 1000 units to 1500 units, his earnings will increase from $1000 to $1250. An increase of 50% in volume brought about only 25% increase in cost.

Figure B2.4 shows the behavior pattern of semi-variable overhead.

Semi-variable overheads present the biggest problem in cost analysis because there is a readily ascertainable relationship between cost and volume. Semi-variable overhead must be segregated into fixed and variable element. The following are methods of estimating fixed and variable components.

Intelligent estimate of individual items

In this method, past overhead data relating to various activity levels are analyzed and tabulated to show the pattern of overhead relationship with volume. Suitable adjustments are made for anticipated changes. This approach is simple and inexpensive, but its simplicity is its inherent weakness. This method lacks scientific basis required for decision making.

High and low method

It is also known as Range method. Here, levels of highest and lowest expenses are compared with one another and related to output attained in those periods. Since the fixed element of semi-variable overhead is expected to remain fixed for two periods, it is concluded that changes in levels of expenses are due to variable elements. Variable cost per unit is calculated as follows,

Change in expenses corresponding to these levels should be divided by changes in output levels.

Illustration-1:

Considering highest and lowest levels of output:

Only variable cost will change,
Variable cost per unit = $13,200/4,400 units = $3 per unit.
Fixed cost will be = $ 38,200 – (9,400 × $ 3) = $10,000.

This method of segregating semi-variable overhead in their fixed and variable components is not good, because it lacks scientific basis required for decision making.

Method of averages

Under this method, averages of two selected groups are first taken and then the high and low method is followed to separate the fixed and variable components of semi-variable overhead. The method is explained below:

Variable cost = $ 1,650/ 550 units = $3 per unit.
Fixed overhead = $ 32,200 – (7400 × $ 3) = $10,000.

This method suffers from all the limitations of the high and low method.

Analytical method

In this method, the degree of variability is found out for each item of semi-variable expense. With this information, variable and fixed components for each item are separated.

E.g. Semi-variable overhead for October is $300. Variability element 60%. Variable element will be $180 and fixed element will be $120.

It does not present scientific basis and determining variability may be influenced by personal bias.

Scattergraph method

This is the statistical method, where a line is fitted to a series of data by observation. It is explained below:

Illustration-2:

Drawing a line of best fit from the following data

The scatter graph is a simple method requiring no complicated formulae (see Figure B2.5). It shows cost behavior pattern graphically and is easily understood. It has one serious limitation: fitting the trend line may be influenced by personal bias. The advantage of this method is speed and simplicity rather than accuracy.

Least square method

Under this method, ‘line of best fit’ is drawn for a number of observations with the help of a statistical method. Here, the straight line formula, y = mx + c, where x and y are degree variables, m and c are constant. C is the fixed element of cost, and m is the degree of variability.

Thus for each period,
y₁ = mx₁ + c
y₂ = mx₂ + c
y_n = mx_n + c

By addition, Σy = mΣx + Nc ……………………………………………(i)

Again, multiplying both sides of linear equation y = mx + c by x, we get
x₁y₁ = mx₁² + cx₁
x₂y₂ = mx₂² + cx₂
x_ny_n = mx_n² + cx_n

By addition, Σxy = mΣx² + cΣx…………………………………………(ii)

From (i) & (ii) value of constant m and c can be obtained and a pattern of cost line can be determined accordingly. Once m and c are known both x and y can be found out.

Illustration-3:

We have to find out the regression line by least square method. What will the semi-variable overhead be in July if production level increases to 500 units?

Solution

We know,

Σy = mΣx + Nc ……………………………………………(i)
Σxy = mΣx² + cΣx…………………………………………(ii)
Substituting the above (i) & (ii),
210 = 1800m +6c………………………………………… (iii)
67,000 = 580000 m + 1800c………………………………..(iv)

By multiplying (iii) with 300,
63,000 = 540000 m + 1800 c…………………………………(v)
From (iv) and (v), m = 0.10
Putting the value of m in (iii), c = 5

Putting the values of constants m and c the equation line reduces to y = 0.1x + 5.

This is the regression line of best fit, where y = semi-variable overhead;
X = volume of production.

If x = 500, y = 0.1(500) + 5 = 55.
Thus, if production level is 500 in July, semi-variable overhead will be $55.

Limitations of the ‘Line of best fit’

The most important limitation of this method is the assumption that there is an ongoing stable relationship between costs and volume of activity. Therefore, with the increase of both cost and volume it cannot be inferred that a rise in cost has been necessarily caused by an increase in volume.

B2.3.4 Distribution of overhead

The relationship between items of overhead and their object cannot always clear. Due to this difficulty the distribution of overhead has become a complex problem for the cost accountant.

Three aspects of this problem are shown below:

• Distribution of overhead among production departments and service departments, i.e. primary distribution
• Distribution of cost of service departments among production departments, i.e. absorption of overhead
• Absorption of production department’s overheads by units produced (see Figure B2.6).

It is shown here that items of overhead are distributed in production departments and service departments disregarding their distinction (see Figure B2.7(a) and (b)).

Under secondary distribution, cost of service departments is distributed among production departments.

The above figure shows that absorption of overhead involves distribution overhead of production departments in units produced.

For the purpose of assignment and distribution, the following terms are relevant:

Allocation – the process identification of whole items of overhead to specific departments is termed as allocation. The item of overhead cannot be identified with specific units of production, but with the specific department for the purpose of allocation. For example, the material issued to the repair department cannot be linked with specific units of production, but this item of overhead can be allocated directly to the maintenance service cost center. An item of overhead cannot be allocated to a department, till the two following conditions are satisfied,

• The concerned department should have caused the overhead item to be incurred
• The exact amount of overhead should be known. Original records contain a lot of information to enable the different items of overhead to be allocated to specific departments. It is illustrated in the following table,

Apportionment – The items of overhead, which cannot be identified with specific departments, are prorated or distributed among the related departments and this prorating of distribution is technically referred to as apportionment.

Cost Attribution – It is a process of relating cost to cost center or cost units using cost allocation or apportionment.

Primary distribution of overhead – Primary distribution involves allocation or apportionment of different items of overhead to all departments of the factory. In primary distribution, the distinction between the production and the service department is disregarded. The following points are to be followed for apportionment of items for primary distribution.

• Basis adopted for apportionment for primary distribution should be equitable and practicable
• Charges should be made to different departments in relation to benefit received
• Method adopted for primary distribution should not be time consuming and costly

The following bases are most commonly used for apportioning items of overhead among production and service departments for primary distribution.

Illustration-4:

The SQC & Co. is divided into four departments. A, B, C are production departments and D is a service department. The actual costs for the period are as follows:

The following data of four departments is available

Apportion the costs of the various departments on most equitable basis.

Solution:

Departmental Distribution Summary

Secondary distribution

The process of redistributing the cost of service departments among production departments is known as secondary distribution. The distinction of production departments and service departments dominates secondary distribution.

Criteria for secondary distribution

The available basis for determining the basis for apportionment of cost service departments among production department.

• Services received
• Analysis of survey or survey of existing conditions
• The ability to pay basis
• Efficiency or Incentive Method
• General use indices

Common bases for secondary distribution

The representative lists of bases, which are frequently used for apportioning cost of service departments among production departments, are shown below;

B2.3.5 Methods of redistribution

Once the basis for redistribution of service department cost has been determined, actual redistribution can be done by any of the following methods (see Figure B2.8):

Direct redistribution method

In this method, service departments’ costs are apportioned to production departments (only) ignoring service rendered by one service department to the other. Here, the number of secondary distribution will be equal to number of secondary departments.

Illustration 5:

PJ & Co. Ltd. has three production departments and four service departments. The expenses for these departments as per the primary distribution summary were the following:

The following information is also available in respect of the production departments:

Solution:

Step method

It is a method of secondary distribution on non-reciprocal basis. It gives cognizance to the service rendered by one service department to another service department. In this method, there is no two-way distribution of costs between two service departments. E.g., a portion of power plant cost may be distributed to the tool room, because power plant provides service to tool room. But no part of the tool room cost is distributed to the power plant, even if the tool room renders service to it. The cost of service department, which serves the largest number of other departments, is distributed first. After this, the next largest number of department is apportioned and goes on till the cost of the last service departments is apportioned among production departments only.

Illustration 5:

A manufacturing company has two production departments, X and Y, and three service departments – stores, time-keeping and maintenance. The departmental distribution summary showed the following expenses for January 2003.

Other information relating to these departments was:

Apportion the cost of service departments to production departments keeping in view that the company makes secondary distribution on non-reciprocal basis.

Note:-

1. Bases taken for apportionment of cost of various service departments are

• Time keeping – no. of employees (2:1:4:3)
• Stores – no. of stores requisitions (3:12: 10)
• Maintenance – machine hours (4: 2).

2. It is concluded from the given information that

• The Time-keeping department serves the largest number of departments
• The Stores department serves the next largest number of departments.

Reciprocal service method

This method is applicable when there are two or more service departments and each one may render service to others. These inter-departmental services are considered while distributing expenses of service departments. This reciprocal basis for secondary distribution method facilitates cost control of the service department.

Three methods available for dealing with reciprocal services:

a) Trial and Error method

In this method, cost of one service department is apportioned to another service department. The cost of another service department plus the share received from first service department is again apportioned to first service department and this process is continued till balancing figure becomes negligible.

Illustration 6:

Data assumed cost of service of Department X and Y are $2,000 and $2,400. The analysis reveals that department X renders 30% of its services to department Y and Y department renders 20% of its services to X department. We have to show how reciprocal distribution of cost is taking place between two departments.

Solution:

The cost of Dept. X and Y will be $2,638.29 and $3,191.49 respectively.

Repeated distribution method

It is also known as continued distribution of attrition method and service department costs are distributed to other service departments and production departments on agreed percentages. This process continues to be repeated, till the figures of service departments are too small to be considered for further apportionment.

Illustration 7:

Clive & Co. has three production departments and two service departments. Departmental distribution summary for the month of January 2003 is given below.

The expense of service departments are charged on a percentage basis as follows:

Distribution of service department cost under repeated distribution method has to be ascertained.

Solution:

Secondary Distribution Summary

January 2003

The last step will involve insignificant approximation.

Simultaneous equation method

Under this method true costs of service departments are first ascertained with the help of simultaneous equations. These are then distributed among production departments on the basis of given percentages.

Illustration 8:

Let us consider the same data for this case also. We have to prepare a statement showing the apportionment of two Service Department’s expenses to Production Departments by Simultaneous Equations Method.

Solution:

Let, P = total overhead of department X
N= total overhead of department Y

or P = 702 + 20/100N, and N = 900 + 10/100P.

or 10P-N =7020, and 10N – P = 9000.

Thus, P = 800 and N = 980.
We can now apportion the total overhead,

B2.4 Overhead absorption

Overhead absorption is an exercise by which overheads are properly spread over to production for the period. The selection of the correct method of overhead absorption is very important for pricing, tenders and other managerial decisions. Overhead absorption is accomplished by overhead rates.

B2.4.1 Overhead absorption rates

Absorption rate is a rate charged to the cost unit intended to account for the overhead at a predetermined level of activity. The amount of overhead divided by total number of units of the base selected such as direct labor hours; machine hours, production units etc.

The overhead absorbed in a period will be found out by multiplying overhead rate by total number of units of the base for the period.

The main objectives of determining overheads rates are given below,

• Helps to compute the amount of overhead to be included in unit cost.
• Cost compilation can be done immediately after the production.
• It determines the amount to be debited to WIP account for indirect material, indirect labor and indirect expenses for production.
• It estimates the overhead cost to be included in unit cost in advance of production.

Different types of overhead rates are briefly discussed in the following section.

Actual overhead rate

It is known as the historical overhead rate and is determined as follows:

The disadvantages of the use of the actual overhead rate are as follows,

• Actual overhead rate cannot be determined until the end of the period.
• Seasonal and cyclical influences cause wide fluctuations in actual overhead cost and actual volume of activity.
• Due to frequent changes in product cost, the cost comparison for different periods is very difficult.

Pre-determined overhead rate

Advantages:

• Pre-determined overhead rate facilitates product cost determination immediately after production is completed.
• In this case overhead cost is not distorted by seasonal or cyclic fluctuations.
• It is useful when cost-plus contracts are under taken.
• Cost estimating and competitive pricing offer ideal situations for use of predetermined overhead rates.

Predetermined overhead rates may be determined with any of the bases – previous year’s experience, expected performance, probable future performance, and optimum operating conditions.

Supplementary overhead rates

When predetermined overhead rates are used, a difference arises between overhead absorbed and overhead incurred. This under or over-absorbed overhead divided by base (number of hours, dollars or units) gives a supplementary overhead and is used to carry out adjustment between overhead absorbed and overhead incurred. It is used in addition to some other rates.

Advantages:

• It facilitates absorption of actual overhead incurred for production.
• Actual overhead rates produce erroneous results necessitating use of supplementary overhead rates.
• Where normal overhead rates are in operation, supplementary overhead rate gives good additional cost information of comparison.

Disadvantages:

• These rates can be determined only after the end of the accounting period.
• Use of supplementary rates requires a lot of clerical labor and cost.
• Where normal rates are used application of supplementary rate defeats the basic concept of normal cost.

Normal overhead rate

This overhead rate is based on the concept that actual cost is not necessarily the best criterion of true cost. Proper overhead will be charged to production, when overhead rate is linked with normal capacity i.e., normal overhead rate is a pre-determined rate determined with reference to normal capacity.

Blanket overhead rate

This is known as plant-wise or the single overhead rate for the entire factory.

Disadvantages:

• It invites too much of averaging
• A single overhead rate for the whole factory ignores the differences among production departments

Advantages:

• It is easy and convenient to use for making quick estimates.
• It is most useful in companies producing a main product in continuous processes, e.g., chemical plant, glass factory etc.
• Blanket rate may be used where several products are made, provided:
  • All products pass through all departments,
  • All products utilize the same amount of time in each department and
  • The ratio of one product to another product remains constant.

Multiple overhead rates

If the blanket rate is not found satisfactory, a company uses multiple overhead rates in which the overhead rate is sub-divided into two or more parts for accurate product costing. Sub-division of overhead may be done on any one or more of the following lines:

• Separate rate for each production department.
• Separate rate for each service department.

Overhead rates for service departments are used when secondary distribution is not done, i.e., costs of service departments are not allocated or apportioned to production departments.

• Separate rate for each cost center
These rates are useful in making a comparative study of cost behavior of different
cost centers.

• Separate rate for fixed and variable overhead

• Separate overhead rate for each product line.

• Separate rates for applying the material-related part, the labor-related part and the facility-related part of overhead cost.

Capacity and overhead rate

Maximum plant capacity – the ideal capacity for which plant is designed to operate. It is a theoretical capacity and does not give allowance for waiting, delays and shut-down. For cost consideration, this capacity is not important.

Practical capacity – it is the maximum theoretical capacity with minor unavoidable interruptions like time lost for repairs, inefficiencies, breakdown, delay in delivery of raw materials and supplies, labor shortages and absence, Sundays, holidays, vacation, inventory taking etc. Normal unavoidable interruptions account for 15-25% of the maximum capacity.

Normal Capacity – idle capacity due to long-term sales trend only is reduced from practical capacity to get normal capacity. It is determined for the business as a whole. For normal capacity determination, prime considerations are physical capacity and average sales expectancy. It is important for budget preparation, standard cost calculation, overhead rate determination etc.

The Figure B2.9 given below clarifies the above basic capacity concept.

Capacity based on sales expectancy- The capacity based on sales expectancy may be fixed to be either above normal capacity or below normal capacity. It is always less than practical capacity (see Figure B2.10).

While normal capacity considers the long-term trend analysis of sales, which is based on sales of a cycle of years, the capacity based on sales expectancy is based on sales for the year only. It is influenced more by general economic conditions and forecast of industry than long term sales trends. The main advantages of determining overhead rate based on sales expectancy are:

• Overhead rate is linked with actual sales expectancy,
• Overhead costs are adequately spread over the production and
• Overhead rate determined for this purpose is very useful for making price fixation, etc

Idle capacity and excess capacity – the difference between practical capacity and normal capacity, i.e., the capacity based on long-term sales expectancy is the idle capacity. If actual capacity happens to be different from capacity based on sales expectancy, the idle capacity will be the difference between practical capacity and actual capacity. Idle capacity is that part of practical capacity which is not utilized due to factors like temporary lack of orders, bottlenecks and machine breakdown, etc and is different from excess capacity.

Excess capacity refers to that portion of practical capacity which is available, but no attempt made to for its utilization for strategic or other reasons. It is also results from imbalance or bottlenecks in certain departments. Overhead rate includes cost of idle capacity; excess capacity is excluded from overhead rate consideration.

Illustration 9:

Modern Electricals Ltd. manufactures motor engine parts at the rate of 2 units per hour. The factory normally operates 6 days a week on a single eight- hour shift. During the year it is closed on 16 working days due to holidays. Equipments are idle for 160 hours for cleaning, oiling, etc. Normal sales demand averages 3,000 units over a year a five-year period. The expected sales volume for the year 2003 was 2,800 units. Capacity actually utilized in 2003 turned out to be 1,400 units. The fixed cost is $ 110,376 per year. We have to calculate the idle capacity costs assuming that overhead rates are based on maximum capacity, practical capacity, normal capacity and expected actual capacity respectively.

Solution:

Statement showing idle capacity and machine hour rate for 2003

Statement showing the idle capacity costs

B2.5 Methods of absorption

Production Unit Method – Actual or predetermined overhead rate is calculated by dividing the overhead to be absorbed by the number of units produced or expected to be produced.

Advantage: It is very good for concerns having single product output.

Disadvantage: Not suitable for different products. It is neither time based nor time-related.

Percentage on Direct Wages – This percentage is determined by dividing the overhead to be absorbed by direct wages and multiplying the result by hundred.

Advantage: It is very simple and economical. Labor can be better basis than material for determining overhead.

Disadvantage: Ignores contribution made by other factors of production like machinery. It ignores time-related overheads such as taxes, insurance and depreciation. It is not related to the efficiency of a worker.

Percentage on Direct Material Cost – This percentage is computed by dividing the overhead to be absorbed by direct material cost incurred or expected to be incurred and multiplying the result by hundred.

Advantage: It is simple and easy to understand. This method is useful, when grades of materials and prices of materials do not widely fluctuate and material cost forms a major part of total cost.

Disadvantages: There exists no logical relationship between items of manufacture, overhead and material cost. It ignores the items of overhead linked with time factor, such as rent, etc. This percentage method is inequitable, when a part of the material passes all processes and a part of material passes only through some processes. If prices differ widely, the products made from materials with high prices will be charged with more than their share of overhead.

Percentage on Prime Cost – The percentage is computed by dividing the overhead to be absorbed by prime cost incurred or expected to be incurred and multiplying the result by hundred.

Advantages: Simple and easy to use, since all the data is available and no additional information is required. It is useful in those cases, where there are no wide fluctuations in processing.

Disadvantages: No logical relationship between items of overhead and prime cost. It ignores the items of overhead linked with time factor. The use of prime cost for determining the overhead rate further confuses overhead absorption.

Direct Labor Hour Method – When this method is used, actual pre-determined overhead rate is determined by dividing the overhead to be absorbed by labor hours expended or expected to be expended. It is a time based method of overhead absorption and is sometimes preferred to the direct wage method.

Advantages: It is very useful for labor intensive situations and not affected by output related remuneration schemes.

Disadvantages: This method ignores other factors of production like machines and will not be a good method of overhead absorption where machines represent the prime production factor. It requires collection of additional data, (hours worked) translating into extra clerical labor and cost.

Machine Hour Rate – When this method is used, actual or predetermined overhead rate is calculated by dividing overhead to be absorbed by the number of hours for which a machine or machines are operated or expected to operate. It is used when production is machine based and recognized as the most reliable method of overhead absorption.

The machine hour rate is of three types:

Ordinary Machine Hour Rate – It is calculated by taking into account all the indirect expenses which are directly attributable to the machine. Expenses fall into two categories.

• Proportionate to the running time of the machine i.e., power, fuel, repairs and maintenance and depreciation, known as machine expenses.
• Not having any relation to operating time i.e. insurance, taxes, lubricants etc.

Composite Machine Hour Rate –This rate takes into account not only the expenses directly connected with the machine as mentioned earlier, but also other expenses like supervision, rent, lighting, heating, etc. These indirect expenses are known as standing charges. Hence standing charges plus ordinary machine hour rate gives the composite machine hour rate.

Group Machine Hour Rate – It is determined for a cost center which comprises a specific machine or a group of machines. This method is applicable where identical machines are grouped as a machine center such as a turning shop, milling shop, drilling shop, welding shop, etc. All direct expenses are allocated to the cost center and all indirect expenses are apportioned to each group of machines on an appropriate basis.

Illustration 9:

We have to find out the machine hour rate for the month of Jan, 2003, to cover overhead expenses given below (relating to a machine).

Per annum

It is assumed that the machine will run for 1800 hrs. per annum and that it will incur $1,125 for repair and maintenance for life. It is also considered that the machine requires 5 units of power per hour available at 6 cents per unit and that its life will be of 10 years.

Solution:

Sales Price Method – In this method, actual overhead rate or predetermined overhead rate is determined by dividing the overhead to be absorbed by the sales realized or expected to realize. The sale price method is considered very useful for absorption of administration overhead and selling and distribution overhead.

Under or over absorption of overheads – When pre-determined overhead rate is used there happens to be a difference between the overhead absorbed and the overhead incurred during the period under consideration. If the overhead absorbed is less than the overhead incurred, the excess incurred is termed as unabsorbed overhead. If overhead absorbed or overhead charged is more than the overhead incurred during the period, the excess absorbed over incurred is termed as over-absorbed overhead.

The following methods are often used to disposing under-over/absorbed overheads.

• Adjustment to cost of sales
• Write off to profit and loss account
• Adjustment to gross profit
• Use of reserve account
• Adjustment of cost of sales and inventories

B2.6 Case studies

I. P Ltd. manufactures four brands of toys A, B, C, and D. If the company limits the manufacture to just one brand the monthly production will be:

A – 50,000 units, B – 1, 00,000 units, C – 1, 50,000 units, D – 3, 00,000 units.

We have the following set of information from which we have to find out the brand wise profit or loss clearly showing the following elements:

• Direction Cost,
• Works Cost,
• Total Cost.

Factory overhead expenditure for the month was $162,000. Selling and distribution cost should be assumed @ 20% of works cost. Factory overhead expenses should be allocated to each brand on the basis of units which could have been produced in a month when single brand production was in operation.

II. A factory has three production departments (two machine shops and one assembly) and three service departments, one of which (engineering service department), only serves the machine shops.

We have to;

• Prepare on overhead analysis sheet, showing the bases of any apportionment of overhead to departments;
• Calculate suitable overhead absorption rates for the production department, ignoring the apportionment of service department costs amongst service department.
• Calculate the overhead to be absorbed by two products, X and Y, whose cost sheet shows the following times spent in different departments.

Note:

• Because of special fire risks, machine shop A is responsible for a special loading of insurance on the building. This results in a total building insurance cost for machine shop A as one third of the annual premium.
• The general services department is located in a building owned by the company. It is valued at $6,000 and is charged into costs at a notional value of 8% per annum. The cost is additional to the rent and rates shown above.
• The value of issues of material to the production departments are in the same proportion as shown above for consumable supplies.

The following data is also available:

III. Ganesh Enterprises undertakes three different jobs A, B and C. All of them require the use of a special machine and also the use of a computer. The computer is hired and the hire charges work out to $420,000 per annum. The expenses regarding the machine are estimated as follows;
Rent for the quarter $ 17,500
Depreciation per annum $ 200,000
Indirect charges per annum $ 150,000

During the first month of operation, the following details were taken from the job register:
Number of hours the machine was used: A B C
i) Without the use of Computer 600 900 –
ii) With the use of the computer 400 600 1,000

Here, we have to compute the machine hour rate:-

• For the firm as a whole for the month when the computer was used and when the computer was not used.
• For the individual jobs A, B and C.

B3.1 Time rate system

Under this system, the unit of measurement is ‘time’. This system disregards the ‘output’ of a worker. The wage rate of a worker may be determined in hourly, daily, weekly or monthly basis.

The time rate system is useful in the following circumstances:

• Units of output are not distinguishable and measurable
• Employees have little control over the quantity of output or there is no clear-cut relationship between effort and output
• Work delays are frequent and beyond the control of employees
• Quality of work is especially important

Earnings = Hours worked × Rate per hour

B3.2 Piece-rate schemes

Wage payments are made according to the quantity or volume produced, i.e., the payment is made by piece or time spent in completing a piece or a ‘unit’. Piece-rate systems are very useful in the following circumstances.

• Units of output are measurable
• A clear relationship exists between employee effort and quantity of output
• Standardized job, fewer break down and regular work

Different piece rate schemes are discussed mentioned here:

B3.2.4 Gantt task and bonus system

In this method labor cost is high for low production. It is specially recommended for application in heavy engineering and structural workshop, machine tool manufacturing industries, contract costing etc.

Illustration 11:

The performance of workers A, B and C in a factory in as follows:

Standard production per day of 8 hours work is 10 units, day wage guaranteed $ 2 per hour, and bonus rate is 20%. We have to calculate wages of A, B and C under the Gantt Task Bonus Plan.

Solution:

Time allowed for 15 units should be taken as 12 hours.

B3.2.5 Emerson’s efficiency system

Earning is calculated as follows:

B3.2.6 The Bedaux system

In this system, the standard time for a job is determined by time and motion studies. Allowed time for a job is stated in ‘points’. Under this system, a worker receives an hourly or a daily rate plus a bonus of 75% of the number of points saved multiplied by one-sixth of the hourly rate.

Earnings = Hours worked × Rate per hour + (0.75 × Rate per hour × Bedaux point saved/60).

Premium bonus plan guarantees the worker a minimum wage per hour but pays a premium for production in excess of the stipulated wages. Following schemes are under the Premium Bonus Plan:

Halsey plan
Earnings = Hours worked × Rate per hour + (Time saved × Rate per hour × 50/100).

Halsey-weir plan
Earnings = Hours worked × Rate per hour + (Time saved × Rate per hour × 33.33/100).

Rowan system
Earnings = Hours worked × Rate per hour + (Rate per hour × Hours worked × Time saved/ Time allowed).

Barth sharing plan
Earnings = Rate per hour × (Standard hours × Hours worked) ^½

Scanlon plan
Earnings = Avg. annual salaries & wages × 100/Avg. annual salaries revenue.

Illustration 12:

Two employees, Mr. V and Mr. S, produce the same product using the same material and their normal wage rate is also the same. Mr. V is paid bonus according to the Rowan system, Mr. S is paid bonus according to the Hasley system. The time allowed to make the product is 100 hrs. Mr.V takes 60 hrs. while Mr.S takes 80 hrs. to complete the product. The factory overhead rate is $10 per man-hour actually worked. The factory cost for the product for Mr. V is $7,280 and Mr.S is $7,600.

We have to:

• Calculate the normal rate of wages
• Find the cost of materials
• Prepare a statement comparing the factory cost of products as made by the two employees

Solution:

Let x be the cost of material and y be the normal rate of wages per hour.
Factory cost of Mr. V.
Material cost = $x
Wages = 60y

Bonus under Rowan System,
= Hours worked × Rate per hour + (Rate per hour × Hours worked × Time saved/Time allowed).
= (y × 60 × 40/100) = 24y.

Overhead, 60 × 10 = 600
i.e., x + 84y = 7,280 – 600,
or, x + 84y = $6,680………………(I)

Factory cost of Mr. S.
Material cost = $x
Wages = 80 y

Bonus under Halsey System,
= Hrs. saved × Rate per hour × 50/100.
= 20 × ½ y = 10y.

Overhead, 80 × 10 = 800
i.e., x + 90y = 7,600 – 800,
or, x + 90y = $ 6,800………………(II)

From (I) & (II),
a) y = 20, i.e., Rate per hour = $ 20. (Normal wages)
b) Bonus paid to Mr. V = 24 × 20 = $480.
c) Bonus paid to Mr. S = 10 × 20 = $200.
d) The cost of material, x = 6680 – 84y = $ 5,000.

Comparative statement of the factory cost of the product made by two employees;

B3.3 Labor cost distribution

B3.4 Case study

I. Garden Bore Ltd. manufactures various types of garden hose and operates a method of remuneration based on differential piece work. The output for each employee is expressed in standard units using the following conversion factors:

The differential piece work rates are as follows:

In addition an overtime premium is paid based on ‘time and one half’ with a basic week of 36 hours. The total minutes earned from the differential scheme are paid for at the time rate of $ 2.50 per hour. If piecework earnings are less than hours worked at e time rate then time earnings are paid. The following data relates to week 10:

We have to calculate the gross earnings for week 10 for each employee and also state why management and employees consider this remuneration method acceptable.

B4.1 Job costing

Job Costing helps to prepare estimates, monitor and control costs, compile bills, and measure the profitability of projects. It refers to the cost procedure or the system of cost accumulation that ascertains the costs of individual job or work order separately. A job represents the unit of costing. Job costing is used when products are dissimilar and non-repetitive in nature. A job may mean one unit of product or many units of identical/similar products covered by a single production order.

B4.2 Routines under job costing

• Estimation: The production planning department or engineering department along with the cost accounting departments prepares the cost estimates that are based on bids prepared for prospective customers.
• Review of customer’s order by production planning department: The production planning department or engineering department analyzes the customer’s order. Based on its review and analysis, this department determines the material contents for the order and decides the schedule of the work to be done. For every review of a customer’s order, a production order is issued and each order is assigned a number called the job order number.
• Production order: A production order represents instructions to shop personnel to do work. It includes detailed instructions and drawings. A copy of it is sent to the accounting department (see Figure B4.1).

• Job order number: The production planning department assigns each production order a number, which is called job order number.
• Job Cost Card: The job sheet is designed to collect cost of materials, labor and factory overhead applicable to a specific job and is the most important document in job costing system (see Figure B4.2).

When a job is completed, the cost is totaled on the job cost sheet and is used as the basis for transferring the cost of a particular job order from work-in-process account to the finished goods account or the cost of sales account.

B4.2.1 Job costing module

Job Costing module tracks all costs related to a specific job or project. The Job Costing module provides management the information they need to quickly identify project costs which are out of line with budget estimates and requirements. Its flexible design makes it ideal for virtually any business that operates on a job or project basis. The Job Costing module breaks down jobs into as many phases and categories as required.

It supports unlimited cost types that can be grouped into six different classifications: labor, material, equipment, subcontractor, overhead, and miscellaneous. Each job can have an unlimited number of tasks or activities related to it. The job costing module retains original estimates to help budget more accurately, computes the percentage completed on each job, phase, and category to give up-to-the-minute job status.

Functions:

• Calculates billable amounts using either the percentage markup of cost or the unit price
• Allocates overhead on a per job basis, based on labor hours, labor dollars, material dollars or total job cost; can also record overhead directly to a phase
• Allocates employee benefits on a per-job basis, either as a percentage of labor dollars or as a flat rate per labor hour
• Uses job-related labor hours and costs, from Payroll or daily timecard or timesheet entries
• Saves job configurations as templates to simplify bidding and budgeting on subsequent jobs.

The Job Costing module monitors current jobs with budgeted and actual labor, material, and overhead rates which can be used in structuring new projects.

• It provides comparative information for appropriate pricing.
• The system allows interactive entry, editing, and posting. The work-in-process account is updated as costs are accumulated. Costs and inventory status are thereby reflected in the financial statements.

Reporting: The Job Costing module creates a variety of reports including a list of all or selected jobs, work-in-process journal, cost and budgetary reports etc. Presents key information by selected job, phase and category. Maintains detailed records on each job or periodically balances forward jobs selectively for summary records. Provides job information instantly with extensive on-screen inquiry functions.

Illustration 13:

Agrofed Ltd. receives an order to supply cattle feed to the farmers. The job passes through three departments, collecting costs as follows:

The job does not disrupt normal activity levels, which are as follows:

Basis of absorption:	Mixing – Labor hours
	Boiling – machine hours
	Cooling – Labor hours

Selling and administrative expenses are 30% of factory cost.
We have to find out the profit/loss on this job, if the price agreed is $ 2,500.

Solution:

*Overhead:	Mixing $ 1,600/200 = $8 per hour
	Boiling $ 9,100/700 = $13 per hour
	Cooling $ 4,950/550 = $9 per labor hour.

Batch Costing: Batch costing is essentially a variation of job costing. Instead of a single job, a number of similar product units are processed or manufactured in a group as a batch. Batch costing is used in following situations:

• Customer’s orders a quantity of identical items
• Internal manufacturing order is raised for a batch of identical parts, sub-assemblies or products to replenish stocks
• Where it is vital that color, or shading or specific characteristics of goods sold to customer is uniform

Batch costing is generally followed in toy making, footwear, biscuit factories, radio and watch manufacturing factories where manufacture of product or components can be done more conveniently in batches of different numbers.

Economic batch size: The size of a batch chosen for a production tem is likely to be a critical factor in achieving a least-cost operation. The economic batch size may be determined by using the Economic Production Batch Size (similar to EOQ) (see Figure B4.3).

Illustration 14:

Asian Paints Company has an annual demand from a single customer for 50,000 liters of a paint product. The total demand can be made up of a range of colors and will be produced in a continuous production run after which a set-up of the machinery will be required to accommodate the color change. The output of each shade of color will be stored and then delivered to the customer as a single load immediately before producing the next color. The costs are $100 per set-up (outsourced). The holding costs are incurred on rented storage space which costs $50 per sq. meter per annum. Each square meter can hold 250 liters, suitably stacked.

We have to :

• Calculate the total cost per year where batches may range from 4,000 to 10,000 liters in multiples of 1,000 liters and the production batch size which will minimize total cost.
• Calculate the batch size using the economic batch size formula for lowest total cost.

Solution:

a)

Note: For a production batch size of 5,000 liters,
No. of set-up per year = 50,000/5,000 = 10

Therefore, annual set-up cost per year = 100 × 10 = $ 1,000.

Average quantity in stock = 5,000/2 = 2,500 liters.

It assumes a constant rate of production. At the start of a batch, stock is zero. At the end, stock equals to the batch size.

Hence on average, 50% of the batch is on stock at any point of time.
b) Economic Production Batch Size = (2 × C₂ × Q / C₁ × T) ^1/2
= (2 × 100 × 50,000/0.2 × 1) ^1/2
= 7,071 liters

It is slightly different from the closest batch size (7,000 liters). In practice it is quite likely that a batch size which approximates to the minimum cost conditions will be chosen where a convenient quantity is used (7,000 liters) rather that the somewhat artificial quantity of 7,071 liters.

B5.1 Features of process costing

• Costs accumulated by dept, or cost center
• Each dept has its own WIP A/C. – Debited: when costs incurred. Credited: when units complete/transferred to next dept
• Equivalent units (EU) are partially completed units restated in terms of completed units
• Unit costs determined by dept/cost center
• As units & costs leave each dept, the units & costs are carried over to the next dept; when units & costs leave the last dept, they can be used to determine the unit cost of finished goods
• If some units are spoiled in a process, the cost of the spoiled units is borne by units completed and closing stock of unfinished units at the end of the period
• Departmental cost of production reports/performance reports

Process costing is used in industries that produce basically homogenous products such as bricks, flour, and cement on a continuous basis.

There are some similarities between job-order and process costing systems:

• The same basic purpose exists in both systems in assigning material, labor, and overhead cost to products
• Both systems use the same basic manufacturing accounts: Manufacturing Overhead, Raw Materials, Work in Process, and Finished Goods
• The flow of costs through the manufacturing accounts is basically the same in both systems.

The differences between the job-order and process costing occur because the flow of units in a process costing system is more or less continuous and the units are essentially indistinguishable from one another. Under process costing:

• A single homogenous product is produced on a continuous basis over a long period of time. This differs from job-order costing in which many different products may be produced in a single period.
• Total costs are accumulated by the department, rather than by an individual job
• The department production report is the key document showing the accumulation and disposition of cost, (instead of the job-cost sheet)

The pattern of cost accumulations under process costing is illustrated through a flow chart in Figure B5.1.

B5.1.1 Basic steps for solution of problems in process Costing

Most process cost problems can be solved by a uniform approach involving the following steps:

Step No. 1 – Physical flow of production

It is to trace the physical flow of production. A statement is prepared showing input and output of the process in physical units.

It shows:

• Input in the form of opening inventory and fresh units
• Output in the form of:
  • – Completed Opening WIP during process
  • – Completed fresh units introduced
  • – Closing WIP

Step No. 2 – The inventory costing method to be followed

The effect of using LIFO method, FIFO method and average method will be different on the unit cost of the process.

Step No. 3 – The state of introducing the material in process

Material can be introduced in the beginning, in the middle or at the end of the process. The stage at which material is introduced will significantly affect the cost per unit of the process.

Step No. 4 – work done on unfinished units should be expressed in terms of

‘equivalent production’

In order to calculate the average cost per unit, the total number of units must be determined. Partially completed units pose a difficulty that is overcome using the concept of equivalent units. Equivalent units are the equivalent, in terms of completed units, of partially completed units. The formula for computing equivalent units is:
Equivalent units = (Number of partially completed units × Percentage completion)
Equivalent units are the number of complete, whole units one could obtain from the materials and effort contained in partially completed units.

A company which had no beginning inventory completed 100 units last month. In addition, the company worked on another 60 units that were 40% complete. In terms of totally completed units, the amount of effort expended was equivalent to the production of 124 units ([100 + 60] × 40%).

Step No. 5 – Determining element-wise details of total cost of process to be

accounted for

This can be done by preparing a statement of cost for each element.

The element-wise details of cost should be collected and they should be divided by the number of equivalent units at cost per unit for each element.

Step No. 6 – Apportionment of process cost

This a statement prepared showing apportionment of process cost is as follows:

• Cost of units introduced and completed
• Cost of abnormal loss/ gain
• Cost of closing work-in-process.

Determination of cost of process with no process loss
All material, labor, direct expenses and proportionate share of overhead is considered as the raw material cost of that process.

Process costing with normal loss
Certain production techniques are of such a nature that some loss is inherent to the production. If the loss is within the specified limit, it is referred to as normal loss. The cost of normal loss in process is absorbed as additional cost by good production in the process. If the loss forms a particular percentage of production in the process, then the following equation is to be followed.

Production = (Opening Stock + units transferred in process – Closing Stock)

If the scrap fetches some value then the process cost per unit of the process is determined as follows;

Cost per unit = (Cost transferred to the process + additional cost in the process – Scrap value of units representing normal loss)/ (Unit in process – units scrapped.)

Process costing with abnormal loss

Abnormal loss refers to the loss which is not inherent to manufacturing operations. All cost relating to abnormal loss is debited to abnormal loss account and credited to process cost account so that the cost, (which could have been avoided according to norms of operations), is kept separately to facilitate control action to be taken. The following steps are suggested for valuation of abnormal loss in the process:

• Determine the normal production presuming no abnormal loss.
• Determine the total accumulated cost relating to the process, i.e., (Cost transferred to the process + additional cost in the process – Scrap value of units representing normal loss).
• Determine the cost per unit of normal production by dividing the result of step-b by result of step-a.
• Rate arrived at by step-c should be applied for valuation of both unit representing abnormal loss and output of the process.

Illustration 15:

2000 units are transferred to process B @ $4 per unit. Other cost details relating to this process are as follows:

Material	$4,000
Labor	$1,000
Proportionate share of overhead for the process	$ 700

The normal loss has been estimated @ 10% of the process input. Units representing normal loss can be sold @ $1 per unit. Actual production in the process is 1700 units. We have to prepare process B account.

Notes:

• Normal loss is 10% of input, i.e. 2000 × 10/100 = 200 units
• If there had not been an abnormal loss, output of process b would have been 1800 units, i.e., Input – Normal loss
• Accumulated cost relating to the process
  = Cost transferred + Material + Labor + overhead – Scrap value relating to normal loss.
  = $ 8,000 + $ 4,000 + $ 1000 + $ 700 – $ 200 = $ 13,500.
• Cost per unit of normal production = $13,500/1,800 units = $ 7.50.
• Abnormal loss of 100 units is valued at $ 7.50.
• Output 1,700 units should be valued at $ 7.50.

Process costing with abnormal gain

A reverse situation, where actual production may happen to be more than what the norms of the company permit, i.e., actual output is 95 units from a process with 10% normal loss. These 5 units represent abnormal gain of that process. The value of units relating to abnormal gain is debited to process account and credited to abnormal gain account. The following steps are suggested for valuation of abnormal gain in the process:

• Determine the normal production presuming no abnormal gain
• Determine the total accumulated cost relating to the process, i.e., (Cost transferred to the process + additional cost in the process – Scrap value of units representing normal loss)
• Determine the cost per unit of normal production by dividing the result of step-b by result of step-a
• Rate arrived at by step-c should be applied for valuation of both unit representing abnormal gain and output of the process transferred to either next process or finished stock account.

B5.2 Case studies

I. A product is finished in three stages I, II & III. At the first stage a quantity of 72,000 kg was delivered at a cost of $2.50 per kg. The entire material was consumed. The production particulars with the allocated expenses were indicated in the table below.

The producer has assessed the cost at $6.77 per kg based on input expenditure and the finished output. Estimated profit is $36,500 with a selling price at $7.50 per kg. Normal wastage is to be considered as 5% for each stage and no excess wastage is to be allowed to inflate the cost of the end product.

B6.1 Activity-based costing system

In order to achieve the major goals of business process improvement, process simplification and improvement, it is essential to fully understand the cost, time, and quality of activities performed by employees or machines throughout an entire organization. ABC methods enable managers to cost out measurements to business simplification and process improvement (see Figure B6.1).

Activity Based Costing is a modeling technique where costs are expressed in terms of Resources, Activities, and Products. Work (activities) is performed to create products, and resources are consumed by the work.

B6.2 Basic elements of ABC

• Resources
• Activities
• Cost Objects
• Resource Drivers
• Activity Drivers (see Figure B6.2)

Reasons for the introduction of ABC

• Traditional costing is based on assumption: Relation between overhead and the volume based measure
• It often fails to highlight inter-relationship among activities in different departments
• Arbitrarily allocates overhead to the cost objects
• Total company’s overhead is allocated to the products based on volume based measure e.g. labor hours, machine hours
• Traditional costing which is based on averages and estimation
• To determine the ‘true’ cost for a cost object (product, job, service, or customer).

In any business the ‘true’ cost of a product is important

• To identify money makers/money losers
• To finding an economic break-even point
• To compare different options
• To discover opportunities for cost improvement
• To prepare and actualize a business plan
• To improve strategic decision making

Basics of activity based costing

• Identify the major activities such as material handling, mechanical insertion of parts, manual insertion of parts, wave soldering, quality testing etc
• Determine the ‘cost drivers’ for each activity. The cost driver is the underlying factor(s) which causes the incurrence of cost relating to that activity. Cost drivers link activities and resource-consumption and thereby generate less arbitrary costs for decision making
• Create cost pools to collect activity costs having the same cost driver
• Attribute the cost of activities in the cost pools to products/services based on the cost drivers

Illustration 16:

Figure B6.3

Two types of cost drivers–resource drivers and activity drivers (see Figure B6.3)

• Resource drivers assign resource costs to activities based upon consumption
• Activity drivers indicate consumption of activities by cost objects

Five activities that need to occur in order to determine activity costs

• Identify activities
• Determine cost for each activity
• Determine cost drivers
• Collect activity data
• Calculate product cost

Illustration 17:

Traditional costing
In a company two products: product A and product B

Total overhead: $ 100,000.00
Total direct labor: 2,000 hours
$ 100,000/2000 hours = $ 50 / hour
Product A: 1 hour of direct labor
Product B: 2 hours of direct labor

B6.3 Activity based costing

Step-1: Identify activities

Set-up
Machining
Receiving
Packing
Engineering

Step-2: Determine cost for each activity

Step-3: Determine cost drivers

Number of Setups
Machining Hours
Number of Receipts
Number of Deliveries
Engineering Hours

Step-4: Activity data

Step-5: Product cost calculation

Overhead for Product A: $24,500: 100 = $245
Overhead for Product B: $75,500: 950 = $79.47

Traditional costing (TC) vs. ABC

ABC example

ABC is a powerful tool for measuring business performance, determining the cost of business process outputs, and is used as a means of identifying opportunities to improve business process effectiveness and efficiency. Below is a process diagram with the sub-activities shown in a sequential activity order for Correspondence process, which comes under the Executive Secretariat in the Office of the Administrator. For the ABC, the sub-activities were then analyzed and a cost derived (see Figure B6.4).

Disadvantages of ABC

• It is essentially not the panacea for all ills
• It absorbs a lot of resources
• Too much emphasis on customer viability can lead to problems such as cheaper products and, therefore, potentially lower sales
• It may lead to weaker customer segmentation
• It takes no account of opportunity cost.

B7.1 Overview of journal entry trigger points

Trigger point = Point where journal entries are made that accumulate production costs related to the units.

1st variation: Two trigger points = Purchase of raw materials and finished goods completed (RIP and F/G accts- no w/p account).

2nd variation: Two trigger points = Purchase of raw materials and finished units sold (one inventory acct- no W/P or F/G accounts).

3rd variation: One trigger point = Finished goods completion (one F/G account-no RIP or W/P accounts).

B7.2 Difficulties of backflush costing

• It does not strictly adhere to generally accepted accounting principles of external reporting.
• Absence of audit trials.
• It does not identify the use of resources at each step of the production process.
• Backflush Costing is suitable only for JIT production system with virtually no direct material inventory and minimum WIP inventories.

B8.1 LCC calculation

The lifecycle cost of a project can be calculated using the formula:
LCC = C + M_pw + E _pw + R _pw – S _pw.

The pw subscript indicates the present worth of each factor. The capital cost (C) of a project includes the initial capital expense for equipment, the system design, engineering, and installation. This cost is always considered as a single payment occurring in the initial year of the project, regardless of how the project is financed.

Maintenance (M) is the sum of all yearly scheduled operation and maintenance (O&M) costs. Fuel or equipment replacement costs are not included. O&M costs include such items as an operator’s salary, inspections, insurance, property tax, and all scheduled maintenance.

The energy cost (E) of a system is the sum of the yearly fuel cost. Energy cost is calculated separately from operation and maintenance costs, so that differential fuel inflation rates may be used.

Replacement cost (R) is the sum of all repair and equipment replacement cost anticipated over the life of the system. The replacement of a battery is a good example of such a cost that may occur once or twice during the life of a PV system. Normally, these costs occur in specific years and the entire cost is included in those years.

The salvage value (S) of a system is its net worth in the final year of the lifecycle period. It is common practice to assign a salvage value of 20 percent of original cost for mechanical equipment that can be moved. This rate can be modified depending on other factors such as obsolescence and condition of equipment.

B8.2 Advantages of lifecycle costing

• It can provide important information for pricing decisions. This is essential in present day context because for some products, development period is relatively long and many costs are incurred prior and after manufacturing.
• It helps the manager develop insight and plan so that it is possible to generate revenue from the product.
• It broadens the perspective of managers because the complete lifecycle relating to a product is kept in view and for this reason the terms ‘cradle to grave’ and ‘womb to tomb’ are often used in the context of life-costing. It does not have a calendar based focus, but considers the whole life span of the product.
• Full costs associated with each product become relatively more visible. Manufacturing costs are highly visible in most accounting systems. However the costs associated with upstream areas (e.g. R & D) and downstream areas (e.g. customer service) are often less visible at a product-by-product level in the organization following traditional costing. Lifecycle costing finds solution to this problem.
• Lifecycle costing highlights inter-relationships across cost categories. Many companies, who cut R & D costs, later experience major increases in customer-service related costs in subsequent years. The products of these companies also fail to meet promised quality performance levels. A lifecycle revenue and costs statement highlights hidden areas, which get obscured in cost statements having a calendar based focus.
• It is immensely useful in capital budgeting decisions (i.e., long term decision making).It makes explicit the trade-off between higher capital costs and lower maintenance running costs.

B9.1 Process of marginal costing

Under marginal costing, the difference between sales and marginal cost of sales is found out. This difference is technically called contribution. Contribution provides for fixed cost and profit. Excess of contribution over fixed cost is profit or net margin. Emphasis remains on increasing total contribution.

B9.2 Break-even point

Break-even point is the point of sale at which a company makes neither profit nor loss. The marginal costing technique is based on the idea that difference of sales and variable cost of sales provides for a fund, which is referred to as contribution. At break-even point, the contribution is just enough to provide for fixed cost. If actual sales level is above break-even point, the company will make profit. If an actual sale is below break-even point the company will incur loss. When cost-volume-profit relationship is presented graphically, the point, at which total cost line and total sales line intersect each other will be the break-even point (see Figure B9.1).

B9.2.1 Basic marginal cost equation

We know that: Sales – Cost = Profit,
Or, Sales – Variable costs = Fixed costs + Profit
It is known as marginal equation and is expressed as follows:
S – V = F + P,

Profit/volume ratio

When the contribution from sales is expressed as a percentage of sales value, it is known as profit/volume ratio. Better P/V ratio is an index of sound ‘financial health’ of a company. It is expressed as:

P/V ratio	= (Sales – Marginal cost of sales)/Sales
	= Change in contribution/ change in sales
	= Change in profit/ change in sales.

Advantages of P/V ratio

• It helps in determining the break-even point
• It helps in determining profit at various sales levels
• It is to find out the sales volume to earn a desired quantum of profit
• It determines relative profitability of different products, processes and departments.

Improvement of P/V ratio

P/V ratio can be improved by improving the contribution. Contribution can be improved by any of the following steps:

• Increase in the sale price
• Reducing marginal cost by efficient utilization of men, materials and machines
• Concentrating on the sale of products with relatively better P/V ratio.

Illustration 18:

PRF & Co. produces a single article. Following cost data is given about its product:-

Selling price per unit	$ 20
Marginal Cost per unit	$ 12
Fixed cost per annum	$ 800

We have to calculate:

• P/V Ratio,
• Break-even sales,
• Sales to earn profit of $ 1,000
• Profit at sales of $ 6,000
• New break-even sales, if sales price is reduced by 10%.

Solution

Sales – Variable costs = Fixed costs + Profit
By multiplying and dividing left hand side by S,
S(S-V)/S = F + P,
Or, S X P/V Ratio = Contribution

• P/V Ratio = Contribution / Sales

                   = (20 – 12)/20 × 100 = 8/20 × 100 = 40%.

• Break-even sales,

  S X P/V Ratio = Fixed Cost

  (At break-even sales, contribution is equal to fixed cost)

  By putting the values: S × 40/100 = 800, S = $2,000 or 100 units.

• The sales to earn a profit of $ 1,000

  S × P/V Ratio = F + P,

  By putting the values:

  S × 40/100 = 800 + 1,000, S = $4,500 or 225 units.

• Profit at sales of $ 6,000,

  S × P/V Ratio = F + P,

  By putting the values:

  $6,000 × 40/100 = $800 + P,

  P = $ 1,600.

• New break-even sales, if sales price is reduced by 10%.

    New Sales Price = $20 – $2 = $18

    Marginal cost = $12

    Contribution = $6

    P/V Ratio = 6/18 × 100, or 33.33%

S × P/V ratio = F (at BEP contribution is equal to fixed cost)

S × 100/300 = $800,

S = $ 2,400.

Cost-volume-profit relationship

Profit is actually the result of interplay of different factors like cost, volume and selling price. The conventional income and expenditure statement does not provide any answer to the following basic questions:

• What should be the volume to be attempted for obtaining a desired profit?
• How will the change in selling price affect the profit position of the company?
• How will the change in cost affect profit?
• What should be the optimum mix of the company?

The answer to all these questions is provided by cost-volume-profit analysis.

Cost-volume-profit relationship

The result of analysis of Cost-Volume-Profit Relationship can be presented by the following statement.

Forecast of Cost-Volume-Profit Analysis at Different Activity Levels

Illustration 18:

ABC Ltd. is considering renting additional factory space to make two products, L-1 & L-2. Company’s monthly budget is as follows:

The fixed overheads in the budget can only be avoided if neither product is manufactured. Facilities are fully interchangeable between products.

As an alternative to the manual production process assumed in the budget, the company has the option of adopting a computer-aided process. This process would cut variable costs of production by 15% and increase fixed costs by $12,000 per month.

The management is confident about the cost forecasts, but there is considerable uncertainty over demand for the new products. The management believes the company will have to depart from its usual cash sales policy in order to sell L-2. An average of three months credit would be given and bad-debts and administration costs would probably amount to 4% of sales revenue for this product. Both the products will be sold at the price assumed in the budget. The company has a cost of capital of 2% per month. No stocks will be held.

We have to calculate:

• The sales revenue at which operations will break-even for each process (manual and computer-aided) and the sales revenues at which ABC Ltd. will be indifferent between the two processes.

   If L-1 alone is sold;
If L-1 & L-2 units are sold in the ratio 4:1, with L-2 being sold on credit

• We need to explain the implications of our results with regard to the financial viability of L-1 and L-2.

Solution:

Manual Production Computer Aided

* Finance cost = $50 × 0.02 × 3 months = $3.00

i) Only L-1 is sold
Manual process break-even point = 31,500 / 5 = 6,300 units
Or,                                                 = 6,300 × $ 20 = $126,000
Computer Aided break-even point =43,500 / 7.25 = 6,000 units
Or,                                                       = 6,000 × $ 20 = $ 120,000

The point of indifference here will be the point of sales at which contribution under the two alternatives is the same.
Suppose indifference point = n units
5n + 31,500 = 7.25n + 43,500
So, n = 5,333 units = 5,333 × $ 20 = $10,667.

Sales of L-1 and L-2 in the ratio of 4:1,
Manual Process:
Average contribution = {(4 × 5) + (1 × 14)}/5 = $6.80
Break-even point = $31,500/6.80 = 4632.35 units
Or, 4632.35 × $26^# = $ 120,441

Note:

• Break-even point (sales revenue) = Break-even point in unit × Average selling price per unit.
• Average sales revenue per unit = {(4 × 20) + (1 × 50)}/5 = $26^#

If L-1 alone is sold, budgeted sales are 4,000 units and break-even sales are 6,000 units (Computer aided process) and 6,300 units (Manual process).Therefore, there is little point producing L-1 on its own. Even if the two products are substitutes, total budgeted sales are 6,000 units and L-1 is still not worth selling on its own. Only if sales are limited to $180,000 (total budgeted sales revenue) L-1 will be worth selling on its own. However, the presumption that products are perfect substitutes and $180,000 sales can be generated is likely to be over-optimistic. In other words, a single-product policy is very risky. Launching both-products policy is a profitable alternative. It is better to sell L-2 in preference to L-1 based on margin of safety. It is 1375 units of L-1 (34%) and 688 units of L-2 (34%). It is recommended that both the products be sold and computer aided process be adapted.

B9.3 Case study

I. A person is planning to give up his job as an engineer, with a current salary of $1400 per month, and go into business on his own, assembling a component which he has invented. He can obtain the parts required from various manufactures. The sales potential of the component has been estimated by some research are as follows;

• Between 600 and 900 units per month if the price is $ 25 per unit
• Between 900 and 1,250 units per month if the price is $ 22 per unit.

The cost of parts required would be $14 per completed component. However, if more than 1,000 units can be sold each month, a discount of 5% would be received from the parts’ suppliers on all purchases. Assembly cost would be $6,000 per month for assembly of up to 750 components. Beyond this level of activity, costs would increase to $7,000 per month. He has already spent $3,000 on development, which he would write off over the first five years of the venture on a straight line basis.

Calculate for each of the possible sales levels whether that person could expect to benefit by going into business on his own. Also calculate the break-even point of the venture for each of the selling prices.

II. XYZ Inc. manufactures four products, namely A, B, C and D, using the same plant and process. The following information relates to a production period:

Factory overhead applicable to machine-oriented activity is $37,424.
Set-up costs are $4,355.
The cost of ordering material is $1,920 and material handling is $7,580.
Administration for spare parts $8,600.These overhead costs are absorbed by products on a machine hour rate of $4.8 per hour, giving an overhead cost per product of:

However, investigation into the production overhead activities for the period reveals the following total:

It is required

• To compute an overhead cost per product using activity based costing, tracing overheads to production units by means of cost drivers
• To comment briefly on the differences disclosed between overheads traced by the present system and those traced by activity based costing.

B10.1 What is cost estimation?

Cost estimating is one of the fundamental and yet most challenging tasks for contract and project managers. The Society of Cost Estimating and Analysis provides the following definition of cost estimating: ‘The art of approximating the probable cost or value of something based on information available at the time.’

Estimates of the costs associated with project /manufacturing tasks are made for many reasons. For example to:

• Justify planned capital expenditure
• Determine likely production costs, for new or modified products
• Focus attention on areas of high cost

In principal, estimates are made of the resources required (e.g. materials, labor and equipment), the cost of those resources and the time for which they will be used. From these factors an estimate of the costs of carrying out a manufacturing process is made.

B10.2 Cost estimating process

The cost estimating process can be viewed as a systematic approach consisting of the following steps:

• Plan the estimate
• Research, collect, and analyze data
• Develop estimate structure
• Determine estimating methodologies
• Compute the cost estimate
• Document and present the estimate to decision makers for use

The purpose of estimating

• Quoting, bidding, or evaluating bids
• Profitability analysis
• Basis for make versus buy decisions
• Investment justification
• Basis for comparing manufacturing methods
• Basis for cost reduction
• Planning new products and services;

B10.2.3 Develop estimate structure

An essential ingredient for any successful estimate is the work breakdown structure (WBS) since it provides the overall framework for the estimate. The estimator must decide at which level in the WBS to construct the estimate. This will affect the amount of detail in the estimate and have an impact on choice of estimating methodology. For instance, if the system being procured can be defined in great detail, there will be numerous levels in the WBS and estimating methodologies can be chosen at a low level of detail. Reviewing the work element levels should help put the estimate in perspective and the typical element levels are shown here

B10.2.4 Determine estimating methodologies

Estimating is a forecast of future costs based on a logical extrapolation of data currently available. Again, data availability is a key consideration in selecting the estimating methodology. In fact, the amount and quality of data available often dictate the estimating approach. Common estimating methodologies are identified and defined in Figure B10.1.

B10.2.6 Document the cost estimation

The requirement to develop the cost estimate document in a manner that allows an independent cost estimator to understand the methodology adequately to reconstruct the estimate in detail is the keystone to high quality cost estimate documentation.

Documentation content

The cost estimator should understand that every estimate will not be documented to this level of detail. Documentation must be tailored to align with the size and visibility of the program estimates. Consequently, when documenting smaller programs or projects, this tailoring provision would be employed to downscope the content structure provided below. Specifics of this downscoping would be dictated by the size and nature of the program or project involved. However, the requirement for enough detail to support replication must be sustained by the tailored documentation.

Introduction

This portion of the cost estimate document will provide the reader a thumbnail sketch of the program estimated, who estimated it, how it was estimated, and the data used in developing the estimate. The introduction is a highly valuable overview for managers and an extremely useful reference for estimators attempting to determine the applicability of the document’s main body to a current estimate or research study.

The introduction should address the following areas:

• Purpose of the Estimate – State why the estimate was done, whether it is an initial or updated prior estimate and, if an update, identify the prior estimate.
• Direction – Identify the requesting organization, briefly state the specific tasking, and cite relevant correspondence. Copies of tasking messages can be included here, in the main body, or as an appendix to the documentation package.
• Team Composition – Identify each team member, his or her organization, and area of responsibility.
• Program Background and System Description – Characterize significant program and system aspects and status in terms of work accomplished to date, current position, and work remaining. Include information such as detailed technical and programmatic descriptions, pictures of the system and major components, performance parameters, support concepts, contract types, acquisition strategies, and other information that will assist the document user in fully understanding the system estimated.
• Scope of the Estimate – Describe acquisition phases, appropriations, and time periods encompassed by the estimate. Further, if specific areas were not addressed by the estimate, state the reason.
• Program Schedule – Include the master schedule for development, production, and deployment, as well as a detailed delivery schedule.
• Ground Rules and Assumptions – List all technical and programmatic conditions that formed the basis for the estimate.
• Inflation Rates – Simply state which set of inflation rates were used for the basic estimate. A detailed table portraying the rates used can be included either in the main body or as an appendix to the documentation package.
• Estimate Summary – Identify the primary methodology and techniques that were employed to construct the estimate, along with a general statement that relates the rationale for having selected these particular methodologies and techniques. Also, briefly describe the actual cost data and its sources that were used to develop or verify the estimate. The final portion of this section should portray estimate results by major cost elements, in both constant year and current year dollars. A bottom-line track to the previous estimate also should be included, if applicable. For each major cost element, a page reference to the main body of the documentation where a complete description of its estimate can be located should be included.
• Main Body Overview – Provide an overview of how the document’s main body is organized and describe any of its aspects that may facilitate its use.

Main body

This portion of the documentation should describe the derivation of the cost estimate in sufficient detail to allow a cost estimator, independent of the original estimating team, to replicate the estimate. Developing this portion of the document properly requires that documentation be written in parallel with developing the estimate. The main body should be divided into sections using the content areas and titles shown below. Following these guidelines, pertaining to the document’s main body content structure, will allow the estimating team to develop a comprehensive document efficiently.

Estimate description

This provides a detailed description of the primary methods, techniques, and data used to generate each element of the estimate.

• Data – Show all data used, its source (e.g., actuals on current contract/analogous program), and normalization procedure.
• Labor Rates – Identify direct and indirect labor rates as industrial averages or contractor specific, their content, and how they were developed.
• Labor Hours – Discuss how functional labor hours were developed (e.g., contractor proposal, build-up from analogous program, engineering assessments).
• Material/Subcontracts – Depict the material, purchased parts, and subcontracted items that are required, and the development of their cost (e.g., vendor quotes, negotiated subcontracts, catalog prices).
• Cost Improvement Curves – Include the method used to describe the curve selected in terms of its slope, source, and relevance to the cost element and program being estimated. Any unique aspects of curve application must be included in this section.
• Factors and Cost Estimating Relationships (CERs) – Provide the basis, development, and/or source of all factors and CERs used for areas such as support equipment, data, training, etc. This discussion must include a description of how the factor was applied (e.g., against recurring manufacturing labor costs) and its relevance to the program being estimated.
• Cost Models – Describe all models used and their relevance to the estimate, along with complete details regarding parametric input and output (include detailed runs here or as an appendix to the documentation package) and any calibration performed to ensure the model served as an appropriate estimating tool for the cost element and program involved.
• Inflation Index – Document the specific indices and computations used in the estimate including those employed to normalize historical data. A detailed table portraying the rates used can be included either here or as an appendix to the documentation package.
• Timephasing – Identify/describe the approach used to phase the estimate.
• Sufficiency Reviews and Acceptance – Discuss the process used for reviewing an existing cost element estimate to determine its sufficiency and acceptability for incorporation into the estimate. This process should be applied to existing government and contractor estimates that are accepted as throughput to the estimate.
• Estimator Judgment – Document the logic and rationale that led to specific conclusions reached by the estimator regarding various aspects of the estimate.
• Risk and Confidence – Show the details of all risk analysis conducted and how it formed the basis for reaching conclusions regarding estimate confidence.

Documentation format

Documentation must be organized logically with clearly titled, easy to follow sections. The following considerations will contribute towards achieving high quality, useable cost estimate documentation:

• The documentation package should include the program name, reason for the estimate, the identity of both the tasking organization (and office symbol) as well as the organization that accomplished the estimate, and the ‘as of’ date.
• A table of contents should be included that identifies the titles of each numbered section and subsection along with page numbers.
• Pages should be numbered either sequentially or sequentially within each section.
• Where the same data or method is used repeatedly, it should be described in detail at the point of original use, and referenced by page number thereafter.
• All terms and acronyms should be defined fully at the point of first use.
• All figures and tables should be identified by numbers and clear descriptive titles.
• Cross-references should be used to assist the reader in understanding where areas addressing the same subject are located in the document.
• The first time documented information is used, its source should be cited and added to the reference list contained at the end of the documentation package. When the same source is used thereafter, only the reference number needs to be cited.

Documentation process

To carry out the documentation process effectively, the team leader should develop an outline. This estimate specific outline will provide a road map that depicts to the team the planned structure and content of the final documentation package. With this blueprint and the documentation requirements established in this chapter, the estimator can develop notes that will form the basis for the estimate’s documentation. If accomplished properly, the time to clean up and refine the estimator’s notes into final documentation form will be minimized.

A flow diagram (see Figure B10.2) of the documentation process is given below.

B11.1 Risk versus uncertainty

The terms risk and uncertainty are often used interchangeably. However, in the more strict definitions of statistics they have distinct meanings. Reviewing these definitions helps clarify the problem confronting the cost estimator.

The traditional view of risk is a situation, in which the outcome is subject to an uncontrollable random event stemming from a known probability distribution, e.g., drawing an ace of spades. Uncertainty is a situation in which the outcome is subject to an uncontrollable, random event stemming from an unknown probability distribution. The general conclusion is that cost estimating is much more in the realm of uncertainty than risk is.

Factors causing uncertainties

The following table provides a listing of John D. Hwang’s findings about the economic, technical, and program factors causing these uncertainties. Generally, these sources of uncertainty are categorized as requirements’ uncertainty and cost estimating uncertainty.

Requirements uncertainty refers to the variation in cost estimates caused by changes in the general configuration or nature of an end item. This would include deviations or changes to specifications, hardware characteristics, program schedule, operational/deployment concepts, and support concepts.

Cost estimating uncertainty refers to variations in cost estimates when the configuration of an end item remains constant. The source of this uncertainty results from errors in historical data, cost estimating relationships, input parameter specification, analogies, extrapolation, or differences among analysts.

Point estimates versus interval estimates

Development of a cost estimate usually involves the application of a variety of techniques to produce estimates of the individual elements of the item. The summation of these individual estimates becomes the singular, best and most likely estimate of the total system and is referred to as a point estimate. The point estimate provides no information about uncertainty other than the value judged more likely to occur compared to any other value. A confidence interval provides a range within which the actual cost should fall, given the confidence level specified.

Uncertainty in decision making

The point estimate provides a best single value, but with no consideration of uncertainty. In contrast, the interval estimate provides significant information about the uncertainty but little about the single value itself. However, when both measures are taken together, they provide valuable information to the decision maker.

An example of the value of this information is in situations involving choice among alternatives, as in the case of source selection. For instance, suppose systems A and B are being evaluated; and because of equal technical merit, the choice will be made on the basis of estimated cost. According to Paul Dieneman, in his report Estimating Cost Uncertainty Using Monte Carlo Techniques, if the choice is made solely on the basis of the most probable cost, the decision may be a poor one (depending upon which of the four situations in Figure B11.1 applies.)

In situation I, there is no problem in the choice, since all possible costs for A are lower than B. A’s most probable cost is the obvious choice.

Situation II is not quite so clear because there is some chance of A’s costs being higher than B’s. If this chance is low, A’s most probable cost is still the best choice. However, if the overlap is great, then the most probable cost is no longer a valid criterion.

In situation III, both estimates are the same, but the uncertainty ranges are different. At this point, it is the decision maker’s disposition towards risk that decides. If the preference is willingness to risk possible high cost for the chance of obtaining a low cost system, then B is the choice. If the preference is to minimize risk, then A is the appropriate choice.

Finally, situation IV poses a more complicated problem, since the most probable cost of B is lower but with much less certainty than A. If the manager uses only the point estimates in this case, the most probable choice would be the less desirable alternative. In the preceding situations, uncertainty information was a method used to select between alternatives. A quite different use of uncertainty information is when a point estimate must be adjusted for uncertainty.

One particularly effective method of portraying the uncertainty implications of alternative choices is to depict the estimate and its related uncertainty in the form of a cumulative probability distribution, as shown in Figure B11.2 below. The utility of this approach is the easy-to-understand, convenient manner in which the information is presented to the decision maker. In the figure, panel A shows the cost estimate as it might normally be depicted with the most likely value (point estimate at the center); panel B shows the same information in the form of a cumulative curve. It is easy to see, for instance, that the selection of the funding level, F, is at the 75 point, which means that there is only a 25 percent chance of actual cost exceeding this funding level. The manager can see the implications of a particular choice immediately.

Dealing with uncertainty

When actually treating uncertainty in an estimate, several approaches are available, ranging from very subjective judgment calls to rather complex statistical approaches. The order of presentation of these techniques is intentional, because it tends to portray the evolution that has taken place in terms of the tools used to handle uncertainty.

Subjective estimator judgment

This is perhaps one of the oldest methods of accounting for uncertainty and, is the basis for most other approaches. Under this approach the estimator merely reflects upon the assumptions and judgments that were made during the development of the estimate. After evaluating all the ‘ingredients,’ a final adjustment is made to the estimate, usually as a percentage increase. This yields a revised total cost, which explicitly recognizes the existence of uncertainty. The logic supporting this approach is that the estimator is more aware of the uncertainty in the estimate than anyone else, especially if the estimator is a veteran and has experience in systems or items similar to the one being estimated. One method for assisting estimators is to use a questionnaire, which provides a yardstick of their uncertainty beliefs when arriving at their judgment.

Expert judgment/executive jury

It is a technique wherein an independent jury of experts is gathered to review, understand, and discuss the system and its costs. The strengths of this approach are related directly to the diversity, experience, and availability of the group members. The use of such panels or juries requires careful planning, guidance, and control to ensure that the product of the group is objective and reflects the best, unmitigated efforts of each member. Approaches have been designed to contend with the group dynamics of such panels. One classical approach is the Delphi technique, which was originally suggested by RAND. With this technique, a panel of experts is drawn together to evaluate a particular subject and submit their answers anonymously. A composite feedback of all answers is communicated to each panelist, and a second round begins. This process may be repeated a number of times, and ideally, convergence toward a single best solution takes place. By keeping the identities anonymous rather than in a committee session, the panelists can change their minds more easily after each round and provide better assessments, rather than defending their initial evaluation.

The principle drawback of Delphi is that it is cumbersome, and the time elapsed in processing input may present some difficulty to respondents as to their reasons for the ratings. However, it is possible to automate the process with online computer terminals for automatic processing and immediate feedback.

Sensitivity analysis

Another common approach is to measure how sensitive the system cost is to variations in non-cost system parameters. For instance, if system weight is a critical issue, then weight would be varied over its relevant range, and the influence on cost could be observed. Analysis of this type helps to identify major sources of uncertainty.

It also highlights;

• Elements that are cost sensitive,
• Cost obstacles to achieve better program performance, and
• The up gradation possibilities of system performance without increasing program cost substantially.

It does not reveal the extent to which the estimated system cost might differ from the actual cost. It tends to address uncertainty of requirements more than cost uncertainty.

High/low analysis

It requires the estimator to specify the lowest and highest possible values for each system element cost, in addition to its most likely value. These sets of input values are then summed to total system cost estimates. The most likely values establish the central tendency of the system cost, while the sums of the lowest possible values and highest possible values determine the uncertainty range for the cost estimate. It exaggerates the uncertainty of system cost estimates because it is unlikely that all system element costs will be at the lowest (or highest) values at the same time. While the high/low approach is plausible, its shortcoming is that it restricts measurement to three points, without consideration to intermediate values.

Mathematical approaches

Beta and triangular distributions are required to determine the probability distribution for each cost element. Then the individual cost elements are combined and their measures of uncertainty into a total estimate of cost and uncertainty are done by summation of moments and Monte Carlo simulation.

The beta distribution

This distribution is particularly useful in describing cost risk because it is finite, continuous, can easily accommodate a unimodal shape requirement (α > 0, β > 0), and allows virtually any degree of kurtosis and skewness.

Kurtosis characterizes the relative peaks or flats of a distribution as compared to the normal distribution. Skewness characterizes the degree of asymmetry of a distribution around its mean. A few of the many shapes of the Beta are shown in Figure B11.3.

The Generalized Beta Family of Distributions is defined over an interval (a, a+b) as in Equation below.

In the case of skews,

• When α and β are equal the distribution is symmetric
• When α >β the distribution is negatively skewed
• When α <β the distribution is positively skewed.

Similarly, variance (kurtosis) can be categorized as high, medium, or low, based upon the magnitude of α and β. When these notions of skews and kurtosis are combined, the result is nine combinations as shown in the table below and is translated into the specific beta distributions as shown in the following Figure B11.4.

Triangular distribution

An alternative approach to assigning a distribution shape to a cost element is the triangular distribution and it can take on virtually any combination of skews and kurtosis, but the distribution represented by a triangle rather than the smoother curve of Beta, as shown in figure below. The triangular distribution is specified by the lowest, most likely (usually the point estimate), and the highest value. Any point within the range of the distribution can be chosen to locate the mode and the relationship among the three values specifies the amount of kurtosis. The triangular distribution is much easier to use and produces equally satisfactory results (see Figure B11.5).

The summation of moments

This method takes the approach of measuring or describing a distribution through the use of moment statistics. The first moment is the mean (x) and the second, third, and fourth moments (about the mean) take the form of an equation

The second moment is the variance. The third and fourth moments are used to calculate two measures that provide additional insight into the shape of a particular distribution.

Those measures are:

• The coefficient of skews, which provides a measure of symmetry
• The coefficient of kurtosis, which measures the peaks or height of a distribution (see B11.6).

The critical assumption in this approach is that, the total cost distribution will be normal even though the individual cost element distributions may not be normal. This is shown above.

Monte carlo simulation

An alternative to the summation approach is to use the Monte Carlo Simulation Technique. In this approach, the distribution defined for each cost element (using beta, triangular, or an empirical distribution) is treated as a population from which several random samples are drawn.

For example, a single cost element has been estimated and its uncertainty described as shown in A of Figure below From the probability density function, Y=f(X), a cumulative distribution is plotted, as shown in B of Figure B11.7 below.

Qualitative indices of uncertainty

The use of qualitative indices has been proposed as a method of communicating a cost estimate’s goodness, accuracy, or believability. Most of the indices are based upon the quality of the data and the quality of the estimating methodology.

John D. Hwang proposed the rating scheme using a two-digit code with ratings of l to 5 for data and for methodology.

• 1 – highest quality and
• 5 – representing lowest quality. Thus, a rating of 1, 1 would reflect that the estimate was the result of the highest quality level for both. The complete scoring system is shown in Figure B11.8 below.

B12.1 Parametric estimation

Parametric technology is the ‘best practice’ for estimating. Parametric tools bring speed, accuracy and flexibility to estimating processes, which are often bogged down in bureaucracy and unnecessary detail.

Parametric techniques are a credible cost estimating methodology that can provide accurate and supportable contractor estimates, lower cost proposal processes, and more cost-effective estimating systems.

The parametric method estimates costs based upon various characteristics and attributes of the system being estimated. It depends upon the existence of a casual relationship between system costs and these parameters. Such relationships, known as CERs, typically are estimated from historical data using statistical techniques. If such a relationship can be established, the CER will capture the relationship in mathematical terms relating cost as the dependent variable to one or more independent variables. Examples would be estimating costs as a function of such parameters as equipment weight, vehicle payload or maximum speed, number of units to be produced, or number of lines of software code to be written.

B12.1.1 Overview of parametric estimating

Parametric estimating is the process of estimating cost by using mathematical equations that relate cost to one or more physical or performance characteristics of the item being estimated. A simple example of a parametric estimate is the use of square footage to estimate building costs. Square footage is a physical characteristic of a building that has been shown through statistical analyses of building trends to be one way of estimating building costs. A graphical representation of the complete parametric cost estimating process is shown below. The figure indicates the process from inputs through modeling and into a post processor phase. The post processor allows for the conversion of parametric output into a cost proposal (see Figure B11.2).

B12.2 Collection and normalization of parametric data

The collecting point for cost and labor hours data is, called the general ledger or a company accounting system. All cost and labor hours data, used in parametric CER’s or cost models, must be consistent with and traceable back to the original collecting point (the source). The data should also be consistent with accounting procedures and cost accounting standards. Technical non cost data comes from engineering drawings, engineering specifications, certification documents, or direct experience (i.e., weighing an item). Schedule, quantity and equivalent units, and similar information comes from Industrial engineering, operations departments, program files or other program intelligence. Any data included in calculating parametric parameters will vary between model developers.

B12.2.2 Cost estimating relationships (CERs)

A CER predicts the cost of some part of a program or of the entire program based on specific design or program characteristics. A CER may be used to predict the cost of an entire project.

Definition: Cost Estimating Relationships (CERs) are mathematical expressions relating cost as the dependent variable to one or more independent cost driving variables.

Types of CERs

CERs can be divided into several classes depending on:

• The kind of costs to be estimated
• The cost drivers chosen to predict costs
• The complexity of the estimating relationship
• The aggregation level of the CER

The kind of costs to be estimated can be grouped into the three phases of a program’s life cycle:

• Research, engineering and development (RE&D)
• Production
• Operating and support (O&S).

CERs classified by type of cost driver

The type of cost driver also classifies CERs. Cost estimators have discovered a variety of quantitative cost drivers to apply to CERs. The most common variable for hardware remains weight.

CERs classified by aggregation level

CERs can be classified in terms of the aggregation level of the estimate. For instance, CERs can be developed for the whole system, major subsystems, other major non-hardware elements (training, data, etc.) and components. The aggregation level of the cost drivers, as shown in Figure B12.3, should match the aggregation level of the costs to be estimated.

Uses of CERs

CERs are used to estimate costs at many points in the acquisition cycle when little is known about the cost to be estimated. CERs are of greatest use in the early stages of a system’s development and can play a valuable role in estimating the cost of a design approach.

CERs can serve as checks for reasonableness on bids proposed by contractors. Even after the start of the development and production phases, CERs can be used to estimate the costs of non-hardware elements. For example, they can be used to make estimates of O&S costs. This may be especially important when trying to determine downstream costs of alternative design, performance, logistic, or support choices that must be made early in the development process.

Developing CERs

A CER is a mathematical equation that relates one variable such as cost (a dependent variable) to one or more other cost drivers (independent variables). The objective of constructing the equation is to use the independent variables about which information is available or can be obtained to predict the value of the dependent variable that is unknown. When developing a CER, the analyst must first hypothesize a logical estimating relationship. After developing a hypothetical relationship, the analyst needs to assemble a database.

Hypothesis testing of a logical CER

The analyst must structure the forecasting model and formulate the hypothesis to be tested. The work may take several forms depending upon forecasting needs. It involves discussions with engineers to identify potential cost driving variables, scrutiny of the technical and cost proposals, and identification of cost relationships. Only with an understanding of hardware requirements can an analyst attempt to hypothesize a forecasting model necessary to develop a CER.

The CER model

Once the database is developed and a hypothesis determined, the analyst is ready to mathematically model the CER – both linear and curvilinear, considering one simple model – the LSBF model.

When to use a CER

When a CER has been built from an assembled database based on a hypothesized logical statistical relationship, one is ready to apply the CER. It may be used to forecast future costs or it may be used as cross checks of an estimate done with another estimating technique. CERs are a fundamental estimating tool used by cost analysts.

Strengths and weaknesses of CER’S

Some of the more common ones are presented below:
Strengths

• One of the principle strengths of CERs is that they are quick and easy to use. Given a CER equation and the required input data, one can generally turn out an estimate quickly.
• A CER can be used with limited system information. Consequently, CERs are especially useful in the RDT&E phase of a program.
• A CER is an excellent (statistically sound) predictor if derived from a sound database, and can be relied upon to produce quality estimates.

Weaknesses

• CERs are sometimes too simplistic to forecast costs. Generally, if one has detailed information, the detail may be reliably used for estimates. If available, another estimating approach may be selected rather than a CER.
• Problems with the database may mean that a particular CER should not be used. A cost model should not be used without reviewing its source documentation.

Regression analysis

The purpose of regression analysis is to improve the ability to predict the next ‘real world’ occurrence of our dependent variable. Regression analysis may be defined as the mathematical nature of the association between two variables. The association is determined in the form of a mathematical equation. Such an equation provides the ability to predict one variable on the basis of the knowledge of the other variable. The variable whose value is to be predicted is called the dependent variable. The variable about which knowledge is available or can be obtained is called the independent variable. The dependent variable is dependent upon the value of independent variables. The relationships between variables may be linear or curvilinear. By linear, the functional relationship can be described graphically (on a common X-Y coordinate system) by a straight line and mathematically by the common form:

       y = a + bx

where y = (represents) the calculated value of y – the dependent variable
x = the independent variable
b = the slope of the line, the change in y divided by the corresponding change in x.
a and b are constants for any value of x and y.

For the bi-variate regression equation – the linear relationship of two variables can be described by an equation, which consists of two distinctive parts, the functional part and the random part. The equation for a bi-variate regression population is:

       Y = A + BX + E

where;
A + BX is the functional part (a straight line) and E is the random part.
A and B are parameters of the population that exactly describe the intercept and slope of the relationship.
E represents the ‘error’ part of the equation i.e., the errors of assigning values, the errors of measurement, and errors of observation due to human limitations, and the limitations associated with real world events.

The above equation is adjusted to the form:

y = a + bx + e,

where;
a + bx represents the functional part of the equation and e represents the random part.

Curve fitting

There are two standard methods of curve fitting. One method has the analyst plot the data and fit a smooth curve to the data. This is known as the graphical method. The other method uses formulas or a ‘best-fit’ approach where an appropriate theoretical curve is assumed and mathematical procedures are used to provide the one ‘best-fit’ curve; this is known as the Least squares best fit (LSBF) method.

We are going to work the simplest model to handle, the straight line, which is expressed as:

       Y = a + bx

Graphical method

To apply the graphical method, the data must first be plotted on a graph paper. No attempt should be made to make the smooth curve actually pass through the data points which have been plotted; rather, the curve should pass between the data points leaving approximately an equal number of points on either side of the line. For linear data, a clear ruler or other straightedge may be used to fit the curve. The objective in fitting the curve, i.e. to ‘best-fit’ the curve to the data points plotted; that is, each data point plotted is equally important and the curve you fit must consider each and every data point.

LSBF method

The LSBF method specifies the one line, which best fits the data set we are working with. The method does this by minimizing the sum of the squared deviations of the observed values of Y and calculated values of Y i.e., (Y₁ − Y_C1)² + (Y₂ − Y_C2)² + (Y₃ − Y_C3)² + … + (Y_n − Y_Cn)² (see Figure B12.4).

Therefore, the LSBF line is one that can be defined as:
ΣE² is a minimum because Σ (Y − Y_C)² = ΣE²

For a straight line,
Y = a + bx
and, with N points,

The sum of the squares of the distances is a minimum if,
ΣY = AN + BΣX and
ΣXY = AΣX + BΣX²

These two equations are called the normal equations of the LSBF line. LSBF regression properties are:

• The technique considers all points.
• The sum of the deviations between the line and observed points is zero.
• Now, the LSBF regression line intercepts the Y-axis at a distance ‘a’ and with a slope of ‘b’. A spreadsheet is used for the calculation.

Table Needed to Get Sums, Squares and Cross Products

X	Y	X×Y	X2	Y2
X1	Y1	X1 × Y1	X12	Y12
X2	Y2	X2 × Y2	X22	Y22
X3	Y3	X3 × Y3	X32	Y32
–	–	–	–	–
–	–	–	–	–
ΣXn	ΣYn	Σ(Xn × Yn)	ΣXn2	ΣYn2

X	Y	X Y	X2	Y2
4	10	40	16	100
11	24	264	121	576
3	8	24	9	64
9	12	108	81	144
7	9	63	49	81
2	3	6	4	9
36	66	505	280	974

where

Therefore, the regression equation (calculated y) is

Multiple regressions

In simple regression analysis, a single independent variable (X) is used to estimate the dependent variable (Y), and the relationship is assumed to be linear (a straight line). This is the most common form of regression analysis used in contract pricing. However, there are more complex versions of regression equations that can be used to consider the effects of more than one independent variable on Y. That is, multiple regression analysis assumes that the change in Y can be better explained by using more than one independent variable. For example, the number of miles driven may largely explain automobile gasoline consumption. However, it might be better explained if we also considered factors such as the weight of the automobile. In this case, the value of Y would be explained by two independent variables.

Yc = A + B₁X₁ + B₂X₂

where:
Yc = the calculated or estimated value for the dependent variable
A = the Y intercept, the value of Y when X = 0
X₁ = the first independent (explanatory) variable
B₁ = the slope of the line related to the change in X₁, the value by which change when X₁ changes by one
X₂ = the second independent variable
B₂ = the slope of the line related to the change in X₂, the value by which change when X₂ changes by one.

Curvilinear regression

In some cases, the relationship between the independent variable(s) may not be linear. Instead, a graph of the relationship on ordinary graph paper would depict a curve.

‘Goodness’ of fit, R and R²

After the development of the LSBF regression equations, now we need to determine how good a forecast we will get by using our equation. In order to answer this question, we must consider a check for the ‘goodness’ of fit, the coefficient of correlation (R) and the related coefficient of determination (R²).

Correlation analysis

One indicator of the ‘goodness’ of fit of a LSBF regression equation is correlation analysis. Correlation analysis considers how closely the observed points fall to the LSBF regression equation and more closely the observed values are to the regression equation, the better the fit; hence, the more confidence in the forecasting capability. Correlation analysis refers only to the ‘goodness’ of fit or how closely the observed values are to the regression equation but nothing about cause and effect.

Coefficient of determination

The coefficient of determination (R²) represents the proportion of variation in the dependent variable that has been explained or accounted for by the regression line. The value of the coefficient of determination may vary from zero to one. A coefficient of determination of zero indicates that none of the variation in Y is explained by the regression equation; whereas a coefficient of determination of one indicates that 100 percent of the variation of Y has been explained by the regression equation. Graphically, when R² is zero, the observed values appear as in Figure B12.7 (bottom) and when the R² is one, the observed values all fall right on the regression line as in Figure B12.8 (top).

In order to calculate R² we need to use the equation:

R² tells us the proportion of total variation that is explained by the regression line. Thus R² is a relative measure of the ‘goodness’ of fit of the observed data points to the regression line. If the regression line perfectly fits all the observed data points, then all residuals will be zero, which means that R² = 1.00. The lowest value of R² is 0, which means that none of the variation in Y is explained by the observed values of X.

Coefficient of correlation

The coefficient of correlation (R) measures both the strength and direction of the relationship between X and Y. R takes the same sign as the slope; if b is positive, use the positive root of R² and vice versa. For example, if R² = 0.81; then R = ±0.9 and we determine whether R takes the positive root (+) or the negative root (−) by noting the sign of b. If b is negative, then we use the negative root of R² to determine R. So to calculate R it is required to know the sign of the slope of the line. R only indicates the direct / an inverse relationship and the strength of the association.

Learning curve effect

Wright first observed the learning curve in the 1930s in the American aircraft industry, and Crawford confirmed his pioneering work in the 1940s. The learning effect is not concerned with reduction in unit cost as production increases and /or production facilities are scaled up to manufacture larger batches of products.

Learning effect

The learning effect is concerned with cumulative production over time-not the manufacture of a single product/batch at a particular moment in time-and recognizes that it takes less time to assemble a product, the more that product is made by the same worker, or group of workers. That is the learning effect.

Cost reduction tool

It is important to appreciate that the learning curve is not a cost-reduction technique since the learning curve model can predict the rate of future time reduction accurately. Cost reduction only occurs if management action is taken, for example, to increase the rate of time reduction by providing additional training, provision of better tools etc. The learning effect occurs because people are inventive, learn from earlier mistakes, and are generally keen to take less time to complete tasks, for a variety of reasons. It should also be noted that the learning process might be done consciously and/or intuitively. The learning curve consequently reflects human behavior.

Learning curve sectors

While the learning curve can be applied to many sectors, its impact is most pronounced in sectors, which have repetitive, complex operations where people principally determine the pace of work, not machines. Examples of sectors where the learning effect is pronounced include:

• Aerospace
• Electronics
• Shipbuilding
• Construction
• Defense

The learning curve is also being utilized by rail operators; for example, seek to extend cost-effectively the lives of their assets. Another sector, which makes considerable use of this technique, is the space industry. NASA uses the learning curve to estimate costs for the production of space shuttles, time to complete tasks in space etc.

Learning curve model

Wright observed that the cumulative average time per unit decreases by a fixed percentage each time cumulative production doubles over time. The following table illustrates this effect:

The above table indicates that the cumulative average time per unit falls by 10% each time cumulative production doubles, i.e. it is depicting a 90% learning curve. The above relationship between cumulative output and time can be represented by the following formula:

Basic form of the ‘learning curve’ equation is,
y = a.x^b or, Log y = Log a + b Log x

where,
y = Cost of Unit #x (or average for x units)
a = Cost of first unit
b = Learning curve coefficient

The equation Log y = Log a + b Log x is of precisely the same form as the linear equation y = a + bx. This means that the equation Log y = Log a + b Log x can be graphed as a straight line on log-log graph paper and all the regression formulae apply to this equation just as they do to equation y = a + bx. In order to derive a learning curve from cost data (units or lots) the regression equations need to be used whether or not the calculations are performed manually or using a statistical package and the learning curve equation is a special case of the LSBF technique.

Since in learning curve methodologies cost is assumed to decrease by a fixed amount each time quantity doubles, then this constant is called the learning curve ‘slope’ or percentage (i.e., 90%). For example,

For unit #1
Y₁ = A (1) ^b = A (First Unit Cost) and
For unit #2
Y² = A (2) ^b = Second Unit Cost

So,
Y₂/ Y₁ = A. (2) ^b / A = 2^b = a Constant, or ‘Slope’
Slope = 2^b, and, Log Slope = bLog2

Therefore, b = Log Slope/ Log2

For a 90% ‘Slope,’
b = Log.9/ Log 2 = −0.152

If we assume that A = 1.0, then the relative cost between any units can be computed.
Y₃ = (3)−^0.152 = 0.8462
Y₆ = (6)−^0.152 = 0.7616

Note that:
Y₆ /Y_{3 =} .7616 /.8462 = 0.9

Statistical package i.e., Stat View can perform all the calculations shown and greatly simplified using these tools.

Decision-making

While a great deal has been written about the use of the learning curve for control purposes, this technique can also be used to determine costs for potential contracts in sectors, which exhibit the learning effect. For example, Above & Beyond Ltd, which produces high-technology guidance systems, is preparing a tender for the Aurora project, the new generation of space shuttles. The guidance systems for the Aurora project will be very similar to those recently supplied by the company for the Dark Star project, experimental Stealth aircraft capable of flying outside the earth’s atmosphere. The company has been asked to submit a tender to install ten guidance systems for this project. While a tender would take account of all costs that would apply to a particular project, one of the key costs for a high-technology project is labor time, as highly skilled personnel (who are highly paid) are required to assemble and test such systems. The following analysis will focus on the labor time required for this project.

Aurora project

Above & Beyond Ltd’s engineers believe it is possible to estimate the time required to install the guidance systems for the new generation of space shuttles from the learning derived from the Dark Star project. The same system will be installed in the space shuttles. The following data was consequently obtained in respect of the Stealth project:

• Time to install first system: 12,000 hours
• Total installed: to date 9 systems
• Total cumulative time: 69,595 hours.

The first figure to be calculated is b, the index of learning, and this can be derived from the learning curve equation, Yx = ax b, since all the other figures are known.

It is now possible to estimate the time required to install the guidance systems for this project.

Please note that the learning curve would produce an estimate of 75,715 hours to install the guidance systems using a learning rate of 87% if no account was taken of the learning derived from Dark Star. This difference of 18,783 hours is extremely significant since the costs of hiring specialist engineers, and supporting these engineers, could be £100+ per hour, i.e. £1.8m+.

Limitations, errors and caveats of LSBF techniques

• Extrapolation
  A LSBF equation is truly valid only over the same range as the one from which the sample data was initially taken.
• Cause and Effect
  Regression and correlation analysis can in no way determine cause and effect.

Illustration of CER use

Assume an item of equipment in 1980 cost $28,000 when an appropriate Consumer Price Index (CPI) was 140. If the current index is now 190 and an offer to sell the equipment for $40,000 has been suggested, how much of the price increase is due to inflation? How much of the price increase is due to other factors?

Solution

$38,000 now is roughly the equivalent of $28,000 in 1980. Hence the price difference due to inflation is $38,000 − $28,000 = $10,000. The difference due to other causes is $2,000 ($40,000 − $38,000).

The above example would illustrate the use of CPI numbers for a material cost analysis. The steps were:

• If we know what the price of an item was in the past, and we know the index numbers for both that time period and today, we can then predict what the price of that item should be now based on inflation alone.
• If we have the same information as above, and we have a proposed price, we can compare that price to what it should be based on inflation alone. If the proposed price is higher or lower than we expect with inflation, then we must investigate further to determine why a price or cost is higher or lower.

Illustration:

A house to be purchased. Historical data for other houses purchased, may be examined during an analysis of proposed prices for a newly designed house. Table below shows data collected on five house plans so that we can determine a fair and reasonable price for a house of 2100 square feet and 2.5 baths.

House Model	Unit Cost	Baths	Sq. Feet Living Area	Sq. Feet Exterior Wall Surface
Burger	166,500	2.5	2,800	2,170
Metro	165,000	2.0	2,700	2,250
Suburban	168,000	3.0	2,860	2,190
Executive	160,000	2.0	2,440	1,990
Ambassador	157,000	2.0	1,600	1,400
New House	Unknown	2.5	2,600	2,100

Solution:

Using this data, we can demonstrate a procedure for developing a CER.

Step 1: Designation and definition of the dependent variable. In this case we will attempt to directly estimate the cost of a new house.

Step 2: Selection of item characteristics to be tested for estimating the dependent variable. A variety of home characteristics could be used to estimate cost. These include such characteristics as: square feet of living area, exterior wall surface area, number of baths, and others.

Step 3: Collection of data concerning the relationship between the dependent and independent variable.

Step 4: Building the relationship between the independent and dependent variables.

Step 5: Determining the relationship that best predicts the dependent variable.

Figure B12.8 graphically depicts the relationship between the number of baths in the house and the price of the house. The relationship may not be a good estimating tool, since three houses with a nearly $8,000 price difference (12 percent of the most expensive house) have the same number of baths.

Figure B12.9 graphically relates square feet of living area to price. In this graph, there appears to be a strong linear relationship between house price and living area.

Figure B12.10 graphically depicts the relationship between price and exterior wall surface area. Again, there appears to be a linear relationship between house price and this independent variable.

Based on this graphic analysis, it appears that square feet of living area and exterior wall surface have the most potential for development of a cost estimating relationship. We may now develop a ‘line-of-best-fit’ graphic relationship by drawing a line through the average of the x values and the average of the y values and minimizing the vertical distance between the data points and the line (Figure B12.11 and B12.12).

Viewing both these relationships, we might question whether the Ambassador model data should be included in developing our CER. However, we should not eliminate data just to get a better-looking relationship. Here, we find that the Ambassador’s size is substantially different from the other houses for which we have data and price estimation. This substantial difference in size might logically affect the relative construction cost. The trend relationship using the data for the four other houses would be substantially different than relationships using the Ambassador data. Based on this information, we may decide not to consider the Ambassador data in CER development.

If we eliminate the Ambassador data, we will find that the fit of a straight-line relationship of price to the exterior wall surface is improved.

If we have to choose one relationship, we would probably select the one shown in the table (square feet of living area) over the relationship involving exterior wall surface because there is so little variance shown about the trend line. If the analysis of these characteristics does not reveal a useful predictive relationship, we may consider combining two or more of the characteristics already discussed, or explore new characteristics. However, since the relationship between living area and price is so close, we may reasonably use it for our CER.

In documenting our findings, we can relate the process involved in selecting the living area for price estimation. We can use the graph developed as an estimating tool. The cost of the house could be calculated by using the same regression analysis formula discussed herein:

For square feet of living area:	Y = $117,750 + $17.50 (2600)
	Y = $117,750 + $45,500
	Y = $163,250 estimated price

Common CERS

A list of some common CERs used to predict prices or costs of certain items are given below. In addition to CERs used for estimating total cost and prices, others may be used to estimate and evaluate individual elements of cost. CERs are frequently used to estimate labor hours. Tooling costs may be related to production labor hours, or some other facet of production. Other direct costs may be directly related to the labor effort involved in a program.

A flow chart of the CER development process is shown in Figure B12.14.