The Expense Statement


The Expense Statement

The P&L expense statement is one of the three most important financial statements that the controller will provide to the project manager. The other two financial statements that are useful to project managers, as were discussed in Chapter 5, are the cash flow statement and the balance sheet. The project manager has little to say about the expense categories on the P&L; the controller usually defines the expense categories when the chart of accounts is put together. On the other hand, the project manager has nearly full freedom to create the work breakdown structure (WBS) and define the expense categories on the WBS. [1]

Although the WBS is traditionally thought of as the document that defines the scope, and all the scope, for the project, in fact it can also serve as an important financial document, connecting as it does to the chart of accounts. To employ the earned value methodology, we must have a complete WBS; to dollar-denominate the earned value reports and also allocate the budget to the WBS, we must understand the chart of accounts, or at least the chart of accounts as it is represented on the P&L statements. Since it is the P&L by which managers govern and are measured for success, the various tools must all correlate and reconcile.

Let us begin this chapter by discussing more thoroughly the nature of the expenses that will be on the P&L. We will look at how these expenses can be traced to the WBS, and then from the WBS back to the P&L.

Direct and Indirect, Fixed and Variable Expenses in Projects

We know from Chapter 5 that the P&L records the project expenses each month. The P&L does not necessarily indicate the cash flow, and not all expenses on the P&L are cash. Depreciation and various P&L accruals for taxes, compensation, and benefits are not cash. Expenses, like payments to a vendor, are "recognized" according to the business rules of your business. The expense recognition might be at a different time from when the credit is made to the accounts payable liability account (the usual expense "recognition trigger"), or different from the time the vendor check is mailed after the liability is created, and different yet from when the check clears the banking system and is credited to the checking account. Thus, timing may be an issue for the project manager as the project manager reconciles expenses between the controller reports and the project reports.

In larger companies, the expense recognition rules tend toward recognizing expenses as soon as the expense obligation is created. Actually paying the cash is not so important to the project per se. The company treasurer or chief financial officer usually sets policies for actually paying the cash to the vendor since there can be some financing income from the checking account "float."

The controller may choose to categorize expenses and show those categories on the expense statement. For instance, expenses that are for the express benefit of the project, and would not be incurred if not for the project, are usually called "direct expenses." Project travel is a good example of direct expenses.

However, many expenses of the company, such as executive and general management expenses, are present whether or not there is a project. The controller may make an allocation of these expenses to the project. Expenses such as these are called "indirect" or "overhead" expenses. Project managers can think of them as an internal "flat tax" on the direct expenses since the allocation is often made as a fixed percentage of the direct expenses.

Other expenses may simply be assigned to the project as a means to account for them on the company's overall P&L. For example, if a paint shop is needed by the project, and no other projects are using the paint shop, its expenses may be assigned to the project. If not for the project, perhaps the paint shop would be closed.

Expenses can also be categorized as fixed or variable. Fixed expenses are not subject to the volume of work being done. For instance, the project manager's compensation is usually a fixed expense each period. Fixed expenses are incurred each expense period regardless of the work being done. Fixed expenses are sometimes called "marching army" expenses because they are the cost of running the project even when there is little going on. Obviously, the cost of the "marching army" represents a significant risk to the project manager's plan to execute the project on budget. One strategy to mitigate "marching army" expense risk is to convert fixed expenses to variable expenses whenever possible.

Variable expenses track the workload: more work, more expense. For example, the number of painters in the paint shop may be variable according to workload. The risk associated with variable costs is the setup and teardown costs, even if the cost item is software system engineers rather than painters. If the same system engineers do not return to the project when needed, then the setup and training costs for new system engineers may be prohibitive. Thus, the project manager may elect to convert a variable category to a fixed category and bear the risk of the "marching army" of system engineers as a better bet than the recruiting of a variable workforce of system engineers.

Variable Expenses and Lean Thinking

Lean Thinking [2] is the name of a book by James Womack and Daniel Jones [3] and a concept of optimizing variable activity and expense. The essence of the concept is to create "flows" of activities leading to valuable deliverables. Minimizing batch cycles that cause interruption in the value stream and require high cost to initiate and terminate creates flows. Initiation and termination costs are "nonvalue add" in the sense that they do not contribute to the value of the deliverable. For example, if a project deliverable required painting, say the color red, should all red painting wait until all red painting requirements are ready to be satisfied in a red paint batch, or could a specific deliverable be painted red now and not be held up for others not ready to be painted?

What about sequential development? A familiar methodology is the so-called "waterfall" in which each successive step is completed before the next step is taken. The objective of the waterfall is to obviate scrap and rework if new requirements are discovered late. As an example, in the waterfall methodology all requirements are documented on one step of the waterfall before design begins on the next successive step. Each step is a "batch." Flow in the value stream is interrupted by stopping to evaluate whether or not each step is completed, but "marching army" variable costs are minimized: once the requirements staff is finished, they are no longer needed, so there is no subsequent nonvalue add to bringing them back on the project.

Lean thinking applied to project cost management has many potential benefits. If the cost to initiate the batch work could be made negligible, whether painting or developing, project managers would plan the project exclusively around the requirements for deliverables and not around the deliverables as influenced by the requirements of the process itself. Many fixed costs could be converted easily to variable expenses, nonvalue-add variable costs could be reduced, and the overall cost to the project would be less.

Standard Costs and Actual Costs

There is yet one more way to show costs on the expense statement: manage to standard costs rather than actual costs. Simply put, standard costs are average costs. The controller sets the period over which the average is made, determines any weighting that is to be applied in the averaging process, and selects the pool of participants in the average. Table 6-1 provides an illustration of how standard costs are applied to labor categories.

Table 6-1: Standard Costs Example

Labor Code

Labor Category

Standard Cost, $/hour

Actual Compensation, Range $/hour

1001

Programmer

$22.25

$20.10–$26.00

1002

Lead Programmer

$26.50

$24.90–$30.25

1003

Senior Programmer

$31.25

$27.00–$38.00

1004

Systems Programmer

$40.00

$33.50–$50.25

2001

Welder

$12.25

$10.10–$16.00

2002

Senior Welder

$16.50

$14.90–$20.25

2003

Welding Specialist 1

$21.25

$17.00–$28.00

2004

Welding Specialist 2

$30.00

$23.50–$40.25

In some businesses, the project is charged the standard cost for, for example, a welder or forklift operator rather than the actual cost. The controller's office manages the variance between the sum of the standard costs and the sum of the actual costs on the project. Sometimes this variance is charged to the project and sometimes it goes into the indirect cost pool and therefore is liquidated by charge back to projects in the overhead rate. Thus, the variance to standard cost could become a project expense over which the project manager has some control with other project managers if more than one project is contributing to the standard cost pool. However, even more problematic for the project manager, the standard cost variance could be passed to a customer if the customer has contracted for the project on a cost-reimbursable contract. Such arrangements are common in federal government contracting, especially in the defense sector. [4]

Cost Categories on the Profit and Loss Statement

Cost categories on the P&L can be interlaced in a hierarchy according to the view most advantageous to managers. Direct expenses could be divided into fixed and variable, or you could turn it around so that fixed expenses could be divided into direct and indirect. At the bottom line, the sum total is indifferent to the management's selection of the cost hierarchy.

[1]The exception to the project manager creating the WBS occurs when the project is on a contract for a customer who chooses to define the WBS. Typically, the customer will define the WBS down to the second or third level. To the customer, this WBS is the contractor WBS (CWBS). The contractor uses this CWBS, but extends it to lower levels to encompass the project detail of the implementing organization. Further explanation of this concept can be found in MIL-HDBK-881, Department of Defense Handbook Work Breakdown Structure, January 1998, Chapter 3.

[2]Womack, James P. and Jones, Daniel T., Lean Thinking, Simon & Schuster, New York, 1996, Introduction, pp. 15–28.

[3]James Womack and Daniel Jones are probably best known for their groundbreaking study of just-in-time quality manufacturing at Toyota that was documented in their famous book with co-author David Roos, The Machine That Changed the World.

[4]As an example of standard costs in reimbursable-cost-type contracts, consider the situation in which a customer contracts for a project and the proposal for the work is prepared by the project manager using standard costs. As named individuals are assigned by the project manager to do contracted work, the compensation of the named individuals may be more or less than the standard costs for their labor category. The variance to standard costs, either favorable or unfavorable, would be passed to the customer on a cost-reimbursable contract. On the other hand, if the contract is fixed price standard cost, then the variance to standard cost is absorbed by the project and is not passed to the customer.