Cost Control (Operating Cycle, Budgets & Allocations)

15/12/2021 0 By indiafreenotes

Cost control is the task of overseeing and managing project expenses and preparing for potential financial risks. This is typically the project manager’s responsibility. Cost control involves managing the budget, as well as planning, and preparing for potential risks. Risks can set projects back and sometimes even require unexpected expenses. Preparation for these setbacks can save your team time and potentially, money. Cost control is necessary to keep a record of monetary expenditure for purposes such as:

  • Minimising cost where possible;
  • Revealing areas of cost overspend.

Cost control information is fundamental to the lessons learned process, as it can provide a database of actual costs against activities and work packages that be used to inform future projects.

Cost Control Techniques

Following are some of the valuable and essential techniques used for efficient project cost control:

Planning the Project Budget

You would need to ideally make a budget at the beginning of the planning session with regard to the project at hand. It is this budget that you would have to help you for all payments that need to be made and costs that you will incur during the project life cycle. The making of this budget therefore entails a lot of research and critical thinking.

Like any other budget, you would always have to leave room for adjustments as the costs may not remain the same right through the period of the project. Adhering to the project budget at all times is key to the profit from project.

Keeping a Track of Costs

Keeping track of all actual costs is also equally important as any other technique. Here, it is best to prepare a budget that is time-based. This will help you keep track of the budget of a project in each of its phases. The actual costs will have to be tracked against the periodic targets that have been set out in the budget. These targets could be on a monthly or weekly basis or even yearly if the project will go on for long.

This is much easier to work with rather than having one complete budget for the entire period of the project. If any new work is required to be carried out, you would need to make estimations for this and see if it can be accommodated with the final amount in the budget. If not, you may have to work on necessary arrangements for ‘Change Requests’, where the client will pay for the new work or the changes.

Effective Time Management

Another effective technique would be effective time management. Although this technique does apply to various management areas, it is very important with regard to project cost control.

The reason for this is that the cost of your project could keep rising if you are unable to meet the project deadlines; the longer the project is dragged on for, the higher the costs incurred which effectively means that the budget will be exceeded.

The project manager would need to constantly remind his/her team of the important deadlines of the project in order to ensure that work is completed on time.

Project Change Control

Project change control is yet another vital technique. Change control systems are essential to take into account any potential changes that could occur during the course of the project.

This is due to the fact that each change to the scope of the project will have an impact on the deadlines of the deliverables, so the changes may increase project cost by increasing the effort needed for the project.

Use of Earned Value

Similarly, in order to identify the value of the work that has been carried out thus far, it is very helpful to use the accounting technique commonly known as ‘Earned Value’.

This is particularly helpful for large projects and will help you make any quick changes that are absolutely essential for the success of the project.

It is advisable to constantly review the budget as well as the trends and other financial information. Providing reports on project financials at regular intervals will also help keep track of the progress of the project.

This will ensure that overspending does not take place, as you would not want to find out when it is too late. The earlier the problem is found, the more easily and quickly it could be remedied.

All documents should also be provided at regular intervals to auditors, who would also be able to point out to you any potential cost risks.

Operating Cycle

An operating cycle refers to the time it takes a company to buy goods, sell them and receive cash from the sale of said goods. In other words, it’s how long it takes a company to turn its inventories into cash. The length of an operating cycle is dependent upon the industry. Understanding a company’s operating cycle can help determine its financial health by giving them an idea of whether or not they’ll be able to pay off any liabilities.

For example, if a business has a short operating cycle, this means they’ll be receiving payment at a steady rate. The faster the company generates cash, the more it’ll be able to pay off any outstanding debts or expand its business accordingly.

The flow of a cash operating cycle is as follows:

  • Obtaining raw material
  • Producing goods
  • Having finished goods
  • Having receivables from making a sale
  • Obtaining cash (receiving payment from customers)

Factors Impacting the Operating Cycle:

  • The payment terms extended to the company by its suppliers. Longer payment terms shorten the operating cycle, since the company can delay paying out cash.
  • The order fulfillment policy, since a higher assumed initial fulfillment rate increases the amount of inventory on hand, which increases the operating cycle.
  • The credit policy and related payment terms, since looser credit equates to a longer interval before customers pay, which extends the operating cycle.

Budgets

The budget for a project is the sum of costs of individual activities that the project must accomplish.

Budgeting is important in the development of any major business project. Without a well-planned budget, projects can scatter and be left incomplete. Budgeting is not an easy process. It provides a number of different advantages that a project manager should consider.

Establishing Guidelines: Project budget allows you to establish the main objectives of a project. Without proper budgeting, a project may not be completed on time. It allows the project manager to know how much he can spend on any given aspect of the project.

Cost Estimating: Once a budget is in place, the project manager can determine how much money can be spent on each component of the project. Hence it also determines what percentage of the available funds can be allocated to the remaining elements of the project. It gives the chance to decide whether or not the project can be completed in the available budget.

Prioritizing: Another advantage of having a project budget is that it helps you to prioritize the different tasks of the project. Sometimes it might seem to be completed at once, but it doesn’t happen due to some inefficiency. A budget will allow you to prioritize which parts of the project can be completed first.

Allocations

Cost allocation is the distribution of one cost across multiple entities, business units, or cost centers. An example is when health insurance premiums are paid by the main corporate office but allocated to different branches or departments.

When cost allocations are carried out, a basis for the allocation must be established, such as the headcount in each branch or department.

Cost Allocation Methods

The very term “allocation” implies that there is no overly precise method available for charging a cost to a cost object, so the allocating entity is using an approximate method for doing so. Thus, you may continue to refine the basis upon which you allocate costs, using such allocation bases as square footage, headcount, cost of assets employed, or (as in the example) electricity usage. The goal of whichever cost allocation method you use is to either spread the cost in the fairest way possible, or to do so in a way that impacts the behavior patterns of the cost objects. Thus, an allocation method based on headcount might drive department managers to reduce their headcount or to outsource functions to third parties.

Cost Allocation and Taxes

A company may allocate costs to its various divisions with the intent of charging extra expenses to those divisions located in high-tax areas, which minimizes the amount of reportable taxable income for those divisions. In such cases, an entity usually employs expert legal counsel to ensure that it is complying with local government regulations for cost allocation.

Reasons Not to Allocate Costs

An entirely justifiable reason for not allocating costs is that no cost should be charged that the recipient has no control over. Thus, in the African Bongo Corporation example above, the company could forbear from allocating the cost of its power station, on the grounds that none of the six operating departments have any control over the power station. In such a situation, the entity simply includes the unallocated cost in the company’s entire cost of doing business. Any profit generated by the departments contributes toward paying for the unallocated cost.

Process for Performing Cost Allocations

Using a basis for allocation, costs are spread to each business unit or cost center that incurred the cost based on their proportional share of the cost. For example, if headcount forms the basis of allocation for insurance costs, and there are 1000 total employees, then a department with 100 employees would be allocated 10% of the insurance costs.

While there are numerous ways cost allocations can be calculated, it is important to ensure the reasoning behind them is documented. This is often done by establishing allocation formulas or tables.

Once the calculation is established and cost distributions are calculated, journal entries are created to transfer costs from the providing or paying entity to the appropriate consuming entities. During each financial period, as periodic expenses are incurred, this calculation is repeated and allocating entries are made.