cash flow analysis

When Contractors work on a project they typically pay their workers as the work is completed every week or every other week. Materials used on the project, tools and equipment must also be purchased or rented. Contractors accumulate these costs over a period of time and submit a request for payment or invoice to the Owner's Representative. Depending upon the owner and or local law the owner has up to 30 days to process that payment. As a result of this payment delay, Contractors must know how much money will be needed at what point in the project to insure that workers and suppliers are paid on a timely basis.

Cash Flow analysis assists in predicting, based on the current status of the project, the expected working capital needed to fund the project, the expected break-even point for the project. Cash Flow analysis may also assist in the evaluation of working capital and break even point under varying sets of subcontracting options, supplier payment terms, and short-term interest rates.

The steps required to perform the cash flow analysis are shown below. You may want to open another browser window and follow along on the next page that shows a completed analysis.

step 1. material, labor, and equipment cost

  1. Separate activities that combine prime-contractor and subcontractor work. This is required because there is a time lag between the prime-contractor payment period and the subcontractor payment period.
  2. Separate activities that combine equipment or material that will be stored in an off-site warehouse or stored on-site prior to installation. This is required since the prime-contractor should request payment for the delivery of the equipment and material.
  3. Any activity that is greater than the payment period, typically 30 calendar or 20 working days, should be split into multiple activities. Making activity durations less than the typical monthly payment invoice cycle, will force a more accurate evaluation of the status of an activity.
  4. The exception to splitting work activities into multiple activities of less than 30 calendar or 20 working days is for activities that by contract incorporate unit costs schedules.
  5. Any activity that includes more than one unit cost item should be split until each activity has only one unit cost item. This is important since it will be easier to reconcile unit cost items if they are clearly delineated as separate activities.
  6. The delivery and installation of specialized construction equipment, such as cranes, job-site trailers etc… should be identified as separate schedule activities since may owners will allow payment for the lease of this equipment independent of the cost of installation activities.
  7. The cost of items job-site wide items whose costs is paid up front may also be removed from monthly site overhead costs and included as individual activities supporting the mobilization to the site. While a “mobilization” activity is typically not allowed items such as site fencing and signage that are specifically required in the contract to be installed at the start of the project may, for some owners, be paid out individually, instead of as part of monthly overhead costs.

step 2. direct cost

  1. Create a value-loaded, time-scaled schedule in a bar chart, or fenced bar chart. Note that the location of bars within their possible range of float should reflect the way that you plan to do the work. Use of the default early-start sort for laying out your bar chart may be unrealistic and result in increased cost of project working capital.
  2. The major vertical grid lines of the schedule should be in 30 calendar or 20 working days to reflect the payment period.
  3. Split the costs of activities that span a given payment cycle into their pro-rated portions based on a dollar per day estimate of activity earned value.
  4. Sum activities' cost that you plan to complete during the each payment cycle. Transfer this information to a spreadsheet to speed up the remaining steps in the Cash Flow analysis procedure.

step 3. overhead costs

Overhead costs must be paid in order to perform the work, but are not directly tied to one specific activity. There are two kinds of overheads job-site and home-office overheads.

a. job site overheads

Calculate the cost of small tools, gang boxes, permits, telephone services, site internet connections, security guards, and site superintendant for the whole project. These are examples of some of the job-site specific overheads on your project. Your project may also include other costs such as trailers, fencing, and signage that, depending on the way that the items are paid for may be either individual activities or monthly charges.

Once the total cost of job-site overheads are calculated divide that total buy the number of payment cycles in the project. If payment cycles are in months, as they typically are, then you will obtain the cost per month to run that project.

b. office overhead

There also costs that must be paid related to the functioning of the home-office. The largest of these costs is likely to be the salaries of home-office staff. Company equipment used across all projects should also be included as part of home-office overheads. Home office overhead costs include: office personnel, equipment for several sites, utilities, legal and accounting fees, company vehicles, travel and business lunches, etc ... Needless to say ensuring that fixed home office-overhead costs are as low as possible is the key to running a small construction business (but that’s the topic of another course!)

The allocation of home office costs is a bit trickier than allocating job-site overheads. This is because the home office may be working on several projects at the same time. The standard way of allocating home office overhead is called the "Eichleay" formula.

Before showing the formula, consider the following "thought experiment." If you have a single project how would you allocate your home office overhead? Simple, the entire cost of the home office divided by the number of payment periods for the project. This case is just like that for job-site overhead.

What happens if the office is providing support for two projects of the same size? Your intuition probably has told you that each project should pay for one-half of the home office costs. For the purpose of the Cash Flow analysis, this answer would be correct.

Now let’s consider if the office still has two projects, but on project is much larger than the other project. Is a split of the home office costs between the two projects reasonable in this case? No, most people would say that it is not because home office staff should be working on the larger project more than the smaller project.

Now we have the full intuitive understanding home office allocation. The Eichleay formula states that a proportional cost of the home office overhead should be allocated to each project based on the size of the project compared with the total volume of work. The formula itself is shown below:

((Home Office Cost) / (Number of Payment Cycles)) * ((Current Project Cost)/(Total Cost of All Projects))

step 4. markup

Contingency costs are those costs that could be incurred given the uncertainty of the project. While a detailed risk analysis could be conducted, experienced company owners use percentages to estimate the "known unknown" additional costs for the project. Contingency is often based on factors such as project type, project location, level of specificity of the design, market conditions, and experience with the owner.

Stated another way contingency is the contractor’s compensation for the uncertainty in the contract requirements: the higher the uncertainty, the higher the contingency, the higher the price of the contract.

Hopefully readers who represent building owners already understand that the lower the contractor"s risk in accepting the project, the lower the price of the contract. Issues directly under the owner’s (or owner representative"s) control, that may lower construction costs are the specificity of design requirements and clear understanding of working relationships and administrative requirements imposed by the contract.

Another kind of contingency costs, particularly for projects in uncertain economic conditions is inflation. Projects that require the purchase of materials from multiple countries also have a currency risk that can be estimated. The costs and overheads identified in the previous steps are typically calculated based on the current value of a single currency and under expectation of zero inflation. An adjustment for expected future cost adjustments should be added to projects being built in uncertain settings.

Profit is the return on the investment needed by those who are providing the up-front funding of the project. While different industries have different average levels of profit, there is a bottom line that often helps students understand the idea of profit. Consider a business many who has $10,000 to invest in something. If they put that money in a bank savings account, they may be able to realize a 5% annual return and receive 10,500 at the end of a year. If they put that money in a construction contract, then the return they receive should be at least as much as that received by the bank.

step 5. expected earned value

Add the markup to the previously calculated cost and overhead figure.

step 6. payment offset

Assuming that the billing is accomplished the first day of the month after the work is accomplished, then the owner’s processing of that check will take some time. A good owner will pay within 30 days of receipt of the invoice. A poor owner (and one for whom contractors increase their contingency costs) may or may not provide prompt payments.

step 7. overdraft

At the start of the project there will be no payment for a period of time. During this period the contractor must still pay salaries and suppliers. The difference between the total of the project earned and the total the owner has paid is the "overdraft".

step 8. interest

The organization that pays for the cost of the work before the owner has paid for the value of the work result is essentially loaning money to the project team. The project team will not get this money for free. The company providing the loan would evaluate the loan the same way that the contractor evaluates its potential profit. The way that the company providing the loan makes a profit on that loan is to charge "interest." Interest accrues during the project as long as there is an overdraft on the project.

step 9. retainage

During the project the owner may hold back a portion of the payment as "retainage." This amount of value earned but not paid will often be held in the case of open punch-list or other deficiencies in the quality of the installed work. Some owners also hold retainage to ensure that once the contractor breaks-even on the job, that the remaining tasks at the end of the job are completed.