Financial Management in Construction Contracting Andrew Ross& Peter Williams

This authoritative text provides a detailed insight into how construction companies manage their finances at both corporate and project level. It guides students and practitioners through the complexities of the financial reporting of construction projects within the constraints of accepted accounting practice. The book is written for non-accountants and from a contractors perspective and is equally relevant to subcontractors and main contractors.

The authors examine the relationship between the external annual accounts and the internal cost-value reconciliation process. CVR is covered in depth and the authors consider issues such as interim payments, subcontract accounts, contractual claims, final accounts, cash flow management and the reporting of the physical and financial progress of contracts.

A broad perspective of all the financial aspects of contracting is taken along with related legal issues and the authors explain how things operate in the real world. They describe good practice in financial control while at the same time being honest about some of the more questionable practices that can - and do - happen. The approach taken is unique as the financial management of construction projects is considered from the perspective of the contractors quantity surveyor. The book deals with the real issues that surveyors have to address when using their judgment to report turnover, profitability, cash flow, and work in progress on projects and the financial problems faced by subcontractors are frankly and pragmatically explored.

The payment and notice requirements of the Construction Act are explained in detail and relevant provisions of JCT2011, NEC3, ICC, DOM/1 and other standard contracts and subcontracts are also covered.

Financial Management in Construction Contracting addresses the wide variety of external factors that influence how construction companies operate, including government policy, banking covenants and the financial aspects of supply chain management. Cost reporting systems are described and real-life examples are used to illustrate cost reports, accrual systems and how computerised systems can be employed to provide the QS with information that can be audited.

This is the ideal core text for final year degree and post-graduate students and provides an invaluable reference source for all engaged in the financial management of construction projects.

This books companion website is atwww.wiley.com/go/rossfinancialmanagement and offers invaluable resources for both students and lecturers:PowerPoint slides for lectures on each chapterExcel worksheets to practice what you learnSample valuations and cashflows

Andrew Ross, BSc(Hons) MSc PhD MRICS MCIOB, Head of postgraduate programmes, School of the Built environment, Liverpool John Moores University. Andrew is a chartered quantity surveyor and chartered builder, after graduation he worked as a commercial manager for Balfour Beatty Building and financially managed projects ranging from refurbishment, adaptation of industrial facilities, health care and new build industrial building. He joined Liverpool John Moores University and has an MSc in Information Technology and a PhD in Construction Economics. He has published over 100 journal and conference papers on construction economics and procurement and is the joint author of three text books, Building Design Cost Management, Construction UK and Financial Management for Construction contracting. His current position at LJMU is head of post graduate programmes and he teaches construction project financial management to undergraduate and post graduate students.  He has successfully supervised many PhD students and has been an external examiner to numerous UK and overseas Universities for undergraduate, postgraduate and research degree courses.

Peter Williams is a Consultant and Lecturer with extensive practical experience in building, civil engineering and surveying. Formerly a chartered builder, chartered quantity surveyor and principal lecturer, he is now a writer, researcher, lecturer and consultant with particular interests in contracts and finance, delay analysis and health and safety management.

About the Authors xvii

Preface xviii

1 Finance in the construction industry 1

1.1 Introduction 1

1.2 The purpose of this book 2

1.3 Construction contracting 3

1.4 Work in progress 3

1.5 Reporting 4

1.6 Structure of the book 5

1.7 The construction industry 6

1.7.1 Industry reports 6

1.7.2 Industry reform: origins and responses 7

1.7.3 Housing Grants, Construction and Regeneration Act 1996 9

1.8 Industry output 12

1.9 Industry clients 15

1.9.1 Clients for small buildings 16

1.9.2 Major clients developing for their own occupation 16

1.9.3 Property developers 17

1.9.4 Private house buyers 17

1.10 Structure of the industry 17

1.10.1 Size and distribution of firms 17

1.10.2 Risk culture 19

1.10.3 Specialist contractors 20

1.10.4 Payment processes 21

References 22

2 Stakeholders and the regulatory environment 23

2.1 Accounting 24

2.1.1 Accounting reference period 24

2.1.2 Accounting reference date 24

2.1.3 Statutory compliance 24

2.1.4 Annual accounts 25

2.1.5 Audit procedures 26

2.2 The Companies Acts 26

2.3 Accounting standards 26

2.4 UK accounting standards 27

2.4.1 SSAP9 27

2.5 International accounting standards 28

2.6 Financial reporting 28

2.7 Financial reports 29

2.7.1 Management reports 30

2.7.2 Lenders and banking covenants 31

2.7.3 HMRC reports 33

2.7.4 VAT returns 33

2.7.5 Companies House 35

2.8 Annual accounts 35

2.8.1 Operating statement 36

2.8.2 Directors report 36

2.8.3 Profit and loss account 37

2.8.4 Balance sheet 37

2.8.5 Movement of funds statement 39

2.8.6 Auditors report 39

2.8.7 Notes to the accounts 41

2.8.8 Group accounts 41

References 41

3 Risk and uncertainty 42

3.1 Definitions 43

3.2 Risk and reward 45

3.2.1 Risk 46

3.2.2 Reward 47

3.3 Corporate governance 48

3.3.1 Definition 48

3.3.2 The Cadbury Report 48

3.3.3 The Financial Reporting Council 48

3.3.4 The Companies Acts 48

3.3.5 The Turnbull Report 49

3.4 Market risk 49

3.4.1 Definition 49

3.4.2 Market risk factors 49

3.4.3 Governance 50

3.5 Working capital 50

3.5.1 Sources of working capital 50

3.5.2 The annual accounts 51

3.5.3 Loan capital 51

3.5.4 Risk capital 54

3.5.5 Overdrafts 55

3.5.6 Trade credit 55

3.5.7 PAYE, NIC and VAT 55

3.5.8 Capital gearing 56

3.5.9 Working capital ratios 56

3.5.10 Liquidity 57

3.5.11 Cash flow 57

3.6 Competition 58

3.6.1 Definition 58

3.6.2 Procurement 58

3.6.3 Subcontractors 58

3.7 Profitability 59

3.7.1 Definitions 59

3.7.2 Income gearing 59

3.8 Work in progress 60

3.8.1 Payment in arrears 61

3.8.2 Valuations and payments 62

3.9 Insolvency risk 62

3.9.1 Industry structure 63

3.9.2 Sole traders 63

3.9.3 Limited liability 63

3.9.4 Large firms 64

3.10 Instability 64

3.10.1 Living with instability 65

3.10.2 Indicators of instability 66

3.10.3 Multiple discriminant analysis 66

3.11 Credit control 67

3.11.1 Debtor days 68

3.11.2 Creditor days 68

References 68

4 Contracts and documentation 70

4.1 Types of contract 70

4.1.1 Form of tender 71

4.1.2 Lump sum contracts 71

4.1.3 Measure and value contracts 73

4.1.4 Cost reimbursement contracts 73

4.2 Financial implications of contracts 75

4.2.1 Lump sum contracts 75

4.2.2 Measure and value contracts 76

4.2.3 Cost reimbursement contracts 77

4.3 Project documentation 78

4.3.1 Definitions 78

4.3.2 Priority of documents 79

4.3.3 Drawings 79

4.3.4 Specification 80

4.3.5 Bills of quantities 82

4.3.6 Schedule of rates 84

4.3.7 Schedule of works 85

References 86

5 Payments in construction 88

5.1 Industry credit system 89

5.1.1 Labour and wages 89

5.1.2 Materials 90

5.1.3 Subcontractors 90

5.1.4 Plant hire 91

5.1.5 Credit terms 91

5.1.6 Discounts 92

5.2 Payment problems 93

5.2.1 Trust and money 94

5.2.2 The Construction Act 1996 95

5.2.3 The Construction Act scope and application 95

5.3 The scheme for construction contracts 96

5.4 Payment under the Construction Act 96

5.4.1 Payment period 96

5.4.2 Periodic payments 97

5.5 Payment notification under the Construction Act 97

5.5.1 Contractual provisions 97

5.5.2 Payment notice 98

5.5.3 Default payment notice 98

5.5.4 Withholding (or pay-less) notice 98

5.6 Conditional payments 99

5.6.1 Pay-when-paid 99

5.6.2 Pay-when-certified 100

5.6.3 Pay-when-notified 100

5.7 Late payments 100

5.7.1 Legislation 100

5.7.2 Interest 101

5.8 Suspension of performance 101

5.9 Adjudication 102

5.10 Value Added Tax 103

5.10.1 VAT in construction 103

5.10.2 How VAT works 103

References 104

6 Managing the supply chain 105

6.1 Supply chain management 106

6.1.1 Definitions 106

6.1.2 Integrated supply chains 106

6.1.3 Managing cost and profit 107

6.1.4 Practical applications 107

6.1.5 Context 108

6.2 Subcontractors 108

6.2.1 The growth of subcontracting 108

6.2.2 Types of subcontractors 109

6.2.3 Construction Industry Scheme 110

6.2.4 Trade and other references 111

6.2.5 Bonds 111

6.3 Subcontract tenders 112

6.3.1 The decision to sublet 112

6.3.2 Tender enquiries/send outs 112

6.3.3 Scoping of work packages 113

6.3.4 Subcontractor selection 114

6.3.5 Pre-subcontract stage 114

6.4 Subcontract stage 115

6.4.1 Placing the subcontract 115

6.4.2 Battle of the forms 116

6.4.3 The discount spiral 116

6.4.4 Partnering 117

6.5 Payment 118

6.5.1 Terms of payment 118

6.5.2 Retention and defects correction 118

6.5.3 Valuations and applications for payment 119

6.5.4 Liabilities, claims and accruals 120

References 121

7 Getting work 122

7.1 Business development 122

7.2 Decision to tender 124

7.3 Competitive tendering 129

7.4 Tender lists 130

7.4.1 Open competition 131

7.4.2 Frameworks and approved lists 131

7.4.3

Ad hoc

list 132

7.5 E-bidding and reverse auctions 134

7.5.1 Auctions 134

7.5.2 Online and reverse auctions 134

7.5.3 The process 135

7.5.4 Advantages 135

7.5.5 Disadvantages 135

References 135

8 Corporate governance and management 136

8.1 Definitions 137

8.1.1 Corporate Governance 137

8.1.2 Management 137

8.1.3 Directors 137

8.2 The UK Corporate Governance Code 138

8.2.1 Application 138

8.2.2 Principles 139

8.2.3 Other approaches to governance 139

8.2.4 Corporate governance and contracts 140

8.3 Turnover 140

8.3.1 Definition 140

8.3.2 Calculating turnover 140

8.3.3 Work in progress 141

8.3.4 Cost of turnover 142

8.4 Profit 142

8.4.1 Definition 142

8.4.2 Corporate profit 143

8.4.3 Project profit 144

8.4.4 Profit distribution 144

8.5 Long-term contracts 145

8.6 Management accounts 145

8.6.1 Control 145

8.6.2 Cost value reconciliation 146

8.7 Accounting for contracts 147

8.7.1 The role of directors 147

8.7.2 Work in progress 148

8.7.3 Short-term contracts 149

8.7.4 Long-term contracts 149

8.7.5 Worked examples 150

Reference 152

9 Company structure 153

9.1 Management functions 153

9.1.1 Principles 154

9.1.2 Estimating and tendering 155

9.1.3 Purchasing 156

9.1.4 Production 157

9.1.5 Quantity surveying 157

9.1.6 Supply chain management 158

9.1.7 Accounting 159

9.2 Organisation structures 159

9.2.1 Structure 160

9.2.2 SMEs 163

9.2.3 Large firms 163

9.2.4 Very large firms 163

10 Service departments 165

10.1 Estimating and tendering 166

10.1.1 Preparing the estimate 168

10.1.2 Tender enquires 169

10.1.3 Preliminaries 171

10.1.4 Employers requirements 172

10.1.5 Contractors requirements 172

10.1.6 Measured items 175

10.1.7 Attendances and profit associated with domestic

subcontract works 175

10.2 Tender submission 176

10.2.1 Tender margin 176

10.2.2 Design risks 177

10.2.3 Construction risks/opportunities 177

10.2.4 Tender committee 177

10.2.5 Final adjustments 178

10.2.6 Qualification 178

10.2.7 Production of allowance bill 178

10.3 Planning 179

10.4 Buying 179

10.5 Accounting, costs and information 179

10.5.1 Definitions of costs 180

10.5.2 Timing of cost information flows and reporting 181

10.6 Company management accounting systems 181

10.6.1 Company information systems 181

10.6.2 Contract operational ledger 184

10.7 Contract cost reports 190

10.7.1 Principle of cost cut off 190

10.7.2 Direct costs and accruals 190

10.7.3 Cumulative and period reporting 194

10.7.4 Cost provisions 194

10.7.5 Individuals involved 196

10.8 Project audits and site processes 196

References 197

11 Financial management 198

11.1 Budgetary control 198

11.2 Definitions 200

11.2.1 Cost 200

11.2.2 Value 200

11.3 Cash flow 201

11.3.1 Movement of funds 201

11.3.2 Cash flow forecasting 202

11.3.3 Client and contractor 202

11.3.4 Cash flow forecast limitations 203

11.3.5 Simple forecasting models 204

11.3.6 Credit terms 208

11.3.7 Minimum and maximum cash requirements 209

11.3.8 Capital lock up 211

11.3.9 Expediting receipts 211

11.3.10 Delaying payment to suppliers 211

11.3.11 Project cash flow 214

11.3.12 Organisational cash flow 217

11.4 Working capital 218

11.4.1 Current assets 218

11.4.2 Current liabilities 221

11.4.3 Profitability ratio 221

References 221

12 Project governance 222

12.1 Introduction 223

12.2 Procurement methods 224

12.2.1 Traditional 224

12.2.2 Design and build 226

12.2.3 Management contracts 227

12.2.4 Pain and gain systems 228

12.2.5 Partnering 229

12.3 Conditions of contract 229

12.3.1 Payment mechanisms 229

12.3.2 Payment procedures 230

12.3.3 JCT Standard Building Contract with Quantities 2011 (SBC/Q) 231

12.3.4 Infrastructure Conditions of Contract (ICC) Measurement Version 231

12.3.5 NEC Engineering and Construction Contract 3rd Edition 232

12.3.6 Other standard forms of contract 232

12.3.7 Conditions of subcontract 232

12.4 Method of measurement 237

12.4.1 Standard methods of measurement 237

12.4.2 Basis of quantities 237

12.4.3 Classification systems 238

12.4.4 SMM rules 239

12.4.5 Waste 239

12.4.6 Working space 241

12.4.7 Temporary works 243

12.5 Bills of quantities 244

12.5.1 The use of bills of quantities 244

12.5.2 Structure and layout 244

12.5.3 Preliminaries 245

12.5.4 Measured work 247

12.5.5 Prime cost sums 250

12.5.6 Provisional sums 251

12.5.7 Daywork 252

12.5.8 Contingencies 253

12.5.9 Final summary 254

12.5.10 Adjustment item 254

References 254

13 Budgets 255

13.1 Developing and monitoring budgets 256

13.2 Types of budget 256

13.2.1 Strategic budgets 256

13.2.2 Turnover budget 256

13.2.3 Overhead budget 257

13.3 Project level budgets 259

13.3.1 Project turnover budgets 259

13.3.2 Project cash budgets 259

13.3.3 Production budgets 260

13.3.4 Procurement budgets 260

13.4 Activity level budgets 262

13.5 De-scoping bills of quantities 263

13.6 Budget development 264

13.6.1 Labour 264

13.6.2 Materials 267

13.6.3 Plant 268

13.6.4 Preliminaries 269

13.7 Variance analysis 270

13.7.1 Productivity assessment: an example 270

13.8 Control procedures 272

13.9 Earned value analysis 272

13.9.1 Definition of EVA 273

13.9.2 The components of EVA 274

13.9.3 EVA in practice 275

13.9.4 Work breakdown structures 276

13.9.5 Establishment of an EVA management system 276

13.9.6 Benchmarking project performance using EVA 277

13.9.7 Predicting performance 277

13.9.8 EVA in action: an example 278

13.9.9 Making predictions based on the derived metrics 281

13.9.10 Benefits of EVMS 282

References 282

14 Resource procurement 284

14.1 Introduction 284

14.2 The resource budget 285

14.3 Resource procurement programme: subcontractors 285

14.4 Tender assessment 286

14.5 Tender negotiation 287

14.6 Buying gains and losses 287

14.7 Newer approaches to subcontract procurement 287

14.7.1 Reverse e-auction 288

14.7.2 Pre-auction stage 288

14.7.3 The auction stage 289

14.7.4 Post-auction stage 289

14.7.5 Live e-auction results 290

14.7.6 Reflections 291

14.8 Materials procurement 291

14.9 Plant procurement 292

14.10 Labour procurement 292

14.11 Labour-only subcontractors 293

15 Project risk and control 294

15.1 Introduction 294

15.2 Tender risk 295

15.2.1 Programme and method 295

15.2.2 Ground conditions 296

15.2.3 Subcontractors 299

15.2.4 Suppliers and materials 300

15.2.5 Commercial opportunity 304

15.3 Contract risk 307

15.3.1 Delay and disruption 307

15.3.2 Delay analysis 308

15.4 Claims 311

15.4.1 Extensions of time 311

15.4.2 Loss and expense 312

15.4.3 Evaluating prolongation expenses 314

15.5 Insolvency risk 315

15.5.1 Risk rating 315

15.5.2 Definitions 315

15.5.3 Legislation 316

15.5.4 Termination of main contracts and subcontracts 317

15.5.5 The effect of termination 317

15.5.6 Subcontractors insolvency 318

15.5.7 Employers insolvency 323

15.5.8 Contractors insolvency 324

References 328

16 Programme and progress 329

16.1 Contractors obligations 329

16.2 Programme 330

16.2.1 The tender stage 331

16.2.2 The pre-contract stage 333

16.2.3 The contract or master programme 334

16.2.4 Contractors method 337

16.2.5 Shortened programmes 337

16.2.6 The contract stage 338

16.3 Progress 338

16.3.1 Contractors obligations 338

16.3.2 The baseline programme 339

16.3.3 Extensions of time 339

16.3.4 Mitigation of loss 343

16.3.5 Measuring progress 343

16.4 S-curves 344

16.4.1 Principles 344

16.4.2 Measuring physical progress 344

16.4.3 Measuring financial progress 345

16.5 Project acceleration 349

References 351

17 Valuations and payments 352

17.1 Valuations and interim certificates 353

17.1.1 The purpose of valuations 353

17.1.2 The timing of valuations 354

17.1.3 The timing of interim certificates 354

17.1.4 The status of interim certificates 355

17.2 Interim payment 355

17.2.1 Contractual provisions 355

17.2.2 Methods of payment 355

17.2.3 Payment notification 356

17.2.4 Retention 356

17.2.5 Alternatives to retention 357

17.3 Principles and procedures 358

17.3.1 Valuation principles 358

17.3.2 Valuation procedures 359

17.3.3 Types of valuation 360

17.4 Valuation techniques 362

17.4.1 Inspection 362

17.4.2 Measurement 362

17.4.3 Ogive curve 363

17.4.4 Gantt chart 363

17.4.5 Adjustment and judgement 363

17.5 Materials on site 364

17.5.1 Valuing materials on site 364

17.5.2 Retention of title 365

17.6 Basic valuation procedure 366

17.7.1 Contract provisions 370

17.7.2 Components of an interim valuation 370

17.8 Preparing the external valuation 371

17.8.1 Measured work 372

17.8.2 Variations 372

17.8.3 Daywork 373

17.8.4 Prime cost sums 375

17.8.5 Provisional sums 377

17.8.6 Preliminaries 377

17.8.7 Progress 378

17.9 Internal valuation 378

17.9.1 Purpose 378

17.9.2 Link to the external valuation 379

17.9.3 Link to the estimate 384

17.10 Subcontract valuation 384

17.11 Final accounts 386

17.11.1 Purpose 386

17.11.2 Timing 387

17.11.3 Preparation 387

17.11.4 The final certificate 389

17.11.5 Contractual significance of final certificate 389

References 389

18 Cost value reconciliation 391

18.1 Introduction 392

18.1.1 Accounting standards 392

18.2 Guiding principles 393

18.2.1 Costs 393

18.2.2 Site cost information 395

18.2.3 Labour 395

18.2.4 Materials 397

18.2.5 Plant costs 398

18.2.6 Subcontract costs 399

18.3 Cost reporting 401

18.3.1 Timing 401

18.3.2 Overheads 403

18.4 Net sales value (NSV) 405

18.4.1 Calculation of net value 406

18.4.2 Calculation of profit 407

18.5 Losses 407

18.5.1 Foreseeable losses 407

18.6 Claims and variations 408

18.7 Valuation: application and internal valuation 409

18.7.1 Adjustments: overmeasure 411

18.7.2 Adjustments: undermeasure 412

18.8 Development of the internal valuation: an example 412

18.9 Reconciliation 414

18.9.1 On-costs in advance 414

18.10 Explaining variances 419

18.11 Summary 421

References 421

Glossary 422

Index 429