2. International Research Journal of Finance and Economics - Issue 28 (2009) 43can be improved by better communication among major project participants such as design engineersand construction professionals. Communication among these participants reduces the chance of projectfailure and other related performance problems. Cost shifting 2 is an accidental or deliberate misstatement in a contractor’s job cost system thatcan have a substantial impact on the contractor’s balance sheet and income statement. Both contractorsand their auditors should be aware of the potential impact of shifts in job costs from one contract toanother. The contractor should have a reliable job cost system in place to record contract costsaccurately. The auditor should always test contract costs and look for unusual contract costing trends. There is considerable discussion among industry professionals as to how constructability isrelated to Total Quality Management (TQM) and value engineering. This paper attempts toconceptually describe these interrelations. It also presents a framework to measure costs and benefitsrelated to constructability.Significant attention has been given to the topic of Construction Contract (IAS-11), The ConstructionManagement 1991, "Constructability: A Primer" 1986, “ Audit of Contract”: A Practical Guide 2005,Constructability: An Article of Tauqir Haider in The NEWS”, “Total Quality Management inConstruction Contracts”: By James. Santee 2006, “Value Engineering and Cost Benefit: CostingTechniques” By Houston & jordeen 2003.2. Evolution of Construction Contract ManagementConstruction contract may be negotiated for the construction of a single asset such as a bridge,building, dam, pipeline, road, ship or tunnel. A construction contract may also deal with theconstruction of a number of assets which are closely interrelated or interdependent in terms of theirdesign, technology and function or their ultimate purpose or use; examples of such contracts includethose for the construction of refineries and other complex pieces of plant or equipment. Construction contract include contracts for the rendering of services which are directly relatedto the construction of the asset, for example, those for the service of project managers and architects;and contracts for the destruction or restoration of assets, and the restoration of the environmentfollowing the demolition of assets.Construction contracts are formulated in various ways such as fixedprice contracts 3 and Cost plus contracts 4.3. Construction Contracts – Financial ManagementWhen a contract covers a number of assets, the construction of each asset shall be treated as a separateconstruction contract when: a. Separate proposals have been submitted for each asset. b. Each asset has been subject to separate negotiation and the contractor and customer have been able to accept or reject that part of the contract relating to each asset. c. The cost and revenue of each asset can be identified. A group of contracts whether with a single customer or with several customers, shall be treatedas a single contract when: • The group of projects are negotiated as a single package • The contracts are so closely interrelated that they are, in effect, part of a single project with an overall profit margin • The contracts are performed concurrently or in a continuous sequence.2 Cost shifting is an illegal practice that can change results and outcomes seriously.3 A fixed price contract is a construction contract in which the contractor agrees to a fixed contract price, or fixed rate per unit of output, which in some cases is subject to cost escalation clauses.4 A cost plus contract is a construction contract in which the contractor is reimbursed for allowable or otherwise defined costs, plus a percentage of these costs or a fixed fee.
3. 44 International Research Journal of Finance and Economics - Issue 28 (2009) A contract may provide for the construction of an additional asset at the option of the customeror may be amended to include the construction of an additional asset. The construction of theadditional asset shall be treated as a separate construction contract when: a. The asset differs significantly in design, technology or function from the asset or assets covered by the original contract. b. The price of the asset is negotiated without regard to the original contract price.4. Cost & Revenue RecognitionContract Revenue 5 is measured at a fair value of the consideration received or receivable. Themeasurement of the contract revenue is effected by a variety of uncertainties that depend on theoutcome of the future events. The estimates often need to be revised as events occur and uncertaintiesare resolved. Therefore, the amount of contract revenue may increase or decrease from one period tothe next. For example: a. A contractor and a customer may agree variations or claims that increase or decrease contract revenue in a period subsequent to that in which the contract was initially agreed. b. The amount of revenue agreed in a fixed price contract may increase as a result of cost escalation clauses. c. The amount of contract revenue may decrease a result of penalties arising from delays caused by the contractor in the completion of the contract. d. When a fixed price contract involves a fixed price per unit of output, contract revenue increases as the number of units is increased. A variation is an instruction by the customer for a change in the scope of the work to beperformed under the contract. A variation may lead to an increase or decrease in the contract revenue.In addition to incentive payments are additional amounts paid to the contractor if the specifiedperformance standards are met or exceeded. Contract Cost 6 include site labor costs inclusive of supervision costs, cost of material used incontract, depreciation of plant & equipment used on the contract, cost of moving plant, equipment andmaterial to and from the contract site, cost of hiring plant & equipment, cost of design and technicalassistance, estimated cost of rectification and claims from third party. Contract cost however can bereduced by the incidental income. Attributable costs may include insurance, cost of design andtechnical assistance and construction overheads. Non attributable costs are general admin costs forwhich reimbursement is not specified in the contract or selling costs. When the outcome of the construction contract can be estimated reliably, contract revenue andcontract costs associated with the construction contract shall be recognized as revenue and expensesrespectively by the reference to the stage of completion of the contract activity at the Balance Sheet. Practically in Financial Management of Construction contracts PC 7-I is devised as a measurewhich works as a base for all estimations and variations. As per PC-1 cost of the total constructioncontract is phased along with its targeted completion stages. Out of the total Construction cost there is a division for direct cost and indirect cost, Civilworks and phase wise cost associated with it. Mobilization advance 8 is paid at the start of the projectto the contractor so that he can mobilize the job to be done in future and this is subject to adjustment inthe Running Bills 9. Through these Bills a certain position is calculated along with its financial impact5 Contract revenue is the initial amount of revenue agreed or variation in contract and claim or reliable measurement.6 Contract cost directly relates to the specific contract, costs are attributable to the contract activity in general and other costs specifically chargeable to the customer under the terms of the contract.7 A format used to describe the cost and structure of a project. This PC-1 is required to be approved by the Planning Commission before execution.8 Mobilization advance is normally a certain percentage (usually 10%) of the total contract that is paid as advance to start work on it against bank guarantee.9 Running Bill is a periodic basis Bill which is submitted along with stage of completion for payment.
4. International Research Journal of Finance and Economics - Issue 28 (2009) 45and the payment is made on the work which is certified by the concerned professionals. Some advancepayment cans also be availed on the availability of material stock which is again adjusted in future. Inthe Final Bill all adjustments are done to close the matter however Bank guarantee remains in custodyup till the end of the specified period of satisfactory work.5. Cost ShiftingIt is now a day in routine to find out many corporations improperly booking assets related touncompleted construction contracts. To the public, it seems improbable that a qualified auditor couldsimply overlook the improper capitalization of significant assets. However, traditional audit proceduresdesigned without construction accounting in mind can fail to detect the improper booking of assetsrelated to uncompleted construction contracts. Significant cost shifting can quickly cause a materialmisstatement to a contractor’s financial statement and leave the contractor and the auditor open toserious charges. Cost shifting is an accidental or deliberate misstatement in a contractor’s job cost system thatcan have a substantial impact on the contractor’s balance sheet and income statement. The mostdangerous type of cost shifting involves moving or misdirecting job costs from an unprofitable job to aprofitable job. Cash and accounts payable balances are unaffected. Accounts receivable and expenseaccount balances are also unaffected. In many cases, however, cost shifting can have a balance sheetand income statement impact larger than the amount of the costs that have been shifted.5.1. What is the Effect of Cost Shifting?At first glance, the movement of costs from one contract to another would seem to have little or nooverall financial statement impact. It seems improbable that a substantial misstatement of profits couldoccur without affecting any expense accounts. It also seems improbable that profits could swingwithout booking any additional billings. However, many contractors and their auditors have discoveredthe dramatic impact that cost shifting can have on a company’s financial statement. The example belowshows the substantial gross profit impact of a $200,000 cost shifting entry: Contract A Contract B Completed Uncompleted Contract Contract Before Cost Shifting Contract Amount $1,200,000 $1,500,000 Estimated Job Costs (1,300,000) (1,200,000) Estimated Profit ($ 100,000) $ 300,000 Billings to date $1,200,000 $ 600,000 Overbilling (Liability) - (100,000) Revenue to date 1,200,000 500,000 Costs to date (1,300,000) (400,000) Gross Profit to date ($ 100,000) $ 100,000 Job percentage complete 100% 33%
5. 46 International Research Journal of Finance and Economics - Issue 28 (2009) After Cost Shifting ($200,000 of costs are shifted from Contract A to Contract B) Contract Amount $1,200,000 $1,500,000 Estimated Job Costs (1,100,000) (1,200,000) Estimated Profit $ 100,000 $ 300,000 Billings to date $1,200,000 $ 600,000 Underbilling (Asset) - 150,000 Revenue to date 1,200,000 750,000 Costs to date (1,100,000) (600,000) Gross Profit to date $ 100,000 $ 150,000 Job percentage complete 100% 50% Increase in gross profit $ 200,000 $ 50,000 In this example, Completed Contract A improves by $200,000 due to the costs shifted off thejob. However, Uncompleted Contract B also improves because the contract is now 50% completerather than 33% complete. Because Contract B is incomplete, gross profit is recognized on thepercentage of completion basis. Therefore, Contract B recognizes 50% of the estimated gross profit forthe entire job ($150,000) rather than 33% of the gross profit for the entire job ($100,000). The$200,000 cost shifting entry improved the books of the contractor by a total of $250,000. In this example, Uncompleted Contract B received $200,000 of costs which did not belong tothat job. When Contract B is completed, it will either finish $200,000 over budget or another costshifting entry will occur.5.2. Who Benefits from Cost Shifting?Although the big corporate cases grab the headlines, most cost shifting does not occur when acorporation tries to manipulate its balance sheet. Cost shifting occurs most frequently when field levelmanagers attempt to manipulate contract profitability. Cost shifting can also happen accidentallyalthough the consequences usually are not as severe. Contractors often pay bonuses to their field managers and estimators based on the profitabilityof completed contracts. In the above example, the estimator of Contract A might receive a bonus basedon the false assumption that the contract was profitable. Or, the superintendent of Contracts A and Bmight deliberately miscode invoices from one job to another to hide losses that occurred under hissupervision.5.3. How to Spot Cost ShiftingThe only way the contractor’s balance sheet changes when cost shifting occurs is that under billings(an asset) increase and over billings (a liability) decrease. Under billings should be rare, especially incontracts over 50% complete. Auditors and other users of contractors’ financial statements should lookat under billings skeptically and investigate each under billing carefully. Many users of contractors’ financial statements prepare fade schedules. A fade schedulemeasures a contractor’s job profit forecasts versus the final profit on a job. At a minimum, significantcontract fades can indicate poor job profitability forecasting. At worst, contract fades can indicate costshifting has occurred. Traditional audit procedures designed for non-contractors will not detect cost shifting. Testsdesigned to search for unrecorded liabilities or to detect improper cutoff of expenses will only reflectthat all costs have been reported in the proper period. Tests designed to find improperly bookedbillings or receivables will find no exceptions. Audit test work for cost shifting must focus on theaccuracy of job costing procedures.
6. International Research Journal of Finance and Economics - Issue 28 (2009) 475.4. Controls and Audit Steps Designed to Detect Cost ShiftingIntentional cost shifting constitutes fraud by some member of a contractor’s management. While auditsare not specifically designed to detect fraud, an auditor must test contract costs and internal controlsystems. The following steps are designed to prevent or detect cost shifting: 5.4.1 Strong internal controls for job cost coding Project managers should not have free reign to code job cost invoices without accounting review. 5.4.2 Test Job costs for accuracy – At a minimum, every audit of a contractor must include random testing of contract costs and the related cost coding. The most significant components of the contractor’s job costs should receive the heaviest scrutiny. 5.4.3 Compare job costs against bid documents – Every contractor should estimate contracts in the same manner in which they record job costs. An auditor should test job costs for significant contracts by comparing each line item of job cost against the original forecast. Any overruns should be explained and, preferably, documented with a change order. 5.4.4 Test revised profitability estimates against bid documents – Very often, cost shifting is accompanied by an upward revision in contract profitability. This actually makes the financial impact of the cost shift even more drastic. An auditor should test revised profitability estimates against original bid estimates in the same manner in which job costs are compared against bid documents. Cost shifting by field personnel can also involve directing a subcontractor to invoice the wrong contract. Comparison of subcontract costs on particular line items versus the original bid amount can help spot this type of cost shifting. 5.4.5 Analytically test job cost components – Contractors who perform similar types of work should have comparable costs from job to job. For instance, a grading contractor whose overall direct costs are 40% equipment related should have about the same percentage of equipment costs on each job. 5.4.6 Review allocations of indirect job costs – Cost shifting is often hidden in the allocation of indirect costs such as internally-owned equipment costs, shop costs, insurance, and labor burden. Periodic tests should be performed to ensure that each job is being charged its fair share of indirect costs. 5.4.7 Perform a fade analysis – The best contractors tend to finish jobs at the same profit levels at which they were forecast. Two fade schedules should be prepared. The first measures each job’s prior period profitability forecasts against current forecasts or actual results. The second schedule should restate prior period uncompleted contract schedules using revised profitability figures. Each of these schedules helps an auditor determine which contracts have had unusual fluctuations in profits. 5.4.8 Examine bid spreads – Examining bid results can help an auditor determine whether a contractor has been awarded a job at an unusually low price. The auditor should compare the contractor’s bid price versus the second place bidder and versus the average bid price of all the contractor’s competitors bidding for each job. If a contractor is more than 5% to 10% low on a job, the contractor will likely make little or no profit on that job. Such a job is a prime target for cost shifting. 5.4.9 Compare profitability estimates against historical results – A contractor may attempt to hide cost shifting by increasing profit estimates on uncompleted jobs. When this occurs, the gross profit percentages on uncompleted jobs will often exceed the contractor’s historical results. Another test for this would be to compare uncompleted contract gross profit percentages with completed contract percentages.
7. 48 International Research Journal of Finance and Economics - Issue 28 (2009)5.5. An Ongoing ProcessBoth contractors and their auditors should be aware of the potential impact of shifts in job costs fromone contract to another. The contractor should have a reliable job cost system in place to recordcontract costs accurately. The auditor should be careful always to test contract costs and look forunusual contract costing trends.6. ConstructabilitySince the formalization of constructability, constructability has been an evolving work process. Yearsago, construction and design activities were integrated within the master builders organization. Masterbuilders were responsible for all project activities required to plan, design, and construct a facility.During the planning and design phases, the master builder focused on the entire project and consideredthe impact early decisions had on the construction process. In a sense, the level of design andconstruction integration achieved within these organizations serves today as the model for modernconstructability programs.7. Total Quality Management & ConstructabilityTQM 10 requirements may be defined separately for a particular organization or may be in adherence toestablished standards, such as the International Organization for Standardizations ISO 9000 series.TQM can be applied to any type of organization; it originated in the manufacturing sector and hassince been adapted for use in almost every type of organization imaginable, including schools, highwaymaintenance, hotel management, and churches. During recent years, the use of TQM has spread beyond the manufacturing industry toconstruction. Organizations embracing TQM are adopting a management philosophy that makesquality a strategic objective for the organization. Successful application of TQM to constructor hasincreased its recognition as an effective method to improve quality and productivity. TQM has two principal objectives: (1) customer satisfaction and (2) continuous improvement.Within the construction industry, each party involved on a project, including the owner, constructor,and designer, plays the role of customer and supplier of services. The owner supplies the requirementsto the designer, the designer supplies the plans and specifications to the constructor, and theconstructor supplies the built facility to the owner. A principal focus of TQM is for each supplier ofservices to identify and satisfy or exceed their customers needs in terms of cost, quality, and time. Continuous improvement not only involves problem solving on projects but also a proactivesearch for methods of completing a task more efficiently. The first step of the process is problemavoidance. That is, looking and accounting for areas that may later cause problems. In the constructionindustry, this means making a formal effort to recognize problems during the planning and designphases instead of discovering problems during construction. The second step in continuousimprovement is identifying methods that increase productivity including technological innovations. Both steps towards continuous improvement create progress toward more productive andhigher quality construction. However, these steps must be accompanied by a method of measuring theprogress and cost effectiveness of the TQM program. This assures that quality and productivity are notonly increased but also maintained. Measurement of cost effectiveness may also be used to increasecorporate awareness and commitment by showing the financial benefits accrued as a result of the TQMprocess. A constructability system can enhance customer satisfaction by facilitating teamwork amongowner, designer, and constructor representatives as early as the planning phase of a project. By so10 Total Quality Management (TQM) is a comprehensive and structured approach to organizational management that seeks to improve the quality of products and services through ongoing refinements in response to continuous feedback
8. International Research Journal of Finance and Economics - Issue 28 (2009) 49doing, it provides more resources, including construction knowledge and experience, for planning anddesigning a quality project that maximizes construction productivity. Constructability is a means of continuous improvement in several respects. Maintaining alessons-learned database allows communication of positive and negative activities and experiencesfrom one project to future projects. Thus, improvements and innovations can be implemented in futuredesigns. Also, construction personnel may be more aware of innovations in equipment or constructiontechniques that may play a key role in improving designs. Measurement of program effectiveness is also a key aspect of both a TQM and constructabilityprogram. This includes tabulating quantitative costs and benefits stemming from constructability andTQM such as dollar and schedule savings, as well as recognizing qualitative effects such as higherquality and increased customer satisfaction. TQM and constructability both stress commitment from all personnel. This commitment mustbe established from the executive level to the construction craftsmen on the site. This is a proactiveprocess requiring teamwork, recognition of the need for education regarding the program, and a self-assessment regarding capabilities and resources available to achieve the desired goals.8. Value EngineeringImplementation of value engineering 11 involves six steps: a. information, b. functional analysis, c. creative, d. evaluation, e. planning/proposal, and f. implementation/follow-up The creative step involves a brainstorming session where life-cycle cost alternatives for designcomponents are considered. Value engineering may be performed in two ways: (1) proactively or (2) reactively. A proactive approach uses value engineering to collect ideas starting at the beginning of design.Thus, multiple design alternatives are considered and the most cost effective selected on a continualbasis throughout the design phase. A reactive approach gathers cost effective alternatives throughdesign reviews by other project personnel such as constructors and other designer engineers. This isperformed after the entire design or specific component of design is complete. Thus, suggestions forimprovement require design rework. In the building sector, often the term V.E. is synonymous with "The project is over budget andwe need to cut X Rupees from the projects scope." Some designers view V.E. as an attack on theirdesign. The primary objective of value engineering is to reduce the total life-cycle cost of a facility,whereas constructability focuses upon optimization of the entire construction process. In most cases ofindustry implementation, value engineering is normally performed during the design phase of thefacility delivery process. An effective formal constructability program ideally begins during theconceptual planning phase and continues through construction. Constructability and value engineering differ in terms of the criteria discussed above. However,this does not mean that they are mutually exclusive. Rather, activities within the two work processesmay complement each other in achieving their goals. This may result in construction optimization11 Value Engineering (VE) has been defined as "the systematic effort directed at analyzing the functional requirements of systems, equipment, facilities, procedures, and supplies for the purpose of achieving the essential function at the lowest total (life-cycle) cost, consistent with meeting needed performance, reliability, quality, maintainability, aesthetics, safety, and fire resistance" ( Kavanagh)
9. 50 International Research Journal of Finance and Economics - Issue 28 (2009)while, at the same time, achieving lowest life-cycle cost. Constructability implementation can act as aprecursor to value engineering, providing information through constructor input and lessons learnedfrom past projects such that value engineering may be more effective.9. Cost EffectivenessAs with TQM, improvements of a constructability program depend upon accurate and consistentmeasurements of its effectiveness. Inconsistent means of cost/benefit measurement may incorrectlyreflect the effectiveness of constructability on a project in comparison to other projects or programs inindustry. Thus, a need exists for standardized cost effective parameters so that constructabilityperformance may be documented and compared among projects and organizations. This sectiondescribes a simplified framework for identifying and quantifying the costs and benefits stemming fromimplementing constructability at the project-level.10. Cost FactorsTo quantify the costs of implementing constructability at the project-level, a cost estimation frameworkis necessary. Cost parameters primarily consist of personnel and miscellaneous cost items. Personnelfrom many organizations including the owner, constructability consultant, constructor, design engineer,and when appropriate vendors and major subcontractors. A common concern among parties that procure construction input is the difficulty of accuratelyestimating its value or benefit. Benefits accrued through implementing constructability are oftendifficult to quantify. They are typically measured through documented benefits from constructabilityideas implemented. It is relatively simple to track the cost of design, construction labor, and materialsused to complete a given design alternative. Constructability, however, involves generating ideas thatoptimize the construction process. Thus, the question, how do you estimate the value of such ideas?11. ConclusionIn Developing Countries there is an immense need of actual application of COST & MANAGEMENTAccountants to find out the ways to improve the construction quality and its financial impacts so thatwe can handle the natural disasters and other problems leading to causalities and loss of precious lives.Summing up Total Quality Management, value engineering, and constructability are not mutuallyexclusive. Instead, value engineering and constructability are complementary work processes that maybe used as key elements in achieving total quality. A coordinated effort with the application ofavailable standards the Financial Management Aspect as well as cost shifting can be evaluated. Apractical approach towards implementation of standards can yield desired resultsReferences International Accounting Standard –IAS(11) Published in 2005 "Manual for special project management." (2006). Value Analysis in Design and Construction, J.J e- Brown (2007) "Benefits and Costs of Constructability: Four Case Studies," J.S & J.G "A Comparison of Two Corporate Constructability Programs," J.S & J.G Snodgrass, T.J. and Kasi, M. (1986). Function Analysis: The Stepping Stones to Good Value, The Department of Engineering Professional Development, University of Wisconsin, Madison, WI, pp. 1-3. "Total Quality Management: The Competitive Edge." (1990). “Cost Shifting Analysis by Norton Cannons” (2007)
10. International Research Journal of Finance and Economics - Issue 28 (2009) 51 "Constructability for drilled shafts," James "A model for design/construction integration during the initial phases of design for building construction projects," James "Total Quality Management: The Competitive Edge." (1990). Publication 10-4, Construction Industry Institute, Univ. of Texas at Austin, Austin, TX. Tucker, R.L. (1986). "Management of Construction Productivity," Journal of Management in Engineering, ASCE, 2(3), 148-156. Turner, J.P. (1992). "Constructability for drilled shafts," Journal of Construction Engineering and Management, ASCE, 118(1), 77-93. OBrien, J.J. (1976). Value Analysis in Design and Construction, McGraw Hill, Inc., New York, NY. OConnor, J.T. and Tucker, R.L. (1986). "Industrial project constructability improvement," Journal of Construction Engineering and Management, ASCE, 112(1), 69-82. Radtke, M.W. (1992). "Model Constructability Implementation Procedures," thesis presented to University of Wisconsin, at Madison, Wisconsin, in partial fulfillment of the requirements for the degree of Master of Science in Civil and Environmental Engineering. Rowings, J.E. and Kaspar, S.L. (1991). "Constructability of cable-stayed bridges," Journal of Construction Engineering and Management, ASCE, 117(2), 259-278. Russell, J.S. and Gugel, J.G. (1992). "A Comparison of Two Corporate Constructability Programs," accepted for publication in the ASCE Journal of Construction Engineering and Management. www.wikipidea.com www.comanag.com www.ocmi.com www.wisegeek.com