We’ve said it before and we’ll say it again: money makes the world go ’round! Project management is certainly not an exception. Projects are initiated because an individual or an organization wants a certain type of work done. In turn, they’re willing to pay people to perform the work. Simple, right? At it’s core, that is the essence of finance in project management – one party wants the work done and pays for it; other parties want to do the work and get paid for it. While this is project finance in a nutshell, there are many fine details to be aware of. In this article, we’re discussing the importance of finance in project management, along with some key terms and processes to know!
Why Is Finance Important In Project Management?
Although we’ve covered the core of what project finance is all about, here are a few additional reasons as to why finance is so important in project management:
- Funding: Without the ability to fund a project, it won’t get done. This requires cash, a loan or a grant before any work can start.
- Qualifications: The firms that are hired to perform work must be qualified and in good standing, which includes their credit, revenue and overall track record.
- Savings: Firms are usually expected to finance portions of a project prior to receiving any payments. This means that contractors, consultants and other companies need to already have money before they begin working on a new project.
- Progress: There is a synergistic relationship between firms completing their work efficiently and ownership releasing fair, timely payments. For the project to run smoothly, both of these things must occur.
- Accounting: If firms have any hope of finishing the project and staying in business, they must regularly account for their revenue, costs and margins.
- Growth & Expansion: In order for firms to grow and get bigger, they first must complete projects profitably. Then, they must spend this profit wisely on growing the business.
Importance Of Finance In Project Management: The Financial Lifecycle Of A Project
Below is an infographic that represents six common phases of the financial lifecycle of a typical project. We’ll continue to reference these six phases throughout this article.
Just to provide you with a text version of the infographic above, below are the six phases of the financial lifecycle of a project, which we’ll explore throughout this article:
- The Project Initiator Secures Funding To Pay For The Project
- The Ownership Seeks Out Qualified To Do The Work
- Contracts Are Issued To Firms To Perform A Portion Of The Project
- The Initiator (Owner) Releases Progress Payments As The Work Is Completed
- Firms Account For Their Own Costs, Revenue & Profit Throughout The Project
- When The Project Is Done, The Firms Must Pay All Costs, Account For Profit & Use Their Funds To Keep The Business Moving Forward
Below, we will dive into the common terms and steps associated with each one of these project finance phases!
Phase 1 – Project Initiation
All projects begin with an initiation. A project is initiated by a person, party or organization when they want something done. This can be anything from developing software to construction a bridge. Ideas are where projects start, but that’s not all…
They need funding!
Project funding comes in several forms:
- Cash: Simple enough – having the money on-hand to pay for the project.
- Loans: The project Owner borrows more to pay. This can be from a bank, private lender or a loan from the government. Loans must be paid back.
- Grants: The Owner receives funding from an organization, such as the government, a charity or a foundation. Unlike loans, grants don’t need to be paid back.
There are other forms of project funding, but these three are the most common.
Read Next: What Is The Waterfall Model Used For In Project Management?
Phase 2 – The Initiator Seeks Out Firms To Perform The Work
Once funding is secured, the project Owner can begin seeking out contractors, consultants and other firms to actually do the work. The firms that’ll be selected should be the most qualified. Here are a few financial factors that determine how qualified a firm is:
- Credit: This is the go-to metric that determines how financially qualified a firm may be. Credit represents their track record for paying bills on time and acting responsibly in regards to their finances.
- Bond Rating: Similar to a credit rating, bonds are given based on the financial reputation of a company. Bonds are a form of surety; an agency that issues a bond for a project is essentially saying that they’ll step in an fund the project if the company who paid for the bond defaults. The more financially trustworthy a company is, the less they’ll need to pay for a bond, because they’re less likely to actually default.
- Revenue: How much money does a particular firm make in a year? A company making $10 million in revenue per year might appear less trustworthy than a company making $50 million in revenue from a financial perspective.
Read Next: Overwhelmed By Big Projects? 6 Approaches With Metaphors & Examples
Phase 3 – Firms Are Hired Under Contract
Once an Owner selects firms to work on their project, they issue official contracts to these firms, which now legally obligate them to perform the work.
Here are some financial terms to be aware of at this stage:
- Contract Value: In some form or another, the Owner and contractor have agreed to perform the work for a certain amount of money. This is known as the contract value.
- Penalties: Also known as damages, penalties usually take the form of reduction of contract value if the contractor fails to perform as agreed.
- Payment Schedule: Commonly referred to as a Schedule of Values or Unit Pricing, the payment schedule dictates how much will be paid to the firm when they’ve completed certain tasks or ___ amount of work.
Read Next: How Do You Manage Subcontractors? 7 Essential Tips
Phase 4 – Progress Payments Are Released As Work Is Completed
When discussing the importance of finance in project management, its instinctual to think in terms of ‘getting paid’, and we’re right to do so! Ironically, there isn’t too much to say about this project phase given that it’s the most important phase! That is – releasing payments.
As work is completed, the Owner must release payment to firms working on the project in a timely manner.
Payment amounts and timing will vary wildly from project to project. What’s most important is a clear payment schedule, adequate performance of work and timely release of payment in accordance with the contract.
Read Next: How Does Progress Billing Work In Construction? The 8 Essential Steps
Phase 5 – Firms Account For Their Own Costs, Revenue & Profit
At this stage, firms working on a project will REALLY know just how well the project is going for them. This phase is all about accounting.
Below are some crucial terms and processes that make up the accounting phase of a project. Some are quite simple but are included anyways for the full picture of this phase:
- Costs: How much has a company paid to do the work so far?
- Revenue: In turn, how much revenue has come in via payments?
- Overhead: What costs does the firm have that aren’t directly tied to a specific project, but are still required to stay in business? This includes an office, administrative staff, employees, insurance, etc.
- Cost Accrual: An accrual is a cost that is not yet on the books, but is forced into a particular accounting period (i.e. month) as a placeholder on the books. Once the costs do hit the books, the placeholder accrual cost is removed. This is particularly common in industries with monthly billing cycles such as construction. A contractor may bill the client for, say, 10,000 bricks. The bricks are onsite, but the brick manufacturer hasn’t yet sent an invoice. This contractor will bill their client for the cost of the bricks without actually having paid for them yet. Therefore, the cost of these bricks will be accrued on the books in the same month they’re billed.
- Cost Deferral: A deferral is the opposite of an accrual in accounting. A deferral is a cost that has hit the books, but is intentionally not shown as a cost yet. Let’s use the same brick example from above. If the contractor has paid for the bricks but is not yet able to bill the Client for whatever reason. In the billing cycle that the bricks were bought, the cost of them will be shown, but no revenue will be collected for those bricks. To keep margins steady month over month, the contractor will defer the cost of the bricks until they can collect payment for them.
- Cost-To-Complete: Also known as Estimate-To-Complete (ETC), Estimate-At-Completion (EAC) or Budget-At-Completion (BAC), a Cost-To-Complete estimate allows us to account for performance, progress, revenue and costs to-date on the project, and forecast the remaining revenue, budget and profitability for the rest of the project.
- Gross Profit: This is calculated by subtracting the project costs from the revenue brought in on the project. This does not account of overhead expenses.
- Net Profit: Also known as Operating Profit, the Net Profit is what’s TRULY left over when all revenue has been received and all costs have been paid – including overhead.
It’s worth noting that in a subcontractor scenario, where a firm working on the project hires another company to perform part of their scope of work, they’ll go through a financial cycle similar to these six phases with their own subcontractor.
Read Next: Cost To Complete Template: FREE Excel Download (ETC, EAC, BAC)
Phase 6 – Upon Completion, Firms Are (Hopefully) Left With Profit
At this phase, the project is done. All payments have been collected and costs have been paid.
If the project was successful from a financial perspective, the firm will have money left over after paying all of their costs, including overhead. As said above, this is considered net profit or operating profit.
While a portion of this net profit surely should go to the firm’s employees in the form of bonuses (yes, including the owners!), the majority must be used for a few different things, should the business want to grow and succeed in the future:
- Expansion: This comes in the form of hiring more people, moving to a larger office, making large purchases for the business, etc.
- Maintenance: There will always be ongoing costs that arise in a business. This includes old equipment being replaced when worn out as well as upgrading technology.
- Reinvestment: Profit can also be reinvested into the business. While both expansion and maintenance are forms of reinvestment, this can also take form of training/education for employees, raises, etc.
Read Next: Our Comprehensive List Of 25 Ways Contractors Lose Money
Importance Of Finance In Project Management: In Summary
We’ve covered quite a bit of ground in this article. As you can see, there are several phases of any particular project. Each one of them contains several financial aspects that all project managers should be aware of for maximal success. I hope this deeper dive into the importance of finance in project management has been helpful, and that we’ve addressed any questions you may have. Thanks for reading!
