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Section 4 - Financial Aspects

Key Points

• Investment decision makers must ensure that there is a clear understanding amongst project owners and project sponsors of budgetary limits or other variables in the projects for which they are responsible. They should, as standard practice, ensure that effective monitoring and reporting arrangements are in place, including when it is appropriate for matters to be reported to them personally, and to Ministers or a governing board. Particular care is required in cases which have a high public profile, or those with particularly high risk factors, to ensure effective monitoring and reporting. The outcome of Gateway Reviews of mission critical or high risk projects must be reported to the Accountable Officer who should in turn inform Ministers if serious deficiencies or difficulties have been identified
• A primary measure of success in preparing budget estimates is predicting the project outturn capital cost and the whole life cost accurately at project inception. Without the ability to predict the outcome of a project with some degree of accuracy, it is not possible to determine which solution offers the best value for money
• The initial budget estimate and all subsequent budget estimates should allow for all capital, life cycle and whole life costs in connection with the project (eg VAT, in-house costs, consultancy costs, land costs, legal costs, design and construction costs, fit-out costs, concession payments, decommissioning costs and, depending on the procurement route, operation and maintenance costs)
• Budget estimates should, for each element, consist of a base estimate and a risk allowance
• The risk allowance should be assessed for identified risks and not be just guessed at as a percentage of the total. The risk allowance may well exceed the base estimate during the early project stages
• Expenditure of risk allowance should be for identified risks only. Project change control procedures should be invoked where unidentified risks occur

Section 4: Financial Aspects

Investment decision makers must ensure that there is a clear understanding amongst project owners and project sponsors of budgetary limits or other variables in the projects for which they are responsible. They should, as standard practice, ensure that effective monitoring and reporting arrangements are in place, including when it is appropriate for matters to be reported to them personally, and to Ministers or a governing board. Particular care is required in cases which have a high public profile, or those with particularly high risk factors, to ensure effective monitoring and reporting. The outcome of Gateway Reviews of mission critical or high risk projects must be reported to the Accountable Officer who should in turn inform Ministers if serious deficiencies or difficulties have been identified.

This section provides specific advice on budget estimates, risk management, budgets and cost management and financial reviews.

The total cost of a project is made up of many factors having capital, life cycle and whole life implications, including:

• in-house costs and expenses (including all central support services, administration, overheads etc)
• consultancy fees and expenses (design, feasibility, client advice, legal, construction management, site supervision etc)
• land costs
• wayleaves and compensation
• demolition and diversion of existing facilities
• new construction or refurbishment costs
• fit-out costs
• operating costs
• maintenance
• decommissioning
• disposal
• insurances
• VAT
• all other costs relating to the project not listed above, including an adequate allowance for risk

At this early stage, the cost estimates for each factor necessarily will be based on the limited outline information available, and so it may be necessary to make a number of assumptions. Any assumptions should be set down clearly so that they can be verified if necessary and referred to at a later stage. As the project progresses and becomes more clearly defined, the cost estimates need to be revisited and more finely tuned to reflect the better, more detailed information as it becomes available.

During the early project stages, it will be necessary to prepare estimates for a number of options, some of which may include the privately financed non profit distributing model. Advice should be sought from the Scottish Futures Trust.

Budget estimates should, for each element, consist of a base estimate and a risk allowance.

• The base estimate is calculated using estimating techniques appropriate for the stage of the project
• The risk allowance is the sum which is included in the estimate to cover the expected costs of all risks identified by the project team, including the project sponsor, acting collaboratively and participating as stakeholders in the success of the project. The risk allowance should be assessed for identified risks and not be just guessed at as a percentage of the total. During the early stages, it may well exceed the base estimate. As the project progresses, and becomes more clearly defined as the design develops and further studies are carried out, the risk allowance can be expected to diminish as a result of good risk management. At the same time the base estimate will generally increase as those costs that will definitely be expended become clearer (see Figure 1)

Figure 1: Change in base estimate, risk allowance and expenditure with time

What is it?

All projects contain risks that may affect their costs and quality, and the time taken to complete them. Risk management is the identification and assessment of these risks followed by the production, and implementation, of an action plan to manage and control them during the life of the project (i.e. the capital expenditure phase).

Whilst risk can be managed, minimised, shared or accepted, it cannot be ignored and the success or failure of a project depends on the approach taken towards risk. Traditionally, risk management has been applied instinctively, with risks remaining implicit and managed by judgement informed by experience. Systematic risk management, however, explicitly and formally identifies risks, and provides a management tool which supports decision making and informs instinctive judgement. Whilst it is unrealistic to expect that systematic risk management will remove all uncertainties, it can improve the likelihood of a successful project outcome and should be applied wherever possible, depending on the stage of the project and the nature of the risks identifiable at that stage.

Systematic risk management techniques aim to impose control systems in order to deal with risks which have been identified as potential threats to the success of a project. Risk management is a specialist service and the extent to which it is applied will be determined by the particular nature and circumstances of individual projects. For very large, novel or complex projects it is important that appropriate risk management expertise is available within the project team. The existence of an effective risk management framework will be one of the issues that will be examined as part of the regular Gateway Reviews for these projects.

What comprises a comprehensive risk management process?

It will normally cover these stages:

• Identification - what are the risks
• Assessment - probability of occurrence and potential impact on the project
• Response - action taken to manage the risks
• Monitoring and feedback - regularly updating the risk register

Identification

The initial identification of as many risks as possible is essential in terms of understanding the project.

All those involved must devote time to discussing the project in a structured manner, normally at workshops led by a risk management specialist, in order to encourage effective communication and the creative thinking necessary for identifying all foreseeable risks relating to the project. The outcome of these workshops will form the basis of a risk register. Risks may be categorised according to those which are 'fixed' or 'variable' in nature.

• Fixed risks are those which will either be incurred as a whole, or not at all, for example, a new electricity sub-station might be required
• Variable risks relate to circumstances which have a varying probability of occurrence with a variable outcome, for example the demand for car parking spaces may not be known

Assessment

Each identified risk and its possible consequences should be assessed and expressed in terms of cost, time and performance. The estimating technique adopted should be appropriate for the standard of information available. The resultant sums will be the estimated cost to, or effect on, the project if each foreseeable risk was to occur to the fullest possible extent. This estimating stage should result in a statement of risks ranked in terms of their financial, or other, impact on the project, and this should be recorded in the risk register.

The probability of each risk occurring must also be considered. Again, project team collaboration is recommended. 'Probability' relates to the degree of certainty with which it is agreed that a risk will occur. The combination of assessments of risk identification, occurrence and outcome will be set out in the risk register, which should clearly identify and quantify each threat which the stakeholders perceive exists to the successful delivery of the project. The assessment stage will result in each risk having a potential financial implication which reflects its likely cost and the probability of it occurring.

Response

The process of identifying, estimating and evaluating risks allows decisions to be made on how best to manage them. The aim should be to minimise or eliminate any threat posed to the successful delivery of the project. A by-product of these preliminary steps will be the identification of the ownership of any particular risk.

A risk management plan should be prepared and updated regularly to record the management process for monitoring and controlling those risks identified. Care should be taken to ensure that the potential impact of each risk is not outweighed by related direct costs (cost of reducing the risk, cost of transfer or insurance and management/administrative/professional time involved).

A risk response should be formulated once the cause and effect of identified risks have been fully understood. The response will take the form of one or more of the following management actions:

• avoidance - where risks have such serious consequences for the project outcome that they are unacceptable. Avoidance measures might include possible review of project objectives, and re-appraisal of the project in total
• reduction - possible actions could include: further investigation work, re-design, change of materials, components or systems, alternative construction methods and revising the contract strategy
• transfer - passing the risk to another party better able to manage it, although a cost for this transfer is usually paid. To achieve VFM, transfer should only be exercised where the cost of the risk to the organisation is reduced by more than the cost of transfer
• retention - items that are not transferred, avoided or eliminated, and thus have to be managed by the organisation to minimise their potential impact

Risk and procurement strategies are interrelated, with the chosen strategy and form of contract having a substantial bearing on the allocation of risk, the project management requirements, the design strategy, the employment of consultants and contractors, and the way in which the project team work together to achieve the client's objectives. The risks and benefits associated with procurement strategies should be fully identified, considered and evaluated prior to selection and, in the case of mission critical or high risk projects, this information and the recommendation should be presented to the responsible Minister for decision.

Monitoring and Feedback

Risk management is a continuous process that systematically and continually seeks to minimise and eliminate potential threats to successful project delivery. It is important, therefore, that the project team, including the project sponsor, commits itself to regularly updating the risk register and risk management plan as the effects of responses begin to develop. For example, a risk that is dealt with by the incorporation of a design feature will ultimately transfer the quantum from the risk estimate to the base estimate: it cannot exist in both estimates simultaneously.

Regular updating of the risk register and the risk allowance will be included as part of the formal Gateway Review process, and will provide a formal and explicit statement of quantified risks and responses. As the project progresses, effective risk management should ensure the number of risks in the register, and their cost consequences, should diminish.

Investment decision makers must ensure that there is a clear understanding amongst project owners and project sponsors of budgetary limits or other variables in the projects for which they are responsible.

They should, as standard practice, ensure that effective monitoring and reporting arrangements are in place, including when it is appropriate for matters to be reported to them personally, and to Ministers, the Accountable Officer or a governing board. Particular care is required in cases which have a high public profile, or those with particularly high risk factors, to ensure effective monitoring and reporting. The outcome of Gateway Reviews of mission critical or high risk projects must be reported to the Accountable Officer who should in turn inform Ministers if serious deficiencies or difficulties have been identified.

How should budgets be calculated?

At all project stages, for each element of the project, budgets should be calculated on the sum of the base estimate and the risk allowance for that element of the project.

The most important aspect of estimating is to predict at the earliest project stages both the outturn capital cost of the project and its whole life cost. It cannot be over emphasised that an estimate that fails to predict the outturn cost with some degree of certainty is of little value. It is much more important to produce an estimate that properly allows for the cost consequences of risks - and that ultimately predicts the outturn costs - rather than generate a very detailed costing of every single item but which fails to allow for risks and hence fails to predict the outturn cost.

How do risk allowances fit into the picture?

It should not be assumed that the full financial, or other, effect of every risk identified in the risk register will actually occur in practice. In deciding the value of the risk allowance component of any estimate, it is essential to take account of the probability of each risk occurring. The risk allowance should not, therefore, be simply an aggregation of the maximum possible costs of all the individual risks identified but should be based on a sound professional judgement and evaluation of the probability of occurrence and potential impact. This should form the basis of cost reporting.

Expenditure of risk allowance should be for identified risks only. Project change control procedures should be invoked where unidentified risks occur (see Section 2 Annex A).

How effective are cost control measures here?

The establishment of effective procedures (including risk management) at an early stage in the development of a project will help ensure success. Established and effective cost control systems and procedures, understood and adopted by all members of the project team, entail less effort than "crisis management" and will release management effort to other areas of the project.

Cost management should ensure that, throughout the project, full and proper accounts are maintained of all transactions - including commitments, payments and changes - to ensure that all transactions are fully in accord with the requirements of public accountability and probity.

Where does cash flow fit in?

Accurate cash flow forecasting is necessary to help manage expenditure within the budget and to help set future budgets. Experience has shown that projects tend to fall behind programme and hence that expenditure on a particular project is not as rapid as anticipated.

What's the process for monitoring and reporting on expenditure?

To exercise cost control, project sponsors need to review and act on the best and most appropriate cost information. This means that they should receive regular, consistent and accurate cost reports that are both comprehensive in detail and presented in a manner that permits easy understanding of both status and trends. Reports need to be tailored to suit the individual needs of each project and should always be presented to give a comparison of the present position with the control estimate.

Reports to project sponsors normally give only the status of the project overall. But sponsors will, on occasion, need to monitor costs against a specific cost centre in more detail. The typical contents of a cost report are given in Annex A.

The concept of approval gateways is described in Section 1. These gateways are points in the life of a project, beyond which it should not proceed unless specific management and financial reviews have been undertaken. Section 2 describes these processes briefly, including the need for a financial review.

When should financial reviews happen?

They should be carried out at each approval gateway to ensure that:

• a risk management procedure is in place that is appropriate to the particular nature and circumstances of the project
• the base estimate for each element of the project is reasonable and up to date
• the risk allowance for each element of the project is reasonable and up to date (the risk allowance should be for identified risks only)
• the latest estimate for each element is made up of the base estimate and the risk allowance
• the project is affordable
• funds are available for the planned expenditure up to the next approval gateway
• appropriate cost management and reporting procedures for capital, life cycle and whole life costs are in place and being followed

Annex A: Contents of a Financial Report

A.1 The following aspects should be addressed in a financial report (rather than repeating detailed information available in earlier reports, later reports can summarise the key points and cross refer to the relevant earlier reports). The report should cover capital costs as well as the related whole life costs:

• development of budget
• original authorised budget
• new budget authorisations (giving justification for changes)
• current authorised budget
• expenditure to date (each section on budgets and expenditure should address the original base estimates and risk allowances for each element)
• commitments
• agreed variations (giving justification for variations)
• potential/expected claims or disputes awaiting resolution (if the project is going well, this area should be small)
• commitments required to complete
• orders yet to be placed
• variations pending
• future changes anticipated

A.2 Each of the cost elements referred to at the start of Budget Estimates should be covered.

A.3 All prices need to be discounted to a common base.

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