QUT Research Week 2005

Conference Proceedings
Edited by A. C. Sidwell 45 July 2005, Brisbane, Australia

COBRA the Construction Research Conference of the RICS Foundation AUBEA the Australasian Universities' Building Educators Association Conference 3rd CIB Student Chapters International Symposium CIB W89 Building Education and Research CIB TG53 Postgraduate Research Training in Building and Construction

A COLLABORATION OF:

Australasian Universities Building Educators Association

The Queensland University of Technology Research Week International Conference

4-8 July 2005 Brisbane, Australia

Conference Proceedings

Editor: A. C. Sidwell July 2005

Published by: Queensland University of Technology Australia

ISBN 1-74107-101-1

COST VALUE RECONCILIATION (CVR) IN THE UK CONSTRUCTION INDUSTRY

Paul Stephenson and Matthew Steven Hill
Faculty of Development and Society, Sheffield Hallam University, Sheffield, UK

ABSTRACT
The application of cost value reconciliation (CVR) in the construction industry is considered an important part of cost management for the financial control of construction projects. However, it is often assumed that CVR is not widely utilised by contracting organisations operating in the UK construction sector. This is purported to be due to the associated resource requirements and technical skills necessary to accurately incorporate the technique into an organisations processes. Clearly, this is especially the case with regard to smaller contractors with less financial capabilities, and a requirement to keep overhead costs to a minimum. This assumption has formulated the basis of this research. The review of literature indicated that the field of CVR is not a widely covered topic. This paper therefore considers the application of CVR in the UK construction industry. This includes how CVRs are produced and the information output, in addition to a measure of its utilisation within industry. Additionally, areas are identified that may be adapted in order to increase its application. From the research theoretical CVR models are developed aimed at enhancing CVR as a management tool. The proposed models are devised to widen the application of CVR amongst contractors with less financial capabilities or for those that operate mostly on shortterm contracts. Additionally, the proposed models will provide the opportunity to enhance the benefits to those who regularly apply the technique in practice. Keywords: budget monitoring, cost and value forecasts, project cost accounts.

INTRODUCTION
There are many aspects of construction work which impinge on the process of bringing a project to a successful conclusion (Pilcher, 1994). Almost every project undertaken within the construction industry is to some extent unique and will contain some elements of uncertainty. Therefore, losses and possible ultimate financial failure are an ever present problem, and even the most sophisticated contractors may operate on a very low percentage profit turnover (Upson, 1987). With clients demanding more complex and sophisticated buildings, to be constructed with increasingly tight budgets, cost control and financial management is of paramount importance. Therefore, for all construction projects, costs must be monitored and controlled, whether from the point of view of the client or owner, or the designer or builder. It is suggested that many contractors only compare cost and value when the final account has been agreed. However, it is essential that such reconciliations are completed during intermediate stages of individual contracts, primarily to establish the respective profitability but also to identify any financial difficulties.

Stephenson and Hill

Financial control through a CVR can provide detailed information to identify the need for reserves, downturns in cash flow, and information to make decisions to stem future losses (Perceval, 1997).

OVERVIEW OF COST VALUE RECONCILIATION

Cost Value Reconciliation (CVR) brings together the established totals for cost and value to illustrate the profitability of a company. Its intention is to ensure that the profits shown in company accounts are accurate and realistically display the current financial position. In this respect, the purpose of CVR is twofold. Firstly, there is the requirement to provide statutory accounts, which is a legal obligation to provide certain financial information (Perceval, 1997), in addition to the Standard Statement of Accounting Practice number 9 (SSAP9), (ICAEW, 1998) which set out accounting recommendations and requirements for the construction industry. Secondly, and perhaps more importantly, is the provision of information which can have a direct bearing on the management of the operations within a company, at all levels (Perceval, 1997). This is of course dependent upon the information being properly and accurately provided and interpreted. Therefore, the information must be in a format that will enable management decisions to be made, taking influence from the figures displayed.

APPLICATION OF CVR
A CVR at a specific data is relatively meaningless unless it is accompanied by an analysis of the final position of the contract (Capon, 1990). Without additional data; such as a cost to complete analysis, or means of being certain of a profit at the final position of the contract, there can be no justification of taking profit. However, the detailed preparation of the reconciliation together with the associated forecasts to completion, provide management with a very powerful tool for the identification of potential problems or critical elements of the contract. In this respect, if reconciliations identify that a project is making a loss, the process has relatively limited value without being able to identify the reasons for the losses occurring and thus providing vital information to prevent a repetition of the loss (Harrison, 1993). An effective CVR form should generally contain: the initial tender figures and expected profit, forecast figures at completion for value and profit, the current payment applications by the contractor, the current certified value, an account of any adjustments or provisions to the certified valuation, the cost to date at the accounting period in question, and the cash received to date including the retention deducted and certified sums unpaid (Barrett, 1992). Such information will facilitate a comprehensive CVR assessment to be completed, which will allow the current financial position of the project to be determined. This will also better indicate the final position of a contract. The responsibility for cost value reconciliations will vary from company to company. However, it is essential that those responsible are aware of all of the implications and requirements of SSAP9 (Upson, 1987). Those performing such financial management techniques should be prudent to ensure that they are accurate and realistic to prevent a company claiming that they are more profitable than they actually are. There is no defined frequency at which CVRs should take place and there is no timing criteria set in SSAP9. However, good management practice denotes that to effectively control project finances such reports should be carried out on a reliable and regular

CVR in the UK construction industry

basis, and should ideally coincide with either the availability of cost figures or current valuations, and preferably both (Upson, 1987).

DATA COLLECTION AND ANALYSIS

To ascertain the current status of CVR in the UK postal questionnaires were obtained based on one hundred contractors operating in the construction sector, throughout England, Scotland and Wales. The selected contractors were identified by turnover, as being medium or large companies. Also, such organisations will have the most experience and knowledge of the production and application of CVR, and therefore, will be in a more suitable position to provide rich and consequential data, especially regarding how CVR can be standardised. A sample of the findings is presented here. Contractors were specifically asked if they utilised CVR techniques to control project costs. From the response received 84% utilise CVR and the remaining 16% used other techniques. Attention was also focused on how are CVRs were produced within organisations to establish if there was a common trend in the production of cost value reconciliations. This provided an insight into what aspect of the CVR process, either cost or value, could best be adapted. From the respondents, 81% indicated that they produced CVRs by amending the interim valuations for the work completed, and the remaining 19% made adjustments to their cost accounts. By adjusting the interim valuations, the production of CVRs was considered to become far more complicated and requires greater resources expenditure, regarding cost, time, and technical skills. This is one aspect that is of particular significance as considerable developments could be made to the way in which the production of CVRs is approached, especially by smaller companies. Additionally assessment was made of the awareness of information output of CVRs, either during the CVR process or once the reconciliation has been completed. Such data relates to both individual projects and the operations and provisions of a company. Again this question was subdivided to determine not only the awareness of the information output of CVRs, but also the perceived usefulness of such data. Table 1 illustrates the responses received. Here, the respondents were more aware of the potential to derive information from CVRs regarding individual projects rather than that relating to the management of the company. This was particularly so where additional information was provided, which generally related to statements of cost accruals and claims recovery.
Table 1: Analysis of the information output from CVRs Information output from CVRs Awareness of the information: Yes Accurate statement of the present profit/loss on individual projects Accurate statement of the current profit/loss for the present accounting period Accurate statement of the current profit/loss for the present financial year Current cash position of company Summary of the companys provisions 56% Details of overhead recovery on individual projects 53% 44% 47% 84% 75% 16% 25% 100% 97% 94% 78% 3% 6% 22% No Usefulness of the information: Very 100% 100% 94% 91% 6% 9% Not very

Stephenson and Hill

Data were also collected in relation to CVR and other cost control techniques. This provided for identification of where CVR was under performing or where other techniques were performing better than CVR. From such data, ideas can be generated relating to standardisation of the application of CVR that could also be validated by hard evidence. The majority of organisations used a budget monitor system followed by those using a cost coding system. These were the main two techniques used though others such as, earned value management, and network analysis methods were also applied to control project costs. The main features of the cost control systems in the survey were also reflective of the perceived usefulness of the techniques. Budget monitoring systems illustrated close assessment of identified budgets with actual expenditure for monitoring purposes. Cost coding systems identified the features of identifiable costs which could be coded and related to cost centres and sections of work, some being integrated into company accounting systems. Earned value management, while being less popular than the previous two, provides the opportunity for project assessment in terms of cost and time. Data can be established, and also presented graphically, for budgeted cost of work performed (BCWP), actual cost of work performed (ACWP) and budgeted cost of work performed (BCWP) i.e. earned value. This provides a powerful tool for use in project cost control and is starting to gain more widespread use within UK construction. Network analysis, however, did not feature strongly in the survey, although its use in cost control can be directly related to programmed activities of construction work. The responses from companies using these techniques are shown in figure 1.

40 35 Number of respondents 30 25 20 15 10 5 1 0 Budget monitor system Network analysis Cost coding system Earned value management 9 23 34

Cost control techniques

Figure 1: Additional cost control techniques utilised

Furthermore, the reasons for the selection of the cost control techniques utilised, including CVR, were examined to identify what the determining factors are. The responses received are demonstrated in figure 2. It was identified that company polices and best practice procedures were the most dominant selection factors. With regards to CVR, best practice procedures tend to relate to SSAP9 and the production of management of company accounts. This also

CVR in the UK construction industry

30 27 25 25 Number of respondents

20 15 15

10 7 5 4 6

0 Company policy Best practice procedures Legislation/audit trails Cost/time constraints Contractual obligations Contract length

Selection factors

Figure 2: How the techniques utilised are determined

relates to compliance of company policy, although only 18% of the respondents regard audit trails as determining selection factors. Additionally, cost and time constraints were a predominant selection factor, as it was highlighted by 39% of the responding contractors. In relation to CVR, as highlighted previously, the time and cost to complete is a particular drawback of the technique and is one of the main factors that discourages contractors from utilising the process. In terms of specific advantages of CVR over these techniques, respondents identified that the specific aspects of CVR that stand out from other cost control techniques relate to the accuracy of the information produced. Though, it was stated that this information is subjective to judgment and is only as accurate as that used in its production. Despite these factors, it was stated: That close control over project cost, company provisions and overheads, and value earned are vital to the success of a construction company, and that CVR provides such control the most accurately. Furthermore, it was also recognised that greater control outside the boundaries of an individual project is received from CVR above other techniques. These responses validate the utilisation of CVR as a primary measure to be used in the construction sector, though through its current use, its application amongst smaller contractors in many cases remains unjustifiable. The disadvantages of CVR over these techniques focused on skill requirements of the individuals producing the CVRs, and that they are based on the judgment of a specific individual. In this respect, this should not be a factor to discourage the application of CVR as it must be considered that such factors are not the cause of the technique but rather the individuals involved and that prudence is an essential factor in CVR accuracy and success.

Stephenson and Hill

CVR MODEL
From the knowledge gained on the application of CVR and the information extracted from the research, a theoretical model was developed in order to standardise the application of CVR and enhance the benefits. This is shown in Figure 3.

Establish project cost accounting system for duration of project

External interim valuation received from Cut-off cost accounts to establish cost to date for work performed Completion by contractor Amend external valuation (to incorporate: claims, variations, overvaluation, and undervaluation) Adjust cost to date figures (to include cost accruals for materials, plant, labour and subcontractors) Completion by contractor Completion by contractor

Add provisions for additional future work not recoverable under the contract

Reconcile adjusted totals to determine present project performance and profit

Note: Completion by contractor refers to an individual with detailed knowledge of the contract (e.g. a site manager)

Information Output: profit earned to date, profit expectations of project, movement in company provisions, present cash position

Figure 3: Flowchart of proposed CVR model

To increase the utilisation of CVR amongst contractors with lower financial capabilities or who largely participate in contracts of a lesser value, a CVR system could be set up where each individual project establishes its own cost accounts, which is on-going for the duration of the project.

CVR in the UK construction industry

By this method, when the interim external valuation is certified by the clients architect, the project costing account is cut-off to coincide with the date of the valuation. Here a total for the cost to date can be established, which will cover the same quantity of work as that certified in the valuation. However, before these totals can be reconciled, some preliminary adjustments may be required. From the external valuation received, adjustments may be necessary to incorporate the anticipated value of any disputed items or variations involved in the contract, or for items that have been under/over valued. For such adjustments SSAP9 requires a conservative estimate to be made. Therefore, the completion of this aspect of the CVR can be performed by an individual with detailed knowledge of the contract, but without specialist skills in this field; for example, a site manager. By producing the totals for the valuation side, a large proportion of the required calculations and assessments will have been transferred to the clients QS. Thus, the process of establishing the value earned to date is largely shortened whilst the accuracy is maintained. However, such a process does denote that the value earned may be determined by the client rather than the contractor if the external valuations are not closely examine to ensure they represent the work completed. Furthermore, additional calculations may be necessary to incorporate any provisions required for future costs not recoverable under the conditions of the contract. To maintain the accuracy of the reconciliations, the project cost will need to be closely monitored to ensure that the costs included have actually been incurred and therefore, that cost matches revenue. If the contractor can make every endeavour to ensure that the monthly valuations coincide as nearly as possible with the companys accounting period, then this will quicken the CVR process as it will substantially reduce the adjustments to be made. However, this is often unlikely, and therefore to ensure that they represent the same quantity of work, necessary adjustments may be required to the established actual cost to date totals. The adjustments will be predominantly made to material, plant and subcontractor costs. When the interim valuation is prepared materials incorporated into the works or stored on site will be included in the detailed make-up of the valuation. However, the relevant invoices for such materials may not necessarily have been raised by the supplier or indeed received by the contractor, and consequently they will be excluded from the cost accounts. In such circumstances a schedule of accruals will need to be prepared in order that cost may be adjusted to match the valuation. Where plant is hired externally similar problems to those outlined above will also apply to plant invoices. In fact, it is probably more common for plant invoices to be delayed as plant hire companies often delay raising invoices until the plant is taken off hire. Moreover, delivery and collection charges may also distort the true costs at various stages of the contract, and the contractor may be contra-charged for any losses or damage to plant. It is therefore essential that provisions for anticipated losses or damage are made and any adjustments for distortions or late invoices are made to the cost accounts. Payments to subcontractors are likely to be inaccurate during the course of an accounting period for a number of reasons. Primarily, there is likely to be a difference in the date of the close down of the cost accounts to the date that the subcontractor submits their application for payment. Such payment applications will cover a difference quantity of work to that of the cost accounts, and therefore, adjustment will be necessary to the cost of the subcontracted work to ensure that it covers the same

Stephenson and Hill

volume of work. Such adjustments can easily be made on a pro-rata basis. In this respect, the valuation of the subcontractors work may also be inaccurate as it may be considerably under or overvalued. In such circumstances, the contractor will be required to establish an accurate valuation of the work carried out by the subcontractor and take the relevant costs of such work into their cost accounts. Additional difficulties may occur where the subcontractor has claims against the main contractor which have not been settled. Here, the amount of the claim must be added to the adjusted cost. The process of the cost side of the reconciliation, including the adjustments that may be required, is largely unchanged from that of the traditional CVR process. Though additional calculations are necessary to primarily establish the cost to date when the cost account is cut off. However, this does not denote that additionally skills or resources are required on the individual producing the CVR. Again, any individual with detailed knowledge of the contract, such as a site manager, can prepare such calculations, as they are relatively straight forward. This should therefore become routine practice in a short period of time. Additionally, it is unlikely that any training would be required to enable such an individual to produce such data. Once realistic and accurate totals have been calculated for the costs incurred and value earned, including provisions for future additional costs and foreseeable losses, the figures can be reconciled. By subtracting the cost from the value, the present profitability performance of the contract will be determined. At project level, the information output, accuracy and control received from this CVR model would be the same as a traditional CVR system; thus enabling management to make essential decisions regarding the performance of the project. However, the skills, resources and time required to produce the reconciliation outcomes would be significantly shorten as a large quantity of the calculations will be produced outside the organisation. As previously highlighted, this does transfer the establishment of the contractors value earned to the clients representatives, and therefore, the contractors must demonstrate caution. Conversely, at an organisation level, the simplified CVR model is less satisfactory as accurately transferring the established data to company accounts becomes difficult. This is because the dates at which the reconciliations will take place will be determined by the production of the external valuations for each project, rather than a standard cost cut off date across all projects undertaken by the contractor. Therefore, annual reporting would require additional reconciliations or the continuation of techniques already in place. Furthermore, on long-term contracts, the determination of attributable profits to be taken into a companys accounts would also become difficult, especially in conformance to the provisions of SSAP9 and general rules of prudence. However, it was established that the level of control extracted from CVRs by those that apply the technique was significantly less than for contracts of a smaller value or shorter duration. With regards to smaller contractors, it could be assumed that they would be predominantly involved in such contracts and therefore the level of control received at project level would be sufficient to justify its application.

CVR AND BUDGET MONITOR SYSTEMS

The CVR model previously proposed does not significantly advance the technique and is rather an adaptation of the traditional CVR process. From the research

CVR in the UK construction industry

undertaken it was noted that some contractors proposed the application of CVR in conjunction with a budget monitor system. By combining such techniques, it is possible to enhance management control of project costing accounts in addition to the variation of standards of prudence. This should inevitably increase the accuracy of the information produced from the reconciliations completed. If a budget monitor system is to be used in conjunction with CVR, it should be set up alongside project cost accounts, to allow relevant costing information to be transferred across. This is illustrated in figure 4.

Cost Value Reconciliation (CVR)

Budget Monitor System (BMS)

Receive External Valuation from clients QS

Record and monitor costs incurred and cost accruals

Calculate cost to date to for work completed to valuation date

Completed by contractor

Records of cost accruals and project progress against programme, used to aid calculations

Adjust valuation and costs totals as necessary to accurately represent value earned and costs incurred

Completed by contractor

Forecasts of financial performance of future events used to aid calculations

Assessment of provisions used to aid calculations

Establish cost to complete and anticipated future position of contract

Reconcile established totals to determine current trading position of contract

Information produced: Profit/loss summaries, Provisions summary, Cash position, Future position of contract, Progress assessments, Performance of work executed

Figure 4: Flowchart of CVR and BMS model used to enhance management control

Cost value reconciliations provide a snap shot of the financial status at a particular time, without necessarily presenting information regarding the final outcome of a project. Combined with a budget monitory system, data concerning future resource

Stephenson and Hill

levels, methods of sequence of work, and programme progress, would also be provided. This would facilitate cost/time assessment and provide a direct relationship between cost and progress/performance on construction projects. Financial control through a CVR and BMS would also provide detailed information to identify the need for reserves, downturns in cash flow and information to make decisions to stem future losses. Therefore, management should use CVRs in conjunction a BMS to highlight variances and consider what can or should be done to improve the current position. Such considerations are mainly concerned with adverse variances, but opportunities to improve on a favourable variance should not be overlooked. In this respect, the combination of a CVR and BMS provide management with relevant information allowing them to make appropriate decisions with regards to future activities to be undertaken on a project. The main advantage of utilising a BMS is to add to the accuracy of the information produced, which will be received through the determination of the future position of the contract. As work commences more is known about the likely actual costs of future work. For example, the number of resources required in the performance of major activities, sub-contracts let at greater or smaller margins than provided in the tender, and progress against programme. By bringing such data together it will be possible to set out the expected costs and income from the main activities, which may reveal that the original targets and profit expectations may no longer be attainable, or even may be exceeded. For such information the establishment of costs to complete, foreseeable losses, future provisions or unprofitable future work becomes far simpler to calculate. Furthermore, it will also indicate the areas of the contract or programme requiring change or remedial action, in far greater detail than could be established solely from a CVR. Using a BMS in conjunction with CVRs would certainly enhance the performance and accuracy of the information produced, and the extent of management control from a traditional CVR. However, such a system would require a greater number of resources, certainly in relation to IT provisions, but would also have cost and time constraints. Therefore, with regards to the application of such a system amongst smaller contractors, the additional resources requirements and levels of control may be too vast to justify its utilisation. This is especially so if the budget is to be used in conjunction with the CVR model as accurately transferring the information produced to company accounts would remain difficult. Such a system would therefore be better suited to a traditional approach to CVR, where the reconciliations are produced at the close of the companys cost accounts for all projects undertaken. Here the budget system would certify and enhance the accuracy of the information produced by control in the standards of prudence, but would also greatly aid management in their decision making processes. Additionally, profits taken up on long-term contracts would be further certified, allowing companies to ensure their accounts are fairly representative of their actual trading position. In this respect, using the two techniques in conjunction would be better utilised by larger contractors with the financial capabilities to establish and support the resource demands.

SUMMARY
From the research and the application of CVR in the UK construction industry it has been established that, as a whole, the full potential of CVR is being realised by those

CVR in the UK construction industry

that utilise it. It was observed that CVR is mostly applied as a management tool, at both project level and throughout the financial management of company operations. The research also identified the essential characteristics of CVR in addition to specific areas which were comparably underperforming. The theoretical models developed on the findings of the research demonstrate how CVR could be adapted to increase the benefits realised by contractors. Firstly, a model was identified that would increase the application of CVR amongst contractors with lower financial capabilities, referred to as smaller contractors. Such companies could not justify the application of a traditional CVR technique as the value received, with regards to the level of control desired, would be largely outweighed by the resource input required. Therefore, by simplifying the process of producing CVRs without reducing the accuracy of the information output at project level, the introduction of project costing accounts provide a satisfactory alternative. More conclusively, by utilising CVRs in conjunction with a BMS, the benefits received are enhanced as a contractor is more able to forecast and control future activities and is able to base decisions made on reliable information. Additionally, by combining the techniques the accuracy of the information produced is validated as the BMS reduces the judgments to be made and restricts variances in standards of prudence; thus enhancing the benefits received.

REFERENCES
Barrett, F. R. (1992) Cost Value Reconciliation (2nd edition), Berkshire, The Chartered Institute of Building. Capon, G. C. C. (1990) Construction Industry: An industry accounting and auditing guide, London, Chartac Books. Harrison, R. S. (1993) The transfer of information between estimating and other functions in a contractors organisation, Construction Papers, Berkshire, The Chartered Institute of Building. Perceval, C. S. (1997) Management and Financial Reporting, Construction Papers, Berkshire, The Chartered Institute of Building. Pilcher, R. (1994) Project Cost Control in Construction (2nd edition), Oxford, Blackwell Scientific Publications. The Institute of Chartered Accountants in England and Wales (ICAEW) (1998) Standard Statement of Accounting Practice 9 (Revised): Stocks and long-term contracts, London, The Institute of Chartered Accountants in England and Wales. Upson, A. (1987) Financial Management for Contractors, Oxford, BSP Profession Books.