Cash flow forecasting for construction – art or science?

Howard Wellings MSc MRICS FCInstCES, Managing Quantity Surveyor 

The importance of cash forecasting in construction

IN general terms a typical definition of cash flow is the movement of money into and out of a business (or project) at specified periods of time. It is important a cash flow forecast that can be relied upon is in place from inception of a project so that the client is aware of the amount and timing of payments so it can have the liquid funds available to meet its obligations to the supply chain when they become due.

Profile of expenditure for a construction project

To determine the monthly expenditure the easiest solution would be to divide the forecast construction cost by the number of interim valuations. This would produce an equal monthly rate of spend which when plotted on a chart would generate a straight line. Construction projects are much more complex than this.

The construction phase of a project starts slowly as the site facilities are established, trades are brought on to the site and the labour force progressively increased until optimum rates of production are being achieved. This situation continues through the middle part of the project until the rate of production starts to fall as the works are gradually completed, trades leave the site and the labour force is reduced as the project is prepared for handing over to the client.

If the forecast cumulative expenditure is plotted on a chart it creates a line in the shape of a lazy ‘s’ which is known as an S-curve. The monthly period values plotted on the same chart produce a shape known, in statistical terminology, as a normal distribution or ‘bell curve’.

Chart showing expected profile of expenditure.

Information required to prepare a cash flow forecast

A project cash flow forecast will use information already prepared to determine the forecast total construction cost and expected programme and will comprise:

Construction cost

• During the pre-construction period this would be based on the forecast cost plan. 
• At contract award/commencement of the works the agreed contract sum can be used. 
• During the construction stage of the project the forecast final account will be used.

Construction programme

• During the pre-construction period this would be based on the preliminary programme.
• At contract award/commencement of the works the agreed programme can be used. 
• During the construction stage of the project the current programme and forecast completion date will be used.

Payment arrangements: These will be in accordance with the contract between the client and the contractor and determine how interim valuations will be prepared and when they will be required to be paid. 

• Construction act: In the United Kingdom (UK) the payment arrangements will have to comply with the Housing Grants, Construction and Regeneration Act (HGCRA) 1996 as updated by the Local Democracy, Economic Development and Construction Act 2009.
• Frequency of interim valuations: These will usually be at monthly intervals.
• Payment period: The period between the preparation of an interim valuation and the payment being made to the contractor will typically be three to four weeks, however, some developers and private clients may try to negotiate longer periods.
• Retention: This is usually 3% but on lower value projects may be 5%. Retention funds cany be subject to an upper limit. 
• Defects liability period: This will be either 12 or 24 months from the date of project handover. Half the retention will be held until the end of the defects liability period and until all defects have been corrected by the contractor. 
• Taxation: In the UK Value Added Tax (VAT) will apply to the supply of construction works in accordance with the latest procedures issued by His Majesty’s Revenue and Customs.

Payment mechanism: The method selected will be set out in the contract together with any other specific requirements being either: 

• Measurement based: Firm bills of quantities (lump sum), approximate bills of quantities (remeasurement) or a schedule of rates and prices. 
• Performance related: Activity schedules, milestones or stage payments. 
• Cost reimbursement methods: Cost plus fixed lump sum fee, cost plus variable % fee or target cost.

Cash flow forecasting techniques

Various alternative techniques are available to allow cash flow forecasts to be prepared at different times in the life cycle of a project and these are described below.

Pre-construction period

Thirds and quarters method: This method states that:

• One quarter of expenditure will occur during the first third of the project.
• Half the expenditure will happen in the in the second third of the project.
• One quarter of expenditure will take place during the final third of the project.

The monthly amounts will then be established by interpolation between the four known values (i.e. at 0%, 33%, 67% and 100%). While this is a simple approach suitable for straight forward projects it provides results which are in line with those produced by the Department of Health and Social Security (DHSS) formula when using the same data.

DHSS expenditure forecasting method: During the 1960s the DHSS was finding that forecasts of the expenditure expected during hospital construction projects was generally not accurate enough. A programme of research led by KW Hudson was then undertaken during the late 1960s into the early 1970s to determine the rate of expenditure achieved on numerous projects, and this resulted in the creation of the DHSS expenditure forecasting method that used a formula for calculating interim payments. The formula is expressed in the following terms:

The DHSS formula was derived solely from hospital projects carried out over 50 years ago but despite concerns regarding its reliability it is still being widely used today.

The construction industry is continually developing and the ways in which it operates are evolving and since this research was carried out the following aspects have changed and need appropriate consideration when this formula is being used:

• Procurement: In the 1970s the principal procurement route would have been single stage competitive tendering with contractors commonly appointed using the JCT Form of Contract 1963 edition, whereas today frameworks using the latest version of the New Engineering Contract (NEC4) are often the preferred option.
• Design: At the time of the research the design would have been organised by the client using either in-house resources or external consultants. While this is still an option today the design responsibility is often taken by the contractor under design and build arrangements.
• Construction periods: The construction industry is now more efficient with faster rates of construction, with this benefit being reflected in the forecast programme for the construction works.
• Resourcing: Historically contractors used predominately directly employed labour and mainly their own plant. Today, most of the work is carried out by subcontractors working under supply and fix arrangements with some trades such as structural steelwork, precast concrete, engineering services and others carrying out the design of their works as well.
• Inflation: In the 50 or so years since the original formula was created the cost categories upon which the different parameters apply need to be brought forward to current day prices by using a suitable index such as the Building Cost Information Service (BCIS) All-in Tender Price Index or General Building Cost Index.

The standard parameters C and K form the basis of forecasts produced by the DHSS formula, but they can be changed to simulate different rates of expenditure. Parameter C affects the rate of build-up and run down whereas K affects the rate of expenditure over the middle portion of the project. While the formula is often used in its original form, if the information is available, different standard C and K parameters can be calculated for any type of building project – schools, offices, warehouse, etc.

In the 1970s the principal procurement route would have been single stage competitive tendering with contractors commonly appointed using the JCT Form of Contract 1963 edition.Proprietary software

Proprietary software packages are available to manage the cash flow forecasting process. Typically, this software includes the following features: 

• A formula method for use in the preconstruction period.
• A priced programme approach for the construction period.
• The facility to update forecasts.
• The capability to provide output intabular or graphical form.

Although this software does not allow you to do anything that cannot be achieved by using a custom spreadsheet some organisations like the control given by these applications and the consistent results and outputs they provide.

Chart showing period between valuation and payment.

Further considerations

All construction projects are different and cash flow forecasts need to reflect the specific requirements of the project for which they are being prepared. Adjustments to formula-based methods may be needed during the pre-construction phase and these could include:

• Allowances for site shutdowns for public holidays, Easter and Christmas/New year holidays. 
• Phased or sectional commencement and/or completion of the works including any non-working time between phases or sections.
• The use of modern methods of construction which transfer work to offsite facilities and can result in later cash flows than would occur if the work was carried out traditionally on site.

Construction phase

Pricing the programme

When the contractor has been appointed the agreed build-up to the contract sum and the proposed programme can be used to create the construction phase cash flow forecast. By combining these two sets of information a forecast that is more accurate than those obtained during the preconstruction stage can be prepared.

The ease with which this task can be carried out is dependent on which of the available pricing options is being used for the contract. Each individual method will require different approaches and the rules set out in the contract need to be fully understood when preparing the forecast. If bills of quantities are being used the individual items can be allocated to the appropriate programme activity. If one of the performance related methods is being used the dates when activities, milestones or stage payments are planned to be completed can be matched with each item.

The use of the performance related options is intended to make the interim valuation process simpler and less adversarial and to incentivise the contractor to complete the items of work on or before the programmed date to enable their cash inflows to be maximised. These options are not, however, always as straightforward to use as the process intends.

Variations may be instructed, progress of the works delayed or there may be differences regarding what constitutes completion e.g. Is a concrete structure complete if there are still concrete finishing works to carry out? Clients and contractors must ensure that it is clearly recorded what constitutes completion of items when the content of the pricing document is being agreed.

The cost reimbursement options are initially straightforward because the value to be paid for each item equals the cost plus the fee, however, as the works proceed the contractor’s cost ledger may include items which are included within the fee % and there may be disallowed costs to deduct.

Chart showing forecast vs actual expenditure.

GC/works/1(edition 3) form of contract

A different use for a cash flow forecast was included within the General Conditions of Contract for Building and Civil Engineering Standard Form of Contract – Lump Sum Without Quantities GC/Works/1(Edition 3) produced by the Department of Environment in August 1991. This contract included a model stage payment chart for contract values above £5,500,000.00 (at August 1991 prices). Each invitation to tender then included a project specific stage payment chart which set out the % proportion of the contract sum payable for each week of the contract period and was intended to be a tabulated mathematical expression of the payment S-curve.

When the contract was awarded, and the valuation dates agreed, the amounts forecast to be paid would be determined by multiplying the contract sum by the % payable for the week in which each interim valuation was to be prepared. When the interim valuations were prepared the amount originally calculated would be subject to adjustment for variations, claims and progress of the works not being in accordance with the programme.

Reporting and updating

A cash flow forecast should comprise:

1.  A supporting narrative explaining the basis of the report and the sources of the information used in its preparation.
2.  A table of figures showing the current forecast compared with the previous forecast.
3.  A chart derived from the table of figures.

Each month the cash flow forecast should be updated and any variances to the previous forecast identified and fully explained to allow them to be interrogated in detail. Differences of opinion between the client and the contractor regarding the forecast value of the works and/or the completion date can make the updating process more difficult as the contractor’s report will be based on its view of the expected outcomes.

Clients and contractors must ensure that it is clearly recorded what constitutes completion of items when the content of the pricing document is being agreed.Client’s specific requirements

In addition to the construction cost quantity surveyors working for or advising client organisations will be required to create a whole life project expenditure forecast by including the other costs the client will also incur in carrying out the project.

These costs may include: 

• Land purchase. 
• Consultant’s fees. 
• Staff costs. 
• Advance or enabling works contracts. 
• Information and computer technology (ICT).
• Fitting out including furniture, equipment and machinery.
• Finance charges (money borrowed or provided from own resources).
• Contingencies and risk provisions.

Contractor’s additional requirements

In addition to needing to know under the construction contract with the client what it can expect to be paid and when, contractors will also have requirements for other cash flow forecasts.

Tender Settlements

Some contractors require a cash flow forecast to be prepared for discussion at tender settlement meetings. This will inform management of the finance required to be provided by the contractor until such time the project will achieve positive cash flows. Based on this cash flow forecast the contractor’s management may decide an additional allowance needs to be included in the tender for financing the project and/ or the risks associated with this obligation.

Accounting procedures and reporting requirements

Each month the contractor’s reporting arrangements will usually involve the preparation of a cost and value report (CVR) together with attendance at a project review. The forecast value (turnover) still to be earned and the cost to be spent to complete the project will have been ascertained but it will also be necessary to determine what the amounts will be for each remaining month of the project. While not a cash flow forecast in the truest sense the same methodology is used to forecast what these monthly amounts will be.

Value

The internal value will be calculated using the contractor’s internal build-up to the contract sum and must comply with the contactor’s accounting procedures and reporting requirements.

While these will vary from firm to firm, they could include:

• Treatment of unfixed materials stored on or off the site. 
• Criteria for taking variations or claims into value.
• The amounts and timing when any margin can be drawn down.

In addition, local management will determine the treatment of any adjustments to the tender, the use of the firm price allowances and the expenditure of reserves for contingencies and risk. These procedures are in place to ensure cost reports, and the turnover and cost flow forecasts they include, are always prepared in a consistent manner throughout the business and to ensure that project results are not overstated.

Chart showing contractor's cash flows during the early part of a project.

Cost

In addition to the direct costs to be incurred in completing the project allowances will usually be made for provisions and prepayments:

Provisions: These are liabilities of uncertain amount for items which are expected to occur at some point in the future and may include:

• Staff bonuses.
• Repairs and losses to plant.
• Uninsured amounts.
• Redundancy payments. 
• Snagging and defects liabilities.

Prepayments: These are for items paid for in advance but where all or part of the benefit is received in a later period and may include:

• Annual subscriptions for trade memberships or staff professional fees.
• Land rental for site compound.
• Standing charges for services such as electricity or water provided to the site compound.

Cost must always be matched with the corresponding value. As most goods or services are paid out in arrears, they should be allocated to the month in which they are to be incurred rather than when they will be paid. If this requirement is not properly complied with the margin (profit or loss) being generated by the project could be incorrectly stated.

Actual cash flows

A final requirement may be the preparation of a cash flow forecast that shows:

1.  When the payment of the client’s interim valuations will be received
2.  When the costs being incurred by the contractor are required to be paid out
3.  The cumulative cash flow position.

The combination of this data will show the true cash flows and the point in time when the contractor can expect to achieve a continual positive cash position. Due to the period between interim valuations being prepared and the corresponding interim payment being received, the deduction of retention, possibly the late agreement of variations and claims and the low margins that contractors earn it can be late in the life cycle of a project before positive cash flows can be maintained.

Conclusion

Preparing and maintaining up to date cash flow forecasts can be a demanding and time-consuming task but they are of great importance to both the client and contractor and play an important role in the successful commercial management of construction projects. 

Howard Wellings MSc MRICS FCInstCES

howardmw27@gmail.com