Capital project cash flow management: using these tools to manage capital project cash flows can increase investment earnings, reduce borrowing costs, and prevent potentially embarrassing and frustrating cash flow problems.

Last minute changes in payment schedules on capital projects can be among the most frustrating and unpredictable complicating factors in effective municipal cash management. Capital projects are by definition big ticket items that have a major impact on municipal finances; consequently they require significant planning and coordination on the part of government finance officers. Managing capital project cash flows is often complicated by the need to manage time-limited grant funds and proceeds from debt that are subject to arbitrage regulations.

Changes in payment schedules, can create serious problems for governments. However, such changes in schedule are sometimes unavoidable. Managers responsible for the construction of facilities or completion of economic development projects often face unforeseen changes in circumstances and conditions that impact project timing and cost.

WHY ARE CAPITAL PROJECTS SO UNPREDICTABLE?

While blaming a project's engineers may be the most emotionally gratifying way to explain the unpredictability of capital projects, there are other common causes. Understanding these other common causes can help government finance officers better manage related cash flows.

Project Costs Estimates and Budgets. A number of factors can lead to discrepancies between initial project cost estimates and actual project costs. For example, if inflation is underestimated or not built into the project budget, an estimate that was made a year or more before the project actually begins will be insufficient from the start. Another common error in project budgeting is misunderstanding the nature of the engineering estimate being used. While a conceptual cost estimate may be needed for initial discussions on whether or not to move forward with a project, these types of estimates are not based on a thorough analysis of project-specific conditions. As a result, actual project costs could very likely be significantly different.

Changes in Scope. Changes in project scope are another, particularly frustrating, source of project unpredictability. Changes in scope are sometimes the result of errors or oversights in project planning that are required to ensure the facility functions as necessary upon completion. However, many scope changes result from stakeholder requests to add functionality to the project after work has started.

Unforeseeable Circumstances. Unforeseeable changes in circumstances can take place on a local or a global level that can have major impacts on project costs. On a local level, unexpected soil conditions, property acquisition costs, or labor shortages in key trades can result in project delays or cost overruns on even the best-planned project. On a global level, changes in the cost of steel, concrete, or fuel can have major effects on actual project cost.

Communication and Coordination. Human error also causes project unpredictability. When project managers fail either to effectively manage project costs or communicate potential changes to the appropriate finance officials in a timely manner, cash flow problems can also result.

MAKING THE UNPREDICTABLE MORE PREDICTABLE

While the challenges that capital projects present to municipal cash flow management are substantial, government finance officers can take actions in several areas to make the unpredictable more predictable.

Start with a Good Project Budget. The foundation of a predictable, and successful, capital project is a detailed and accurate budget. Capital projects should be thoroughly analyzed by budget staff to ensure that all costs are appropriately estimated and that inflation is accurately accounted for in the capital planning process. (1)

Develop Good Policies. Municipal governments can create formal policies supplemented by administrative procedures in several areas to aid in the management of cash flows related to capital projects.

* Scope Management: Policies and procedures for the consideration and approval of changes to project scope help to make the impact of these changes on cash flows more predictable and controlled.

* Project Contingencies: Establishing requirements for appropriate project contingencies can increase the potential for project managers to accommodate many changes within overall project budgets.

* Budgetary Transfers: Providing the flexibility to make budgetary transfers between projects, with appropriate approvals, can enhance the organization's ability to manage cash flows. For example if one large project is delayed due to unforeseen difficulties acquiring necessary properties, it may be possible and beneficial to accelerate another project.

* Capital Fund Reserves: The creation of capital reserve funds equivalent to a predetermined percentage of the capital budget will provide a tool for governments that consistently budget for capital projects to better manage cash flows.

Develop (and use) a Formal Project Plan. A detailed project plan that identifies key milestones and incorporates the contract payment schedule will provide invaluable information for finance officials planning for cash flows. These project plans can also serve as a baseline for project reporting.

Obtain Regular Progress Reports. Project progress reports will provide finance officers with critical information on changes in the project budget, project expenditures to date, and progress toward project completion. A robust capital reporting system will also track key issues that arise during the project, identify their potential impacts, and track their resolution. Since capital budget adjustments often are driven by these types of issues, this information may be of particular value for predicting potential changes to planned cash flows. (2)

Communication with Project Managers. Maintaining open and active lines of communication with project managers is also an important tool for finance officers to use in cash flow management. Some local governments hold quarterly or even monthly meetings with project managers for a face-to-face project update. Educating project managers on the impact of changes in project budgets or schedules and the importance of informing finance officers as early as possible can improve the overall level of cooperation. Focusing on problem solving instead of blame fixing can also lead to more open communication.

CONCLUSIONS

Unexpected changes to payment schedules related to capital projects can create significant difficulties for finance officers responsible for cash management. However, finance officers do have several tools available to improve their ability to minimize these disruptions. Effective use of these tools can increase investment earnings, reduce borrowing costs, and prevent potentially embarrassing and frustrating cash flow problems.

Notes

(1.) For a more extensive discussion on analyzing capital project budgets, please see the Solutions Column titled, "Best Practices for Capital Project Analysis," in the December 2006 issue of Government Finance Review.

(2.) For a more extensive discussion on capital program reporting please see, "Staying on Track: Creating a Capital Program Reporting System," in the October 2006 issue of Government Finance Review

STEVEN R. KREKLOW is a senior manager in the GFOA's Research and Consulting Center in Chicago, Illinois.