Cost Value Reconciliation: A Worked Example of Where Margin Leaks

The monthly comparison of what a contract has earned against what it has cost, worked through in illustrative riyals to show how a profitable job turns into a loss unnoticed.

Cost value reconciliation compares the value earned on a contract with the cost incurred to earn it, on the same cut off date and the same scope. Done monthly it reveals margin erosion within weeks. Done at the end it reveals a loss that is already fixed. The example below works one month on one contract using illustrative figures.

The situation

A contractor is six months into a twelve month building contract. The valuation for month six has been certified and the accounts show the cost ledger for the same period. The tender allowed a margin, and the question is whether that margin still exists. The reconciliation below separates real performance from timing effects. Every figure is an illustrative assumption used to demonstrate the method.

Assumptions (illustrative)

• Contract sum: 18,000,000 riyals, including a tendered margin of 8 per cent, so a tender cost allowance of 16,560,000 riyals.
• Cumulative certified gross value at month six: 8,200,000 riyals.
• Cumulative cost in the ledger at month six: 7,900,000 riyals.
• Materials delivered and valued but not yet installed: 450,000 riyals of value.
• Subcontract work completed but not yet invoiced by the subcontractors: an estimated 320,000 riyals of cost.
• Instructed variations valued at 260,000 riyals in the certificate, with costs of 300,000 riyals already in the ledger.

Step 1: Start with the crude comparison

Certified value of 8,200,000 riyals less ledger cost of 7,900,000 riyals gives an apparent profit of 300,000 riyals, which is 3.7 per cent of the value earned.

Against a tendered margin of 8 per cent this looks like a serious shortfall, but the crude comparison is unreliable because the value and the cost are not measuring the same thing. The adjustments below are what make the comparison honest.

Step 2: Remove value that has no matching cost yet

Materials valued but not installed are 450,000 riyals of value. Those materials have been paid for or invoiced, so their cost is in the ledger, but they have earned no production value. Treat the materials as stock: remove 450,000 riyals from value and remove the corresponding material cost, assumed here at 430,000 riyals, from cost. Adjusted value 7,750,000 riyals, adjusted cost 7,470,000 riyals.

The adjusted profit is 280,000 riyals, or 3.6 per cent. Stripping out stock removes a distortion that can flatter or depress a reconciliation substantially in a month with heavy procurement.

Step 3: Accrue cost that has been incurred but not invoiced

Subcontract work completed but not yet invoiced is estimated at 320,000 riyals. Add it to cost: 7,470,000 plus 320,000 gives 7,790,000 riyals against value of 7,750,000 riyals.

The contract is now showing a loss of 40,000 riyals rather than a profit. This single adjustment is the most common reason a job appears profitable for months and then collapses: the cost has been incurred on site and simply has not reached the ledger.

Step 4: Separate the variation account from the base contract

Variations have been valued at 260,000 riyals and have cost 300,000 riyals, a shortfall of 40,000 riyals. Removing both from the figures leaves base contract value of 7,490,000 riyals and base cost of 7,490,000 riyals, which is break even on the base work.

The whole of the reported loss sits in the variation account, and the base contract is performing at break even rather than at the tendered 8 per cent. Two separate problems are now visible, and they need different responses.

Step 5: Diagnose the base contract shortfall

At month six the contract should have earned 8 per cent on 7,490,000 riyals of value, which is about 599,000 riyals of margin. It has earned nothing. Compare the cost ledger against the tender allowances by package to find where the 599,000 riyals went: labour hours against the tender allowance, subcontract let values against the tender, preliminaries spend against the tender rate per month.

A package by package comparison nearly always localises the problem. Preliminaries running at a higher monthly rate than tendered, or one subcontract let above the allowance, accounts for most of these shortfalls, and both are visible from month two if anyone looks.

Step 6: Forecast the outturn and decide what to change

If the remaining 10,510,000 riyals of base value performs at the same break even rate, the contract finishes with no margin, and the variation account adds a loss unless the unagreed valuation improves. Recovering the 40,000 riyal variation shortfall requires revisiting the valuation basis for those variations. Restoring base margin requires action on whichever package the comparison identified.

The purpose of the reconciliation is the forecast, not the historical number. A monthly reconciliation at month two would have left ten months to act, which is the whole argument for doing it monthly.

What changes the answer

• Accrual accuracy: understating uninvoiced subcontract cost by a modest amount can turn a reported loss into a reported profit, which is why accruals should come from site measurement rather than from the invoice register.
• Stock treatment: including or excluding materials on site moves the result in both value and cost, so the treatment must be consistent every month or the trend becomes meaningless.
• Valuation of unagreed variations: carrying unagreed variations at the claimed value rather than a prudent one flatters the reconciliation until the valuation is settled.
• Preliminaries run rate: an overrun of a few per cent a month on preliminaries is small in any single month and significant across a twelve month contract.
• Retention treatment: reconciling against gross certified value rather than net cash avoids confusing a margin problem with a cash flow one, and the two need separate reporting.

What the numbers tell you

• Value and cost must be measured on the same date and the same scope, or the comparison is noise.
• Uninvoiced cost is the most common reason a contract looks healthy and is not.
• Separating the variation account from the base contract turns one vague problem into two specific ones.
• A package by package comparison against the tender allowances localises a shortfall far faster than any aggregate figure.
• The value of the exercise is entirely in the forecast and the time it leaves you to act, which is why monthly beats quarterly by a wide margin.

Limits of this example

Every figure above is an illustrative assumption used to show the method, not a quote, valuation or market rate. Costs, rates, fees and regulations change and must be confirmed with the relevant authority, lender or supplier before you commit.

Domira builds and supervises projects across Saudi Arabia, and the commercial discipline above is how its projects stay inside their budget and their programme. Send the drawings, the contract or the site and Domira will tell you where the risk actually sits.