Project’s Financials Simplified
During my discussions with IT Project/Program Managers, sometimes I get query regarding the various terms used in project financials such as Revenue, Invoice, GM, OM etc and how these are calculated for any Project. In this article, I will try to explain these terms (with few examples) and also describe simple way to calculate Revenue, OM, GM etc from IT Projects perspective (although the same can be extended to other industry as well).
What is Revenue: If you talk to management team (at any strata), you will hear these terms most frequently: Revenue, Top-line, Turnover, Income, Sales etc. Essentially they refer to the same thing and we will use word “Revenue” going forward in this article.
Revenue is the total amount of income generated by the sale of goods and services related to a business within a particular timeline (normally measured monthly, reported quarterly and yearly). Project’s Revenue is how much is earned on a project and depends on the progress of project tasks/activities for specific duration & commercial value of project. Revenue is the expected cash flow based on signed contract value of Project and work completed during specific duration.
Revenues are recognized when they are realized or realizable, and are earned (usually when goods are transferred or services rendered), no matter when Invoice is sent to customer or when cash is received. So, if a project team has completed a deliverable worth 10,000 Euro, Revenue of 10,000 Euro is recognized.
Invoice is related to actual cash flow and includes all account receivables (i.e. invoices sent to the customer). Invoice is sent to customer based on fixed/planned milestones in most cases and paid by customer as per agreed payment term (normally 30/45 days).
Invoice may be different than Revenue at any given point of time (except at normal project closure where Revenue & Invoice become equal).
How is Revenue Calculated: There are different methods to calculate Revenue for IT projects, it varies significantly based on type of projects.
- T&M Project- Revenue for Time & Material project is calculated based on actuals (i.e. hours worked by any specific team/resource, cost of travel, cost of any material, any additional allowances etc). This is normally invoiced every month based on actuals and Revenue is recognized as per total invoice amount. Even if invoice is not issued due to any reason (ex: missing Purchase Order from customer), still Revenue is recognized based on actuals.
- Fixed Price Project- Revenue for Fixed Price Project can be calculated in multiple ways, below are the most simplified:
a) For Small Projects- Definition of small project may differ for every organization. As the name suggests, this may be defined either based on total commercial value and/or duration of a project. We may consider small project with commercial value < 20,000 Euro and/or duration < 2 months. For these projects, Invoice is normally sent after project completion and Revenue is realized at project closure, that is equal to Invoice amount.
b) For Large Projects- For large projects, Revenue is recognized every month based on actual work completion and there are different ways to estimate the same. This is mainly estimated by percentage of completion (POC) or Earned Value Management method.
Revenue is recognized depending upon the actual progress of Project i.e if actual work completed is 5%, then 5% of total commercial value of Project is taken as Revenue. If you are using Microsoft Project Plan and update it regularly, you will see incremental percent of completion (POC) for a specific duration. This incremental POC is then used with commercial value of project to get Revenue.
Ex: If a project’s value is 200,000 Euro and incremental POC for a particular month is 10%, revenue for that month will be 20,000 Euro (i.e 10% of 200,000 Euro).
If you follow Earned Value Management (EVM) technique, total commercial value of Project is distributed among many smaller deliverables/tasks and Revenue is earned depending upon the deliverables/tasks completed within a particular timeframe.
Ex: if a project’s value is 200,000 Euro and there are 4 deliverables with equal size (or complexity/weightage). When team completes first deliverable, revenue of 50,000 Euro will be recognized. The method to realize revenue should be agreed with your finance and accounting team.
c) Project based on Resource Units- If the project’s commercial is based on a specific Resource Unit (ex: number of server, number of Applications, number of tickets etc) and corresponding Unit Rate, Revenue is calculated based on actual Resource Unit and Unit Rate for a given month.
Ex: If your team is supporting 1000 server per month and customer pays 10 Euro per server per month, Revenue for a month will be 10,000 Euro.
For any successful Project, total Revenue and Invoice amount will always match at Project Closure. Revenue & Invoice may not match if a Project is closed unsuccessfully, as final Invoice amount may vary depending upon termination clause and customer relationship.
Cost is measured based on actual spent (human resource cost, material cost, sub-contractor cost, operational costs etc) and it does not depend on Revenue. However, Cost vs Revenue decides whether the Project is profitable or not.
How is GM or OM calculated:
a) Gross Margin (GM) is calculated as: 1- (Total Direct Cost/Total Revenue)
Ex: If you have signed a project worth 100,000 Euro with a customer (Total Revenue) and your resource cost, material cost, sub-contractor cost, other costs (travel, seating, all allowances etc) is 70,000 Euro (Total Direct Cost). GM can be calculated for this situation:
GM = 1- (70,000/100,000) = 0.3 or 30%
In case you are not aware of other costs, you may add some percentage (say 5 to 10%) on top of known cost to give you rough estimate of GM.
b) Operating Margin is calculated similar to Gross Margin, but it includes Indirect Cost such as Sales, Marketing, other wages, depreciation etc also. This indirect cost is generally calculated by finance team at organizational level as a percentage of Total Indirect Cost vs Total Revenue, which can be deducted from GM to estimate OM.
Ex: Indirect Cost % at organization level = Total Indirect Cost/ Total Revenue = 2,000,000 / 20,000,000 = 10%
OM = GM- Indirect Cost% = 30%-10%= 20%
Generally, OM higher than15% is considered as good for any business.
Below is the sample monitoring of a project’s commercial:
You can make following inferences from above sheet:
- Revenue & total Invoice becomes equal at normal Project Closure (i.e. Euro 400,000 in this case).
- Invoice amount is based on milestone and may not be equal to Revenue on monthly basis.
- GM/OM are dependent on Revenue & Cost and they can be positive or negative.
- This project is completed with 4% OM (considering 12% Indirect Cost at organization level), so this project is profitable.
I hope this article could clarify few widely used financial terms of Project Management. You will be able to effectively monitor any project’s financials with these key parameters. Even if you need to use some approximations to estimate these parameters, these may help you to understand your project’s actual situation and take quick decisions.
