Page 139 - DMGT521_PROJECT_MANAGEMENT

Project Management

Notes Pre-operative expenses are directly related to the project implementation schedule. So, delays in
project implementation, which are fairly common, tend to push up these expenses. Appreciative
of this, financial institutions allow for some delay (20 to 25 percent) in the project implementation
schedule and accordingly permit a cushion in the estimate for pre-operative expenses.
Pre-operative expenses incurred up to the point of time the plant and machinery are set up may
be capitalized by apportioning them to fixed assets on some acceptable basis. Pre-operative
expenses incurred from the point of time the plant and machinery are set up are treated as
revenue expenditure. The firm may, however, treat them as deferred revenue expenditure and
write them off over a period of time.

Provision for Contingencies

A provision for contingencies is made to provide for certain unforeseen expenses and price
increases over and above the normal inflation rate which is already incorporated in the cost
estimates.

To estimate the provision for contingencies the following procedure may be followed: (i) Divide
the project cost items into two categories, viz., ‘firm’ cost items and ‘non-firm’ cost items (firm
cost items are those which have already been acquired or for which definite arrangements have
been made). (ii) Set the provision for contingencies at 5 to 10 percent of the estimated cost of non-
firm cost items. Alternatively, make a provision of 10 percent for all items (including the
margin money for working capital) if the implementation period is one year or less. For every
additional one year, make an additional provision of 5 percent.

Margin Money for Working Capital

The principal support for working capital is provided by commercial banks and trade creditors.
However, a certain part of the working capital requirement has to come from long-term sources
of finance. Referred to as the ‘margin money for working capital’, this is an important element
of the project cost.
The margin money for working capital is sometimes utilised for meeting over runs in capital
cost. This leads to a working capital problem (and sometimes a crisis) when the project is
commissioned. To mitigate this problem, financial institutions stipulate that a portion of the
loan amount, equal to the margin money for working capital, be blocked initially so that it can
be released when the project is completed.

Initial Cash Losses

Most of the projects incur cash losses in the initial years. Yet, promoters typically do not disclose
the initial cash losses because they want the project to appear attractive to the financial institutions
and the investing public. Failure to make a provision for such cash losses in the project cost
generally affects the liquidity position and impairs the operations. Hence prudence calls for
making a provision, overt or covert, for the estimated initial cash losses.

Self Assessment

Fill in the blanks:
1. A ………………… for contingencies is made to provide for certain unforeseen expenses
and price increases over and above the normal inflation rate which is already incorporated
in the cost estimates.

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