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Time is literally money. The money we have now is worth more than the same amount we may receive in the future. This also means that money received sooner is more valuable than money received later. The rationale behind this is that we can invest money in either projects or financial accounts and receive a return. Rather than put all your eggs in one basket, so to speak, you will invest in a variety of projects or investment vehicles to protect the value of your cash. While bank accounts in our current economy are paying less than 1%, investments in stocks and bonds are still paying anywhere from 2-10% and higher. Project returns from successful products may also be higher.
The time value of money creates a natural tension in the economy. Your investments can increase in value. On the other hand, inflation in the long term can reduce buying power, so it may be beneficial to spend some of the cash now, or at least more evenly over time. It also means that both you and your suppliers will be motivated to hold the cash, if possible.
With this in mind, let's take a look at the various means by which payments for project resources can be made. There are many ways to structure payments, and we will focus on the 5 most fundamental.
Cost Reimbursable Contracts: Cost reimbursable contracts in their simplest form are where contractors can bill for allowed costs plus an allowed profit. This billing typically is performed monthly, so if you are the contractor, you will need to know the allowable costs and what was expended on them in each period. If you are the buyer, you will need to audit invoices more carefully to ensure that only allowable costs are included and that the expected work and value was provided.
Incentive Payments: Incentive payments are often made to contractors for meeting specific targets, such as keeping to within a specified timeline or budget amount.
Stage Payments: Stage payments are payments due when certain stages or other defined work activities of the project complete. They are often based on major WBS groupings and the project manager will need to consult the schedule for appropriate times to approve these payments.
Payment Plans: Many projects work on some form of payment plan that includes a down payment and some form of additional progress or monthly payments until a certain percentage of the estimated project has been billed. Progress payments are typically based on milestones, so you will need to consult the project schedule (and have a good one) to approve these payments. Once the final project is delivered and accepted, any remaining payments are made and received.
Payment in Advance: While payment in advance is less common, there are some suppliers that may require being paid in advance. Some larger payments may front-load the cash used in the first month (e.g., the contractor requires full payment at the start of the project). Others may happen as needed (e.g., when materials are purchased).
Contractors and suppliers may include a variety of invoice payment terms, and as the project manager, you may need to ask to find out what these are upfront for the purpose of planning payments. Four popular terms are included here.
Immediate Payment: With immediate payment required (also known as cash on delivery or due on receipt), you will need to plan the payment for the month in which the invoice was received.
Net X: Some invoices may have the language “Net x” included, where x is normally 7, 10, 30, or 60. This specifies the number days in which the invoice should be paid and during which period there is no penalty or interest due. The invoice or contract will specify what happens if that period passes and the bill is not paid. However, keep in mind, that from a time value of money perspective, you will want to pay the bill as close to the due date without exceeding it. Modern payment systems and transactions often make in possible to make a payment immediately or within a specified short time frame. For example, most bill paying systems will withdraw the money in your account and post the payment overnight for participating parties and make the payment within 5-7 business days to those not participating in the electronic exchange of payments.
X/Y Net Z: Another form that may be encountered is x/y Net z, where x is a percentage discount that may be taken if the invoice is paid within y days, and overall, the payment is due in z days. As an example, a 2/10 Net 30 invoice means that I can take a 2% discount if I pay the invoice within 10 days and overall, the payment is due within 30 days. Here, some may be incentivized to make the payment sooner to lower the need for cash.
Line of Credit: Finally, some invoices may be set up to be paid from a line of credit. In this case, cash is saved until the line of credit requires a payment, usually within a month or quarter as specified by the line of credit.
If you have questions about project payments, please drop us a line in the comments below. Next week, we will look at how payments affect the flow of project cash over time.
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