Job Cost Accounting for Construction Contractors
Helping contractors determine if they are making money brings back a nightmare of my own from many years ago.
It was during our October monthly profit and loss (P&L) meeting when our controller delivered the devastating news to the Lang Masonry Contractors (LMC) staff. We just lost $500,000 in September and it would negatively impact everyone’s monthly incentives. Totally in disarray, I couldn’t believe it was possible to show a profit of $300,000 the first eight months of the year and lose $500,000 in a single month. “You mean we were showing a $300,000 year to date net profit as of August 31 and as of September 30 we are now showing a $200,000 loss on the year? How could P&L results change so drastically over 30 days?” I asked.
Searching for answers, I had one of my business coaches, who also facilitates one of my networking peer groups, look at our financial statements to see what was going on. He found that LMC’s under billings were $600,000 higher than our over billings. “Under billings usually show up in the form of a loss, so you were not making money like you thought you were,” he explained.
Being nervous about how over and under billings affect the financials, and from the advice of a contractor friend, I picked up a construction accounting book and shared it with my controller. We learned that current costs-to-date as a percentage of job costs at completion is the real measure that should be used to determine job completion to date. So, we dug deep into the costs we had incurred on current projects compared to the percentage complete our project managers were reporting on the same projects.
We found that LMC did not make $300,000 through the first eight months of that year, nor did it lose $500,000 in September. What really happened was that we lost $200,000 over the first nine months of the year. And, most of the loss came from a couple projects that did not go as we had planned during the nine-month period.
The cold hard truth was that we did not know how to account for job completion to date values verses what our project managers (PM) reported as percentage complete on each job. So, when the $600,000 in under billings was trued up, and because most of the work we under billed for was not in place, it became a liability instead of an asset on the balance sheet. Therefore, prior monthly P&L statements showed profits that were not there.
Another lesson learned the hard way!
Recently looking at the P&L’s of a contractor I was working with, I noticed he had the same issues I experienced years ago. He did not understand how to properly evaluate completion to date, nor how under and over billings really affect the P&L. Therefore, when we dug into his numbers, we had no way of accurately knowing if he was making or losing money for the year.
Without knowing how to evaluate completion to date and how under and over billing affects the monthly P&L, you won’t know your profitability until you close your books next year in March (December 31 was his fiscal year end and allowing three months to get his outside accountants statements back). If there are underlying issues on any of your projects, this could be a major problem, as waiting a year can be much, much too late to correct the issues, I explained.
Under billings are listed on your balance sheet as an asset because it displays work in place but not yet invoiced. This asset increases your current year to date profit and will be reported in net earnings as reflected on your balance sheet. Over billings, on the other hand, show that you billed for more work than you have earned and completed, so it goes on your books as a liability because you have billed for work that is not yet completed. This decreases current year to date profit. And until the billed for work is put in place or project costs are incurred, over billings remain a liability. Something we never understood in the early years at LMC.
Here’s how I think many contractors struggle getting their monthly P&L correct: To do billing, management asks the project manager (PM) what percentage complete he or she is at on a project. The PM looks at the prints and observes the progress that has been made on the job and says they are X% complete. Without considering what the true costs to date are as a percentage of total job costs at completion, the PM could be overstating (and often is!) the percentage complete. Unless the overstated amount is put into over billings, profits are unintentionally inflated.
Like LMC did in the past, I have seen contractors report percentage complete on a job at 80% one month and 60% the next. We all know you can’t work on a project a month longer while percentage of complete actually goes down.
So, how do you get the percentage complete correct every month to ensure you don’t get financial surprises later in the job? You do this by only allowing the PM to report percentage complete based on current job costs incurred to date and not what he or she shows as a mere estimation of percentage completion.
Let’s look at a $1,000,000 project bid at 20% gross profit and break it down to see how this really works:
- Job costs are $800,000 or 80%, which includes all actual job costs that are billed to the project (labor, materials, sub contract work, equipment, and job overhead).
- Gross profit is $200,000 or 20%. This is what is left over to pay for Overhead which includes non-related job costs (office salaries and expenses). Also, expected net profit is included in the gross profit percentage.
The only accurate way to determine project profitability at any given time is to track costs to date compared to job costs at completion.
How do we know when our project is 25% complete? When we incur $200,000 of the job costs, we are 25% complete as $800,000 X .25 = $200,000. Our billing for the month would be $250,000 (25% of the $1,000,000 contract). If the PM says you are 40% complete, and the GC or customer will let you bill $400,000, that’s great as the extra billing will help you cash flow the job. However, the extra $150,000 must be carried on your books as a liability in overbilling. If not, you will later take a big hit on your financials for not having your over and under billing correct.
The secret is to overbill as much as possible so the job is cash flowing itself instead of you cash flowing it out of your own bank account. So, in the above scenario, we would want to bill the general contractor (GC) or customer $400,000 if they will allow it. GC’s are often fine with this as they want to bill their customer as much as possible so the customer is cash flowing the project for them too. Most Contractors are good at overbilling, but what they often miss is the extra (in this case $150,000) that should ultimately be listed on the balance sheet as overbillings, and therefore a liability, because work invoiced hasn’t even started.
Get your monthly P&L correct by doing your percentage complete based on project costs incurred to date and adjust your over and under billings accordingly. This will avoid the nightmare of getting a future surprise by finding that you did not make near as much money as you expected, not to mention vulnerability to learning of job issues way too late to make the necessary changes.
Damian Lang is CEO at Lang Masonry Contractors, Wolf Creek Construction, Malta Dynamics, and EZG Manufacturing. To view the products and equipment his companies created to make jobsites more efficient, visit his websites at ezgmfg.com or maltadynamics.com. To receive his free e-newsletters or to speak with Damian on his management systems or products, email:firstname.lastname@example.org or call 740-749-3512.