At one time or another, even the best managed contracting firms begin to feel they are slipping off the financial tracks. To the top managers, it seems the company is as busy as ever, maybe busier, but cash flow doesn’t reflect it.
Often times, the culprit for this dissonance is a declining level of knowledge about current projects. This happens when managers either stop paying attention to their work-in-progress (WIP) reports or have undependable reports.
Today, there is no excuse for contactors to lack valid WIP reports. Modern software being what it is, the process of creating these reports and regularly updating them is quite easy.
TRUE VALUE OF A PROJECT
All of this is consequential because a WIP report, if properly created, identifies the true value of a project. Without such documentation, contractors can only extrapolate.
WIP reports provide valuable guidance for both project managers and financial officers. For project managers, the reports detail what has been billed and what is available to bill.
Project managers can utilize this information to proactively manage a project’s budget, help guide billing, and help identify any potential overruns.
For financial officers, the reports provide a way to closely monitor a project’s schedule of values, total cost estimate, costs to date, and the amount billed to date. These values are monitored and updated monthly, with the goal being to determine whether a contractor is billing out properly and is receiving payment on schedule.
Construction tax accounting typically has line items on both the balance sheet and income statement for over- and under-billings. The value on that line is determined by a WIP report. The over- and under-billing result from the WIP shows up in the revenue area of a contractor’s income statement. If a contractor is under-billed, it will show up as additional revenue. If the contractor is over-billed, it will show up as negative revenue. On the balance sheet, over-billing is a short-term liability and under-billing is a short-term asset.
MONITORING THE BILLING CYCLE
WIP reports provide this information by monitoring the billing cycle. Here’s an example of a typical billing cycle: Let’s assume a project is estimated to cost $70,000 by the time work is complete. Let’s also assume that at the end of December, $35,000 has been spent to date. By dividing $35,000 by $70,000 you get 50 percent. Therefore, the project can be considered 50-percent complete at December 31.
Close monitoring of costs incurred on a project is a valuable tool to aid in the determination of how much the client should be billed. It is important that billings, and even collection of these billings, are greater than the costs expended to do the work. This ensures that the client is directly funding the construction work, and that the contracting firm minimizes borrowing on behalf of the client.
Using the example above, suppose the following (A) the sales price of the project is $100,000, (B) $100,000 times 50 percent (the level of completion) equals $50,000, and (C) costs incurred to date at $35,000. Therefore, for the period ending December 31, the clients should be invoiced at least $35,000 in order to properly fund the work.
KNOW YOUR NUMBERS
It’s important for a contractor to understand the costs, cash flow, and profitability of the finished work versus the amount of work left to complete. This provides a much earlier warning when the job is slipping and in danger of going over budget. The WIP report shows where the costs are likely to end up at the completion of the project long before that future is locked in, potentially saving tens of thousands of dollars.
For each contract, a WIP report should reflect the total contract amount (including approved change orders) and the estimated gross profit. Some WIP reports even show the original estimated cost to complete a project, including direct and indirect costs. Additional items shown include:
- Current year totals for revenues earned, cost of revenues, gross profit, and percentage complete on each job
- Estimated costs to complete each project
- Billings to date
- Actual project cost to date
- Actual gross profit recognized to date
Some WIP reports also have a backlog column to represent billings left on each contract.
ABUNDANT INFORMATION
WIP reports provide an abundance of helpful information, including patterns that may need to be corrected. For example, if a contractor regularly estimates a 15-percent gross profit but the actual profit is typically 10 percent, the company may need to reexamine its estimating strategies.
The reports can also be used to track projects by region, project manager, project type, and any other relevant sorting for the construction firm. This helps to understand profitability by different locations, types of projects and project managers, etc.
For a contractor, billings are the engine that drives the cash-flow train. But it can be hard to keep billings synchronized with a project’s schedule. When mistakes are made, contractors can be forced to use their own cash for materials and other expenses budgeted by the client. WIP reports are a good tool to help eliminate these discrepancies.
KNOW YOUR FINANCES
Although it may sound like a major undertaking, creating an effective WIP report is actually quite simple. There are many software packages on the market today that make it easy to create the reports. In addition, many existing systems allow WIP reporting to be added.
Contractors who need guidance can receive it from their certified public accountant. It’s a step all contractors should take since it will both streamline and protect their finances. ■
About The Author: Denise Bendele, CPA, CVA, has more than 28 years’ experience in public accounting and leads the construction industry practice for Padgett Stratemann. She also works with organizations that specialize in wholesale, retail, and manufacturing. www.padgett-cpa.com.
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Modern Contractor Solutions – March 2016
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