Applying the Percentage-of-Completion Method

Typically, contractors calculate a project’s percentage of completion based on the ratio of incurred cost to estimated final cost. For example, suppose you are hired to construct a $1 million office building at an estimated cost of $900,000. At the end of year one, you have incurred $300,000 in costs and believe that your original cost estimate of $900,000 is still accurate, so the project is 33.3 percent complete.  

You recognize 33.3 percent of the $1 million contract price as revenue, or $333,000, in year one. By subtracting your $300,000 of incurred costs, you arrive at a first-year profit of $33,000.

Monitoring Work in Progress

Solid accounting practices do much more than provide lenders and sureties with an accurate picture of your financial performance. They also provide you with a valuable management tool. To prepare financial statements using the percentage-of-completion method, you need to track key information for each job, including contract price, projected final costs, estimated gross profits, costs incurred to date and amounts billed to date. By compiling this information in regular work-in-progress (WIP) reports, you can spot important trends that have an impact on your profitability and cash flow.  

For example, WIP reports that show a pattern of shrinking gross profits (“profit fade”) may reflect poor estimating, lax project management or other problems. Billings that lag behind a job’s progress (“underbilling”) may be a sign of cost overruns, management inefficiencies or slipshod billing practices, all of which can hurt your cash flow.

Properly prepared and analyzed, the WIP report can provide more insight into a construction company’s financial performance than the balance sheet or income statement. Monitoring this information on a continual basis allows you to identify and address weaknesses in project management, estimating and administrative practices before they do lasting damage.

Understanding the True Cost of Jobs

One of the greatest benefits of an effective construction accounting system is that it lets you know the true cost of each job, enabling you to measure job profitability more accurately and put together more reliable bids.  

The key is to develop a system for properly allocating costs—both direct and indirect—to specific jobs. Direct costs are straightforward: They include those generated by and directly traceable to a project, such as direct labor, subcontractor expenses, materials, equipment and tools. But to get an accurate picture of job profitability, you also need to analyze your indirect costs and allocate them to specific jobs whenever possible.

Indirect costs—often referred to as “overhead”—are those that are a part of the construction process and benefit all of your jobs. Examples include quality control and supervision, supplies, insurance, tools and equipment and, in some circumstances, support costs such as payroll processing.

By developing a reasonable method for allocating these indirect costs among the jobs that drive them, you can track profitability more accurately while jobs are in progress. If you don’t assign indirect costs to jobs, large amounts of “unabsorbed overhead” can result in inaccurate information about your company’s job profitability during the year.