The Importance of Accounting Estimates in an Uncertain Economy

“A journey of a thousand miles begins with a single step,” was the saying of Lao Tzu, an ancient Chinese philosopher. Understanding this basic principle sheds light on the most fundamental element at the heart of every construction firm’s finances: accounting estimates, specifically related to job costing. 

These estimates provide management with a foundation to effectively interpret costs, profitability and bid processes.
The constant monitoring of these various indicators will ultimately be what separates success from failure in a contract. 

Under generally accepted accounting principles (GAAP), management is required to make estimates and assumptions that affect assets, liabilities and disclosures reported in the financial statements that have near-term exposure and from which actual results may be materially different. 

Examples of such job cost estimates include takeoffs, labor hours, labor rates, material prices, equipment costs, subcontractor expenses and allocated indirect costs. Understanding the estimated costs to complete a contract is paramount in determining profitability. It is virtually impossible that initial estimates will be the same as the overall completed contract costs, thus necessitating the need for ongoing monitoring throughout the life cycle of the project. 

Market Outlook

• Taking a deeper look at labor hours and rates, it makes sense to review the most recent economic data surrounding construction employment to assist in understanding. Current data suggests record employment levels across both residential and nonresidential construction, with average year-over-year increases of approximately 3.4%, coupled with increased wages for production and nonsupervisory employees increasing approximately 6.1% over that same time period. Record demand coupled with pervasive worker shortages created a shift in overall power dynamics, significantly favoring workers. This caused a historic low level of layoffs and a higher-than-normal number of workers who quit. This overall shift caused wages to rise much faster than in other industries and elevated already-inflated construction costs.
• Material prices and input costs have continued to surge in the wake of post-pandemic supply chain constraints, an inflationary buying environment and increases in overall construction demand. Transportation-related issues including driver shortages and extreme weather events have led to continued supply chain issues, coupled with increased building demand, particularly in education, health care and research laboratories. Material prices for copper, aluminum and concrete were partially offset by a decrease in diesel, polyvinyl chloride (PVC) and lumber. Short supply items included transformers and appliances. Input costs have risen at more than twice the rate of inflation since the beginning of the pandemic, causing constraint on overall profitability and requiring additional scrutiny on initial takeoffs. 
• Demand continues, specifically in the multifamily sector (five or more units), with February multifamily housing starts increasing by 24% for the month compared to January, and 14% year-over-year. In furtherance of the industry’s optimism, multifamily permits rose 24% from January and 17% year-over-year. Overall permits rose 13.8%, and building starts increased 9.8% on an annualized basis. Levels are still lower than a year ago (approximately 18%) but represent solid growth in an industry that is so affected by market conditions. The uptick is reflective of rebounding homebuyer demand, coupled with overall builder confidence. However, recent events may dampen this momentum into the second quarter.

Translating this ever-changing data in an uncertain economy will ensure accountability on the part of both the project owner and the contractor, as well as spotlight when increased costs and overruns can equate to change orders. Using certain tools to manage these estimates can assist in uncovering issues before they have a harmful
impact. One such tool is the monitoring of profit fade and gain on jobs while utilizing trend analysis. 

Taking a cross-section of similar-sized jobs over a three-to-five-year period will allow for a broader understanding of estimating capabilities and where adjustments may be needed. Conservative estimating starts from the onset, but the ability to pivot and adjust as jobs progress will ensure better estimating along the way. 

Management Tools for Effective Estimates

Having proper, effective controls over estimating are necessary to ensure adequate documentation, clerical verification and required approvals at all levels of management. 

To achieve this and avoid unreliable estimates that can obscure losses on contracts in their early stages, or overstate or understate profitability, management can undertake various actions. 

• First, independent reviews of general contract cost estimates based on job specifications, plans and drawings against actual costs incurred will provide assurances that the estimates reflect all relevant costs. For example, review quantities of materials and hours of labor in bid estimates, and compare them to the overall specifications. Review material costs to published vendor price lists, price quotes or subcontractor bids. 
• Second, verify the clerical accuracy of final contract estimates — review the reasonableness of final estimates, ensuring that unnecessary or undocumented management-level adjustments are not arbitrarily made. Ensure proper review and approval by designated management personnel and that all revisions are properly supported.  
• Third, understand general overhead and other indirect cost allocations applied to each contract, and constantly review for reasonableness against actual expenses incurred. 

Further, consistency in estimating and accounting will allow for detailed comparison of actual to estimated costs at the completion of contracts. For example, accumulating historical competitor bids, if available, may provide evidence of reliable estimating. Conferences with project engineers and architects to review progress reports, field reports and project manager reports, as well as change order reviews — including unpriced and unsigned orders — will provide for substantive contract evaluation and administration. 

At the time of this writing, breaking news regarding the second- and third-largest bank failures in U.S. history
came to light and further heightened the volatility in the U.S. economy. The feeling of angst is more palpable than
ever, and any premature celebration regarding a “soft landing” has been overshadowed. Managing through these times of record low unemployment, unprecedented consumer spending outpacing supply and high-profile layoffs in the tech sector point to uncertainty that appears likely to hang around. Combating this will require constant revision and review of accounting estimates to ensure a complete and accurate picture of results of operations.