One of the most important, and often misunderstood, aspects of construction accounting is the relationship between work in progress (WIP) and the recognition of revenue. The failure to understand these concepts can often result in future cash flows from a project being insufficient to meet the costs yet to be incurred or owed. Where did the money go?
Consider a $1.5 million project that will be performed over the span of six months. The estimated gross profit on the project is $300,000. In summary, the contract value is $1.5 million; the projected cost is $1.2 million; and the estimated gross profit is $300,000.
Let’s assume that by the end of the third month, you have billed and been paid a total of $900,000. Your costs incurred to date are $400,000—all of which you have paid. How much profit should you recognize on the project at this time? a) $0, b) $100,000, c) $150,000, d) $300,000, or e) $500,000? According to Generally Accepted Accounting Practices (GAAP), there is only one correct answer, which I will cover later. The real importance here is the impact of the project’s cash flow on your business and your decision-making process.
A business owner is the chief financial officer of a construction company. At the end of the day, there is no one higher up the ladder than the owner. Although the owner may have delegated financial or accounting responsibilities to someone else in the organization, he or she should be assured that those individuals understand the cash flow, and are managing and sharing information in a timely manner, so that decisions are made based on accurate and reasonably current profit projections.
Cash flow and profitability are related, but future cash flows cannot be accurately predicted without precise profit projections.
Accountants can make educated guesses all day long, but input from the field is critical to ensure nothing gets missed. These two sides must collaborate on profit projections, including any change orders, to accurately forecast where the project will end up financially.
In too many organizations, the finance function and project management function appear at odds when it comes to answering the question of where the project will end up financially. This is primarily due to a lack of understanding and poor communication.
Often, the financial side doesn’t understand enough about construction from a process, schedule or technical point of view, and the field side doesn’t know enough about why periodic, interim profit projections have value. Until and unless your two departments understand each other, they can’t collaborate effectively. Someone has to lead these horses to water and make sure they take a drink. Explain the why and how, and remember that you’re all wearing the same jersey.
The finance staff needs to understand that the project manager (PM) is not simply managing a project. That one project involves up to 16 divisions, several suppliers, many subcontractors, his own labor force, an owner, architects, engineers and designers, a schedule, weather and inevitable change requests.
On the flip side, it isn’t just one project for the finance team either—it is a piece of the puzzle. There are several projects in various stages from preconstruction to punch list.
Each project and its projected financial impact must be funneled through the WIP schedule to produce an accurate financial snapshot of the business at the end of the month, quarter and year.
So, how often should you be updating gross profit projections on your projects? A sliding scale is recommended.
If your projects typically run less than six months, then update every two weeks. A lot can happen in thirty days and you want to stay on top of those estimates-to-complete so that management is making decisions on information that is no more than two weeks old.
If your projects are longer than a year, then you can probably slide the projection to once per month. It’s always better to sit together and work through the projections, because that is how members from each side learn.
With advances in technology, cloud-based access, remote connections and so on, it is even possible to work together on long-distance projects and still have dialogue, ask questions and get greater clarity than ever before.
Let’s review the project mentioned at the beginning of the article. Remember, by the end of the third month, you have billed and been paid a total of $900,000. Your costs incurred to date are $400,000, all of which you have paid.
How much profit should you recognize on the project at this time? According to GAAP revenue is recognized on a cost basis. The amount of revenue and related gross profit is as follows:
- Costs incurred ÷ by total projected costs ($400,000 ÷ $1.2 million) = 33 percent
- 33 percent × total contract value ($1.5 million) = $500,000 in revenue
- Revenue – expenses (costs incurred) = gross profit ($100,000)
In the case of this project, we’ve received $900,000, paid out $400,000 and are holding onto $500,000; we’ve only earned $100,000 of that $500,000 in cash.
$200,000 will be earned in the remaining three months, and $200,000 is owed to subcontractors, suppliers and our labor force in those same three months. So, as flush as you might feel when looking at your bank statement, don’t go out and buy that new boat you’ve been eyeing.
Go right ahead, if you know for certain that the gross profit that was estimated 90 days ago is still accurate and the contract value hasn’t changed. But, how certain are you? What if change orders totaling $200,000 have been approved with an estimated gross profit margin of 5 percent?
The revised contract value is now $1.7 million; the revised project cost is $1.39 million; and the revised estimated gross profit is $310,000. This is assuming the project duration is six months.
- Costs incurred ÷ total projected costs ($400,000 ÷ $1.39 million) = 28 percent
- 28 percent × total contract value ($1.7 million) = $476,000 in revenue
- Revenue – expenses (costs incurred) = gross profit ($76,000)
The impact on the company’s financials is as follows for this period:
Gross Profit $76,000
That’s a pretty significant decrease in gross profit to be recognized for the period. Multiply that by the number of projects your company may have going on at any one time, and it’s enough to keep you up at night.
In construction, there is always a great emphasis on winning work. Construction companies and their owners expend a lot of time and energy on this process, but it is equally important to continue to measure the financial reality of a project against the expectations at award throughout the project, not just at completion. Playing good defense—or going on the offensive to protect margin—is key to the success of every contractor, no matter the size or segment of the industry.