At the end of a year-long project, the CEO of a construction company joked that he loved it when a plan came together. Although the CEO was pleased that the project went as planned, he felt that the success was due as much to luck as to planning. After all, only 28% of construction projects come in on time or budget.
A 2020 survey found that construction businesses blame delays on::
- Change orders (62%),
- Weather (60%),
- Poor project coordination (54%),
- Delayed payments (12%).
Delayed projects impact more than a schedule. The delays ripple through a general contractor’s finances as well. By following these four best accounting practices, contractors can achieve more than a 28% success rate.
Job costing and project management go hand in hand. Without job costing, projects lack the details that ensure an on-time and budget delivery. When preparing job quotes, contractors should look at:
- Labor. Labor is the largest expense; misjudge labor costs, and your project moves from profit to loss. It’s a good idea to break out labor costs to include hourly rates, plus worker’s comp and other labor-related expenses. Factor in pay increases and overtime hours. For general contractors, breaking down costs by subcontractor means evaluating performance.
- Materials. Direct material costs are the items that are required for the job. In contrast, indirect costs are for materials used across multiple projects—things such as screws and fasteners that are purchased in bulk fall under indirect costs. Depending on the length of the project, contractors may want to factor in inflation as part of material costs.
- Overhead. Direct overhead costs are expenses for a specific project. They may include office space, project managers, and equipment. Indirect costs are non-project-specific costs such as office equipment and supplies. An answering service would fall under indirect overhead costs.
With job costing, construction firms can monitor expenditures against budget and identify deviations early to make adjustments before they impact the overall project costs. Careful costing provides a template for similar jobs, making estimating costs on future projects easier. Finally, monitoring planned vs. actual expenses against a project schedule can help maintain a strong cash flow.
Many general contractors default to a cash-based accounting method; however, that option is not available if annual revenue exceeds $1 million and the material costs are more than 15% of the project. If cash-based methods are not available, general contractors must use an accrual-based system.
The simplest way to track job costs is to declare revenue when it is received and deduct expenses when paid. This method makes estimating cash flow easy. Prompt invoicing and payment are essential for stable financial operations in a cash-based system.
Since the majority of contractors (81%) spend time trying to collect a payment, contractors need to shorten pay terms and assess penalties for late payment. A recent study found that almost 50% of contractors wait over 30 days for payment. Nearly 50% offer payment terms that exceed 30 days.
Tying expenses to revenues on long-term projects may prove challenging, depending on the number and complexity of the jobs. The percentage of completion method allows construction companies to declare income based on how much of the project is complete. For example, a contractor has an 18-month project worth $1 million. Assuming an equal distribution over the life of the project, the contractor would declare a little over $55,000 per month.
The contractor estimates that 25% of the work is done at the three-month mark but determines that only 15% of the revenue has been used. After 12 months, 75% of the revenue has been declared, but only 50% of the work is done. This difference means the project is likely to have cost overruns that will decrease its profitability.
Contract completion means declaring income when the project completes. It doesn’t mean that payments are not made; however, best accounting practices require that material costs be viewed as assets until the items are used. This approach can impact financial statements by overstating assets.
Waiting until a project completes before declaring income means taxes are not paid until the project ends. This approach can shift the tax burden from one year to the next. Moving revenue from one reporting period to another can lower the tax burden over two years.
Tax Reporting Strategies
How a contractor decides to declare income has a direct impact on taxes. It can also affect financial and balance sheet reports. Understanding the ramifications enables general contractors to have a more accurate assessment of their financial position.
- Cash-Based. With this method, taxes are paid based on when cash is received. Expenses are deducted when an invoice is received. For SMB-sized contractors, cash may be an appropriate accounting method; however, funds should be set aside to offset the tax burden on a quarterly basis. If a contractor requires installments, the payment may be declared as income before the offsetting expenses are incurred which could increase taxes for a given tax period.
- Completion Percentages. This approach to tax reporting normalizes the tax fluctuations that often occur in the construction industry. No matter when payment is received or expenses incurred, tax reporting is based on what percentage of work is complete. This method may require added IRS paperwork and may require an accounting specialist to help with tax preparations.
- Completed. Declaring all expenses and income at the end of a project works well for short-term projects. For example, a series of small jobs occur in the fourth quarter. Many projects won’t complete until early January. Accepting full payment at the end of the project would defer the tax liability to the next tax year.
Understanding the implications of income declaration can help general contractors maintain a steady cash flow. It can help present the best financial picture when looking for loans or investors.
Best accounting practices begin with having accounting professionals with experience in construction accounting. Job costing may seem tedious, but the data is a valuable resource for managing costs. Working with a professional can help with job costing accuracy as well as data analysis. Knowing, rather than guessing, means making data-driven decisions that can help your business grow.
When and how you declare income and expenses has a direct impact on cash flow and tax liabilities. Understanding how to interpret financial data based on accounting and income declaration methods means having a firm grasp of your business’s stability. Accounting professionals can help you develop tax reporting strategies that maintain a consistent cash flow.
If you want to be the CEO who knows that projects will be on-time and budget, contact us to start informing your business of the best accounting practices.