It’s been a long day. You were up at 6:00 and at the construction site by 7:00. It’s 10:00 pm, and you’re trying to pull together a proposal for a huge construction project that is due tomorrow. Somehow, the numbers aren’t coming together, plus you aren’t sure what is the best revenue recognition approach to use. Maybe, it’s time to think about accounting professionals or a firm with construction experience to help.
How is Construction Accounting Different?
Most businesses organize their financials around products that last decades. Updated versions may be released, but it’s still the same basic toothbrush or can of soup. Construction companies are project-based. Each job is a project that has specific costs associated with it, and each project is expected to be profitable. When preparing a bid, construction companies need to consider the financial implications of the following:
- Direct and indirect costs
- Revenue recognition
Let’s look at how these factors can impact the financial health of a construction company.
Forecasting Direct and Indirect Costs
Many construction projects span months, even years, making it difficult to predict the costs for materials and equipment. Even indirect costs can be a forecasting challenge if the project lasts multiple years. Keeping building supplies for years is impractical, and it can impact a company’s balance sheet if held too long.
At the same time, overhead expenses can be reasonably predicted. Annual forecasts of expenditures are common across all industries; however, projecting what expenses will look like two years into the future is more difficult. What happens if insurance premiums go up 20% in the second year of a contract?
Construction companies have options when it comes to revenue recognition. Deciding when to recognize income for tax purposes is complex, and the wrong choice can cost a company millions.
All companies use one of two accounting methods — cash or accrual.
- Cash. Cash-based accounting means recognizing revenue when it is received and expenses when paid.
- Accrual. Accrual-based accounting is more complex in that revenue is acknowledged when it is earned, and expenses become liabilities when they are received. It doesn’t matter when the funds actually exchange hands.
If a company’s revenue falls above a set threshold, the accrual method may be required. Accounting professionals are familiar with tax law and can advise construction firms on the best accounting method for their business.
Percentage of Completion vs. Completed Contract
Most construction firms use a percentage of completion approach to declaring income. At the end of an accounting period, companies determine how much of a project has been delivered. Are they 25% complete or 75%? The business recognizes that portion of the contract’s revenue and expenses based on the completion percentage.
Construction companies can use a completed contract method (CCM) to declare income; however, the approach is not compliant with generally accepted accounting practices. The CCM approach does allow companies to defer revenue recognition to a different accounting period which can reduce tax liabilities for the current period. In general, this approach is used for short-term projects.
Most companies require a retainage fee to protect against problems that may appear after the project is complete. Depending on the size of the project, the fee can be as much as 5% to 10% of the project cost. Accounting professionals can help construction firms establish financial management practices that minimize tax liabilities while maintaining a strong balance sheet.
Underestimating labor costs can reduce if not eliminate a project’s profit margin. Including too much of a cushion can mean losing the contract. Effective job costing requires an understanding of the factors that impact labor costs. For example, is union labor required? Will there be a diversity clause? These are factors to consider when preparing a bid.
Labor costing should include the following:
- Prevailing wage. For government contracts, construction firms must use the prevailing wage; however, those wages can change based on the state and local governments. Determining the correct value to use for each trade can become complex and require a professional to help determine the appropriate value.
- Union labor. When projecting labor costs, companies need to determine if union labor is required and the hourly wage for each trade.
- Multi-state jurisdictions. Labor that lives in one state but works in another may be subject to different employment and tax laws. Even labor that lives in one county but works across the state may present different tax liabilities. Misjudging the requirements can impact a project’s profitability.
- Compliance reports. Construction focuses on the labor required to execute a project but forgets the costs associated with administrative functions. Minimal reporting can be absorbed into indirect administrative costs. If extensive reporting is required, as with government contracts, a separate line item may be needed to ensure the costs are included in an official bid.
Not every bid will include these factors, but they must be looked at before submitting a bid. Overlooking one of these requirements could significantly reduce any profit margin.
Construction companies can bill clients for services rendered based on the type of job costing that was used. The industry typically uses one of the following methods:
- Time and Materials. Companies bill the client based on time spent and materials used. A cap may be placed on the overall project costs.
- Fixed Price. Fixed-price means that the construction company will complete the project for the quoted price. Some form of incremental billing is used with this method, although the fixed-price method carries a significant risk to a construction firm.
- Unit Price. Companies define the “unit” for the contract such as per mile. In this costing, the total cost of the project is broken down into units. For example, a construction company may bid on a per-mile unit price. As a unit is complete, it is billed.
- Progress Billing. Construction companies bill the client at intervals throughout a project. Government contracts have specific guidelines and forms for receiving payments.
Some projects may stipulate the type of contract while others may allow the bidders to decide. Knowing which billing method is best for a project requires experienced accounting professionals who understand the business.
Why Use a Construction Accounting Professionals
The number one accounting error that construction companies make is inaccurate job costing. They fail to take into account a few factors such as revenue recognition, labor costs, or pricing models. As a result, companies end up delivering jobs for little to no profit. They rush through the bidding process, increasing the risk of a poorly constructed response.
If your construction firm is without knowledgeable accounting professionals, contact us to discuss how we can help improve your bottom line.