Running a construction business is different than running other types of businesses. It requires a unique approach to accounting and financial management that is distinct from traditional accounting methods. For contractors and construction business owners, understanding the key principals of construction accounting is crucial for long-term success and profitability. This guide will explore the key elements of construction accounting, including revenue recognition, job costing, Work in Progress (WIP) reporting, cash flow management, and the critical role of retainage in the construction industry.
📽️ Chris breaks down the heart of construction accounting in the video below 👇
Why Construction Accounting is Different from Traditional Accounting
Unlike other industries, construction businesses face unique challenges that make their accounting needs more complex:
- Project-based work
- Long-term construction contracts spanning multiple accounting periods
- Fluctuating material and labor costs
- Unpredictable project timelines
- Cash-intensive operations
- Long pay cycles and retainage
These factors contribute to the high failure rate of construction companies, with many failing before reaching the 10-year mark. Now, we aren’t telling you these statistics to scare you away from building a construction business, but we do want to paint a clear picture to help you avoid becoming part of this statistic, and to do that it's essential to gain a firm grasp on construction accounting principles and best practices.
Understanding Your Financial Dashboard
In construction, like any business, there are certain numbers you need to monitor closely to effectively run your company. Your financial dashboard consists of three main components, which can be compared to the gauges used to operate your car or truck:
- Net Income Statement (Speedometer): Shows how profitable the business is by comparing revenue with expenses.
- Cash Flow Statement (Gas Gauge): Indicates how quickly you're burning through cash.
- Balance Sheet (Oil Pressure Gauge): Reflects your business's overall financial health.
Let's dive deeper into these components:
Net Income Statement
The income statement, also known as the profit or loss statement, shows if your business is making a profit, breaking even, or losing money each month.
It consists of:
- Revenue: All money coming into the business during a specific period.
- Cost of Goods Sold: Direct costs required to produce a good or service (labor, cost of materials, equipment, subcontractors).
- Gross Profit: The difference between revenue and cost of goods sold.
- Selling, General and Administrative (Overhead): Costs needed to run your business (rent, sales, marketing, estimating, phones, trucks).
- Net Profit: Your bottom line, all money left over after operations.
Key ratios to monitor for contractors:
- Gross Profit Margin: (Gross Profit / Gross Revenues) x 100
This ratio shows the percentage of revenue that exceeds the cost of goods sold (labor, materials, subcontractors, equipment). It's a crucial indicator of a contractors potential for strong net profits. - Overhead Ratio: (SG&A Expenses / Cost of Goods Sold) x 100
The overhead ratio compares your indirect expenses (office, estimating, admin) to your Cost of Goods Sold (COGS). This ratio helps you understand how much you're spending on overhead relative to your direct project costs. A lower ratio indicates better efficiency in the business. - Net Profit Margin: (Net Profit / Gross Revenues) x 100
This ratio represents the percentage of revenue that translates into profit after all expenses are deducted. It's a measure of overall profitability.
Understanding these ratios can help you:
- Assess if your business is generating enough profit to justify the effort and risk.
- Determine if you're pursuing the right customers and projects.
- Evaluate your estimating and pricing strategies.
- Analyze if your overhead expenses are appropriate for your construction volume.
Cash Flow Statement
The cash flow statement tracks the movement of cash in and out of your business. It's crucial for construction companies due to the industry's cash-intensive nature.
Key components include:
- Operating Activities: Cash generated from core business operations.
- Investing Activities: Cash used for long-term investments.
- Financing Activities: Cash from loans, equity, or debt repayments.
Balance Sheet
The balance sheet provides a snapshot of your company's financial position at a specific point in time. It includes:
- Assets: What your company owns (cash, accounts receivable, equipment).
- Liabilities: What your company owes (accounts payable, loans, retainage owed).
- Equity: The difference between assets and liabilities.
Understanding and regularly monitoring these three "gauges" will help you make informed decisions and steer your business in the right direction.
When you look at your financial dashboard, always remember the old business adage: “Revenue is vanity, profit is sanity, and cash is king.” This saying emphasizes that while high revenue might look impressive, it's profitability, cash flow, and assets that truly determine a construction business's health and longevity.
Revenue Recognition Methods in Construction
Choosing the right revenue recognition method is critical for accurate financial reporting. The four main methods are:
- Cash Method: Revenue is recognized when cash is received.
- Accrual Method: Revenue is recognized when earned, regardless of when cash is received.
- Percentage of Completion Method: Revenue is recognized based on the percentage of work completed.
- Completed Contract Method: Revenue is recognized only when the project is completed.
For most construction businesses, especially those working on long-term contracts, the percentage of completion method is generally the most suitable option. Note: With ASC 606, you'll want to make sure you're recognizing revenue using a suitable measure, such as percentage of completion method.
Percentage of Completion Method (POC)
The POC method allows for more accurate representation of your financial position throughout the project lifecycle. Here's how it works:
- Calculate the percentage of completion:
Cost to Date / Total Project Costs = POC - Use this percentage to calculate revenue to recognize:
Total Contract Price x POC = Recognized Revenue
For example, if you've incurred $50,000 in costs on a $250,000 project:
$50,000 / $250,000 = 20% POC
If the total contract price is $300,000:
$300,000 x 20% = $60,000 recognized revenue
This method provides a more accurate picture of your construction job’s profitability over time, rather than showing large spikes in expenses without associated revenue.
👉 Keep Learning: The Percentage of Completion Method Explained (with Examples)
Job Costing: The Heart of Construction Accounting
Job costing is a fundamental aspect of construction accounting that involves:
- Setting a budget for each job using estimated costs
- Tracking expenses against that budget using cost codes
- Analyzing completed job data to improve future bids
How Job Costing Works
- Creating a Job Budget: Start with a detailed job budget based on your estimate. This serves as a baseline to measure actual costs against estimated costs.
- Cost Categorization: Categorize costs into budget lines using cost codes and cost types for precise tracking.
- Cost Coding: Code all costs to the appropriate job number, cost code, and cost type. This enables real-time expense monitoring.
- Direct vs. Indirect Costs: Break down costs into:
- Direct Costs: Expenses tied to specific tasks (labor, materials, subcontractors, equipment).
- Indirect Costs: Essential for running the job but not tied to specific tasks (project management, jobsite trailers, clean-up crews). These are categorized the cost type "other".
Benefits of Effective Job Costing
- Improved Bidding: Analyze historical cost data to create more accurate and competitive bids.
- Better Estimating: Refine your estimating process for more precise change orders and project budgets.
- Cost Control: Identify cost overruns early for timely corrective actions.
- Performance Evaluation: Assess different aspects of your operations and make improvements.
- Strategic Decision Making: Identify which types of projects are most profitable for your business.
Job Costing and Forecasting
Use job costing data to make increasingly accurate projections of future project costs and profitability. Consider these factors when forecasting:
- Historical cost data from similar past projects
- Project size and scope
- Project timeline and duration
- Fully burdened labor costs
Regularly revisit your forecasts and adjust them based on actual costs incurred as the project progresses.
👉 Keep Learning: Mastering Construction Job Costing: How to Enhance Profitability With the Builder’s Feedback Loop
WIP Reports: Keeping a Pulse on Your Project Status
Work in Progress (WIP) reports are essential tools for monitoring the financial health of your ongoing projects and their impact to the overall business.
What are WIP Reports?
A WIP report provides an overview of all open projects' status at a specific point in time, consolidating information on project revenue, costs incurred, billings, and progress. It combines all job costing data in one place, offering an accurate representation of each job's current status and your business's overall financial health.
Key Components of a WIP Report
A typical WIP report includes:
- Total contract amount
- Estimated costs to complete
- Estimated profit and profit percentage
- Actual job costs to date
- Billings to date
- Project percent complete
- Revenue recognized
- Over/underbilling status
- Backlog (Revenue yet to be earned)
Benefits of WIP Reporting
- Bird's Eye View: WIP reports offer a comprehensive overview of your business, allowing you to understand both high-level trends and individual project performance.
- Improved Planning: With clear visibility into remaining work, you can better allocate resources and plan for future projects, or lack of projects (gaps in work).
- Cash Flow Management: WIP reports help identify overbilling or underbilling situations, allowing you to better manage underbilled projects.
- Performance Tracking: By comparing actual progress to estimates, you can quickly identify underperforming projects and take corrective action.
- Strategic Insights: Backlog details from the WIP report, when used in conjunction with sales pipeline reports, can guide strategic estimating decisions.
Using WIP Reports for Cash Flow Management
WIP reports are particularly useful for managing cash flow through proper billing practices:
- Overbilling: This occurs when you invoice for more than you've completed. While it can help with cash flow, excessive overbilling can lead to payment delays or disputes.
- Underbilling: This happens when you bill for less than the work completed, essentially financing the project yourself. WIP reports help identify underbilling situations so you can address them promptly.
👉 Keep Learning: Leveraging WIP Reports for Effective Construction Management
Managing Cash Flow and Retainage in Construction
Cash flow management is particularly challenging in the construction industry due to several factors:
- High upfront costs
- Slow payment cycles
- Long project durations
- Retainage practices
Understanding Retainage
Retainage is a standard practice in the construction industry where a portion of payments is withheld as a financial incentive to ensure successful completion of a project. This holdback can significantly impact cash flow, especially for newer contractors with limited cash reserves.
Impact of Retainage on Cash Flow
Retainage can have a substantial effect on your cash flow because the amount, generally 10% is approximately the same as the net profit that most contractors can expect to make on any given project. Considering that your profitability likely is funding future projects, it doesn't take long for this to get out of hand. That's why it's critical, to save up cash reserves early in the construction industry.
Best Practices for Managing Cash Flow and Retainage
- Monitor your cash conversion cycle (CCC): Understand how quickly you can convert resources into cash flows. The CCC in construction typically spans from the day you purchase materials and mobilize your workforce to when you get paid for the work, typically a monthly billing milestone. This is in excess of 60 days for most contractors.
- Implement efficient billing practices: Bill promptly and accurately to minimize delays in payment. Make it a best practice to call and confirm that invoices have been received and that the owner has what they need to pay the invoice. Countless contractors have delayed payment because of small clerical issues that could have been resolved.
- Negotiate favorable payment terms:
- With clients: Try to include a retainage reduction rider in your contracts. This can reduce the amount of retainage withheld as the project progresses. For example, the rate might start at 10% but decrease to 5% after the project is 50% complete.
- With suppliers: Negotiate terms that align better with your cash inflows, considering the impact of retainage on your account receivables.
- Apply retainage to subcontractors: If retainage is withheld from your payments, it's generally advisable to withhold retainage from your subcontractors as well. This helps balance the cash flow impact across the project chain.
- Set up specific accounts for retainage: Create separate accounts in your chart of accounts for upstream retainage (accounts receivable) and downstream retainage (accounts payable). This ensures accurate financial statements and proper tracking of amounts owed to and by your company.
- Understand GAAP requirements: Under Generally Accepted Accounting Principles (GAAP), retainage payables move to accounts payable when invoiced, and retainage receivables move to accounts receivable when billed. This distinction is important for proper financial reporting.
- Consider using lines of credit strategically: These can help bridge temporary cash flow gaps caused by retainage holdbacks.
- Communicate effectively: Good communication with project owners from the outset can help reduce the impact of retainage on your cash flow. Discuss potential for early release of retainage or partial payments as project milestones are met.
By understanding and effectively managing retainage alongside your overall cash flow, you can mitigate its impact and maintain a healthier financial position throughout your projects. Remember, while retainage is a standard practice in construction, how you handle it can make a significant difference in your overall financial health.
👉 Keep Learning: The Ultimate Guide to Construction Retainage
Overhead Allocation in Construction Accounting
Properly tracking and allocating overhead costs is essential for accurate job costing and pricing. Overhead includes indirect costs such as:
- Office rent and utilities
- Owner and administrative salaries
- Vehicles and insurance
- Estimating, sales, and marketing expenses
- Computers, phones, and software
Develop a system to allocate these costs across your projects to ensure each job bears its fair share of the company's overhead. Consider using activity-based costing or a predetermined overhead rate based on direct labor hours or direct job costs. So for example, if you have $200,000 in overhead expenses for the previous year and $1,000,000 in direct job costs (COGs) you would have 20% overhead using the direct job cost method.
Setting Up a Cost Coding System
A well-structured cost coding system is a key construction accounting process and crucial for effective job costing and financial management.
Here's how to set one up:
- Job Codes: Assign a unique number to each construction project, typically using the year followed by a sequential number (e.g., 2401, 2402).
- Phase Codes (optional): For larger projects, use phase codes to divide jobs into separate structures or cost groupings.
- Cost Codes: Use a numbering system that aligns with different divisions of work (e.g., 01 – General Requirements, 02 – Existing Conditions).
- Cost Types: Further divide each cost code into types such as labor, materials, subcontractors, equipment, and other (PMs, Supervision, Job Trailers).
Ensure your cost coding structure is simple enough for both field and office staff to understand and implement consistently.
The Importance of Specialized Construction Bookkeeping
Having the right bookkeepers, either internally or externally, who understand construction accounting is crucial for your business's financial health. Using a regular bookkeeper that doesn't have construction experience will get you in trouble quick.
Seek bookkeepers who:
- Have construction industry experience
- Understand construction-specific accounting software
- Are familiar with cost coding and job costing
- Can handle retainage and WIP reporting
- Understand percentage of completion method and proper revenue recognition for construction
Having the right bookkeeping expertise builds a solid foundation for accurate financial management and informed decision-making in your construction business.
A Great Construction Accounting System Helps You Make Better Financial Decisions
Mastering the financial accounting side of your construction business is essential for your long-term success and profitability. By understanding and implementing these key concepts – from revenue recognition and job costing to WIP reporting and cash flow management – you'll be better equipped to make informed decisions, improve project profitability, and build a construction business that stands the test of time.
Remember, construction accounting is an ongoing process. Regularly review your financial data, stay updated on the industry’s accounting standards, and don't hesitate to seek professional advice when needed. With the right approach to construction accounting, you can build a strong foundation for your business's financial success.
Leveraging Technology for Construction Accounting
Implementing the right technology can significantly improve your ability to manage your construction firm’s finances effectively.
At the end of the day, while the construction industry follows a lot of general accounting principles but there are plenty of particular challenges contractors face that require specialized strategies to ensure your financials are managed effectively and your company continues to grow in a healthy way.
A lot of the construction accounting applications out there are powerful, but come with weeks of custom implementation and a hefty price tag. On the other hand, generic accounting software solutions on the lower end require a bunch of workarounds and disjointed third party integrations to complete simple tasks like tracking retainage, progress billing, time tracking, and job costing.
CrewCost is a construction accounting software that solves all those problems for contractors. From job costing, WIP reporting, progressive invoicing, retainage and time tracking — you get everything you need to build a financially healthy contracting business in a modern, simple, and easy to use product.
Plus, it's 100% cloud-based which means your team can access it from anywhere and you don't have do deal with the pains of on-prem software.
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