While the construction industry follows a lot of general accounting principles, there are plenty of particular challenges contractors face that require specialized financial management strategies to ensure your construction firm is running as efficiently and effectively as possible.
What Makes Construction Accounting Different?
All businesses rely on good accounting to lay the groundwork for profitability and success. This is especially true in construction, thanks to the industry’s unique financial challenges and bookkeeping methods. Unlike other businesses, construction companies are project-based, which means you’re more likely to experience irregular cash flow on individual projects that impact the company’s financials. Add in factors like managing retainage, complicated cost structures, long pay cycles and tracking change orders and there’s a lot for contractors to keep up with. That’s why good accounting practices are so critical – they’re the ‘glue’ that holds all of your financial information together and ensures your profits don’t slip through the cracks.
In this guide to construction accounting and financial management, we’ll walk you through the basics, from understanding generally accepted accounting principles (GAAP), setting up an accurate accounting system to controlling cash flow and more. If you want to understand the keys to sound construction financial management in your business, read on.
Accounting Methods for Construction
There are four primary accounting methods that can be used in construction. The size of your construction business and type of work being performed will dictate which accounting method is the best. It’s important that you consider how the accounting method you choose will impact your financial statements, like the income statement, balance sheet, and revenue recognition. There are IRS guidelines that require companies above a certain size to use a particular accounting method.
Cash Method
The cash method of accounting is reserved for small businesses that are operating under 30 million in annual revenue as of 2024 for corporations and partnerships per IRS publication 538 and is the easiest to use. The revenue maximum is pegged to inflation and is the average of your last three years of revenue. Revenue is recognized when money exchanges hands —when you receive a check from your customer or write a check to a vendor. Because it is easy to set up and use, it’s the preferred method for small contractors, however; it has its disadvantages. Because you do not recognize revenues until money exchanges hands it’s very difficult to forecast income and expenses, additionally, most banks and financial institutes will not accept financial statements produced using cash basis for loans, or lines of credit.
Accrual Method
The accrual method provides a more accurate financial picture than the cash method because you recognize revenue when you invoice a project owner and when your vendors and suppliers bill you regardless of when money actually exchanges hands. This improves the accuracy of your financial statements and gives you better tools for financial management. By recognizing revenue and expenses as they occur, you’re able to better plan and forecast cashflow versus just report profitability. On the other hand, one of the biggest downsides of the accrual method is that you may end up paying taxes on income that has not been received and may never be received if the project falls apart or if the project owner has financial problems.
Percentage of Completion Method
The percentage of completion method records revenue and expenses when they are earned or incurred and factors in the amount of work you have put in up to that time. For example, if you bill a customer the revenue is considered earned at that time based on the amount of work you have put in place. The formula to determine the percent of completion is based on the total costs you expect to incur on the project compared to the costs you have incurred on the job. This lets you determine the amount of revenue you have earned.
Completed Contract Method
The completed contract method is reserved for home builders or contractors working on long-term contracts. In this method, revenue and expenses are only recognized once the project is completed. You would still have accounts which keep track of the construction in progress as costs are paid, and a billing account and accounts receivable account as the project progresses. At the end of the project you would record the total construction costs and the total expenses. This method is not often used by contractors.
A Note on GAAP
The accrual, percent of completion, and contract completed methods all come from Generally Accepted Accounting Principles (GAAP). These are issued by a board that dictates the rules of accounting that must be followed by publicly traded companies. Many private companies also follow some form of the GAAP rules for revenue because it helps banks and other financial institutions understand how their revenue and expenses are being captured. That allows everyone involved with the company to better understand their financial statements.
Setting Up a Successful Construction Accounting System
When all’s said and done, your construction accounting system should be able to address all of your business’s most critical processes, including:
- Job costing – Job costing is the process of setting a budget for a job using estimated costs, tracking expenses (like material costs, labor costs, subcontractor costs and equipment costs) against the construction job budget (using cost codes) and then using the information gained once the job is complete to make better bids in the future. This is a vital part of your construction accounting process, and will be something you keep track of with every new project you take on.
- Change order management – Change orders…you might hate them, but they’re pretty much unavoidable. And because of that, properly capturing, tracking, and managing them is necessary to avoid losing money.
- Labor costs – Understanding your fully-burdened labor costs is incredibly important, and contractors often underestimate them. If you want to avoid throttling your bottom line here, you’ll need to calculate any and all associated expenditures like insurance, benefits, taxes, and payroll processing on top of your base payroll amounts.
- Bookkeeping – Another component of good construction accounting is your bookkeeping, particularly how you handle invoicing and cash flow management. You’ll want to consistently track accounts receivable and monitor invoices to ensure you’re paid on time. In our experience, cash flow problems due to late or missing payments are one of the most common reasons construction businesses fail.
- Revenue recognition – Don’t overlook proper revenue recognition if you want to accurately record project income. There are four methods you can use to go about this, including recording income and expenses after contract completion, the percentage of completion method, accrual accounting method recording revenue and expenses by transactions, and cash-basis accounting, where payments are recorded only upon receipt.
- Progress Billing – Construction projects are long and it’s important that you set up a way to progressively bill against the job as work is completed. This is called progress billing and it’s standard in the construction world. In fact, most companies have standardized on the AIA invoicing which incorporates it.
- Monitoring and Controlling Overhead Costs – It’s imperative that you monitor the overhead costs that are required to run your business. Any expenses that hit your general ledger that aren’t direct costs on a job site are typically considered overhead costs. Thinkabout the office space, marketing, sales, computers, etc.
- Payroll and Prevailing Wages – You need to do some basics when it comes to payroll to ensure you are compliant like: collecting time correctly, withholding all the amounts required by law (including voluntary deductions, pay employees and tax agencies) in a timely manner, and file reports for local, state, and federal agencies. Along with payroll you want to understand how prevailing wages work so you can compete for work where they are required.
While you could keep track of all of these things on a set of spreadsheets or a generic accounting product like QuickBooks, DIY management of your financial data isn’t something that’s easy to scale with your business. That’s why experienced contractors often rely on purpose-built construction accounting software to manage their finances. The right software applications can automate many of these accounting processes and provide accurate, real-time information so you can know where you stand on every project at any time.
The Importance of Cost Tracking and Job Costing
Tracking project costs (both direct and indirect costs) and measuring them against your estimated expenses is fundamental to completing profitable projects and increasing your overall profit margin. Remember, job costing helps account for expenses associated with labor, materials, subcontractors, equipment, and other direct costs tied to each specific project you undertake. Over time, the data you gather here can help you make better decisions and keep future projects on budget.
Tracking your labor and materials costs is particularly important here, because as you well know, these expenses often represent a significant portion of a job’s overall cost, especially on fixed price jobs where variances will eat into your profits. As discussed before, don’t forget to account for all related expenses like overtime, insurance, and payroll processing to get the full picture behind your labor costs. With accurate data, you can experiment with different labor mixes – and ultimately tighten your future cost estimates based on what you learn. Proper job costing also provides insight into resource allocation on projects, allowing contractors to test and measure different labor mixes and tighten future estimates based on what they learn.
A few more job costing best practices include:
- Providing detailed breakout pricing and allocation of all project tasks
- Making accurate cost estimates
- Scheduling regular data reviews to identify any discrepancies
- Insure you’re capturing indirect costs
These best practices can help empower you and your leadership team to take action and make any adjustments needed to keep your jobs on schedule and on budget.
💥 For a more detailed guide on how to do job costing, check out this resource.
Budgeting and Forecasting
As the name implies, forecasts are estimates of a specific project’s projected expenses. Ideally, you’ll make these forecasts based on data from previous projects. These forecasts play an essential part in helping you as a general contractor or subcontractor build out accurate project budgets. Here are a few factors to consider when making these forecasts:
- Historic data from similar projects in the past
- The size and scope of the project you’re estimating for
- Project timeline/duration
- Your fully-burdened labor costs
As you incorporate forecasting into your construction accounting process, you’ll be able to develop tighter budgets over time. One thing that can be helpful here is revisiting your forecasted numbers often as a project progresses – making adjustments where necessary to align estimates with the actual costs you’re incurring. Lastly, we can’t overstate the importance of consistently communicating with your employees, subcontractors, and suppliers. The more you can communicate, the more likely everyone will be on the same page – and sharing the same information.
Accounts Payable and Receivable
Let’s talk about tracking and managing your accounts payable and receivable. For many contractors, it can take an average of two and a half months just to get paid. If you’ve got an efficient method for managing your invoices, receivables, and follow-ups though, you can potentially cut down on that waiting time.
If you want to be smart about improving your accounts receivable, we’d recommend implementing and following a solid credit policy, as well as incorporating an effective follow-up process for invoices. We’d also recommend staying up to date on your options in the event of delayed receivables, including reserving your right to file a mechanics lien, or at the last resort, file a lawsuit.
On the flip side, managing your accounts payable is just as important to maintaining good cash flow. Put simply, accounts payable are the amounts you owe to suppliers and subcontractors for expenses associated with a specific project . If you want to effectively control these payments, you’ll need to maintain a designated receiver for all incoming invoices to a) simplify tracking and b) facilitate immediate and consistent entry into your construction accounting software or system.
One last note here: Accurately monitoring retainage (the withholding of a portion of the funds that are due to a contractor or subcontractor until project completion) is also essential, as is sticking to an established payment schedule whenever possible to ensure your accounts payable are managed regularly.
Cash Flow Management
Construction projects are a cash-intensive undertaking, and you’ll often find that they require significant upfront spending for materials and supplies, along with ongoing expenses like labor. One of the big challenges this brings is matching your constant cash outlay against the delays you might experience with incoming payments. Basically, avoiding significant financial problems means building a solid cash flow despite these consistent differences between receivables and payables. This means you have to have a daily understanding of what revenue has been earned vs. made and how long you are likely to wait before receiving payment for jobs done.
If you want to get even more strategic, you can try a couple things like negotiating more favorable payment terms with your suppliers, and creating a consistent system for billing and follow-ups.
Lastly, if you don’t have a sufficient line of credit and a good relationship with your bank, a lot of this hard work can go to waste. Don’t wait to take care of these. If you experience a late payment or other challenge, having a solid line of credit in place will ensure you have enough cash reserves to keep your business going.
Maximizing Success with Financial Reporting
Construction accounting is an ongoing process, and it pays to regularly review your progress to make sure you’re staying on track with your financial goals. For example, consistently reviewing your forecasts vs. actual project performance can help you identify potential problem areas and course correct before your project profitability and cash flow becomes negatively impacted.
The larger the construction project, the more important it is to have a good review and analysis process in place, simply because bigger jobs generally carry more financial risk, particularly in terms of labor and material costs. Taking the time to review your accounting data from time to time will help you improve your estimates and create more accurate budgets for all of your future projects.
Integrating Payroll and Project Management
A good construction accounting system doesn’t stand alone. Instead, we recommend integrating your accounting system and software with your other business systems, like payroll, project management, and the tools use use to construction contracts. This way, you can eliminate the need for multiple entries of the same data, and reduce the amount of time you and your team has to spend doing tedious admin work in these systems.
What’s more, integrating all of your systems into one place provides better overall visibility into your financial health, and makes collaboration between your team members much easier. More eyes on every project means less time spent managing miscommunication – and more time doing what you do best.
How Construction Accounting Software Can Help
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 software options 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 invoicing, time tracking, and job costing.
So, shameless plug here: CrewCost is construction accounting software that solves all those problems for emerging contractors. From built-in retainage management and tracking to job costing, progress invoicing, time tracking, automatic labor costs in your budgets — we decided there had to be a better solution for the construction industry than what was out there, and that’s what we built.
Sign up and be the first to try it when we release in early 2024.
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