Construction accounting exists to provide two key financial points of information to contractors and the management team of a construction company. The first and most important financial point is field production profit. This particular profit measurement is commonly referred to as job profits. It is essential contract revenue less direct (hard) costs of construction. The secondary and almost as important as the primary key financial point is the company’s net profit after taxes. This particular key financial point is the customary financial profit of the company. The first financial point is tied to job costing and therefore, construction accounting is comprised of two different accounting systems. The two systems are job costing and traditional financial GAAP (Generally Accepted Accounting Principles) reporting.
The primary key performance indicator with construction is the annual financial income statement (profit and loss statement). For most traditional contractors, the bottom line, net profit after taxes should be no less than 7% with an average of 9.4%. If the contractor desires to be in the upper 10% of the industry, net profit must be greater than 12%. For those involved in the trades, minimum net profit should be greater than 10%, with the average being 14% and the upper tenth percentile bracket having greater than 18% net profit. Again, after income taxes are paid. However, a year is a long time to wait to review performance. In the interim there are other key performance indicators to identify trends and provide feedback to the management team. They consist of three distinct groups of indicators: 1) Production Reports, 2) Backlog/Pipeline Information, and 3) Interim Financial Outcomes.
The residential construction industry’s average net profit after taxes equals 9.4% during 2019. The top four companies in the United States built and sold 151,366 homes with an average sales price of $376,703. Each home netted after income taxes $35,464 of profit. This equates to an average net profit of 9.4% in the residential construction industry.
There is no preset national standard for markup on materials. The Internal Revenue Service’s Construction Industry Audit Technique Guide (May 2009) states that from the Means Contractor’s Pricing Guide include a standard 10% markup on material for profit. However, profit is only one portion of total markup; therefore, markup on materials starts at a minimum 10%. In some cases markup on materials can exceed 100%. This article provides guidance to the contractor, estimator or project manager with setting the markup rates on materials.
Labor burden in construction is a value added on to the respective hourly labor base wage to to determine the total cost per hour for a particular trade or employee. Labor burden rates are used extensively with estimating and recording actual results. The key to labor burden is that the rate is NOT universal. The value is different per company and in some cases per trade/employee. The rate is highly dependent on the various employee benefits provided and the structure of the organization.
The core tenet of an estimate is that each is unique. This uniqueness is driven by hard costs of construction. There are five distinct hard cost drivers in every estimate. Each cost driver has different application principles (introduced in this lesson), different sources of value and final markup formulas to determine the final estimated hard cost. The five distinct cost drivers are 1) materials, 2) subcontracted services, 3) equipment application, 4) labor and 5) intangible expenditures. Each type of cost (driver) has principles of application, i.e. thought processes an estimator must consider. Some of the principles are common among all five types of costs. Others may be unique to just that particular cost driver. This lesson introduces these five cost drivers and the various application principles involved with each driver.
Financial success in construction is tied directly to job costing. Without job costing, financial wellness is likely a product of coincidence than authority within this industry. Implementing job costing in construction is the absolute best financial control a contractor can do to ensure success. Tie cost accounting to the estimating process, and prosperity is all but certain. Rarely does any contractor fail when they implement job cost accounting.
Well developed, accurate and timely estimates are the best tool ensuring profitability in the construction industry. No other internal control mechanism is as valuable to the contractor as the estimate. Good estimating systems in construction provide the management team with the necessary confidence to make long-term decisions benefiting all parties involved with the company. Customers receive a higher quality structure with less warranty requirements, employees get a sense of security with their tenure, and vendors/subcontractors acquire desirable relationships with their contractor assuring delivery of best practices for their respective trades. Simple put, good estimates deliver profits to the contractor.
Estimates in construction are prepared in a similar timeline fashion as project milestones with an overall section to cover those costs that are ongoing throughout the project’s entire time frame. For the purposes of this lesson, the term ‘Phase’ is used to indicate these respective steps of physical construction. In Parts I and II of this series, estimates are created using hard costs of construction; those costs that are directly assignable to the respective project. Throughout this project’s timeline, all assignable costs are keyed to the project and ultimately aggregated by cost type (materials, labor, subcontractor, equipment, other) in the direct costs of construction section of the income statement (P&L statement). To break these costs down into phases, the estimator needs to understand how data in entered into the accounting software. Once entered, the costs can then be accumulated by phase using a customized report from the accounting software. Most accounting software allow an estimate to be entered thus the customized report can compare actual hard costs by phase against the estimated costs by phase. With this report, the construction management team can now hone in on any cost overruns by phase or cost savings.