Bookkeeping – Phase Costing (Lesson 73)

Phase costing takes accounting to the next level. Phase accounting (costing and accounting are interchangeable at this level of detail) can only be used with job costing. It is designed to break a job down into distinct functions (stages) for analysis. It is a tool to identify discrepancies from estimates. Basically management compares actual results against a standard or an initial estimate. Furthermore, it is by far the most effective return information for the feedback loop concept of accounting. Phase costing is one of the advanced skills of an accountant.

This lesson teaches the accountant the fundamentals of phase accounting, how to set it up in the books of record along with recording information. Next, I’ll explain how to retrieve this information and use it to compare to the original estimate created. Finally, I’ll illustrate a couple of examples to help the reader grasp the overall idea behind this accounting tool.

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Phase Costing Fundamentals

Every job has stages of production and delivery to a customer. Some may be relatively uncomplicated like technology where there is a design, hardware/software acquisition, install, programming/testing and final turnover to the client. Others can be extremely complicated and intricate like building a ship. No matter the job, each stage has some estimate of materials and labor to complete. Whether this is in the estimator’s head or on paper.  The final results are what phase accounting is all about. The idea is to compare actual outcomes against the original estimated amounts.

The comparison allows the estimator to understand the details of what he or she miss priced. Here is an example.

New Home Builder

A client of mine builds new homes. One of the phases of construction is the footer/foundation whereby concrete is poured into a dug out outline of the house. On top of this concrete are stacked concrete masonry blocks (cinder blocks) to form a foundation. The builder expected five courses (layers) of block to form the foundation. He was billed for eight. He went back to the brick mason to find out why. The brick layer explained that the lay of the land was not level and that there was a two and one-half foot difference from one end of the house to the other. This required an additional three courses at one end of the house. This leveling process cost the contractor $1,800 more overall. With this knowledge, any grade difference was adjusted for additional courses in future estimates.       

Fundamental Rule of Phase Costing # 1 – Phase costing is used to compare actual costs of the job’s stage of construction/process to the original estimated cost.

Each phase has a list of every bill posted so a project manager and management can look at the details. Typical errors consist of timing, too much or inadequate materials, unsupervised labor and/or misjudgments. These cost overruns are easily identifiable in the reports. Owners can then address the issue with project management.

Fundamental Rule of Phase Costing # 2 – Phase costing serves as a performance evaluation tool of project management.

Another purpose of phase costing is its use as a tool to evaluate project management’s performance. It is actually the number one tool to review a project manager’s skills in organizing, getting the best prices and addressing variances during construction.

Fundamental Rule of Phase Costing # 3 – Existing results for a phase are used as a reference for future estimates with similar phase characteristics.

A third and critical use of phase accounting (costing) is its historical reference capacity. If management has a job with a similar scope several years from now, they can use the existing results as supporting documentation for an estimate. Any stage with deviations from the past can simply be estimated based on the results of another job’s phase with similar characteristics.

The idea behind phase costing is to break a job down into stages to identify issues and analyze cost overruns. To do this, the accountant must set up the accounting software to utilize phase costing.

Setting up Phase Costing

Setting up phase costing is a two-step process. The first step is identification of the various stages (phases) of the project. The second step involves programming the software to receive the information and report the results.

Identification of Phases

Each industry uses its own terms and standards to complete a project. Sometimes projects are broken down into jobs, very large projects with distinctly different functions.

As an example, a road construction project may have sections of a road as jobs, a bridge as a job and maybe an intersection as another job. In small business this is highly unlikely so therefore the entire project is a job.   Each job is broken down into distinct stages of construction. As an example, here is how a new home contractor breaks out a job into phases:

Phase
Code   Name                                Description
01       Design/Documentation    This phase includes architectural and engineering costs. It also includes permits, capitalization costs, debris removal, safety and closing costs.
02       Site Development             Includes site clearing, temporary access, drainage, surveying, septic system and wells. Other costs include landscaping, swells, and driveway.
03       Footer/Foundation           From digging the footer to laying the foundation block, this phase includes the garage floor pour, termite treatment, basement and crawl space.
04       Framing/Exterior            The most expensive phase of construction, includes framing, the roof, exterior siding, windows, exterior doors, deck, gutters and shutters.
05       Trades                               This is plumbing and associated fixtures, electrical, mechanical and communications. Rough-ins and trimming out are inclusive.
06       Walls                                 Any item associated with a wall is recorded here. This includes insulation, sheetrock, trim, interior doors, painting, closets, stairs and railings.
07       Kitchen/Baths                  This phase is usually defined by allowances in a contract. It includes cabinets, vanities,  appliances, counter tops and custom work for shelving.
08       Flooring                            All floor types and tile work
09       Extras                               This phase is designed for exterior extras such as sheds, lighting and/or a pool. Change orders are included along with governmental compliance items.

Notice that the above example restricts the project to nine phases. It is relatively simple math. A $1 Million home costing $650,000 to build means that no single phase of construction will have more than $125,000 of costs loaded in its details. The number one fundamental is to break out costs so any deviation can be easily identified.               

Breaking out a project into 11% increments can easily succeed in identifying issues. I encourage accountants and business owners to have at least four phases and no more than nine phases. It really depends on the respective industry and the magnitude of the project’s variables.

Some insights to identifying phases is warranted.

1)   Do not go to the extreme and create item codes for multiple variables of a stage of production. You’ll miss the whole point of phase costing and get lost in the bureaucracy of the details. As an example, an engineering fabricator building cell towers had separate phases for different delivery methods. He had one for using low-boys, another for trailers, another for vans and so on. The phase is delivery, the method is completely separate.  Do not create phases that will not be used with the majority of jobs.

2)   Some industries may have jobs but it isn’t necessary to break them down further. Basically the volume of information in the job is limited and pretty much similar to the next job. Also the jobs are extremely short-term in duration like less than one week to complete. As an example, a dentist wanted to have jobs for each patient. I explained that phases and for that matter even jobs were unproductive. The cost of materials are not unique nor is differing levels of expertise by different dentists. A simple extraction (tooth pulling) is an X-Ray, Novocaine and extraction. This process is very similar to all patients. Fundamental purpose number two is designed to evaluate performance on a job. Over time a dentist will have a similar time pattern for an extraction. Any deviation is due to uncontrollable variables (impacted tooth, patient history etc.).

A good rule of thumb is to have phases for jobs that are long-term oriented like more than a couple of weeks in duration. Each job is unique enough to warrant stages of completion.

3) Keep it simple is an adage applicable to identifying phases of completion. Almost all projects go through the following phases:

A) Design and Engineering
B) Production
C) Delivery
D) Testing and Approval (acceptance by customer)

Each industry will have different variables of this but this is the most simplistic breakout.

Programming Accounting Software

Just like the programming related to job costing, accounting software will allow for phases to be created. Construction software will use the term ‘Phase’ or ‘Stage’ of construction. QuickBooks uses the item code table to create phases.  Once they are set-up; the additional field is included in the date entry form (journal entry source). In QuickBooks, the entry form has two tabs, expense and item. Select the item tab and enter the journal entry as before except now there is an item code too.

Each entry has the traditional fields plus the fields associated with jobs and phases as shown in this chart.

   Traditional       Departmental          Job                   Phase
      Entry              Accounting         Costing              Costing
Transaction ID      Transaction ID    Transaction ID   Transaction ID
Ledger                   Ledger                 Ledger               Ledger
Control ID             Control ID           Control ID         Control ID
Description            Description          Description       Description
Debit                      Debit                   Debit                  Debit
Credit                     Credit                  Credit                Credit
   —                        Department         Department       Department
   —                         —-                      Job ID               Job ID(if applicable)
   —                         —-                       —                     Phase ID *Item Code in QuickBooks

Just like job costing, it is only necessary to post cost of sales transactions to a phase of the project. Do not post balance sheet or overhead expenses with a phase code. Any complex entries with multiple lines, be sure NOT to assign a job ID to overhead or balance sheet accounts.

There is only one exception to this rule and it relates to the percentage of completion and completed contract method line items which are explained in Lessons 74 and 75.

Once data is in the system it is time to review the reports.

Phase Costing Reports

Phase costing is designed to compare the estimated cost against the actual results. One of the common errors is to look at a report and believe it is accurate. The phases of construction or fabrication are mostly cost comparisons against estimates. It is normal to receive bills well after the job is closed. It is a good idea to have a contract with vendors indicating compliance dates such as  ‘Within 90 days of delivery or service’. This way all information is in the system no later than 90 days after the completion of the project.

Projects are then reported by phases. For example, here is a phase costing report for a brake spacer project by a metal fabricator.

Engineering and Fabrication LTD.
Job Costing Report by Phases
Project:  20170617B
Project to Date:  August 31, 2017

Phase
ID       Phase Description           Costs     Estimate   Variance +(-)
01       Engineering/Design         $3,214        $3,400       $186
02       Fabrication/Production    18,301        18,200        (101)
03       Testing/Quality Control        709             640          (69)
04       Packaging/Shipping           2,008          1,900        (108)
05       Installation                          4,331          2,200     (2,131)
06       On-Site Testing/Program    3,188          3,650         462
                                                   $31,751      $29,990   ($1,761)

First off, let me reiterate something very important here. The report is dated as of August 31, 2017. This doesn’t mean all the costs have been posted. It is quite possible there is still on-site testing going on which may add to the costs. Also look at the report’s title, specifically the date line. It says ‘Project to Date’. This covers all costs incurred to date for this project. Most of the accounting software programs allow for date restrictions such as ‘For the month ending …’ which will exclude costs outside of that date range. Be sure to date the reports for maximum inclusion of costs.

When preparing phase costing reports it is imperative that the accountant pay close attention to the timeline of the project. This is why I explained how important it is to have cut-off dates with suppliers and contractors.

Secondly, notice that the report doesn’t include revenue (sales) associated with phases. Why? This is because phase costing is about costs and not revenue. A project like this will have a contract value upwards of $100,000. The revenue covers not only direct costs (which are recorded to phases) but indirect costs too.

Furthermore the value includes the gross profit desired. Some companies will allocate the contract value to the respective phases. In a small business like this, this will have little if any value to management. What would result is large margins for each phase as illustrated below:

Engineering and Fabrication LTD.
Project Profitability Report by Phases
Project:  20170617B
Project to Date:  August 31, 2017

Phase  Phase
ID        Description                     Costs     Revenue     Margin
01        Engineering Design         $3,214      $6,000        $2,786
02        Fabrication/Produc.         18,301      55,000        36,699
03        Testing/Quality Control       709        3,000          2,291
04        Packaging/Shipping          2,008        5,000          2,992
05        Installation                        4,331      15,000        10,669
06        On-Site/Programming      3,188       16,000        12,812
                                                  $31,751   $100,000      $68,249

Comparing costs to costs by phases makes sense. It allows management the ability to identify discrepancies for the future. Comparing costs without any allocated indirect costs or allocated overhead against revenue provides little if any value.

Look at the report, what exactly can be gained in knowledge? There is no real apples to applies comparison, costs are actually the direct costs without markup. Revenue is the final amount including all markup. The only value the report identifies is the total profit from the job which is ascertained in a standard job costing report.

The job costing report breaks the job out into expenditures by cost function such as materials, labor, subcontractors, tooling and so on. Phase costing breaks the job out into stages of progress to assist management in identifying cost overruns in a logical pattern.

Go back and look at the phase cost to cost estimate report above. Look at the installation phase. Notice the cost overrun at $2,131? Management would want to know the primary reason (cost driver) that creates this cost overrun. A detail report is pulled and is presented as follows:

Engineering and Fabrication LTD.
Phase:  Installation
Phase Code Cost Detail Report
Project: 20170617B
Project to Date: August 31, 2017

Date        Item ID    Control ID      Description                                DR            CR
08/03/16  3742         Payroll #14       JRS –  13.7 Hours On-Site     $389.08
                3742         Payroll #14       JRS – Taxes                                35.57
                3742         Payroll #14       JRS  – Benefits                           67.42
                3748         Payroll #14       BPH –  16.4 Hrs On-Site          323.08
                3748         Payroll #14       BPH – Taxes                               29.53
                3748         Payroll #14       BPH – Benefits                           49.66
08/10       10406       Lanford            Crane for 2 Days                    3,102.00
08/11        55574204 TAG-08           Strap System, Ties                    334.68
Sub-Total Installation Phase                                                          $4,331.02

The estimate details are reviewed for comparison. The estimate had only 1 day of crane service and no strap system either. Upon discussion with the on-site installer he explained the 2nd day was necessary because the part would not align in place without modifying the existing base mount. The strap system was necessary to cradle the fabricated part because existing strap systems were ineffective.

Another insight with phase costing, specifically with the item detail report, do you see a ledger account or a department assigned to each line item? It isn’t necessary with this particular report because the report is about phases of completion and not presented in the typical income statement format which includes sales and cost of sales (in account layout). Again, phase costing is a tool to compare actual results against estimated amounts.  It is an excellent tool in the feedback loop concept of accounting. The reports can be used to evaluate:

A) Production or material issues at each stage of construction,
B) The estimator’s ability to accurately price a job,
C) Project management’s performance, AND
D) Identify discrepancies for future use in similar jobs.

Summary – Phase Costing

Phase costing is used with job costing by identifying stages or completion points with each job. It is designed to identify all costs for that particular stage of production for that project. This value is then compared against the estimated amount costs prepared. The tool is very useful in identifying discrepancies in costs; evaluating the estimator’s and project manager’s performance and as a resource of information for similar jobs in the future.

There are some fundamental rules with phase accounting.

1) It compares actual costs against estimated costs.
2) The information is used to evaluate project management performance.
3) Acts as a database of information for future use.
4) Reports are grouped into stages of production and not in the traditional income statement format.

When pulling reports pay close attention to the dates for information retrieval. Act on Knowledge.

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