Minimum Bottom Line Profit Should Average 9.4%!
For Trades & Subcontractors, at Least 11%
After Income Taxes Are Paid!
In construction accounting accountants and bookkeepers use certain terms and there are distinct meanings associated with these terms. This article is designed to introduce beginner accountants and contractors to these terms from the perspective of financial reporting. If you are a contractor, the term used by accountants may have a different meaning than how the term is used in the field.
The following is a list of the terms and their corresponding definitions:
A project is generally the equivalent of a signed contract. With the exception of a Spec House, every project has a signed contract with the ultimate buyer/owner. Thus, a contract and the term project are interchangeable. Names assigned to projects range from a numbering system (I endorse this method as the best) starting out with YR then MONTH and finally the DAY representing the signature date of the contract. Basically it is a 6 digit numbering system. The value with this numbering format relates to the data relationship research for future references. Some contractors will use the customer’s name while others will use the address. I encourage you to convert to the contract date numbering system.
Very similar to a project, the term ‘Job’ has two different definitions in accounting. The definitions are based on the size of the overall project. If the project is less than $2,000,000 in value, the terms project and job mean the same thing. Both terms refer to the contract. Almost 90% of all construction contracts are valued less than $2,000,000 therefore the terms project and job mean the same thing. For the much larger contracts, the project is broken out into ‘Job’s. Think of building a high rise office complex. One job might be the structure fabrication, while another job might be exterior glass installation and so on.
In your lower value contracts, i.e. less than $2,000,000 the term ‘Phase’ is used instead of ‘Job’.
In construction accounting, I endorse and actually plead with clients to use phase accounting in order to identify both negative and positive financial attributes for the respective progress of construction. Basically a phase breaks a Project/Job into highly functional aspects of construction. For home construction the following is my phase list:
01 – Architectural design, permitting, bonding costs, interest on any debt, inspection fees, waste removal, port-a-potty etc.
02 – Site development, landscaping, drainage, surveying
03 – Footer and Foundation
04 – Framing, exterior windows & doors, siding, roof
05 – Trades
06 – Walls, insulation, sheetrock, painting, interior doors
07 – Flooring
08 – Cabinets, countertops, appliances, tile work, vanities
09 – Extras such as decks, outside lighting, change orders, sheds, sound systems, exterior railings
Notice how each phase is a distinct function of the construction project. The goal is to compare the respective costs related to the phase against similar projects and their corresponding phase and determine any value differences. This is important for the reader to understand, a phase will have materials, labor, subcontractors and other types of costs to complete the phase.
In general item codes relate to the type of cost associated with construction. These include materials, labor, subcontractors and other types of costs (equipment rental, temporary utilities, fuel, taxes etc.). It is important to understand something in regards to QuickBooks and item codes. I write several articles about this in the construction industry standards section. Essentially, I encourage accountants to use phases as the item code in QuickBooks. For example, you would create an item code in QuickBooks of 05 and it is labeled as Trades.
I write a very detailed article called QuickBooks in Construction Accounting – Transfer Work in Process to Cost of Goods Sold that explains in detail how the accountant converts the actual expenses into the different items for use with the profit and loss statement.
The P&L has separate line items in the Costs of Construction section (Cost of Goods Sold) related to the respective item codes of materials, labor, subcontractors and other.
Classes in construction refer to the respective types of project work. Most small contractors build new houses, add additions, remodel homes or provide restoration services. Each one of these forms of construction is considered a ‘Class’ in accounting. The reason for this is that the margins are different for each one of these forms of construction. By separating the construction company into classes of construction it is easier for management to identify and track profitability for each class.
Construction in Process/Progress
In general accounting the term ‘Work in Progress’ means the costs to build or manufacture an item. Well in construction accountants use ‘Construction in Process’ or ‘Construction in Progress’. It is also referred to as ‘CIP’. Just like work in progress, CIP is a current asset and is located on the balance sheet just after the cash accounts. It is exactly like inventory on the balance sheet.
This accounting method basically moves the costs and revenues for a contract to the profit and loss statement once the project is complete. In reality there are two different methods to exercise the completed contract method. The first and easiest is to just record the job information straight to the respective item costs on the profit and loss statement. This works well when the projects have very short durations of construction time, like less than three months. It also works well for very small contracts; like those that are less than $25,000 in value.
For larger contracts, the completed contract method accumulates the costs of construction in the CIP account and upon completion transfers those costs to the profit and loss statement. This works well for contracts up to $1,000,000 in value. The drawback for this relates to having timely information for management decisions as it relates to financial information. This method can create significant variances in the profit and loss statements especially for those P&L’s that have short reporting time frames such as monthly financial statements. Please don’t use completed contract method for higher dollar value contracts if you desire to review your financial information monthly.
Percentage of Completion Method in Construction
The superior construction accounting method is the percentage of completion method. This method accumulates the costs into the CIP during the interim time frame of the financial report and at the end of the financial accounting period the job is evaluated for progress. Any change in progress during the financial period has both costs of construction and project revenues earned transferred to the profit and loss financial statement. This allows the contractor to evaluate financial performance with much greater accuracy.
The primary goal of accounting is to record economic activity during a period of time. This method is by far the best especially for any contractor generating more than $1,000,000 or more per year in contract sales. The information provided on this website is geared towards this particular method of construction accounting.
Costs of Construction
These are the profit and loss statement accounts that report the costs associated with compliance with the contract. These are direct costs of construction. They include materials, labor, subcontractors, equipment and other. Direct cost refers to the actual cash out for the respective item. As an example, if you pay your employee to work on a job and he is paid $10.00 per hour, then that amount plus the matching Social Security/Medicare tax (941 Taxes) is the value in the labor line of this section of the report.
Some accountants, I’m included in this group, refer to this section as the Direct Costs of Construction.
Indirect Costs of Construction
There are a multitude of other costs associated with completing contracts. These costs include project managers, transportation, insurance, communications, equipment and more. The key to all this relates to the ability to assign these costs to a particular project. These costs have no direct assignment to a project. They never end up in CIP and are immediately expensed to the Profit and Loss once incurred. As an example a project manager may manage three or four different projects at the same time. On payday, his compensation is expensed to the management line item in the Indirect Costs of Construction section of the Profit and Loss statement.
Another example is the gallon of gas he puts into the truck. To which project do you assign that gallon of gas?
How do you allocate his payroll costs or the gallon of gas to the projects? You can’t and really you don’t need to allocate. The easiest and simplest method for the small contractor is to simply create a pool or group of costs on the Profit and Loss statement called Indirect and assign the costs there.
This allows the contractor to clearly quantify the minimum markup on direct costs to cover the indirect costs of operations. The following is a short summary of the financial report illustrating the basic sections of the Profit and Loss used by contractors:
Costs of Construction:
Sub-Total Costs of Construction:
Indirect Costs of Construction:
This part of the profit and loss statement reflects the front office costs for the company. Often it is referred to as administration. These costs include the bookkeeper and office managers’ wages. Rent, marketing and advertising, banking, office supplies and your meals and entertainment are located in this section of the financial report too.
In traditional accounting allowances refers to some form of discount provided to a customer for an error made in the actual sale. In construction it is referred to as the dollar value assigned to a component of construction for the customer to use as a guideline in purchasing their preferred product. A good example is appliances. Many new home construction contracts allow for $5,000 of appliances. This assumes the customer selects their package based on reasonable types of appliances. Well, often they spend more than their allowance. Contracts are written to assign any excess dollar value to the customer for their direct payment. In this example, if they spend $5,200 then they pay the appliance dealer the additional $200 of the amount in excess of the allowance.
In accounting, we ignore this additional amount and act as if it never happened. This is not the case with a change order.
Change orders reflect a customer’s desire to modify the contract during construction. Often the change is small but a document needs to be signed and turned into accounting so that any costs associated with the change order are correctly documented and a margin is assigned to the customer for payment. In effect the customer gets invoiced for the change and this includes margin to generate profit from the change order.
The above list of terms is just a short list of the more common terms and how they are interpreted from the accountant’s perspective. If you are in the construction industry, you need to understand the definition of these terms especially when you communicate with the accountant. Act on Knowledge.