Minimum Bottom Line Profit Should Average 9.4%!
For Trades & Subcontractors, at Least 11%
After Income Taxes Are Paid!
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.
Job costing has its own set of guidelines and may at times interfere with traditional financial accounting. However, proper set-up of construction accounting software easily achieves both forms of accounting for the owner(s) and the construction management team. The following sections introduce and elaborate further for both essential forms of accounting related to construction. They explain how they work independently of each other and work together to produce valuable field production results and overall company wide financial performance. This is an introduction to construction accounting. Additional articles go into further detail and cover multiple nuances and proper interpretation for contractors, controllers and the management team of a construction company.
Job Costing With Construction Accounting
Unlike other industries, success with construction is 100% to the job profits generated from the respective projects. If any given project fails to perform in accordance with that company’s standard, it greatly diminishes the bottom line of the company, i.e. the net profit.
An illustration brings home this point. Assume that a roofer does 30 roofs per month, each roof is a $10,000 job and it costs the roofer exactly $6,000 of direct costs (materials, labor, equipment, tooling, permit & insurance) to perform each job. The expected direct profit margin is 40% ($300,000 – $180,000 of costs = $120,000 of direct profit). $120,000 direct profit is 40% of $300,000 in sales. The company’s indirect field operation costs and overhead equals $75,000 per month. Therefore, the company’s net profit is $45,000 per month. This equates to a 15% net profit margin (normal for roofing contractors).
During the month of July, a new project manager comes into the company and is assigned 10 of the 30 jobs during that month. On one job, his actual direct costs were $11,000. Thus, instead of the expected $6,000 of costs, there were an additional $5,000 of cost above an beyond the normal direct field production margin. Here is the company’s financial results for July:
ABC Roofing Inc.
Profit & Loss Statement
July, This Year
Closed Contracts (30 Roofs at $10,000/ea) $300,000
Direct Costs (29 Roofs at $6,000/ea & 1@$11,000) (185,000)
Field Production Profit 115,000 (Exactly $5,000 less than anticipated)
Indirect Field Costs & Overhead 85,000
Net Profit $40,000
ABC Roofing’s net profit is now $5,000 less than normal, which is an 11.11% reduction. Just one job went over budget and look at the impact on the overall company bottom line. Typically, several jobs go over budget, rarely do jobs come in less than anticipated costs. With most roofing companies, typical results are six to seven jobs are off and the balance perform at the expected value.
Job costing allows the contractor to identify which jobs performed poorly and through subjective analysis the management team can determine the underlying reason(s). If used properly, job costing educates the management team by identifying issues and ensuring the team corrects the underlying problems.
*Author’s Note: The most common reason for underperformance with field production is poor labor management. A good project manager or field supervisor gets results from the labor force out in the field. A secondary reason is poor planning by one or two members of team; materials are missing, mistiming for labor/subcontractors and/or equipment issues.
The goal of job costing is to identify issues and have management correct the issues.
Thus, job costing has two groups of values. One is the revenue generated and the second are direct costs of construction (also known as hard costs of construction). The accounting system and the processes are designed to capture this information by job and reports are prepared for the interim and annual reporting cycles. Every job is evaluated against its estimated hard costs. For example, the roofer above would have a spreadsheet output that lists each job completed, revenues earned and the associated direct costs. Here is an example:
ABC Roofing Inc.
Job Profitability Report
August, This Year
Job #1 Job#2 Job#3 Job#4 Job#5 Job#6 Job#7 All Others Combined Totals
Roof Type A D A B B A E Various
Contracted Amounts $9,780 $18,450 $9,300 $14,900 $16,100 $10,200 $23,500 $261,300 $363,530
Direct Costs of Construction
Materials 2,540 6,830 2,750 4,410 5,870 2,650 8,550 72,400 106,000
Labor 3,100 5,000 0 3,600 4,200 2,450 0 43,000 71,350
Subcontractors 0 150 2,200 0 0 0 5,100 20,350 30,000
Other 650 890 550 810 1,100 620 2,050 9,800 16,470
Sub-Total Direct Costs 6,290 12,870 5,500 8,820 11,170 5,720 15,700 145,550 223,820
Direct Field Production Profit $3,490 5,580 3,800 6,080 4,930 4,480 7,800 115,750 139,710
Job Profit Margin % 35.7% 30.2% 40.9% 40.8% 30.6% 43.9% 33.2% 44.3% 38.4%
Job costing with construction allows for a report such as the above. The ‘All Others Combined’ column reflects the other 25 or so jobs ABC Roofing performed during August; with a full spreadsheet, the management team can evaluate all the jobs done during the accounting period.
Notice also that ABC uses a roof type code. With their system, ‘A’ represents a traditional single story 5/12’s pitch roof, ‘B’ is a story home, ‘C’ is a single story with a greater pitch than 5/12’s, ‘D’ is a two story with a greater pitch than 5/12’s. ‘E’ represents a metal roof. This code system allows for a quick evaluation by the management team related to the respective job. The report quickly identifies jobs that performed poorly. Job’s #2, 5 and 7 performed poorly. Notice that Job #2 and #5 are both a two story home. The key is to discover patterns and address them.
Job costing identifies the financial performance in the field. Along with traditional financial accounting, the management team and the owners can evaluate the overall financial performance and identify any expenses that are unreasonable.
Traditional Financial Accounting In Construction
The secondary form of accounting with construction is traditional financial accounting. This form of accounting is designed to match revenue with the associated costs and expenses. The costs are directly correlated to the respective jobs and the job revenue. Expenses are typically a function of traditional monthly or quarterly operating costs such as the management team, office operations, facilities and compliance. There are customarily four different accounting methods for traditional accounting with construction.
- Direct Costing – direct costing takes job revenue and corresponding direct costs straight to the income statement (profit and loss statement). This is common for contractors or subs that have low dollar value jobs and the jobs are customarily completed in less than 90 days. It is normal for service based trades and many subcontractors to use this method. For example, the roofing contractor illustrated above would use this method. Others include concrete contractors, brick masons, electricians, plumbers, HVAC, tile and painters. Take note of the two minimum required elements that triggers this method of traditional accounting: first, low dollar value, e.g. less than $50,000 and two, short duration, i.e. less than 90 days from start to finish.
- Completed Contract – this method works well for contractors that have multi-step jobs whereby more than one or two milestones exist. The required elements to use this method are jobs taking longer than 90 days from start to finish, but in general, less than one year duration; and the dollar value of the respective jobs exceed what is commonly found with subcontractors. In general, jobs should exceed $25,000 in value and in most cases, they exceed $100,000 in value.
- Percentage of Completion – this method of accounting in construction is uncommon with residential and light commercial construction. It is customarily used with large scale projects such as road, stadium and institutional construction (hospitals, high rise hotels, government contracts etc.). The minimum required trigger is that the project will take more than one year to complete. It is quite sophisticated and requires specially trained accountants to administer. This method is never seen with the trades involved in residential or light commercial work.
- Hybrid – many contractors use both the direct and completed contract method depending on the nature of the respective work they perform. For example, concrete form construction may use the direct method for smaller jobs, but for the large jobs taking more than three months to complete, utilize the completed contract method. The hybrid method is a bit more complex than either the direct or completed contract on its own; it requires an attentive accounting staff to ensure accuracy with the recording of bills, payroll and revenue.
Only the completed contract, percentage of completion and the hybrid method utilize the balance sheet to assist with accurate accounting. All four methods can still incorporate job costing as explained above.
A key financial report presented with financial accounting includes job costing with traditional accounting. This report is only available for companies that perform larger jobs and have less than 10 jobs completed per accounting cycle; anymore than 10, the report gets a bit confusing with its presentation.
Here is an example of a profit and loss statement along with a simple summary job costing report included. To keep the illustration readable, the report is for a residential contractor that closed four properties within the accounting cycle.
XYZ Custom Home Construction Inc.
P&L by Job w/Full Accounting (Summary Format)
For the Month Ending July 31, 2020
121 Wine St. 6745 Falcon Dr. 4018 Overland Cir. Totals
Contract Values $729,400 $1,372,600 $1,209,999 $3,311,999
Upgrades/Change Orders 51,632 118,850 96,404 266,886
Closing Costs (52,736) (60,394) (98,010) (211,140)
Adjusted Contract Amounts $728,296 $1,431,056 $1,208,393 $3,367,745
Direct Costs of Construction:
Materials 196,203 381,417 361,084 938,704
Labor 23,785 56,904 72,412 153,101
Subcontractors/Trades 214,902 455,817 383,117 1,053,836
Other 68,551 87,006 72,746 228,303
Sub-Total Direct Costs of Constr. 503,441 931,144 889,359 2,373,944
Field Production Profit (Jobs) $224,855 $449,912 $319,034 993,801
Job Profit Margin % 30.87% 31.44% 26.4% 29.51%
Indirect Costs of Construction:
Field Management 173,619
Net Field Production Profit (Gross Profit) 726,055
Office Management 77,229
Office Operations 12,291
Taxes (Income) 181,749
Net Profit $423,357
XYZ’s net profit margin equals 12.57% which places the company in the top 5% nationwide with performance. How was XYZ able to do this? Look at the individual completed contracts. The worst job performance was 4018 Cleveland Circle. The job profit margin as a percentage of net contract value is 26.4% which reduces the overall average for all three jobs combined. The key to the bottom line is the ability of each job to contribute its respective share of overall field production profit. By evaluating all the jobs completed, the management team can easily identify culprits or good performers. This report is merely a snapshot of the overall financial performance. Each job can be evaluated in further detail by exploring the respective job costing reports.
Take note how the job totals column matches a typical GAAP financial income statement (profit and loss statement) for a contractor. It identifies total sales, adjustments, net sales, direct costs of construction (hard costs), indirect costs (soft costs) and traditional expenses. Job costing reports can clarify where issues exist with field production. Internal reports can facilitate issues related to indirect and expenses. If any of those line items are unusual, management can simply pull an internal report to explore the respective underlying sources of expenditures.
For those readers not familiar with traditional presentation, the above report is presented after the aggregated summary income statement for XYZ Custom Home Construction, Inc. Here is a high end summation report:
XYZ Custom Home Construction Inc.
Income Statement (Summary Format)
For the Month Ending July 31, 2020
Net Contracts (Completed Contract) $3,367,745
Direct Costs 2,373,944
Field Production Profit 993,801
Indirect Costs 267,746
Net Profit $423,357
Thus, the expanded version labeled P&L By Job w/Full Accounting (Summary Format) is in between the above summary format and a full detail report and job costing reports at the job level. In addition, management would review comparison reports of jobs against estimated hard costs and evaluate any deviations at the phase and line item levels. The overall goal is to improve financial performance by maximizing profits at the job level.
Summary – Construction Accounting
Two key financial profit points exist with construction accounting. The most important is field production profits, customarily presented at the job level and by job. This important financial profit point allows management to focus in on the particular drivers of field production profitability. Any deviation from expected can be explored at the job costing level via management reports. The second key financial performance point is the overall net profit for the contractor. Here, traditional GAAP reports are utilized. Many contractors use a combination report whereby the completed jobs are reported along with the overall financial performance. This particular reports acts as a bridge between job costing and traditional financial accounting presentation. Act on Knowledge.