Minimum Bottom Line Profit Should Average 9.4%!
For Trades & Subcontractors, at Least 11%
After Income Taxes Are Paid!
Class accounting is a form of accounting whereby the revenues and direct costs are grouped into divisions within the company. It is a very effective form of accounting in construction. Learning how to use class accounting in construction is easy and works extremely well with phase accounting.
The following describes class accounting especially as it relates to residential construction. In addition, it illustrates how to use class accounting with phases to manage projects and the particular form of construction. It is important for the reader to understand that class accounting is functional for the revenue section and the direct costs section of the profit and loss statement. Indirect costs such as project management costs, transportation, communications can not be assigned a class in your small construction companies. This is because these types of expenses including overhead expenses are spread across the entire group. So there is no need to assign them a class designation.
Most residential contractors do more than just build houses; they also do additions and often do remodeling work. See The Different Types of Residential Contractors for information about the different types of contractors. When a contractor provides more than just one line or type of service, he should break out his costs into classes. This easy to do accounting format allows the owner of the small construction business to identify the types of construction that perform better than the others. He can then make adjustments and take on work that is more profitable. This is a part of the model of excellence discussed here Model of Excellence.
As an example, if a builder constructs new homes and does additions, he would have two classes of construction in his profit and loss statement; see Best Format of the Construction Profit and Loss Statement for more information about the profit and loss statement for contractors. The following is an illustration of that format:
XYZ, Construction Inc.
Profit and Loss Statement
Completed Contract or % of Completion Method
New Home Construction Additions Total
Contract Revenues $ZZZ,ZZZ $ZZ,ZZZ $ZZZ,ZZZ
Adjustments/Allowances (ZZ,ZZZ) (Z,ZZZ) (ZZ,ZZZ)
Adjusted Contract Rev’s ZZZ,ZZZ ZZ,ZZZ ZZZ,ZZZ
Direct Costs of Construction:
Land ZZ,ZZZ – ZZ,ZZZ
Materials ZZZ,ZZZ ZZ,ZZZ ZZZ,ZZZ
Subcontractors ZZ,ZZZ ZZ,ZZZ ZZZ,ZZZ
Labor ZZ,ZZZ Z,ZZZ ZZ,ZZZ
Other ZZ,ZZZ Z,ZZZ ZZ,ZZZ
Direct Profit ZZ,ZZZ Z,ZZZ ZZ,ZZZ
Indirect Costs of Construction: ZZ,ZZZ
Gross Profit $ZZ,ZZZ
From the above illustration, the contractor can best identify any issues for a particular class of work. Furthermore, if used with phase accounting, the phase of construction can be identified as the source of the problem. Phase accounting is breaking out the projects into nine phases of work. From site development to the final trim out, any particular area (phase) of construction can be identified as the source of financial drain or losses. In addition phase accounting works with project management in that it is designed to identify issues with a particular project and not a class of projects. See Phase Accounting in Construction – Part I for more information and examples of phase accounting.
Classes of construction are not tied to the type of work necessarily. Sometimes all a contractor does is remodeling. Well, use class accounting to break this out into the different types of remodeling. Examples include kitchen remodeling, bathroom remodels and/or room modifications. For the new home contractor, he could break this out into ‘Spec’ House Class and Design/Build Class. Or he could go with geographical zones if he feels that this form of classifying revenues and direct costs will provide feedback in what particular class does well against a class or classes of construction that perform poorly.
From the illustrated example of the profit and loss statement above, the contractor should understand that class accounting is only effective through the direct margin line of the P&L Statement. Indirect costs are not identified to a particular class because of the paperwork burden it would generate on the bookkeeper/accountant. It would be extremely difficult if not outright difficult to charge off fuel costs for vehicles to particular classes. It will drive the field workers nuts trying to figure this out let alone understand the reasoning for this detail. Classification of direct costs is easy because those project costs can be easily coded to a class upon arrival in the office. The project dictates the particular class of work.
I have written a series of articles in the construction industry standards page of this website that explains how to process the documents and assign the proper classes to vendor bills, employee time sheets and others. Read the ‘Implement Cost Accounting’ series – three separate articles for a detailed approach to managing the documentation process.
Once the information is entered into the accounting software, the contractor should take advantage of this information and work within the standards of financial markup and the correct margins for each class of work to pinpoint problem areas. Classifying direct costs is the easy part, the difficult part is zeroing in on the issue whether it is a phase function or a project that is generating the unexpected lower margin. By using classification, you can easily identify the class of work in the company as the source of lower profitability, then, by using phase accounting you can pinpoint which area of work (site development, framing, trades or some other phase) that is having issues. From there, you can pinpoint a project or realize that a phase overall is an issue. At this point the contractor can modify the estimating for future projects or detect the culprit and make changes for the future. Remember, accounting is a feedback loop allowing the owner of a company to fix problems as they relate to the financial impact on the company. Act on Knowledge.
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