Minimum Bottom Line Profit Should Average 9.4%!
For Trades & Subcontractors, at Least 11%
After Income Taxes Are Paid!
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.
Cost accounting in construction has several different names including:
- Construction Accounting
- Project Accounting
- Phase Codes Costing
Job costing is a subset of traditional financial accounting and is customarily used in industries that build or manufacture unique products or custom ordered products. In general, the products are expensive and are priced beyond the outer limits of consumer goods. In order for job costing to be cost effective to perform, the product’s end price typically exceeds $10,000. The construction industry qualifies for this form of accounting.
In order for job costing to generate valuable benefits, an additional tool is implemented. A standard of comparison is created prior to recording of actual costs of construction, this standard is commonly referred to as an estimate. Estimates are similar to budgets but have several other benefits as explained in this series: Estimating In Construction. The management team compares actual financial outcomes against the estimated hard costs and evaluates the discrepancies. In effect they learn from their errors and implement changes to either operational or financial procedures.
Implementing job costing requires three distinct steps. The first is to design the system and incorporate the design into the existing or new accounting software. Secondly, the entire organization exercises proper documentation procedures to ensure accurate and timely recording of data into the system. Finally, the management team utilizes a set of protocols to evaluate outcomes and create a set of lessons learned from each completed project. These lessons learned are incorporated into changes for both estimating and operational performance. The end result is a long-term improvement in financial profitability for the contractor. The following subsections of this article explain each of the three distinct steps in more detail.
Design an Effective Job Costing System in Construction Accounting
Designing an effective job costing system in construction is the first step in the implementation of job costing in construction. The accounting and office operations side of the equation is done in conjunction with the design of the estimating program. For additional assistance related to estimating in construction, please read the series: Estimating in Construction found on this website.
The primary design of job costing in construction is built around functional stages of construction for the contractor’s respective industry. The key is to break a job out into respective stages or functional areas of construction. Here are some examples:
Concrete contractors typically have four stages of work. The first is site development whereby the ground or site is modified, typically with heavy equipment; bust sometimes with a shovel. Once the site is prepped (some concrete contractors do not have to perform this stage with certain jobs, it simply is a zero stage of construction), the concrete contractor goes through the process of constructing forms and inserting medal (rebar, wire mesh, steel plates and stringers) to prepare the section for the final pour. The third stage is the actual pouring of concrete. The final stage is called finishing. Sometimes the surface has to be finished to a certain standard, possibly stamped or even cut in accordance with the design of the project. Other finishing steps include clean-up, debris removal and in some cases, additional site work to regrade the surface soil to the concrete grade. Thus, there are generally four stages of concrete work.
New Home Builder
New home construction goes through a minimum of nine stages of building the house. Some contractors will break out their construction into upwards of 30 stages. The key is to create stages that make sense and tie to physical completion of some sort of area of construction. The nine stage breakout is as follows:
- Site Development
- Footer & Foundation
- Change Orders, Upgrades and Extras
Developers go through no less than five stages of construction. The initial stage is acquisition, planning, design and approval. Once the develop is approved by the county/city, the developer then proceeds to clear the site. Once the site is cleared, the third stage begins with installation of utilities. While the site is cleared and utilities are installed, another stage is performed in conjunction which are roads, curbing and drainage. The final stage of the development is hardscaping and landscaping. Some developers will build a model or some sort of common area structures including recreational areas or even a community services building. Thus, the minimum number of stages are five but there can be many more depending on the development.
Once the stages of construction are identified, the next step is assign each stage a simple code commonly referred to as an item code. Contrary to common belief, an item code is not a type of expenditure such as materials, labor etc.; an item code is a function of construction, i.e. a stage or a step in the construction process. Thus, item codes are developed as an output of stages of construction. With this information, the accounting software is customized to reflect the ability to load the five common methods of processing information input into accounting:
- Bill Entry
- Payroll Entry
- Credit Card Purchase
- Debit Card Purchase or a Check
- Journal Entry
Each entry follows a similar data recording process. Each entry includes the job identifier, item code identifier along with the respective type of expense (materials, labor, subcontractor, equipment, and other). Thus, all costs are broken out into the respective stages of construction. This information correlates to the estimated hard costs of construction for the purpose of comparing operational and financial results from the job.
To discover discrepancies, the entire organization must provide the data to source inputs in a timely and accurate manner.
Exercise Proper Documentation Procedures with Job Costing in Construction
Job costing is ineffective without properly recording all economic transactions to the respective job. Any missed cost simply improves the job’s profitability by the corresponding amount resulting in a false sense of performance. Take a simple $100 missed cost not posted to a $100,000 contract. Suppose the goal is to have a $35,000 job profit. If this $100 receipt is not posted to the job, and all other costs and revenues follow the estimated and contracted values, the job’s financial outcome will result in a false profit of $35,100. Thus, instead of a 35% profit performance, the final result is 35.1%. This is an improvement of .3% over the expected outcome. This seems miniscule in value. However, a mere 3% differential is considered significant in business. Thus, the .3% is now 10% of significant change. In effect, .3% is noticeable, not significant yet, but enough to note its value.
To add to this, if this $100 is missed on this job, more than likely it is assigned to another job; thus, distorting that job’s actual results too. The end result is not just one job being financial incorrect; now two jobs are miscalculated.
Therefore, it is imperative to design and implement a document set of procedures to ensure that all costs and issues are accounted for and properly assigned to their correct jobs. How is this done?
The first step is to create a file structure system. This file structure system focuses on the company’s overall field production organization. It utilizes a project numbering layout, classes of construction and finally phases (stages) of building the structure. To learn more read: Implement Cost Accounting in Construction – File Structure.
Once the file structure is designed, the next step is to implement a document flow process. This step requires the front office to:
- Create a Master Paper File
- Assign a Project ID and Corresponding Class of Income/Costs
- Notify all Parties of the Project’s ID
- Set up the Electronic Files to Store all Documents
The key to the document flow process is to store all documents to both a paper file and an electronic file. To learn more read: Implement Cost Accounting in Construction – Document Flow System.
The final step is to have all source documents related to a job follow a predefined flow to final recording of the economic value to the accounting software. It starts with the physical receipt of either a bill, a credit card receipt, a debit entry or a simply cash receipt. All expenditures including time sheets follow a preset authorizing procedure and then routing to the accounting department. Here, the key tool is a stamp that forces all parties to sign off on their respective steps or function. Once the entry is posted, the bookkeeper signs, scans and store’s the final document in the electronic file structure. Many bookkeepers attached the scanned document to the entry in the accounting software for direct view by any member of the management team during the evaluation element of internal control. To learn more read: Implement Cost Accounting in Construction – Processing Documents.
All of the above is designed to provide information needed to evaluate results.
Use Protocols to Evaluate Results of Job Costing in Construction
In 1999, NASA sent a orbital climate satellite to Mars at a cost of $325 Million. It did not go into orbit at the correct altitude and went to low and of course the atmospheric pressure destroyed the entire venture. How did this happen? Upon review, it was learned that since multiple parties from all over the world were involved in designing and creating the software that many of the distance calculations were done in metric and of course these values were not converted to the standard system used in the United States. The end result was the satellite was off course by a few miles out of the 71.72 Million miles to Mars. Total defeat for all involved.
NASA utilizes a process to evaluate all results whether positive or negative and they generate a ‘Lessons Learned’ from the process.
Naturally, it is rare for a total defeat when it comes to construction projects. Often the discrepancies are some form of miscalculation of expected financial results or operational flaws costing the company some money or embarrassment. It doesn’t mean that total failures haven’t occurred, its just that they are rare. Sometimes though they can cost a human life or injury. Thus, just like NASA every project should be reviewed by the management team to evaluate results and create a set of lessons learned even if the results were positive in nature. To do this, a set of protocols must be set up and exercised by all parties.
The best practices model involves all members of the management team including mid managers (estimators, engineering, project management and foreman). A good set of protocols to follow are as follows:
- The end client signs off with a letter of satisfaction and/or completion.
- A delay time period of 30 to 45 days after the letter is issued to receive and process any last minute documents.
- Immediately upon completion, all production team members fill out a form with their subjective opinion of what worked and any issues they feel need addressing for future projects.
- A meeting is set up to review upwards of 3 projects; notice is given to all parties several weeks in advance with a reminder one week before and one day prior to the meeting.
- All cell phones are turned off at the meeting.
- A facilitator is assigned for each project under review. The facilitator creates a set of reports, outcomes and any issues that require discussion. The best facilitator is customarily the controller.
- The team identifies the top three achievements and the underlying reason for success plus the top three discrepancies and the corresponding source causes.
- A Lessons Learned report is generated along with suggested policy or procedure changes. This includes any estimating adjustments necessary to alleviate the financial discrepancies in the future.
Summary – Implement Job Costing in Construction
Job cost accounting in construction is the best tool to discover and alleviate job discrepancies and operational performance. Implementing job costing in construction requires designing an effective system. Better designs break the project down into phases or stages of actual fabrication. Once the design is set in place, the management team exercises proper documentation procedures including file structure creation, implementing a document flow system and finally processing documents.
The end result is the creation of financial reports down to comparative results between the estimated hard costs to the actual costs for each phase of construction. With this information, the management team follows a set of protocols to have a meeting and learn from the job discrepancies. The end result is continuous improvement in both financial and operational performance for the contractor. Act on Knowledge.