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An interesting question was posed to me by a reader in the construction industry. In his company, the costs go directly to the Profit and Loss Statement via cost codes with QuickBooks. Naturally he has read several of my articles and he wants to know why use phase codes? If so, what is the difference between phase codes and cost codes with QuickBooks? To further complicate the subject, QuickBooks uses the term ‘ITEM’ codes when creating cost groups. Please tie all this together he requests.
I’m happy to oblige.
Before I describe and illustrate the differences, I need to explain the basic concept of why we are reporting information in a certain way. That is, I want to explain where I am going and then I can explain how all of us get there.
The whole goal of financial reports is to gain an understanding of financial performance and identify the key issues for changes to make improvements. In accounting we referred to this as a continuous feedback loop method of financial improvement. Insert data, report the data, discover opportunities for improvement; make changes and insert data and begin the whole process all over again. If you are even mildly alert to what is going on, you should easily identify opportunities and make financial improvements and ultimately maximize profitability for your business. It is not going to happen overnight but it will dramatically improve your bottom line within 2 years.
But all of this starts with the estimate for the project.
Two Basic Types of Estimates
Almost every contractor uses one of two major types of estimates to generate a quote for a customer. The first and more basic type of estimate is the cost based estimate. The contractor looks at the project in the aggregate and determines the entire materials costs, labor costs, subcontractors and other costs. This is referred to as a cost driven or cost based estimate.
Almost all small project based contractors use this method to quote a price to the customer. And let’s be honest with each other, if the project is relatively small in value such as a $15,000 deck or even a $25,000 bathroom remodel this method of estimating is very time efficient.
But problems begin to develop as the project heads towards greater complexity and higher dollar values. Think of a $200,000 construction of a simple home. When reviewing the costs to complete, it can get a little hairy trying to determine which particular cost is out of zone in comparison to your estimate.
To simplify and accumulate the total costs, contractors break the house down into functions and quote these respective functional groups and then combine the total amounts for one final estimate. This type of estimating is oriented towards phases of construction. Think of breaking the house down into identifiable stages of completion. We start out with clearing the site and installing the environmental fence, digging the drainage ditches and prepping the building’s footage presence. After that stage of construction, the footer is dug and poured and the concrete masonry units are laid to form the entire foundation. Another stage of construction and this continues until the house is complete.
This form of estimating is referred to as phase or functional estimating.
Now that we all understand the types of estimating, it is a good point in this article to explain the terms of phase and cost codes.
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 stage of the construction project. The goal is to compare the aggregated costs related to the phase against the actual estimated amount for the same stage.
There is one more key to this. All phases will have materials, labor, subcontractors and other types of costs to complete the phase.
One of the interesting concerns for many contractors and estimators focuses on the breakout of costs associated with each phase. That is, they are interested in knowing the cost of materials, labor and so on.
I understand and this can be achieved but in reality it isn’t as important as looking at the details of the phase. In a typical phase for a custom built home, I’ve never entered more than 80 transactions. A typical project will have around 600 to 900 transactions depending on the volume of the in-house labor. Any single phase will most likely never have more than 75 transactions and most often it is merely 25 to 30 transactions. Remember, many of the bills from suppliers are just one line item but you’ll receive 40 to 50 different pieces of materials. Think of your lumber for the framing phase of the project. You’ll receive several hundred pieces of lumber over 30 line items with only one dollar value assigned to that invoice. In your phase report you’ll see that one line item and others related to more materials and the labor you use.
In general, cost codes relate to the group of costs associated with construction. These include materials, labor, subcontractors and other types of costs (equipment rental, temporary utilities, fuel, taxes etc.).
I will restate and emphasize that this form of accounting is effective with your smaller types of projects/jobs in construction. However, this method actually begins to create issues in your larger financial sized projects. In my professional opinion, once the project’s dollar value exceeds $100,000 you should definitely use phase accounting as your method of cost accounting.
In your small projects each group of costs will have less than 50 line items of information. Think of your deck construction; there will be maybe 20 line items related to the materials, another 30 line items related to labor and maybe one or two line items for the subcontractor. But overall, maybe 60 line items or transactions of information for review. So in the smaller projects, using traditional cost codes and sending the information straight to the Profit and Loss Statement makes sense.
Now that I’ve explained phase and cost codes and their relationship to the two types of estimates I want to explain how they are used with QuickBooks.
Item Codes with QuickBooks
QuickBooks has no such thing as phase or cost codes. QuickBooks uses the term ‘Item Codes’ instead. This is one of the drawbacks to this particular software. Now this isn’t a bad thing, it just means you need to understand how you work around this code system.
The secret is to understand that you set up the item codes as your phase or cost codes. But before you even enter the first item (phase or cost) code you need to decide which estimating method you want to use in your construction business. If you are going to use phase (functional estimating) then set up phase codes to match the distinct functions of your estimate. Here is an article explaining this detail: Use Phase Accounting in Construction. I also have an article that gets into using QuickBooks in Construction Accounting. I even illustrate some of the reports that are generated with this form of accounting.
If you are going to go with phase accounting in construction, I encourage you to accumulate the costs in a Construction in Process account. This account is a current assets account found in the upper half of the balance sheet. It works very similarly to a control account whereby each project is given a name and the costs for that project accumulate in this account. The costs are keyed to a particular phase and at any time you can compare the costs of one or more phases of one project with another project.
When it comes time to transfer these costs to the Profit and Loss Statement, the process is a two step procedure and now you have the information over in the P&L grouped by costs. These groups are just like cost code groups I write about above. So at the end of the day, you get both outputs of information: costs by phases and costs by groups of expenses (materials, labor, subs …). 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.
Basically the P&L has separate line items in the Costs of Construction section (Cost of Goods Sold) related to the respective cost groups of materials, labor, subcontractors and other. You can pull reports for any job by phases or by cost groups!
Now you understand the difference between phase and cost codes. In addition, I explained why QuickBooks does not have a set of phase or cost codes as you have to use the ‘ITEM’ code section to set up your respective phases or cost codes. The key is to tie your data input for QuickBooks to the type of estimating you do in construction.
One last note, if you are really sophisticated and are comfortable with QuickBooks; you can actually set up both methods of accounting in construction. This should only be used by those of you that do both levels of work and use both methods of estimating jobs. Act on Knowledge.