Minimum Bottom Line Profit Should Average 9.4%!
For Trades & Subcontractors, at Least 11%
After Income Taxes Are Paid!
Almost every residential contractor I had as a client had no clue of their financial position as it related to any one of their residential contracts. None of them knew whether the project was fully funded, over funded or unfunded at any point in the construction process. The only time they knew if they made any money was once all the sawdust had settled and there were no more bills coming into the office related to that project. Typically it would be two to three months after the final closing on the project.
This is poor project management, really poor management.
As a contractor you need to know at any given moment the exact financial position your company has in any given project. You need a good project accounting process to provide all the needed information.
If you use good accounting processes to manage the flow of information then you can easily determine your financial position in any project at any time. To me, the most important aspect that I would want to know is: ‘How much of my money is in this project?’ When projects tie up your capital, it prevents you from investing or starting other projects. In this industry, timing is essential in making profit. If you don’t have the capital available to purchase that next lot, then you may have some down time in the future.
You are wondering several things: First, how do I track my overall financial position? Once I know my overall status as it relates to the project, how about my status at any point in each of the phases of construction? How is this financial situation affected by the completed contract or percentage of completion method of revenue and costs recognition? If I can’t understand my situation, what can I do to make changes so that I can understand my financial situation?
The following sections answer these questions and point you to information available on this website to assist you in better understanding the subject matter and offer solutions to some of the issues you face. This article is really lengthy especially if you read all the auxiliary articles that get into the details of what you need to do. Please understand, this is a process, this article explains all the various steps you need to take to get the final results related to understanding the financial position of your respected projects.
In offices where this system existed, project management was much smoother, cash flow was not an issue and profitability soared. For one of my contractors, he went from $30,000 profit on $1.8 Million without the system to $237,000 profit (plus a $40,000 salary increase for himself) on $3.1 Million two years later. REAL RESULTS!
Some Preliminary Basics
Before I delve into the principles and I want to make sure we are all on the same page with terminology and some basic relationships in this industry.
I’m going to start out with terminology. The following are terms I use and are customarily used by accountants and financial managers when it relates to construction accounting:
Job – in general, it refers to a distinct function related to constructing a building. As an example, with framing, the deck is a job, installing the water heater is a job and so on.
Project – typically a term used for very large construction contracts, I’m talking about more than $2,000,000. In the large construction contracts, projects have many jobs to complete to finish the project. For the residential contractor, the term is modified to mean the same as a job or the contract. Simply stated, in residential construction, job, project and contract mean the same.
Phase – in residential construction, phases are distinct milestones of completion in building the house. Examples of phases include Foundation/Footer, Framing, Trades and Walls. There is no legal or regulatory guidance on what comprises a phase, the key is for the contractor to identify the elements of each phase and apply this definition consistently throughout the company’s life. I provide a lot of guidance for phase accounting and reasonable definitions in this article: Use Phase Accounting in Construction.
Completed Contract Method – refers to one of the two most common forms of accounting processes in transferring information from the balance sheet to the profit and loss statement. The completed contract method transfers all revenue and costs once the contract has received the occupancy permit.
Percentage of Completion Method – the most common method of transferring revenues and costs to the profit and loss statement. The typical transfer of information occurs once a month or each quarter depending on the accounting cycle frequency. It is the preferred method as it more closely resembles accrual accounting.
Classes of Construction – classes refer to the different divisions of work contractors pursue. A typical residential contractor will build new homes and do additions. Some contractors even do remodeling. In this case, the company has three classes of work: New Construction, Additions and Remodeling. I have two articles to assist the reader in better understanding class account: How to Use Class Accounting in Construction and Using QuickBooks in Construction Accounting.
Next I want to cover some relationship issues. A typical new home construction project generally takes around 10 months from concept to final closing. Most of the contractors I dealt with had about $50,000 of their own money in each project. Almost every project whether an actual contract or a ‘Spec’ house used some form of financial backing via mortgage loans. These loans allowed draws at specific intervals. Most draws occur in 20% to 25% increments. A $1,000,000 home would have draws at the $200,000 point along the project cycle. The builder puts up about $50,000 to fund the initial part of the project and would get his money back at the very end of the project. For the more expensive projects the owner (buyer of the house) also put up a deposit to the tune of 5% and sometimes 7%. Even before the project began, the project was funded from two sources.
Also, in custom home construction contracts the buyer or customer owns the land; the contractor is merely building the house. This is the relationship on Day 1:
Total Funds Advanced $100,000
Costs of Construction -0-
Before the contractor gets his first draw, he has to get about $200,000 worth of work completed and so let’s assume this occurs on Day 60:
Funding Sources to Date:
Total Funds Advanced $100,000
Costs of Construction 200,000
Unfunded Costs 100,000
Draw Request 200,000
Once the bank advances their draw, the builder has a completely different situation. This is what it looks like on Day 61 after the draw request payment:
Funding Sources to Date:
Draws to Date 200,000
Total Funds Advanced $300,000
Costs of Construction 200,000
Over Funded Balance 100,000
And this continues throughout the construction process. Typically as the contractor goes through the rigors of getting a draw from the bank, there are even more costs accumulating and often there is no over funded balance. Now I know, some of you are asking: ‘Hey, how did we cover those unfunded costs on Day 60 above?’ Well, the answer is: If you are like most contractors, you pay your bills about 20 to 30 days after you receive them. Over a 60 day cycle; your accounts payable increases to $100,000 related to just this project. This is reported as Accounts Payable on your balance sheet.
Now for the reality of the situation; most contractors are small businesses and have four to seven homes under construction. Your subs are hounding you to pay them. Worse yet, some of the more professional suppliers will not sign their mechanic’s lien releases until you pay them. Many contractors use funds from other draws to pay the required amounts to get the mechanic’s lien releases to get a draw on this project. There is a lot of juggling going on and honestly it drives accountants like me crazy. Seriously, it is hard to focus on doing the accounting work when the phone rings six to seven times a day from subs wondering if they can get a check on Friday.
This is why it is so important for the contractor to have a good project accounting process in place and use the project accounting principles to properly manage the financial aspect of every project.
Tracking the Overall Financial Position
The key to all of this is to understand the project financial status in terms of percentage of completion against the funds advanced to date and the unfunded balance, i.e. accounts payable related to this project. A good accounting process is essential. As an owner, you will want weekly updates for each project to include total costs to date, amounts funded and any unfunded balance.
Now I have used two accounting programs to achieve this reporting format. One is Sage (formerly Peachtree Accounting) and the other is QuickBooks Pro. I endorse QuickBooks Pro over Sage more because it is easier to find bookkeepers and accountants that understand this software. Sage (formerly Peachtree) is designed for use by more sophisticated accountants and requires more technology expertise than QuickBooks. Also, in the long run Sage is much more expensive. I’ve written several articles related to using QuickBooks and I encourage you to read the following in order to fully grasp how to implement a good accounting process. The following is the article and short description:
Step One – Organize Your Process
- Create a File Structure for Accounting – sets up the internal data files and filing system making it easy to retrieve information and understand.
- Implement Cost Accounting in Construction File Structure – very similar to the Create a File Structure article, but this article focuses in on construction and defines cost accounting in construction.
- Implement Cost Accounting in Construction Document Flow System – explains the design of the system and how the documents flow in the system for final storage.
- Implement Cost Accounting in Construction Processing Documents – this illustrates how each type of document enters the process and how it flows and ends up in the correct file electronically and in the project file cabinet or box.
Step Two – Install the Software
- How to Use Class Accounting – a fundamental concept of dividing the construction company up into respective divisions.
- Use Phase Accounting in Construction – explains what phase accounting is and suggests the respective phases for new home construction; also the phases are applicable to additions and remodeling work.
- Use Phase Accounting in Construction Part II: Trades – continues in the series related to phases and explains the issues associated with the various trades.
- Use Phase Accounting in Construction Part III: Walls & Flooring – identifies all of the cost groups that are applicable to the walls and installation of the floors.
Step Three – Understand the Process
- Best Format for the Construction Profit and Loss Statement – the end result is a P&L that the owner can truly understand and use to make good decisions.
- What is a Reasonable Profit in Construction – helps the reader to understand the formula to determine the markup and the respective margins needed to cover all the other costs of operations.
- How to Calculate the Best Markup for Construction – augments the reasonable profit article and illustrates the formula for the contractor.
- Allowances in New Home Construction – The Business Model – illustrates the contractual issues and explains how to make sure you get your money related to allowances and any change orders related to allowances in construction.
I am currently in the process of writing articles related to the respective reporting requirements and how to generate and read the project reports. But ultimately, these reports will assist you in determining what goes right and what costs exceeded your estimated for the related phases in your project.
Tracking the Phase Costs
I encourage residential contractors to set up nine phases of construction. If the data, i.e. the financial transaction, is entered into the software and assigned to a contract (job or project name), coded with a phase and finally grouped into a class, the accountant can prepare just about any report to illustrate the associated costs. The following is an example:
One of the phases I suggest is ‘Walls’. In this phase the costs associated with insulation, vapor barrier, sheetrock, mudding, skim coat, painting, and trim work is included. Suppose for this $1,000,000 project, you estimated $7,200 for insulation including the labor for insulation.
When the bills came in from the suppliers and subcontractors, total materials were $4.269. If the staff followed the guidelines I laid out above, the receipt would have a stamp on it with the project manager’s signature authorizing the payment. In addition, the stamp displays the job name, the phase code and of course the respective class of ‘New Home’ construction. As the project progresses, you desire to know how you did in determining the insulation costs against the actual costs. You pull a report from the system and it looks like this:
XYZ Construction Inc.
Project Transaction Detail List
March 31, 2014
Project # Phase Date Name Description Invoice # Amount
140819 6 01/17/15 Kindle Insulation Spray Foam/Baffles 153897 $702.08
140819 6 01/12/15 Lowes 53 Rolls R-30 C737659 631.62
140819 6 01/14/15 Lowes 7 Rolls R-30 C871418 84.32
140819 6 01/14/15 Lowes 8 Mil Poly Vapor C883657 44.21
140819 6 02/04/15 Able Insulation Crawl Space Insulation 9456 827.40
140819 6 01/29/15 Kindle Insulation Foam Boards (31) 154005 1,600.00
140819 6 01/15/15 James Kirk 17 Hrs Labor Payroll 204.23
140819 6 01/15/15 Kim Luu 19.4 Hrs Labor Payroll 306.09
140819 6 01/29/15 James Kirk 9.3 Hrs Labor Payroll 111.73
140819 6 01/29/15 Kim Luu 6.5 Hrs Labor Payroll 108.14
140819 6 01/09/15 Insulation Warehouse Various Supplies VP67175 214.07
140819 6 02/07/15 Lowes 14 Cans Exp. Foam C1007347 163.17
140819 6 02/12/15 James Kirk 2.9 Hrs Labor Payroll 34.84
Sub-Total Phase 6 $5,032.00
From the above information you can compare the actual estimated amount for insulation against the actual costs to date. In this situation, the actual costs are shy of your estimated costs by $2,168. Either you haven’t completed the insulation step yet because you are missing a few invoices or you woefully overestimated the costs to insulate the house. But the key to this exercise is that you now have the information in front of you to determine what exactly the issue is.
Just in case you didn’t know, in QuickBooks and in Sage, you can attach a PDF copy of the invoice to the respective line item in the system. If you want more detail about what Able Insulation did for the company, you click on that line item attachment and you can review the actual invoice in more detail; pretty cool if you ask me.
You can’t do this if you just load all the information as detail in the respective job. You wouldn’t be able to filter out all the other invoices related to the other phases; phase coding allows you to separate out the respective line items of information into a well organized presentation format.
The value phase accounting brings to the contractor relates to the project as a whole; but what about the company as a whole as it progresses through several projects at the same time. Well, here you need to decide on whether you implement the completed contract method or use percentage of completion to account for the financial information to your profit and loss statement.
Completed Contract Method or Percentage of Completion
The difference between these two methods is merely a timing question. The completed contract method transfers the accumulated costs to the profit and loss statement at final completion of the project. Whereas the percentage of completion method transfers those costs accumulated within the accounting cycle to the profit and loss statement at the end of the accounting cycle (whether monthly or quarterly).
This particular question is asked of me all the time. In the long run, it really makes no difference which method you decide. However, I encourage the percentage of completion method if you are doing more than $2,000,000 per year in contract work. It is slightly more complicated and requires a few more steps to implement and process; but it is extremely helpful in monitoring your overall financial performance in shorter accounting cycles (quarterly or monthly).
Now for those of you that are doing less than $10,000,000 per year; I urge you to stick with the completed contract method. Especially if your projects have shorter durations of construction, then this method works well. As an example, if you are an additions or remodeler type of contractor, then most of your contracts are completed within four months of signing the contract. Unlike new home or spec house builders where their projects can take upwards of 14 months to complete, your projects easily fall within the calendar cycle of accounting. You may have one or two incomplete at year end, but the overall impact on your financials will be small or insignificant to affect your decision model or impact the final outcome of your financial reports.
If you are doing less than $12,000,000 per year and you are a new home builder and your goal is to expand operations and get to $20,000,000 per year in revenue; then convert to the percentage of completion method. It will serve you well in the long run.
Summary – Project Accounting Principles
If this article didn’t convince you to use project accounting in your residential construction company, nothing is going to convince you. Please send me an e-mail telling me why you don’t want to take these steps to implement. Furthermore, project accounting is so essential in the feedback loop of information to help you make better decisions, you can’t possibly be less than financial successful.
Good processes and using the project accounting system as described above will always allow the contractor to have full understanding of the funded status of each respective project. Act on Knowledge.
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