The construction industry uses three distinct terms to offer their services to customers. Estimates, bids and proposals are terms used to present a dollar value associated with construction work. For less sophisticated contractors, the terms are interchangeable. The reality is far different. Each term has an historical context and legal meaning. Thus, it is prudent for any contractor to understand the differences and use the correct term in an accurate way when offering their respective services.
With the accounting discipline, estimates refer to reasonable calculations for the purpose of determining accounting profits adjusted for depreciation, amortization, warranties, and unusual or infrequent events.
The core tenet of an estimate is that each is unique. This uniqueness is driven by hard costs of construction. There are five distinct hard cost drivers in every estimate. Each cost driver has different application principles (introduced in this lesson), different sources of value and final markup formulas to determine the final estimated hard cost. The five distinct cost drivers are 1) materials, 2) subcontracted services, 3) equipment application, 4) labor and 5) intangible expenditures. Each type of cost (driver) has principles of application, i.e. thought processes an estimator must consider. Some of the principles are common among all five types of costs. Others may be unique to just that particular cost driver. This lesson introduces these five cost drivers and the various application principles involved with each driver.
Financial success in construction is tied directly to job costing. Without job cost accounting, 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.
Estimating in construction is prepared utilizing a similar timeline fashion as project milestones with an overall section to cover those costs that are ongoing throughout the project’s entire time frame. For the purposes of this lesson, the term ‘Phase’ is used to indicate these respective steps of physical construction. In Parts I and II of this series, estimates are created using hard costs of construction; those costs that are directly assignable to the respective project. Throughout this project’s timeline, all assignable costs are keyed to the project and ultimately aggregated by cost type (materials, labor, subcontractor, equipment, other) in the direct costs of construction section of the income statement (P&L statement). To break these costs down into phases, the estimator needs to understand how data in entered into the accounting software. Once entered, the costs can then be accumulated by phase using a customized report from the accounting software. Most accounting software allow an estimate to be entered thus the customized report can compare actual hard costs by phase against the estimated costs by phase. With this report, the construction management team can now hone in on any cost overruns by phase or cost savings.
Estimates are a controlling tool to guide the construction management team towards improved profitability. Estimates by themselves do not generate profits; actual performance creates profitability for the contractor. Estimates act as the technical manual for the project. Once the project is completed, the contractor must compare the actual results against the estimate’s values. In effect, the financial outcomes are evaluated against the originally estimated hard costs. The information gleamed from this evaluation educates the construction management team with what works and any failures. Then end goal, identify poor performance. It is then up to the management team as to how to properly address this issue eliminating this type of mistake in future work. The long-term results are improved profits, higher quality performance, improved customer satisfaction and most importantly, the esprit de corps that comes with team success.
Warranties are assurances to customers that the product sold or service rendered will perform as stated or contracted. Often products or services are defective and therefore require replacement or repair. To properly match the cost of warranty work against the revenue generated an estimate of costs is made and recorded to cost of sales.
There are many transactions in accounting requiring the accountant to use estimates for the respective debits and credits. The following five lessons cover how estimating is performed with depreciation, payroll benefits, bad debts, warranties and extraordinary items. This lesson explains why estimating is needed and used in business.