3 key procedures of construction accounting

Accurate accounting measures such as cash flow, inventory turnover, and gross profit margins are key to any business’s financial success. But the transient and unpredictable nature of construction makes accounting visibility indispensable. With each new project, contractors deal with novel and unexpected conditions that impact finances. For example, each job has:

• Different risk and safety conditions to account for
• The possibility of subcontractors missing completion deadlines, pushing back planned work schedules
• The chance that poor weather condition will delay work
• The possibility that materials will arrive late, damaged, or out of spec.

These are just a few of the factors that can throw off estimates for required personnel, work hours, materials needed, and the timeline for completion, making it necessary to update finance metrics on a day-to-day basis to reflect real-time realities of a project.

Construction accounting is more complex than other business verticals, and the stakes are higher. To overcome the challenges inherent to the industry and remain profitable, contractors need strong accounting practices and digital tools to support strong financial management. This includes better processes to allocate expenses, manage invoicing and cash flow, and an understanding of break-even points.

What makes construction accounting complicated?

“For us, the biggest challenge is the uncertainty,” says Jim Cafiero, CFO at Island Painting Inc., a full-service painting and drywall contractor operating in New York City and the Tri-state area.

In a traditional business, you may make a product for $5 and sell it for $10. You have determined fixed costs and the ability to control your variable costs—you have expected margins and can easily keep track of your profitability. With construction, everything is based on estimates—project timelines and completion are dependent not only on the accuracy of your own estimates but those of other stakeholders as well.

“With construction, estimates are based on the number of hours, material, and other expected costs” Cafiero explains, “But there’s always the possibility of slower production, change in schedule, or the chance you missed something when you estimated the job.”

“As a contractor, you’re also at the mercy and schedule of other trades,” Cafiero points out. Delays with other parts of the building schedule outside of your control can drastically impact your segment of the project. Say you originally scheduled 5 workers to be on a job for 10 days, but the trade in front of you is delayed and you can’t start on time—the client, however, still demands an on-time completion. Under the new circumstances, you need 10 workers for 5 days. To achieve this, you need to have the available manpower and the cash on hand to cover increased payroll and overtime.

Due to situations like these, for Jim to keep Island Painting running, one of the most important things to accurately forecast and control is cash flow. “As a subcontractor, we essentially fund the job for the general contractor.”

Jim likens his painting contractor business to a bank providing loans with expected interest (profit) at the end of a project: “As a contractor, we lay out the payroll every week, the cost of the material every month, insurance, overhead, and other expenses. We then wait 60, 90, or 120 days to recover that cost.”

3 key areas of construction accounting

If a contractor business functions like a bank to fund and complete projects, keeping tight control of finances is all the more important, especially when it comes to tracking and allocating direct and indirect expenses, managing cash flow and invoices, and determining break-even guidelines.

1. Allocation of expenses

In a typical accounting scenario, a business knows the costs of each item it sells and has fairly stable overhead costs—this is not the case with construction accounting. Instead, there are a number of different direct and indirect costs to record and expense. Direct costs are directly related to the installation and preparation of the materials and services needed to complete the final construction project. For example: materials, labor, equipment, and subcontract costs.

Indirect costs are those that are not direct inputs to a specific project but are necessary or beneficial to a project’s completion. There are two types of indirect costs. The first are overhead costs such as rent, utilities, vehicle fleet depreciation, etc. The second are indirect costs that are fixed to a certain project such as project estimation, project administration, transport of workers, use of tools and equipment, and support functions like payroll processes, collections, quality control, and inspections.

So that your business doesn’t find itself in a hole at the end of the year, these indirect expenses need to somehow be estimated, allocated to jobs, and billed for. When deciding which indirect costs should be allocated, ask yourself this question: “If I didn’t have these contracts, would I still have these expenses?” If the answer is no, you should find a way to allocate those costs.

There are several ways to allocate indirect costs, but regardless of the method, detailed accounting records will be key. At Island Painting Inc., Jim takes an average of previous years’ indirect expenses and adjusts that number to fit current sales volume. Indirect costs are then allocated on a pro-rata basis according to job size.

Indirect costs can also be allocated to projects based on estimated or actual hours worked. Expenses such as insurance premiums and non-billable hours for estimating or payroll processes can be allocated to jobs using either of the above-mentioned methods.

Tool use and depreciation is another indirect cost that should be accounted for but often falls through the cracks. According to data from the Institute of Certified Construction Industry Financial Professionals , 42 percent of contractors that accept jobs valued at $1M or greater have no mechanism for tool allocation. This represents a major cost incurred and not recouped. Similar to other indirect costs, contractors can expense tools on a pro-rata basis according to contract sale size, the number of hours worked, the days or weeks required for project completion. For larger jobs that require more equipment, you may be able to expense tools directly to the client as purchased.

Keep in mind, not all clients will be comfortable with general percentages charged on a pro-rata basis and may require invoice line items to explain indirect costs for tools, insurance, home office costs, fleet maintenance, and more.

To ensure your costs are covered and clients are billed fairly, it’s important to have standard, repeatable processes to account and bill for indirect expenses. In addition to strengthening existing processes for expense tracking, software solutions that enable item expense tracking per job can simplify cost allocation and help reduce errors.

2. Invoicing and cash flow

Contractors may need to make large upfront investments in materials, tools, and labor before they can collect a payment from the client. If the work schedule is delayed or a client defaults on the payment, the contractor may not have the cash-on-hand to complete the job, or could even go bankrupt.

To avoid such a situation, timely billing and collection are essential, as are accurate estimates and an accounting system fluid enough to adjust to changes throughout a project.

Contractors typically operate on a progress payment system under which monthly invoices are sent based on the percentage of job completion at the time of billing. This percentage is based on initial project estimates—if these estimates are off, invoices will not reflect the actual to-date cost of the project, and cash flow will fall short. Erroneous estimates can also result in disputes regarding the percent of a project completed at any given time, causing delays in payments and underfunding.

When the original scope, timeline, or required materials for a project change, a change order may be necessary. This enables a contractor to complete a project to updated specifications and remain profitable. Change orders are common, but they are also a source of invoicing errors and cash flow problems. To avoid underpayment following a change order, ensure that all changes are approved in writing, project estimates are revised, and new project completion percentages are applied to invoices.

If invoices are sent out late, with errors, or if the client disputes the invoice amount, there can be a lengthy resolution process with unfortunate repercussions for a contractor’s cash flow. Operating on thin margins and fickle job conditions, most contractors cannot tolerate an unexpected cash flow interruption. A progress payments schedule shared with the client at the beginning of a project can help reduce the chance of collections issues. Invoicing software and online payment collection can also reduce billing cycles and contribute to good construction cash flow.

3. Break-even calculations

Like in all other businesses, the construction break-even point is the level at which sales cover fixed and variable costs. Because each construction job is unique and has different expenses, a break-even calculation will be more of a guideline rather than a rule. The break-even point can be measured annually or per job. Find your break-even point by dividing fixed costs by gross profit margin:

Break-even point =Fixed Costs / Gross Profit Margin

By calculating an annual break-even point you can determine the amount of sales revenue you need to cover fixed costs and home office expenses. Once developed, this can be used as a financial benchmark to see how overall performance compares to previous years on a quarterly or monthly basis.

Developing a per-job break-even point is much more difficult—projects are most often one of a kind and are not easily compared to arrive at break-even metric. However, with the help of a skilled accountant and properly maintained accounting records, you can develop a universal standard of measure (USM) and a break-even guideline.

Start by identifying your most profitable completed jobs by analyzing job costing and P&L reports in your accounting software.

Once you have a group of your most profitable jobs, determine the common factors to find your sweet spot. For example, a painting contractor could lookout for any of the following indicators:

• A certain revenue amount
• Certain client profile
• Number of man-hours
• Suppliers used
• Project type (drywall, interior, exterior)
• Project size (square feet painted)

Once identified, the conditions that unite all of your most profitable jobs can serve as your USM.

Conduct break-even analysis for each job in this group by dividing fixed costs by the gross profit margin. Then take an average of the results to develop a per job break-even point that you can apply to new jobs.

Moving forward, your universal standard of measurement should inform which bids you pursue, and your per job break-even guideline should be used to inform your procurement, labor scheduling, third-party contracting, and more. The result should be more profitable jobs more often.

What role can accounting software play?

The complexity of construction projects necessitates accurate accounting processes and visibility into project costs throughout a job.

Strong accounting software has the functionality to help manage costs throughout the life of a project so contractors can keep a close eye on their bottom line. Advanced reports help to ease the burden of allocating costs and managing cash flow, like:

• Cost by job
• Unpaid bills by job
• Expenses not assigned to jobs
• Cost-to-complete
• Billed vs. unbilled hours
• Customizable cash flow reports

With this information on hand, contractors will always be able to keep track of expenses, monitor profits, and identify where gaps exist.

With built-in functionality to update existing estimates and online invoicing, construction accounting solutions can also improve the implementation and accuracy of change orders to avoid project busting errors. Other reports such as profits and loss, margins per job, and inventory turnover can help contractors zero in on their operational sweet spots.

Improve accounting practices, improve your bottom line

Inaccurate accounting practices can result in project overruns, inadequate cash flow, and even bankruptcy.

To overcome these risks and deliver services as promised, contractors need to improve visibility over their accounting operations, more accurately track expenses, and invoice with speed and precision. By pairing strong accounting processes with a best-fit accounting software, contractors can complete projects more profitably and avoid the headaches of construction money management.