1. What is Construction Accounting
Construction accounting is unique compared with other industries. While it follows the same foundational standards of general accounting, there are specialized processes and methods in construction accounting that help contractors to track the finances for each project alongside the results for the whole company.
What makes construction accounting different from other industries?
a. Construction is project based.
Unlike a company that makes a product like a car, or delivers a service like a hotel, construction companies earn money from a series of short- and long-term projects. That means that the finances of construction companies are subject to constant change with new requirements and inputs for each project.
b. Construction projects are site based.
Every project has different site conditions, and the workforce can be long term or seasonal, or even subcontracted for a specific role on a specific project. In addition, the raw materials that go into each construction project are not easily transferrable from one project to another.
c. Contracts may extend over months or years.
Terms of the contract may allow for payments at key milestones, but most construction contracts provide for withholding. That means that payments can be delayed for significant amounts of time. Because of these circumstances in the construction industry, revenue recognition and cash management present unique challenges.
Traditional methods of accounting (and traditional accounting software) do not account for the specialized accounting and billing methods that are used in construction. In addition to standard accounts payable, accounts receivable, and payroll, construction accounting must track job costing, change orders, deposits, and other accounting features that are unique to construction.
In this post, we’ll provide a complete rundown of construction accounting, including why it’s important to consider the unique characteristics of the construction industry in your accounting, the ways that construction companies recognize revenue, the ways construction invoicing is different, and why construction accounting should include job costing and purchase order management.
2. Construction Accounting Methods for Revenue Recognition
With long term projects as the norm in the construction industry, contractors use revenue recognition to establish when they have officially made money on a project. Construction companies use many different methods for revenue recognition. Let’s have a look at the different recognition methods and some advantages and drawbacks for each.
The cash method of revenue recognition means that costs and income are recognized when cash changes hands. For example, cash accounting recognizes a payable when a check is written to cover the expense, and revenue is recorded when a payment is deposited into a company’s account.
Cash accounting is advantageous because it accurately recognizes cash on hand. But the drawback of cash accounting is that it doesn’t reveal costs and revenues in a timely fashion. This method of accounting is generally best for companies with revenue under $5 million.
Using the accrual method for revenue recognition means you record costs and income at the time when you send the client a bill or when your company receives a bill for materials. Recording costs and income when they are incurred provides a more accurate picture of your current company finances. Additionally, the accrual method is recognized under GAAP (Generally Accepted Accounting Principles), while cash accounting is not.
Completed Contract Method
As the name suggests, this is when a contractor recognizes revenue for a project only after completion of the project. This method of income recognition is riskier because the contractor must take on all the operational expenses for an extended period. Completed contract revenue recognition is used most commonly by homebuilders who build on spec and recognize income after the house is sold.
Percentage Cost to Complete Method
This method is when contractors recognize revenue on a project based on the percentage of costs that have come in. Let’s say you have a project estimated to cost $500,000. Once you have incurred $250,000 in costs, the project is considered 50% complete. By that standard, 50% of the project’s income can be recognized.
But the tricky portion of this method is that revenue recognition may be out of sync with your billing. Using this example, if you have already billed your customer more or less than 50% for the project at the halfway point, you will have to adjust your net income so that only 50% is recognized.
3. What is Construction Job Costing (& Why Does it Matter to Contractors?)
What is Job Costing?
Job costing in construction accounting is the process of allocating project costs like materials, labor, and equipment to a specific job and tracking those costs throughout the life of the project. Job costs are frequently compared with the estimated costs that are established at the beginning of the project to ensure its financial health.
To ensure they stay profitable, construction companies and contractors must be able control expenses by tracking accurate costs for each project.
Construction companies need to track their overall (company) finances in addition to keeping an eye on the financial health of their projects. That means it’s important to keep an eye on the General Ledger and Job Costing in tandem so that you can view a complete picture of your company’s financial health.
General Ledger in Construction
General ledger (GL) is the source of truth in your construction accounting system. It’s a record keeping system that summarizes and categorizes every financial transaction in the company so that you can stay on top of your spending and cash flow. Your GL contains subledgers for the information that is summarized in your financial statements: assets (fixed and current), liabilities (short- and long-term), revenues, expenses, gains, and losses. It’s also the foundation for your business tax returns.
The GL is your insurance that your books are balanced. Using a GL helps your bookkeeper spot any discrepancies or unusual transactions that might indicate errors or fraud.
In construction accounting, general ledgers use the double entry accounting method – every debit in one account should be matched with a credit in another account, or vice versa.
Job Costing and GL work together to provide an overview of your construction finances at the project level and at the company level. For a complete picture of your construction company’s financial health, it’s important to keep an eye on both financial barometers.
How do you calculate job costs on your construction project?
Use the Formula:
- Material costs are the total raw project materials, such as lumber, steel, and concrete, plus indirect, but related costs such as transportation to the site.
- Labor costs are a calculation of a worker’s day rate or hourly rate multiplied by the duration of the job. Include your crew plus subcontractors plus worker’s comp, overtime, and any other relevant expenses.
- Equipment costs are a total of the equipment rental costs used on a project or an allocated equipment charge to the project for equipment the company may own.
- Overhead is the total cost for operating your business, including rent on offices, warehouses, salaries for your administrative staff, and labor overhead like insurance and vacation etc.
Benefits of Job Costing in Construction
It might be stating the obvious, but it should be said that a successful business has a healthy bottom line. If you’re running a construction business and you can’t identify your costs and profitability, it can be too late to correct by the time you have your final numbers entered. A project with cost overruns can really sting.
4. Types of Construction Billing / Invoicing
Construction billing is as unique as the industry. There are varying standard invoicing styles used by contractors to manage different sized projects in different sectors of the construction industry. Here are the most common construction billing formats.
Fixed Price/ Lump Sum
With a fixed price contract, the entire cost of a project is one fixed price. Fixed price billing means that you need to identify one price for the materials and labor required to complete a specific project. On the plus side, projects that are completed early or under budget can result in large profit margins.
However, with any lump sum contract, unexpected issues can negatively impact your bottom line, and your estimates must be airtight, because any change will directly negatively impact your profit. This type of billing is riskier for large projects with multiple variables, or different subcontractors. For these reasons fixed price billing works best for smaller projects.
In this style of invoicing, the owner pays the contractor for the total cost of the project plus an agreed upon fee that will represent contractor’s profit. With a cost-plus contract, costs always include direct costs like labor, materials, and equipment as well as indirect costs such as insurance, travel mileage, and communication expenses. Using cost plus invoicing is less risky because it helps contractors ensure they don’t carry the risks of changing materials prices or other unexpected changes.
At the same time, cost plus invoicing requires diligent documentation to justify the costs. Some owners may be reluctant to pay for indirect costs like travel and other administrative items. These types of contracts must be very specific in their language.
Time & Materials (T&M)
Time and Materials contracts invoice the cost of the materials used in a particular project, plus a defined hourly or daily rate for labor costs. T&M billing provides the contractor with the flexibility to define the materials that will be covered in the contract, while also including change orders. A benefit for time and materials contracts is the guarantee that you will be paid for all of the hours worked, even when a project takes longer than you had expected.
In the case of T&M contracts, you must carefully document materials, labor hours, and change orders. You get paid for what’s documented. Additionally, there’s less incentive for efficient work since every hour that’s documented will be paid out. For that reason, many T&M contracts should and do include a bonus for early completion.
Unit price contracts break a project into segments. The total number of units or segments is often unknown at the start of the project. With unit price billing, you can add additional work or materials to a project. Unit pricing works best when a project can be divided into clear units or blocks, such as paying for gravel by the load.
It can be difficult to forecast the final value of a project when the number of units is undefined. It’s also difficult to define the scope of labor on the project when total units have not been specified.
Progress billing or incremental billing is very common in construction accounting. Invoices are created based on the percentage of completed work to date and payments are made at key agreed points of the project completion. Because progress billing allows contractors to be paid at regular intervals it is especially beneficial for large projects that will take months or years to complete.
Within progress billing contracts, the owner and contractor should agree to a specific payment schedule in advance of the project start and the contract should specify when an invoice should be submitted and paid.
It’s crucial to use a single method of percentage complete calculations throughout the project. Decide up front whether you will use costs, units, or labor hours to calculate the percentage of the project that is complete and use the same method throughout.
Most contractors use costs to calculate percentage of completion. Divide the total costs to date by the total estimated costs for the project.
For a project with an estimated $100,000 in cost, with actual costs to date of $40,000, the percentage of completion would be equal to costs to date ($40,000) divided by total estimated project cost ($100,000). In this example, the percentage of completion is equal to 0.4 or 40%.
Using labor hours to determine the percentage of completion with a total estimated labor hours on the project equal to 5,000. If you have completed 1,250 labor hours, then the Percentage of Completion is equal to 1250 / 5000 = 0.25 or 25%. Using this example on a contract worth $125,000, the invoice would be $31,250.
It’s important to keep a handle on your change orders and track any slow payments so that your POC calculations don’t add up and put you at the risk of overbilling or underbilling.
Construction accounting software can help make more accurate Percentage of Completion calculations by helping you to be certain you have imported the correct data you need for accurate percentage of completion calculations.
What does a typical construction invoice include?
- Invoice creation date
- Invoice number
- Your company’s names and address
- Customer name and address
- Description of goods and / or services
- Prices and quantities for those goods and services
- Payment terms
5. Construction Purchase Orders
What are construction purchase orders?
A construction purchase order is a document that confirms a request for construction materials. A buyer creates a Purchase Order (PO) and sends it to a material supplier or equipment renter as a request to purchase materials from a supplier based on certain terms. The supplier may agree, disagree, or even make a counteroffer. The PO then becomes the legal contract between these two parties, setting terms like price, and payment terms.
How are construction purchase orders used?
POs are used as a contract between a buyer and a supplier to provide materials. Organized documentation reduces duplicate orders.
Large projects have hundreds of POs from multiple different suppliers. Clear and detailed purchase orders from contractors and subcontractors can function like an audit if anything goes wrong. For example, if an order is only partially fulfilled or contains an item that does not meet specifications, a review of the purchase order can illuminate where the mistake was made.
Most everyone in construction uses POs, which means that it’s important to maintain a simple and organized construction purchase order system. Some companies use construction accounting software to create purchase orders, record approvals, and track when materials were delivered and paid for in full. In addition to making construction purchase orders more organized, this means that you can cut down on paper waste and eliminate the problem of losing paper purchase orders.
While purchase orders are not the same as an invoice, you can also consolidate PO information for a more streamlined ability to track payments and expenses.
POs should be simple, standardized, and streamlined and include the following details:
What should a PO include?
- Order date
- PO number
- Name and address of buyer
- Name and addresses of vendor
- Description of the product
- Quantity and price of product, including any discounts
- Payment terms
- Shipment terms
6. Construction Document Management (Accounting & beyond)
One of the biggest challenges of construction accounting is managing the mountains of paperwork. Organizing, tracking, and managing everything including notices, invoices, change orders, purchase orders, and more can be a headache. At the same time, clear and accurate documentation is at the heart of many construction contracts. The often-repeated rule is: if it’s not documented, it doesn’t get paid. That means that a straightforward document management system is as important to a contractor’s bottom line as detailed Purchase Orders.
Many contractors still rely on basic tools like spreadsheets or shared drives to manage and track their documents, which include drawings, plans, change orders, correspondence, checklists, punch lists, and more.
With so much at stake and with so many types of construction documents to handle, a centralized, organized, document management system that is integrated with your construction accounting software is essential for well managed projects.
Construction accounting software can make everything about construction accounting go much more smoothly. While it’s manageable for smaller contractors to use off the shelf software like QuickBooks and MYOB, growing construction companies need specialized accounting software that’s built for construction.
Construction accounting software is made for the specific needs of contractors and construction companies. It’s made to make it easier to handle construction specific needs like job costing, purchase orders, and progress reporting.
It is a good idea to get the advice of your accountant before you implement new software, new business processes, or make any changes that could affect your existing projects.