The financial success of a construction contractor can depend on a variety of factors including the quality of its product, its reputation, the management of the enterprise, and its ability to sell profitable contract work. The financial success of a construction contractor is also dependent on disciplined project management, which is intrinsically linked to a fundamentally sound accounting and financial reporting system. These two functions, when coordinated, will contribute to the financial success of a construction contractor. The relationship requires these two functions to effectively communicate and work together over the estimating, forecasting, cost accounting, revenue recognition, and cash flow processes. Each one of these processes will require the input from each function to ensure the completeness and accuracy of job, management, and financial reporting.
The estimating process is extremely critical to a contractor’s success, since the accomplishment of a project always starts with the initial estimate of how much the project will cost the contractor, and how those costs will be funded. Dependable estimates provide a baseline for monitoring project progress, and financial performance assessments throughout the project’s lifetime. The project management function is typically responsible for project estimates; however, many contractors may have a dedicated estimating department, in which case, project management may be less involved. To that end, if the project is awarded to the Company based on a bid with an estimate developed by an estimating department, it is then typically handed over to project management for conversion into a project budget. It is at this point, where project management should work together with accounting to ensure the project budget is added to the accounting system appropriately, and that all cost items have the appropriate cost codes when entered into the system and measured against the project budget. The other processes, forecasting, job costs, revenue recognition and cash flow, will operate more effectively if initial project estimates are set up correctly.
Forecasting is the act of focusing on future events, such as future billings, costs, and other potential project problems. In other words, forecasts are current estimates after the project begins and potentially changed since the initial project estimate. For project management to effectively make forecasts, strong project management and accounting controls must be in place to ensure the forecast data available is accurate. This entails an accounting system that allows project management and accounting to work together within, or communicate through, to ensure the information available, such as line-by-line project costs, change orders, and progress billings, is current, complete, and accurate. The underlying controls to allow for such a relationship would include a separation of duties that allows each function to check on the other – such as a project manager approving a material purchase initiated by the purchasing department, which is then added to the job cost accounting system by the accounts payable department (accounting function). If this shared system correctly reflects the history of the project’s costs, billings, etc., then the project manager will be able to more accurately forecast the future events that are expected to occur. These forecasts then assist in the other processes including job costs, revenue recognition, cash flows and financial reporting.
The management of job costs requires complete collaboration from project management and accounting. The accounting function is responsible for developing and maintaining a chart of accounts with cost codes that project management can use to manage and forecast the project effectively. Project costs are generally entered into the accounting system by the accounting function upon the approval of project management. These job costs are categorized and measured against initial project estimates and subsequently revised estimates to monitor project performance, and assist in forecasting the project. Accounting then uses these revised estimates and job costs incurred-to-date to determine the percentage of completion, which translates directly to the revenue earned (assuming the percentage of completion method is used by the contractor for financial reporting). Project management often uses percentage of completion to measure the actual progress of a job determining it’s reasonability, and to identify potential project issues requiring further estimate revisions.
One such category that can often have issues is the project labor cost category. Project management and accounting should work to ensure labor hours are properly approved, coded to the proper project, and calculated for the correct amount. The job costing process also requires strong checks in balances between project management and accounting to maintain data integrity job-by-job. In other words, job costs need to be charged correctly or forecasting, cash flow projections and financial reporting will have errors. Finally, a strong job costing process allows for upper management to properly monitor the progress of projects and identify additional potential issues.
The revenue recognition process for financial reporting is completely dependent on the three previously discussed processes functioning correctly, in addition to progress billings occurring regularly (cash flow process). As previously discussed, the most commonly practiced revenue recognition method is the percentage of completion method. Percentage of completion is measured by comparing costs incurred to-date against estimated costs expected to be incurred. This calculation results in a percentage that in theory represents the overall progress of the job. This percentage is then taken against the agreed upon contract price with the customer to determine what portion of the overall contract price has been earned-to-date. (There are variations in this approach to consider, but this is the most commonly practiced method for determining revenue recognition). The accounting function will have errors in this calculation if the project management and accounting functions have errors or issues within the estimating, forecasting and job costing functions. The functions with the greatest degree of variability in this calculation are the estimating and forecasting functions in tandem. Inaccurate cost-to-complete estimates can cause misreported revenue and if not caught in time can result in losses being carried on the balance sheet instead of being recognized, or revenues being smoothed to manage year over year profitability. Though the percentage of completion method for revenue recognition is really representative of accrued accounting, it serves as barometer for final profitability and the cash needs of the project to ensure it will be properly funded through completion.
The cash flow process is the life blood of a company and each of its construction projects. The cash flow process can often be more of an art than a process and is a part of each phase of the project life cycle from pre-bid to close out. This process requires project management and the accounting function to work together in preparing customer bills, recording the bills to the accounting system, and collecting cash receipts from the customer. The accounting function will also hold project management accountable for being paid, and will notify project managers of delinquent collections if the accounting function notices any negative collection trends within the reports generated by the accounting system. In addition, if project management falls behind with billing the customer it will raise a signal to the accounting function that there could be issues with the revenue recognition and that the project could be less profitable than initially expected. Conversely, if project management is ahead in its billing relative to revenue recognized, especially during the later phases in the project life cycle, it will signal the possibility of a more profitable project. That being said, the cash flow process is a barometer for how well the project was initially estimated and subsequently forecasted. Of course, if project billings and collections are not funding the job costs being incurred, it will also signify possible issues within the estimating and forecasting process. Either way, direct communication between the project management and accounting functions will be required to determine a solution.
Disciplined project management and a fundamentally sound accounting function are essential to a construction contractor. The relationship these two functions share together within the estimating, forecasting, cost accounting, revenue recognition and cash flow processes will contribute to the financial success of a construction contractor by effectively communicating and working together to ensure accurate job, management and financial reporting.
For assistance or more details on how you can improve your accounting function, please reach out to Michael Corcoran, Senior Manager, in Aronson LLC’s Construction and Real Estate Group at 301.231.6200.
This is part five of a five-part series on indirect costs.
As we wrap up our series on indirect costs, it’s important to remember the key takeaways from parts one through four:
In addition to the above points, the following items should be considered when evaluating indirect costs:
Though considering indirect costs in your construction contracts may seem like a no-brainer, these costs can be overlooked since they may be related to all projects but not easily allocated to just one. A concerted effort should be made to accurately estimate, allocate, and track these costs on a job-by-job basis to ensure accurate financial reporting, budgeting, and to remain in compliance with GAAP and other standards (FAR, CAS, etc.) that could be applicable to your construction business.
For more information regarding indirect costs and construction contracts, please contract Chris Fischer of Aronson’s Construction Real Estate Group at 301.231.6200.
This is part four of a five part series on indirect costs.
Audit professionals typically approach financial statement information from an external reporting viewpoint . With most contracts, we review a client’s position as of their year-end date. From a cost accounting perspective, however, contracts should be looked at monthly to determine accurate contract status. This includes comparing actual costs incurred (including direct and indirect costs) to budgeted costs to determine variances. This brings us to the concepts of “under application” and “over application” of indirect costs. If indirect costs are under applied, it means that the actual amount of overhead exceeded the amount applied for the period, which would be the amount you budgeted for the period . Additionally, indirect costs would be over applied if the actual amount of overhead was less than the amount estimated for. Consider the following scenario:
Since actual indirect costs allocated to Project A in January 2015 were $60,000 and budgeted costs were $50,000, indirect costs were under applied. As a result, there was an unfavorable variance of $10,000. Note that this additional $10,000 of costs in January 2015 will also affect revenue recognized for contractor using the percentage of completion method for long-term construction contracts. The following scenario demonstrates the implications to the contract:
As you can see, the increase in the costs incurred in January 2015 will increase revenue recognized by approximately $11,000 when compared to revenue recognized in your budget. Comparatively, this is not a large acceleration of revenue recognition as compared to the budget. However, it is very important to employ good estimating and budgeting techniques to ensure that variances are minimal when compared to budgets to accurately project the status of contracts and to ensure that profit is maximized on projects.
Our final article in this indirect cost series will focus on miscellaneous indirect cost items that all contractors should be aware of for their projects. For more information on indirect cost application in budgeting, please contact Chris Fischer of Aronson’s Construction and Real Estate Group at 301.231.6200.
In part one of our indirect costs series, we focused on what indirect costs are and why they are important to contractors. In this post, we will discuss cost pools and how to develop an appropriate indirect cost rate to allocate indirect costs to your construction projects.
As discussed previously, indirect costs are costs that directly arise from contracts but are not easily attributable to individual projects. Due to this, a rate must be determined to allocate these indirect costs to particular jobs. Before determining a rate you must determine how to accumulate indirect costs into cost pools.
Understanding Cost Pools
A cost pool accumulates similar indirect costs to be allocated to individual projects based on the indirect cost rates developed. Examples of cost pools include equipment, labor burden, vehicles, etc. In developing and tracking cost pools, a company must ensure that the money attributed to cost pools are truly indirect costs and not direct costs or general and administrative costs.
Indirect costs must then be allocated in a consistent way once an indirect cost rate has been established. Examples of rates include those based on direct labor costs, direct labor hours, or equipment usage hours. These cost drivers should be matched to cost pools that have a strong relationship with the incurrence of these costs. Take the following scenario (expanding on the example in Part One):
Alternatively, using the same data, Contractor XYZ could have allocated the indirect costs using an indirect cost rate based on the equipment hours incurred throughout the year, compared to waiting until year-end to allocate the costs. The following example demonstrates this scenario:
This scenario provides a total of $230,000, of indirect costs allocated to the job when a total of $250,000 of costs was incurred. The contractor could decide to reallocate the costs to the projects or if total costs incurred where not material, the contractor could attribute the difference as under-applied. A contractor’s specific circumstances will determine what treatment is best.
Additional examples of matching cost pools to cost drivers include:
Correct indirect cost allocation is vital for accurate financial reporting, both internal and external, and to portray an accurate picture of contract status. Stay tuned for part three of our five part indirect cost series, “Indirect Costs – Contract Estimation and Change Orders”. For questions relating to the development of cost pools and indirect rates, please contract Chris Fischer of Aronson’s Construction and Real Estate Group at 301.231.6200.
This is part one of a five-part series on indirect costs.
When contractors are accounting for contracts, it’s easy to account for the typical project costs that come from an invoice for tangible materials delivered to a site. However, other costs, known as indirect costs, are often forgotten in the planning and budgeting process. In a five-part series, we will explore the reasons why indirect costs are just as important, not only for a job’s success, but also for your company’s overall success.
In this initial article, we will delve into the definition of indirect costs and how they contribute to your overall profitability.
Direct Costs and General/Administrative Expenses
To define indirect costs is to first understand which items aren’t indirect costs: direct costs and general and administrative expenses. Direct costs are costs that can easily be directly identifiable with or attributable to a particular job. Examples of these costs include direct materials, direct labor, and subcontractor costs. For instance, a direct subcontractor cost is easily traceable to a job because the subcontractor would submit invoices from the particular job that they are working on.
General and administrative expenses unrelated to contract activity, such as general legal and banking costs are neither direct nor indirect costs, and are typically incurred regardless of whether or not a company has active contracts. Both direct labor and general and administrative costs are easily identifiable, whereas indirect costs are more difficult to determine.
Indirect costs are expenses that are directly identifiable as costs of construction but are not easily attributable to specific contracts. Examples include labor not directly attributable to any one job (i.e., a project manager working on multiple jobs in the office), contract supervision, tools and equipment, supplies, quality control and inspection, insurance, repairs and maintenance, depreciation, and amortization.
When compared to general and administrative costs, indirect costs would not continue to be incurred if the company had no contracts. For example, if a company had no contracts, then the machinery and equipment used on jobs would not incur any additional wear and tear; hence, no additional repair and maintenance costs. Take the following scenario:
In the example above, depreciation and repairs and maintenance are indirect costs because the equipment is used on multiple contracts and the amount for each contract is not easily determinable. Note that the indirect costs would be distributed among Contractor XYZ’s contracts based on an allocation rate, which will be discussed in part two of our indirect cost series.
“Why should I care about indirect costs?”
Proper cost allocation is important for a multitude of reasons, including:
As you can see, it is crucial for your construction business to properly account for indirect costs in order to have a long, profitable existence. Look out for the next article in our five part series on indirect costs, which will focus on developing an indirect cost rate. For more information on indirect costs and why they are important, contact Chris Fischer of Aronson’s Construction and Real Estate Group at 301.231.6200.