Evaluating Contract Profitability, Part One

What is the language of business? The answer is accounting. Accounting speaks to owners and managers through numerous reports and financial statements, including a balance sheet, income statement and cash flow statements.

The procedures and methods regulating the preparation of financial statements for the construction industry are the Generally Accepted Accounting Principles commonly known as GAAP rules, allow some flexibility in reporting transactions within the accounting rules for construction companies. In our industry, contracts do not conveniently start and finish within our fiscal year, which can complicate the measurement of profits and allow room for error.

It is common for new contractors and managers coming up through the ranks or from construction schools to have never taken an accounting course, much less understand the finer points of construction accounting. Most contractors’ fundamental problem with evaluating contract profitability is leaving its calculation to the bookkeepers and accountants. Roofing contractors handle a lot of money that is not theirs. The company only gets to keep the profit, which most of us agree, is too small for the risks we take. Successful contractors and senior managers do not avoid accounting and do understand how to calculate contract profitability from work in progress. This requires accurate input of roofing installation information known only to the people engaged in the field.

The primary reason for being in business is to make a profit. You will not be able to survive long working at or below the breakeven point. One of the most challenging and misunderstood processes in contracting is capturing all of the data accurately, on time and knowing how to use it correctly to track interim profit or loss. Only then can you evaluate final profit or loss.

It can get complicated for roofing companies whose projects run through multiple monthly cycles. The first place to start is with your accounting system.

Begin by knowing what your business needs are. Prepare a complete list for your company, including what you will need to keep up with your projected growth over the next five to ten years. Depending on the type of projects you perform, some features to consider are:

■ Cash flow analysis by job

■ Work-in-progress (WIP) reports

■ Bonding reports

■ Purchase orders

■ Certified payroll

■ AIA billing.

The accounting software you will use should have all the tools you need to manage jobs effectively with a strong accounting core. It must be able to align with your business processes and be as integrated and automated as possible. The goal is to reduce manual work and spreadsheets as much as possible. Take the time and look for the system that fits your company’s needs and then you can get to the business of managing your profitability.

Allowing you to recognize the gain or loss related to your project in every accounting period in which the project remains active is essential. The percentage of completion method recognizes the ongoing revenue and expenses related to longer-term roofing projects based on the total work completed. The method works best when you estimate the stages of your project completion on an ongoing basis or at least estimate the remaining costs to complete your project. The steps you can use for the percentage of completion method are as follows:

■ Subtract the total estimated contract costs from the total estimated contract revenues to find the total estimated gross margin.

■ Field verify the amount of completed installation on the job as a percentage compared to 100 percent completion of installation labor. (Yes, if your project is behind in production, you will get percentages above 100 percent.)

■ Multiply the estimated contract revenue, including change orders, by the estimated completion percentage. This will provide you with the total revenue that can be recognized.

■ Subtract the previously recognized contract revenue from the total revenue that can be recognized in the current account period.

■ Calculating the cost of earned revenue, multiply the same completion percentage by the total estimated contract cost. Then subtract the cost already recognized to arrive at the cost of earned revenue to be recognized in the current accounting period.

An example of what your WIP schedule would look like is at the bottom of the page.

Revenue for a roofing company is a calculation that relies entirely on the accuracy of the contractor’s estimate of the cost to complete their work in progress. If one or more projects do not perform as well as expected, revenue will have been claimed that never existed and will have to be “paid back” in a subsequent accounting period.

As shown in the example WIP schedule below, the amount a company has billed for work completed on a project during an accounting period is not considered in calculating revenue or total sales for that period. The entries “overbilling” and “underbilling” are used to balance the recognized revenue on your project. Over and underbilling is unique to the construction and roofing industry and is a product of the work-inprogress schedule. It corrects the amount that should have been billed according to the work in progress calculations.

The amount earned to date has nothing to do with the amount billed to date. If the earned to date is less than the billed to date, it is recorded as billings in excess of costs, which is considered an accounting liability. If the earned to date exceeds the billed to date, it is recorded as a cost in excess of billings, which is considered an accounting asset.

Because of the effect on cash flow, a contractor should always avoid underbilling. Underbilling implies that the people billing the work are not communicating with those installing the work or that the cost estimate to complete the work is overly optimistic or in error.

Next month, we will discuss cost controls, tracking costs and the dangers of working without the correct information.

John Kenney, CPRC has over 45 years of experience in the roofing industry. He started his career by working as a roofing apprentice at a family business in the Northeast and worked his way up to operating multiple Top 100 Roofing Contractors. As CEO, John is intimately familiar with all aspects of roofing production, estimating and operations. During his tenure in the industry, John ran business units associated with delivering excellent workmanship and unparalleled customer service while ensuring his company’s strong net profits before joining Cotney Consulting Group. If you would like any further information on this or another subject, you can contact John at jkenney@cotneyconsulting.com.