If you own a construction business, then accounting correctly for your sales and costs is ultra-important.
The plain truth is that if you don’t know whether jobs are profitable could be heading for trouble, and you won’t know until it is too late.
In this article, we’re presenting a guide to construction accounting designed specifically for construction company owners.
We’ll demystify some of the more confusing bits of accounting jargon, tell you why construction accounting is so different from ‘normal’ accounting and why it is so important.
Table of Contents
Construction accounting - why bother?
Whatever size of construction company you own, the likelihood is that you spend the vast majority of your time dealing with suppliers, speaking to customers, trying to get your subcontractors in line, and actually working on-site.
It’s understandable that after all of that, you may not return home at the end of the day just desperate to get elbows deep in your accounts.
But if you want to run a professional business, you absolutely must understand the money side of things, even if you get someone else to keep your books.
Accounting for your business
Accurate construction accounting can;
- Help you understand your company profitability
- Stop you getting into financial trouble
- Help you quote accurately for jobs
- Let you understand which types of jobs are profitable and which are not
- Show you where jobs didn’t earn as much money as you expected
- Show you where your cash is going
So from a tactical point of view, construction accounting can help you daily, and strategically, it can help you decide what direction you want your business to go in.
So accurate accounting, far from being a pointless chore, can actually form one of the pillars of your decision-making.
Accounting for clients
For many companies, large businesses form the central plank of their business.
The problem is that the larger the client is, the more paperwork it generates.
Typically giant corporations will expect a fully costed project pitch, a project plan, and a project outturn report showing costs versus expectations.
With larger contracts, suppliers may need to provide waypoint reports with a variance analysis showing how the project’s costs match the original purchase order and the expected outturn.
If you don’t use proper construction job accounting, then you will find this very difficult indeed.
The difference between USGAAP and management accounts
So here’s the first bit of accounting jargon we need to look at.
Some people get confused about the difference between their IRS/local tax returns and management accounting.
The rules are different depending upon which state you are in, but your company will need to submit a set of accounts each year to the IRS and possibly your state.
These are known as ‘statutory’ accounts, and these are produced using a specific set of rules called the US ‘Generally Accepted Accounting Principles’ or USGAAP.
You’ll probably need to engage an accountant to help you with these and ensure that they meet all the requirements, but statutory accounts are different from management accounts.
Management accounts are, as the name implies, a way of managing your company.
This means to a large extent that you can do what you like with them and show whatever you want, in whatever way you want.
The important thing here is that you get management accounts produced that help you understand what is going on in your business and show you the information you need.
That said, there are some general principles that most people will use when they are producing their management and construction accounts, and these are what we are looking at today.
But the health warning here is that in some cases, what you see on your management accounts may be different from what you see on your IRS accounts, and that will be down to USGAAP.
Demystifying some standard accounting elements
One of the problems that we see is that accountants often seem to speak a different language to everyday people.
OK, so we might be being a little harsh here, but the truth is that there is a lot of jargon in accounting, so we thought we’d try and demystify some of the things you may hear.
An excellent example of this is the word ‘ledger.’ You’ll hear this a lot in accounting circles (we even use it below), and it is an increasingly old-fashioned term.
It refers to the books that people used to keep their accounts (hence bookkeeping), and they would have separate ledgers for different uses.
They may have had a general or nominal ledger for the general accounts and payables and receivables ledgers for other information.
The truth is that the world now does its accounting on computers, so when you hear the word ‘ledger,’ you can usefully ignore it.
Accounts payable is an easy place to start in that it is very much what the name implies.
Also known as ‘Payables,’ ‘payables ledger’ or any variation of these, it can refer to a listing of all the things that the company needs to pay, or in much larger businesses, it can mean an entire department.
A payables listing should show precisely what the company owes to its creditors and how old the invoices are.
Often if you are chasing payment from a large company, they will tell you that you need to talk to ‘payables,’ and you could find that you have to send your invoices to an email address that starts ‘accountspayable@’
So when you are chasing cash, try asking to be put through to payables first.
Accounts receivable or ‘receivables’ is the opposite of payables.
Again it can refer to a ledger or a department, but instead of being things that your company needs to pay, it is money that your company is owed.
When you send an invoice to a client, it is entered into your receivables, and when it gets paid, it is removed.
The accounts receivables report is the starting place for you to find out how much cash you expect to receive and when.
You may hear your bookkeeper or accountant saying that they need to do a ‘bank reconciliation’ and wonder what it is.
This is simply the act of working out why your accounting system doesn’t match your bank account.
For example, you may have entered a check sent to you on your accounting system, but it might not have hit your bank account yet. That’s reconciliation.
Think of it like balancing your checkbook (if you still have one).
In smaller companies, they can be easy. In big companies, they can be a massive time drain.
The balance sheet
Every company has a balance sheet. You may not use it in tiny businesses, but your accountant will need to prepare one all the same if you are incorporated.
The balance sheet collects all the assets and liabilities that a company has at any particular point.
For example, you may have $10,000 of plant and cash on the asset side and $5,000 of payables on the liability side.
Generally speaking, the balance sheet doesn’t form part of the management accounts.
The Profit and Loss
The profit and loss are, as the name suggests, the summary of the money you have made (or lost) over a set period.
Also known as P&L, Revenue statement, etc., it’s slightly different from the balance sheet. It collects information for a set period, e.g., the last week, month, financial year, etc., whereas the balance sheet is everything up to a specific date.
You can also find P&L’s done for a project or for a particular department, and they can form the basis of a project or job variance analysis (see below).
Why construction accounting is different
Construction accounting is different because, in most cases, firms are working on discrete jobs or projects.
While other businesses might have product lines that they constantly sell to many customers or subscriptions that are paid every month, construction firms do a specific job for a client.
This means that although many of the accounting principles are the same, construction accounting does need a few tweaks.
Before you start thinking about construction accounting, you have to consider the size of your firm, the type of jobs you do, and the size of your customers.
Small businesses who only ever do small domestic jobs may find that a construction accounting approach just doesn’t add any value.
Conversely, a small company that only subcontracts to substantial businesses may find that they are forced to choose this method because their customer demands it.
And for larger businesses that tend to work on much more extensive projects, construction accounting is a must.
The main feature of construction accounting is ‘job’ or ‘project’ costing.
Essentially this is a method of collecting all of the costs and expenses of doing a particular job so that you can assess its profitability.
For smaller companies, job costing can be as simple as entering all of the information on a single excel worksheet, but specialist software is recommended for larger businesses.
The trick is to match the software with your needs rather than desperately soldier on with Excel when proper accounting software could help.
The good news is that standard accounting software such as Xero, QuickBooks, or Sage will handle project accounting.
Ideally, you'll want to pick construction accounting software that integrates with your bidding and estimating software of choice, like Proest will do.
It is a simple matter of setting up a job or ‘analysis code,’ and then every time you receive a bill or raise an invoice, adding that code onto the transaction.
The system can then pick out all of the transactions with that code and produce a job or project P&L.
Central cost allocations
So let’s imagine you start using project accounting, and you add in all of your revenue and expenses to specific jobs. Each one of them is profitable.
So if all of your jobs are profitable, then your company must be profitable, right?
Well, not necessarily.
That’s because you may well have central costs that haven’t been allocated to a specific project.
Maybe you have a truck that gets used for all of your work, or you have an office, or perhaps you buy fuel in bulk and only fill up your plant when you need to.
In that case, you need to split your central costs (also known as indirect costs) down and add some to each job.
There are various ways to do this. For example, in the case of fuel, you may work out how many liters of diesel your plant uses per hour. You know how many hours you have done on a project, so you charge that amount of fuel to that project.
Perhaps you know that each job requires two hours of estimating and client outreach work, so you charge that amount of time for your project manager to that specific job.
Other costs might have to be charged out on a standard basis. Perhaps you may choose to put a standard charge on each project covering a percentage of your office, receptionist, and IT costs.
The aim here is to ensure that each job bears a reasonable amount of the central costs that aren’t usually allocated directly.
Work In Progress (WIP) accounting
When a regular business sells a phone or some computer memory, the transaction happens all at once so accounting for it is easy.
But construction work takes time, so how do you account for the revenue from a project that might take fourteen months to complete?
The problem is that if you use normal accounting rules, you may have an entire year where your business has only expenses (so it will be making a loss), but then in month 14, you will invoice for fourteen months of work, meaning in that one month you make a huge profit.
For a small business that only does small projects for residential customers and gets paid immediately, this isn’t a problem, but for a subcontractor who spends five years working on a power station, this could be a significant issue.
To deal with this, you can use Work In Progress (WIP) accounting.
This is a method of working out how much of the income should apply to each month.
Called ‘revenue recognition,’ there are several different methods of achieving this.
You may have agreed to stage payments with your client, meaning they pay a certain amount as each stage is completed. In this case, you could recognize your income when the stage is invoiced.
Alternatively, you may decide to split the project down into months (14 for our example above) and then just recognize one-fourteenth every month.
Or you may choose to recognize based on percentage complete. So in our example, we may know that 50% of the work will be done in the first six months, so you’ll recognize half the value across the first half-year and then split the remainder across the last eight months.
WIP is essential when looking at variance analysis during the project’s life (see below). You must also be aware that revenue recognition is one of the areas where USGAAP could differ from the method your accountant suggests.
Retentions and the balance sheet
On larger jobs for bigger clients, it is quite common to see retentions being required.
This is a sum of money, usually a percentage of the job price, that is withheld by the developer to cover any issues that later turn up with the work done.
A contractor may state that there will be a 5% retention for 12 months. They will then pay 95% of the invoice and hold the remaining 5% for later payment. Any snags or remediation needed will be done and money deducted from the retention to pay for it.
As the subcontractor, you’ll need to put the retained amount on your balance sheet as an asset and then only release it as income to the P&L when the retention is finally released.
One practical point here; make sure you have a good way of tracking your retentions for two reasons. The first is that you may well find that contractors will ‘forget’ to send the money on when it is due.
Secondly, if you have a lot of retentions on your balance sheet, they can get out of hand very quickly indeed, and you could find yourself in a bit of a mess.
Construction accounting - do you need an accountant?
So there’s a lot of information there, and you may find that it takes a couple of read-throughs to let it sink in. Don’t worry; some of these concepts can be pretty complicated, so they can take a bit of time to get a grip on.
You may decide that on balance, it is better to get a professional involved.
You could choose to do this in three ways. If you are a bigger company, it may be time to bring in someone full-time to manage your finances.
You may decide that you want to outsource it to your accountant and let them deal with it.
Or alternatively, you could choose to get a professional in to set up your systems, show you how to use them, and then leave you to run it yourself.
You don’t have to get an accountant to do any of this, although you’ll probably find you get a better job done, but whoever you choose to help, make sure they have relevant construction accounting experience.
Accounting and bidding
One of the most significant benefits of accurate construction accounting is that it helps you in the bidding process.
If you want to be confident in your pricing, then using a system like ProEst gives you the information you need to get your direct costs absolutely correct. With excellent construction accounting, you’ll know what your central cost allocations need to be.
Information is the key to taking on projects that will be profitable for your business so understanding the numbers before you bid is vital.
Reporting and variance analysis
Arguably the most beneficial aspect of construction accounting is variance analysis.
This is simply working out differences between what you expect to happen on a project vs. what actually happened.
For short projects, this is typically done after the fact. After all, you may finish a build in a day or two, so variance analysis probably will not help much.
But for more extensive and more prolonged projects, being able to do a variance analysis as you go along will mean that you can take action immediately if the project is going off track.
One of the keys to this is having detailed and reliable estimates.
You can then measure your actual materials spend against your material takeoff and identify any variances so that you can investigate.
Let the software take the strain
If all this sounds like a lot of work, then we’d certainly agree, but just because something is difficult doesn’t mean to say that it isn’t worthwhile.
The trick here is to let the software take the strain.
Admittedly when you first start up, you may only need Excel, but any company that wishes to scale needs to make sure they have the best tools for the job.
Spreadsheets are fine, but just like you may want to get in better machinery or more skilled people when you grow, you also need to invest in your systems.
The starting point to having a profitable business has to be to produce accurate estimates with the least amount of time and effort, and this is where ProEst comes in.
When you have won the job, you need to make sure you have accounting software that will handle all of your business’s general expenses and manage job costing and variance analysis.
Look for systems that allow you to work on-site using apps on mobile devices and choose solutions that mean you can integrate them with things like your CRM and bank accounts to reduce your admin workload.
One practical tip here is, don’t wait until your business is struggling to cope; put in systems that are too good for your current size and complexity so that you have plenty of room to grow.
Types of construction contracts
Lump- Sum contract
This is also called a fixed-price contract, as it shows the total price for the entire project. Owners use it to protect them against future changes and possible setbacks arising. All the materials and time costs are accounted for regardless of the changes. Even though these contracts may benefit the owners the most, most contractors signing them charge a higher percentage to account for the increased risk they put themselves to.
These contracts are made of predetermined fees and accumulated costs. The owners agree on the price to pay the contractors, and it reports the expenses as they get incurred instead of deducting them from a predetermined budget. The contracts ensure little conflict by setting caps on the budget expenses and fair payment to contractors.
Time and Materials Contract
These are used when the scope of work in a project remains unknown, encouraging contractors to charge hourly rates for the materials and labor needed. It is ideal for smaller projects and protects owners from overpaying contractors.
In the design-build contract, the design and construction are done simultaneously. They are then handled with just one contract, unlike the other traditional methods. The designer and construction team can communicate more, and the construction process is faster.
Integrated Project Delivery Contract
It is similar to the design-build contract but used for large complex projects instead. This type of contract is mainly used for large, complex projects. Similar to the design-build contract. It uses a single contract for design and construction and has a multi-party agreement between the owner, designer, and builder. They get to share risks, agree on costs, set applicable waivers, and follow lean principles to reward all the parties evenly.
Incentive construction contract
Here, the contractor and owner agree upon a payment figure should the work be done and completed as per the schedule and within the budget. If the work exceeds the stipulated timelines, the owner expects its completion without more monetary additions to the contractor.
Guaranteed Maximum Price Contract
This is a contract where the maximum price the project owner will have to pay is stipulated. Should the contractor exceed it, they will cover the expenses. Contractors are therefore advised to make estimates of costs more accurately before getting to this contract, especially with the use of software.
Unit Pricing Contract
When an owner intends to buy quantities in bulk, this contract comes into play. They are given unit prices of products for use in the project. The bulk purchases ensure protection against inflation for the owner.
Unpriced Change Order (UCO)
This refers to a unilateral change within the scope of the contract whereby the Government and contractor involved in a project have not agreed, in contract terms, on an equitable adjustment. As such, the project can stall as no direction or licensing is given to warrant the changes in the scope of work.
Construction accounting is an excellent solution to the issues that developers and trades come up against.
At its most basic, it can ensure that your IRS returns are accurate, but it does much more than that.
Construction companies that wish to grow and want to have control over profitability can use it as a strategic and tactical tool in concert with ProEst to ensure that they are bidding right and that projects run to plan.
With extensive reporting and variance analysis, it is possible to fully understand what types of jobs are the most profitable and what customers you wish to concentrate on.
Effective construction accounting does take a small amount of time to set up but once in place, you’ll never look back.