Unless you’re an accountant or a money geek, the thought of creating or reviewing financial statements may have you running for the door.
The average day of a contractor or construction business owner is filled with managing the daily operations of the company, putting out fires, and running around trying to avoid potential disasters all over the place. Financial statements, therefore, are the last thing on your mind.
However, that might just be the biggest mistake you’re making.
Besides displaying the company’s current financial health, financial statements are the ultimate tools for presenting significant markers of future trends.
Financial statements are crucial for companies vying to optimize sustainable growth. These mines of crucial data help in spotting potential problems before they take effect and therefore, allow you to act preemptively. Furthermore, if you’re looking to prove your creditworthiness to financial institutions like banks or investors, producing up-to-date financials is something you can’t avoid. Being a successful construction setup warrants companies to regularly review financial reports like the balance sheet, profit and loss (P&L), cashflow, and work-in-progress statements. This allows a contractor to make informed decisions by identifying potential red flags, accurately forecasting budgets, and retaining sustained financial health.
Being a successful construction setup warrants companies to regularly review financial reports like the balance sheet, profit and loss (P&L), cash flow, and work-in-progress statements. This allows a contractor to make informed decisions by identifying potential red flags, accurately forecasting budgets, and retaining sustained financial health.
For greater insights into this read – Getting Accurate P&L for Contractors
The business is always afforded real-time information regarding its financial position. A review of the company’s receivables, payables, and gross profits for example, enables the business to predict profitability and thus, plan accordingly for future projects be it pricing or determining the business’s liquidity position.
Construction industry and accounting expert Luke Nelson, co-founder and CFO at Beiing Human, stresses the necessity of financial reporting. He highlights three key performance indicators that construction companies should pay particular attention to.
Significant Key Performance Indicators (KPIs) for Contractors
Making each job profitable is the goal all contractors strive for. But this is a very complex undertaking.
Keeping track of expenses against cash inflows while managing multiple projects is a herculean task. Industry expert Luke Nelson emphasizes the use of the right technology as key.
It was experiencing these aspects of the construction work first-hand he says that led him to confound his own company, Beiing Human, pioneering document automation. The accounts payable automation offered by the company reads documents with 99.9% accuracy – including human verification. Aside from dramatically decreasing human error and streamlining the complex transaction processes of the construction industry, the advanced software enables companies to considerably cut down on their labor expenses, a phenomenon in the construction sector which has reached crisis level in 2023.
Contractors must make financial statements their holy grail to be able to plan and forecast profitability for every project.
By being susceptible to the “extreme seasonality effect” contractors have drastic fluctuations in their quantity of work during the year. They need to track the fundamentals – overall profitability, cash flow, and liquidity.
Over and Underbilling
This refers to the phenomenon where the amount billed to the client does not align with the actual progress or costs incurred on a construction project. Here’s an explanation of both scenarios:
Over Billing: Overbilling occurs when the amount billed to the client exceeds the actual progress or costs incurred on the project. This can happen due to various reasons, such as errors in measurement or estimation, incorrect application of billing rates, or intentional misrepresentation. Overbilling can lead to disputes with clients, strained relationships, and potential legal consequences.
To avoid overbilling:
- Ensure accurate measurement and documentation of completed work.
- Review and reconcile billing rates with actual costs and progress.
- Regularly communicate with the client and seek their input on progress and costs.
- Implement internal controls and oversight to prevent errors or intentional misrepresentation.
Underbilling, on the other hand, occurs when the amount billed to the client is less than the actual progress or costs incurred on the project. This situation can arise due to conservative billing practices, changes in project scope, delays in recognizing completed work, or underestimating costs. Underbilling can negatively impact cash flow, profitability, and the financial health of the construction company.
To avoid underbilling:
- Maintain accurate and up-to-date records of completed work and costs.
- Regularly review the progress of the project and compare it to billing milestones.
- Implement a robust change order management process to capture scope changes and their associated costs.
- Conduct regular billing reviews and analyses to ensure that all completed work and costs are appropriately accounted for in the billing.
Both overbilling and underbilling can have significant financial implications for construction companies. It is crucial to establish proper controls, accurate tracking systems, and effective communication with clients to ensure that billing aligns with the actual progress and costs incurred on the project. Regular monitoring, reconciliations, and reviews can help mitigate the risks associated with over and under-billing – hence the importance of monthly financials.
Essentially, this entails keeping tabs on the amount invoiced against the job versus the percentage of progress made on the job. Companies need to consolidate actual and budgeted forecasts and tracking over/under billing ensures, on an accrual basis, that the company is where it should be on the project in relation to revenue.
Labor can equate to 40% of the job cost. Though, this figure is steadily rising as in order to attract and retain the workforce companies must offer incentives like increased rates, benefits, and worker’s compensation. Tracking and maintaining labor costs to align with the budget directly affects overall profitability, making it a crucial financial reporting item to review.
Also read – Top Construction Industry Trends to Watch
Luke, who has maintained the position of CFO in multiple big construction industry players, as well as helped companies on the brink of bankruptcy revert to profitability, credits maintaining up-to-date financials as the defining success factor behind thriving businesses. He says, “There are two key elements to pay particular attention to when reviewing month-end financials: work-in-progress and job cost review.”
Job Cost Review
Job cost review is a critical process for construction companies to assess the financial performance of individual projects. It involves analyzing the costs, revenues, and profitability of each job to ensure accuracy, identify areas for improvement, and make informed business decisions. Some key aspects of this fundamental assessment technique include:
- Cost Tracking
Review the project’s cost-tracking system to ensure all direct and indirect costs are properly recorded and allocated to the respective job. This includes labor costs, materials, subcontractor expenses, equipment rentals, permits, and any other project-related costs.
Errors in this area could lead to a grossly misinterpreted view of the company’s financial analysis, for example allocating advertising expenses to the expense of a product or allocating accounts receivable as the cost of an asset.
- Budget vs. Actual Analysis
Compare the budgeted costs with the actual costs incurred for each project. Identify any significant variances and investigate the reasons behind them. This analysis helps identify cost overruns, cost savings, or areas where the budget may need to be revised.
- Revenue Recognition
Examine how revenue is recognized for each project, ensuring adherence to appropriate accounting standards and methods, such as the percentage of completion method. Verify that revenue recognition aligns with the project’s progress and milestones.
- Change Orders
Evaluate the impact of change orders on project costs and profitability. Assess the frequency, magnitude, and financial impact of change orders. Determine if proper procedures are in place for documenting, pricing, and approving change orders.
- Profitability Analysis
Calculate the gross profit margin and net profit margin for each project. Analyze the profitability of individual jobs to identify profitable and non-profitable projects. This analysis helps assess the effectiveness of pricing strategies, cost control measures, and resource allocation.
- Project Delays and Issues
Evaluate any delays, disruptions, or issues that have affected project costs or schedules. Understand the causes and consequences of these factors and determine their impact on project profitability.
- Lessons Learned
Identify lessons learned from each project to improve future cost estimating, budgeting, and project management. Document best practices, challenges faced, and strategies for mitigating risks or improving efficiency.
- Communication and Collaboration
Ensure effective communication between the project management team, accounting department, and other stakeholders involved in the job cost review process. Collaboration between these teams is crucial for accurate cost tracking and reporting.
- Continuous Improvement
Use the insights gained from the job cost review to implement improvements in cost control, estimating accuracy, project management processes, and overall financial performance. Regularly review and refine these processes to optimize profitability.
A WIP (Work-in-Progress) review is an essential process for construction companies to evaluate the progress and financial status of ongoing projects. It involves assessing the costs incurred, revenues recognized, and the overall profitability of each project at a specific point in time. Here are some important points to consider during a WIP review:
- WIP Schedule
Review the WIP schedule for each project, which provides a snapshot of the project’s status, costs, and revenues. The schedule should include information such as contract value, costs incurred to date, estimated costs to complete, and revenue recognized.
- Cost-to-Complete Analysis
Evaluate the accuracy of the estimated costs to complete the project. This analysis involves assessing the remaining work, considering any changes or variations, and estimating the costs required to finish the project. Compare the estimated costs to complete with the original budget to identify any significant variances.
- Revenue Recognition
Examine the method used to recognize revenue for each project. Ensure that the revenue recognition aligns with the percentage of completion method or another appropriate accounting standard. Verify that revenues are recognized based on the project’s progress and milestones.
- Change Orders
Assess the impact of change orders on the WIP schedule and project costs. Review the documentation and approval process for change orders, ensuring they are properly recorded and accounted for in the WIP schedule and financial statements.
- Margin Analysis
Calculate the gross profit margin and net profit margin for each project based on the WIP schedule. Analyze the profitability of individual projects to identify areas of strength and potential issues. Evaluate the margins in comparison to industry benchmarks and company targets.
- Schedule Performance
Review the project’s progress against the original schedule. Assess any delays or deviations from the planned timeline and evaluate the impact on costs, revenues, and overall project profitability. Identify any factors that may have contributed to the schedule variances.
- Risk Assessment
Identify and evaluate project-specific risks that may impact financial outcomes. Consider factors such as material price fluctuations, labor availability, weather conditions, regulatory changes, and any other risks that could affect costs or revenues. Implement appropriate risk mitigation strategies where necessary.
- Communication and Collaboration
Ensure effective communication and collaboration between the project management team, accounting department, and other stakeholders involved in the WIP review process. Regularly update the WIP schedule and share relevant information to ensure accurate reporting and decision-making.
Maintain detailed documentation of the WIP review process, including any assumptions made, analyses performed, and conclusions drawn. This documentation helps track the project’s progress over time and supports any necessary audits or financial reporting requirements.
- Continuous Improvement
Use the insights gained from the WIP review to improve estimating accuracy, cost control measures, project management processes, and overall financial performance. Implement lessons learned from previous projects to optimize future project outcomes.
Regular WIP reviews are crucial for construction companies to monitor project performance, identify potential issues, and take timely corrective actions. By reviewing costs, revenues, and project progress, companies can ensure accurate financial reporting, optimize project profitability, and enhance overall operational efficiency.
For a deeper understanding of cashflow management read – Cash flow guide: Definition, types, how to analyze in 2023
In the times of today, construction companies face unique financial challenges that require careful attention to detail and accurate reporting. Creating monthly financial statements tailored to the specific needs of the construction industry, is crucial for effective decision-making and ensuring financial stability.
Maintaining current, accurate financial reports also helps banks, creditors, and other lenders to assess a contractor’s creditworthiness when determining loan terms, interest rates, and lines of credit.
By following these recommendations, construction companies and stakeholders can gain a comprehensive understanding of the company’s financial health, make informed decisions, and optimize profitability.
Ultimately, accurate and transparent financial reporting contributes to the long-term success of construction companies in a competitive industry.