This is the first of a 2 part blog with respect to Work In Progress. Check back tomorrow for part 2.
In our last post, Performance Bond Financial Analysis – Working Capital (click here to read), we defined and discussed working capital. As part of defining the current assets and current liabilities of a contractor, we mentioned the following:
- Costs in excess of billings (underbillings)
- Billings in excess of costs (overbillings)
If you are not familiar with percentage of completion accounting, then these terms are probably new to you. But learning this will make you a better contractor, lead to more profitable jobs, and ultimately help to increase bonding capacity. We’ll briefly define, discuss how to calculate, and discuss why they are important to a contractor and surety. But first let’s cover percentage of completion accounting (POC).
There are different accounting methods that are Generally Accepted Accounting Principles (GAAP). For construction, there are only two principles that are acceptable; the completed contracts method and percentage of completion method. Because construction projects are generally over the course of several months, the percentage of completion method makes the most sense and is usually required by banks and surety companies. The completed contracts method would make sense for the contractor that only has fast turning, less than a month type of small projects. We will only focus on the POC method.
In a nutshell, percentage of completion accounting takes reasonable estimates of costs on a project for a given period to calculate revenue; that is, it takes the percentage of completion of the contract to recognize revenue.
Example. If a project value was $120,000 and $20,000 was the estimated profit, estimated costs would be $100,000. If after 6 months, costs incurred was $50,000 the costs percentage would be $50,000/$100,000 =50%. The revenue recognize would be 50% of $120,000, or $60,000.
While this is the simplified example, it’s accurate of how revenue is calculated under the POC method. So where do under and over billings enter into the equation? We’ll address this in tomorrow’s blog, part 2 of the WIP.