Construction Accounting: Managing Your Jobs Profitably

Construction accounting

Managing construction jobs to ensure profitability can be tricky.

There are often situations that develop or changes that need to be made partway through a project which can seriously impact the accuracy of any estimates you have already made.

Construction accounting is something we are very familiar with, having several clients in the industry. We’ve seen plenty of the typical mistakes as well as firms that manage profitability very well.

Here are a few key ways to ensure that your construction jobs remain profitable:

Free download: Common culprits of scope creep

Managing scope creep and changes

One of the first hurdles that often trips up construction projects is “scope creep.” This is when you quote a job based on the specifications you’ve been given, but extra requests “creep” in. For example, perhaps there are extensive changes to the ultimate structure, or requests to change the type of material used for a particular job. It’s easy for these extra requests to blow the initial budget.

What companies often find is that they’re expected to manage these changes within the original budget and timeframe of the project. Sometimes this is impossible. Not only are you spending more on materials, but you could be spending more on labor too.

A Construction Executive article outlines how scope creep not only decreases profitability, but increases risk. The job may simply become much bigger, but there can also be additional liability risk from whatever has been added.

Construction accounting

Minimizing scope creep

This is where a good project manager comes in. It is the job of the project manager to ensure that there is no such thing as scope creep. Sure, there may be changes required, but these need to be managed so that the job is still profitable for the construction company and additional risk is minimized. These types of arrangements don’t qualify as “creep” because the changes are agreed upon and planned for accordingly.

Lack of proper communication channels is often at the root of scope creep. A good project manager establishes communication processes and channels. For example, a typical scenario might involve the client approaching a subcontractor on the job site with a new request; instead, the procedure should always be to consult the project manager first. Further, the PM should have a change order system that requires a proper paper trail.

Of course clients will often try to get changes made at no extra cost — it’s up to your firm to manage expectations and explain the procedure for making changes right at the outset. The client should always be made aware that the change will have to be priced accordingly. Ensuring that your contract contains a clause for change requests is an excellent first step in having the right paper trail available to fall back on. The bottom line is that everything that should be billed for must be captured.

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Pricing to include overheads

When you price construction jobs, you need to understand the job costs, equipment costs, overheads and how much profit you need to make from the project. A common mistake is not having a good grasp over all of these costs, and pricing jobs largely based on the job cost plus profit. This means you may be very busy with work, but still left essentially broke.

Your overheads and your equipment costs make up a sizable portion of your expenses. A further note here is that some companies will roll their equipment costs into their overheads; however, taking this approach means that it will be difficult to tell if owning your equipment is actually making you money.

As a starting place, ensure that each job has its own account, with all applicable labor costs assigned to the individual job. This way you’re able to review each job on its own merits to understand whether you’re making a profit. Being able to do this greatly helps the next time you’re pricing a similar job.

The common way to include overheads in pricing is to understand what all of them are and to have a standard percentage for markup on job pricing. This markup covers overheads and required profit.

Note: your overheads should include all fixed indirect costs of running your company, excluding costs that are charged to the individual job. For example, field labor, field labor worker’s compensation insurance, field labor benefits, field trucks, field equipment, gas and maintenance for field vehicles, job insurance, job supervision, and project management are charged to the job and are not part of overheads.

Rather than guessing what you need to charge to cover overheads and profit, you can work out what your overhead markup needs to be in order to break-even — you’d then add something on top of that for profit.

Use the following formula to calculate your break-even for overheads: Annual Overhead Expenses / Annual Sales. You will usually need to have an estimate of what those annual sales will be. To give an example, if your annual overhead expenses are $500,000 and your annual sales are $2 million, your break-even would be a 25% markup.

Monitoring vendor terms

The main way that vendor terms affect the profitability of a job is via your cash flow. When terms of payment are offered such as NET 30 or NET 60, this gives you the opportunity to spread out your costs, rather than having to make large payouts in a short space of time.

Cash flow and profit are two separate concepts, but they do inter-relate. For example, if you have a whole lot of vendors who delivered supplies or equipment at the same time and want “on delivery” payment, you might find yourself having to use credit cards or business loans to meet the payments, costing you interest. Longer terms might mean that you have the cash available to make the payments without going into debt.

Additionally, you might be able to spread large payments over longer periods of time without incurring any fees or penalties. This can be an especially great option when you have long-term suppliers.

If you don’t currently have longer-term payment options with vendors, this can be an arrangement that is worth negotiating. Most are willing to look at offering terms to proven, reliable clients.

Recording costs correctly and completely

Record-keeping is another financial area that often trips up construction companies. If you’re not accurately recording costs or keeping receipts, it’s easy for profitability to take a dive.

For example, if you quote a job based on material costs that you have recorded somewhere, you need to keep up with any changes. If cable or framing materials go up by even a few cents per foot, this can add up to a large cost inflation across bigger construction projects.

If you regularly misplace receipts, you potentially won’t be able to record the cost and write-off expenses.

Ideally, construction firms should employ a bookkeeper to keep them on-course, but in smaller companies this often falls to the founder or manager. Whatever the case, have a good system in place. Receipts should be recorded and stored as they come in, and using online accounting software is also a best practice.

Construction accounting

Timely billing

Billing is another common issue among construction companies that directly affects cash flow. If you’re regularly tardy with sending out invoices, you can expect that people will probably be tardy with payment.

Poor cash flow can not only result in those fees and charges we mentioned earlier, but it may even mean you have to pass up a good opportunity. For example, what if you could have invested in some equipment that would make your production more efficient, but have to take a pass due to lack of cash?

If you’re offering a client milestone-based payments, then be sure to invoice immediately at every milestone. Otherwise, the downstream effect of a delay can mean that you’ll need to borrow just to cover your own vendor invoices, or even to make your payroll.

What causes scope creep? Download the top factors here

Final thoughts

Good project management, contractual and accounting practices can help construction firms to ensure that every job is profitable. Specifically, firms can:

  • Have a good project manager in place to keep the job on-track
  • Have a contractual process for any change requests
  • Ensure that job pricing accounts for overheads
  • Seek favorable vendor terms
  • Record costs correctly and completely
  • Bill for work as soon as possible.

Lastly, have an accountant who specializes in construction companies help you with your financial management. This is another strategy that can help you improve profits.

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