Introduction
As an Accounting professional in the Construction industry, you understand the critical role that Work in Process (WIP) reporting plays in your company's financial success when using the Percentage of Completion Method (PCM), which is highly recommended by GAAP for long term contracts for Revenue Recognition.
GAAP requires that certain elements be in place in order to use the PCM. These include the existence of a binding contract with enforceable rights, such as the right of the contractor to place a lien when the customer does not pay. GAAP requires an assumption that both the contractor and customer will fulfill their obligations. Another essential element is the contractor’s ability to make dependable estimates regarding the contract’s costs and progress. To measure progress towards completion – in other words, the completion factor – under the PCM, the contract can rely on the costs encountered, the efforts expended, or the units delivered. Projects typically span multiple periods (months), and organizations need a way to report Revenue and Costs (according to GAAP) on a project that is not yet completed by the end of each fiscal period.
Why WIP
A WIP report essentially ensures all stakeholders understand where a job stands, aligns Operations with Accounting teams on billing customers, and proactively monitors for potential profit fade, cash flow issues, and progress delays. It's important to have a firm grasp on the reporting process to ensure accurate and timely financial information. This not only helps with decision-making but also enables the company to maintain a strong financial standing.
WIP reports also calculate how companies should adjust their financials to create an accurate picture while jobs are still in progress. That means underbillings or overbillings can have an impact on your reported revenue.
Companies must be as accurate as possible so that adjustments can be made for jobs encountering unexpected difficulties and avoid overreporting revenue, which can hurt job profit if underlying issues are not addressed as soon as they are discovered. This requires companies to make a precise prediction of the future. Accounting can do that with numbers, but some of those numbers must come from the knowledge, vision, and experience of Project Managers (PM’s).
A question often asked is if Accounting can crunch the numbers, then why do they need information from PM’s. Realistically, everyone understands that plans and conditions change on the jobsite – it’s part of construction. Costs can go up; weather delays might demand more labor; conditions can damage inventory; disputed change orders influence the job long before they make it to Accounting.
The temptation is to simply keep managing the job to make everything work out in the end, but if the estimated cost-to-complete isn’t true-to-life, the percent complete won’t be accurate and neither will billing expectations. As a result, PM’s are critical for WIP reporting.
PM’s possess the knowledge, vision, and experience needed for your finance department to execute the most accurate WIP Analysis possible. PM’s are the experts in knowing the most accurate, real-time costs and what it will take to complete the job. Where a spreadsheet might “think” the job should be 70% complete, an experienced PM might look at the whole situation and know it’s closer to 50%. That’s an invaluable conversation for construction companies. By incorporating their expertise, companies can avoid discrepancies in billing expectations and cash flow shortfalls, and ensure the smooth operation of their projects.
Best Practices
The WIP report gives Operations and Accounting a common goal, so achieving it requires cooperation and understanding. There’s no one right process for completing good WIP reports, but many contractors make best practices work for them.
To start, you have to make sure that your systems are up-to-date, that the data is accurate, and that your approach is team-oriented including all of the stakeholders that are engaged in reviewing the job cost and the WIP schedules. Having a consistent schedule for WIP reporting is crucial.
Monthly reports are recommended, as they provide a comprehensive view of the company's financial standing without overwhelming the management team. Regular reporting intervals also help in identifying trends and addressing any issues that may arise in a timely manner.
Some common KPIs for construction companies include:
- Forecasted Cost at Completion (FCAC) or Estimate at Completion (EAC)
There is always an estimate of what it will cost to complete a project, and it requires stringent scrutiny for a logical and specific solution. A best practice is to include approved change orders in the final figures. This allows you to avoid situations where profits are overstated, and revenues are incorrectly calculated.
- Percentage of Completion (JTD Cost/FCAC (or EAC))
The purpose is to recognize revenue that is earned regardless of the amount billed based on JTD cost versus estimated total cost. This should always be confirmed by analyzing progress against the budget and ensure no costs are erroneously allocated to the incorrect project.
- Earned Revenue (Percentage of Completion * Contract Value)
When using this method, revenue is earned and should be recognized as the project is completed. As a note, according to ASC 605 under most circumstances, as soon as a project is forecasted to have a loss, the loss must be recognized in that period. Anterra’s WIP Management tool streamlines this process by automatically reducing the JTD costs by the loss amount, providing an accurate Earned Revenue amount.
- Over (+)/Under (-) Billings (JTD Billings – Earned Revenue)
Underbillings (an asset on the balance sheet) could represent poor billing practices, an inability to bill for work performed due to a milestone not reached, incurred cost on an unapproved change order deemed unbillable, or an overstatement of estimated gross profit on the project. Overbillings (a liability on the balance sheet) represents potential front-end loading of profit in earlier project stages based on the schedule of values, or deferred profit.
These KPIs can help identify problem areas and measure the overall success of the project. This internal analysis is vital for aiding decision-making and to ensure that the organization maintains a strong financial standing (such as with shareholders, banks, bonding companies, and auditors).
By using Anterra software, Accounting can save time and effort while generating accurate WIP reports. The software can also help identify trends, enable proactive course correction, and highlight areas of improvement in processes and procedures.
Anterra is designed to streamline the reporting process for construction companies, offering numerous benefits that optimize WIP reporting:
- Pre-built calculations: Anterra provides pre-built calculations, eliminating the need to create formulas from scratch. This saves time and reduces the risk of errors in your WIP reporting.
- Cloud-based storage: With Anterra, your WIP report lives in the cloud, ensuring version control and preventing the confusion of managing multiple spreadsheets. This improves collaboration between team members, granting easy access to the most up-to-date information.
- Seamless integration with ERP systems: Anterra directly populates data from your ERP system and your PM’s forecasts. This integration ensures accurate and real-time information, making your WIP reports more reliable and effective.
- Access to historical data: Anterra provides quick access to past month WIP reports, allowing you to analyze trends, compare previous reports, and identify any changes or issues that may require further investigation.
- Export to Excel: Anterra's ability to export WIP reports to Excel makes it easy for you to manipulate, analyze, share data, and create accounting entries. This flexibility ensures you can present your WIP reports in the most effective way possible, catering to various stakeholder preferences.
Common Mistakes
WIP reports are only reliable when used correctly. It's easy to simply compare the total cost spent to date with your estimated budget and assume that a project is running smoothly if your cost spent to date has not exceeded your budget. But, using multiple calculations, you can see a more accurate picture of a project of where the job stands, including if it's been over or underbilled.
Staying on top of your WIP report using multiple calculation methods is therefore crucial for accurately scoping projects. This allows you to act on problems early, such as chasing invoices for payments or re-evaluating budgets where costs are increasing.
Here are some other WIP pitfalls to avoid:
- Not tracking committed costs: Committed costs are those you are committed to paying. These need to be accurately tracked to ensure your project remains profitable and the WIP report is accurate.
Example: Imagine a construction company working on a project with a budget of $1 million. They have spent $600,000 so far, but they haven't tracked $200,000 in committed costs for materials and subcontractor services. By not accounting for these committed costs, their WIP report will show that they have spent only 60% of their budget, when, in reality, they have committed 80% of the budget. This discrepancy can lead to financial issues and an inaccurate assessment of the project's progress.
- Not being timely: An effective WIP schedule requires timely updates of costs and billing details – ideally, this should be done monthly at a minimum. If the updates are in real-time and based on actual costs, the WIP schedule is an insightful business tool for the contractors.
Example: A construction company is working on a six-month project with a budget of $500,000. They update their WIP report every three months instead of monthly. By the third month, they have spent $350,000 (70% of the budget) but only completed 50% of the work. If they had updated their WIP report monthly, they could have identified the budget overrun earlier and made adjustments to avoid further issues.
- Entering figures incorrectly: It's easy to miss an extra zero or enter a "4" rather than a "5." Incorrect figures caused by human error can greatly impact the WIP data and subsequent calculations.
Example: A construction project has a budget of $2 million, and the company has spent $1,000,000 to date. However, a data entry error results in the WIP report showing that they have spent only $100,000. This error could lead to overconfidence in the project's financial standing, causing potential budget overruns and project delays. By the time the error is discovered, the company may have already spent more than they planned, leading to a negative impact on their profit margin and the project's overall success.
- Using overbilling as profit: Overbilling is not profit; it's cash flow to be used for future scheduled work. If businesses use this for a profit, it may leave projects without funds to continue.
- Delayed tracking of expenses and costs: Tracking expenses and costs in real-time makes WIP more accurate. Otherwise, the budget may show a profit, but bills were left out of the calculation.