In the March 2010 article on Measuring Profitability I reviewed the importance of a business taking steps to ensure that profit is properly measured in each month and year and discussed some of the challenges that small businesses face in doing that with some suggested solutions. One of the larger challenges that I did not discuss is for a business that has large contracts or jobs that span a month-end. Typical businesses that encounter this situation are contractors in the construction industry, professional service firms and many other businesses where costs are incurred and invoices generated in different accounting periods.
A client that comes to mind is a contractor whose business includes small and medium sized jobs and regular large jobs that often take several months to complete. As a result the revenue on these jobs was often booked based on when they were entitled to invoice the customer and the costs incurred were often in different time periods. As the jobs were large enough to bridge one or more month ends and even year ends, the allocation of revenue and costs to periods became fundamental to the ability to know how much profit or loss was earned in a period. Although this client recognized the challenge, they were previously unable to set up processes that enabled them to consistently and confidently report their profits.
This is a more complex situation than many of those we discussed in the article on Measuring Profitability and requires a more diligent and capable Controller to deal with the measurement issues. This is true in both fixed price contracts and also variable price arrangements.
The first issue is revenue recognition and the most common basis used is the percentage of completion method, although there are other acceptable methods such as the completed contract method. In the percentage of completion method it is up to the contactor to estimate based on the facts determined on a rational and consistent basis the value of sales (for accounting purposes) on a job to date. Note that it is not necessarily correct to assume that the amount that is eligible for invoicing to the customer is the sales value. Often the amount eligible for invoicing is not based on the work performed e.g. where there is a deposit or advance and also consultants often certify a percentage of completion that is known by the contractor to not necessarily be a true reflection of the work and materials delivered. Also, the amount invoiced may have been determined at a date that is not the month-end date and so may need adjustment.
As you can see the amount of sales on a job will often entail an adjustment from the amount invoiced and can be quite subjective. As a result, the rationale used to determine the amount should be carefully documented. The documentation of a typical construction type job would require the assessment of completion, broken down into the major components of the job. This often requires the consideration of labour and materials separately, as it is very common for these elements to not be in sync as to percentage of completion and also to often be sold at very different gross margins.
Any difference to the amount invoiced to the customer for the job should be transferred from revenue to deferred revenue or accrued as additional sales, as the situation requires.
The second challenge is to try to estimate the actual costs that have been incurred to earn that revenue. Most businesses that do this kind of work accumulate their costs in work in progress (WIP) and often use a software package to track the details of the costs incurred. If you are not doing this and merely accounting for the costs in the period in which they are invoiced by the supplier and treating labour as an expense in the payroll period, then you should implement a system that keeps costs in WIP but this is not essential as similar adjustments can be made to cost of sales once the WIP value has been established.
The release of costs from WIP into cost of sales is done based on the percentage of completion and should normally be split into at least the labour and materials costs. It is usually essential that you keep good records of the basis on which the price of the job to charge the client was determined as it is not uncommon for there to be very different profit margins in different elements of a job.
A common situation for a construction contract is for the materials to be priced to the customer at a different profit margin to the labour. A common misunderstanding is between the charge out rate and the cost of labour. Many businesses have a charge out rate that already includes a profit margin and when they price a job, to determine the selling price, they then sometimes add or subtract an adjustment to the profit inherent in the charge out rate. It is important to recognize in that situation that WIP is maintained at charge out rate and not at cost and not necessarily at selling price.
An example may best illustrate this. If a professional services firm has a charge out rates of 200% of cost on average (giving rise to a gross margin of 50% if there are no price adjustments) and, when estimating the costs for a fixed price job, it estimates that the total labour will be $200,000 at charge out rates but that they are going to quote the job at a selling price of $180,000. The gross margin in this case is 44.44% (((180,000 – (200,000 / 200%))/180,000). This is often made more complicated when adjustments to the price for the job are priced at different rates; as may happen in this example if a change order is priced at the standard charge out rate, as this will change the average gross margin inherent in the job as a whole.
To effectively account for costs at any period end one must relieve WIP with the proportion of costs that is the same as the percentage of completion that was used for determining revenue in each category and charge this to cost of sales.
As large jobs often do not go precisely as planned, it is also important to make an assessment at each period-end of any events that would increase the costs to be incurred on a job, compared to the total estimated when the job was priced, and to set up reserves or provide for a loss for known quantifiable events.
There is one more element that is critical to success with a program such as this and that is implement reporting formats for different levels of management and owners that provides details or summarizes, as is appropriate, the status of each job that is in the system. This can be quite complex as it is common for the same business to have (a) fixed price jobs that do not span any period ends (so revenue and expenses need not be subject to the same scrutiny as all the revenue and expenses will be accounted for in the same period), (b) fixed price jobs that do span period ends, (c) variable price jobs that do not span any period ends (so revenue and expenses need not be subject to the same scrutiny as all the revenue and expenses will be accounted for in the same period), and (d) variable price jobs that do span period ends. Reporting the results of each of these separately should be meaningful.
Establishing a process that evaluates all the factors mentioned above and accounts for the various elements of the revenue and costs of a job in the appropriate accounting period that matches those revenues with the costs incurred will result in more credible financial results that management , owners and other stake holders can have confidence in.
About the Author James Phillipson is a Chartered Accountant and a Principal of Mastermind Solutions Inc. with over twenty years experience in large and small businesses. He has provided financial counselling to his clients since 1996, often in the role of a Controller or Chief Financial Officer. James has experience in financial roles in a wide variety of businesses and industries.
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