Financial reporting in the construction industry is often only as good as your last estimate. From the initial bid to ongoing measurement of costs and to the final pricing of change orders, estimates impact every aspect of a construction project.
Therefore, it’s critical for construction companies to handle all estimation issues properly to increase company profitability and provide management with quicker, more accurate estimates, says Michael S. Essenmacher, CPA, Director, Accounting and Assurance at Barnes Wendling CPAs.
Smart Business spoke with Essenmacher about the three things you can do to ensure more accurate financial reporting on construction project estimates.
1. Avoid burden rate estimation errors
One of the most common errors in contract estimates is incorrect overhead or burden rates. Most construction contractors are very efficient at allocating direct costs such as labor, materials and subcontract costs. However, one of the difficulties when maintaining an accurate burden rate is understanding what costs need to be included.
Burden rates are used to measure indirect contract costs such as payroll taxes, depreciation, insurance and repairs proportionately across contracts in progress. Maintaining an effective burden rate involves constantly monitoring and understanding the composition of indirect costs.
For example, construction companies must understand how changes in workers’ compensation expenses and unemployment taxes affect the payroll tax component of the burden rate. Workplace injuries, layoffs and hiring additional employees can all impact this figure.
Another example of changing indirect costs is equipment usage rates associated with depreciation from new fixed assets or significant repairs to older fixed assets. Construction contractors often assume their burden rate is consistent from year to year; ignoring indirect cost changes that can affect it.
Burden rates should be evaluated annually to maintain their accuracy. Doing so will lead to more informed cost structures on contract bids and improved accuracy of contract costs and estimated costs to finish contracts in progress.
2. Utilize work in progress reports to track financial performance
The next step is to utilize this gathered data within work in progress (WIP) reports to accurately track financial performance. Management should evaluate WIP reports on an ongoing basis to better understand the reasons for variances.
By evaluating WIP within a reasonable timeframe (monthly), information is more readily available from project managers and employees handling change orders.
The timely analysis of WIP reports will provide better estimates of the cost to complete the project and improved comparisons across multiple periods and against completed contracts.
When analyzed with different criteria, these comparisons can indicate contract inefficiencies among project managers, business lines or offices within the company. Accurate WIP reports enable management to increase cash flow within the company through improved billing of customers.
3. Timely billing improves contractor relationships
Timely billing enhances the relationship between contractors and contract managers. When both parties are in agreement regarding the performance of contract work, pay applications are approved and are more likely to be paid quickly by customers.
A quick turnaround of billing will help increase accounts receivable turnover and cash flow, reducing the necessity to rely on lines of credit. A positive cash flow strengthens working capital within construction contractors, and strong working capital and cash flow lead to elevated bonding capacity and the ability to sustain larger contract backlogs. All of these aspects improve the company’s overall financial health and increase its stability.
Developing and maintaining burden rates, minimizing overhead costs, effectively managing contracts and improving estimates within WIP reports allow for additional revenue opportunities from more contracts.
These steps also improve the efficiency and cost management of construction contracts through accurate estimates. ●
Insights Accounting & Consulting is brought to you by Barnes Wendling CPAs