Creativity can be a great thing, but most would agree that your financial statements are not the time or
place to “get creative” especially related to job costs and profit fade.
Most contractors are aware that recognition of revenues is not driven by billings, but instead revenues are recognized based on the following formula:
(cost incurred / total estimated cost) X (contract amount) = revenues recognized
This calculation is known as the percentage-of-completion method, whereby revenues are recognized based on the contractor’s estimate of total job
cost with the difference in billings and revenues recognized on the balance sheet as either a current asset or current liability.
Some construction contractors may be inclined to lower their total cost estimate on a job below what they actually expect it to be in order to recognize more revenues in the current year. However, this lower estimate can cause numerous problems. Jobs open longer than a year will show a decline in gross profit percentages from one year to the next, known in the construction industry as a profit fade. Profit fades can have a negative impact for a number of reasons including the three listed below.
- Underestimating costs during the year of the job’s inception may increase revenues for that year, but it creates problems in subsequent years when there is less revenue to recognize and more cost. By underestimating job cost in the first year, a contractor will have fewer revenues and may have to “clawback” excess profits recognized in the previous year.
- Bonding agents can lose faith in a company’s estimates and become skeptical of the company’s financial statements due to profit fades. Poor job management or cost estimates can lead to a contractor having a large gross profit margin in the first year, followed by shrinking profit margins in subsequent years.
- Profit fades create more work for your CPA and thereby increase accounting fees.
Resourceful Solutions with CRI’s Construction CPAs
First, employ estimators that are credible and proficient. These estimates give contractors a good idea of the best price to bid a job and limit the risk of taking on a bad job. Conservative job cost estimates are best. It is better to be in the final year of a job and have excess gross profits to recognize, instead of recognizing it on the front end and having the job look unprofitable toward completion. This conservatism also signifies to the surety or accountant that good job costing practices are in place and will increase their faith in the validity of the financial statements.
Finally, ensure that job cost and accounting systems track each job in the same way it was estimated so that accurate feedback of the estimators and processes are working properly, and if not, immediate steps can be taken to keep those jobs on track. And, if you’re ready to stand out from the crowd, then call CRI’s construction CPAs for assistance.