A riptide is a strong current that can pull swimmers away from shore and into deeper waters, causing panic, disorientation, and even death. Similarly, an overbilling adjustment can come as a surprise to small construction companies, causing financial panic and disorientation. These adjustments necessary in the percent of completion accounting method can pose a significant challenge for small construction companies. Unlike larger enterprises with robust accounting systems, small businesses often lack specialized modules to address this complex accounting method. Moreover, the financial personnel in these smaller companies usually do not possess the expertise needed to accurately perform work-in-progress (WIP) calculations and accounting adjustments essential for correctly matching revenue with the cost of goods sold (COGS) incurred in construction projects.
WIP, short for work-in-progress, is a common term in the construction industry, describing the outcome of the calculation used in percent of completion accounting. Each construction project must be individually analyzed, and the resulting calculation can lead to one of two scenarios: either an overbilling or an underbilling on the project. It’s important to note that WIP calculations are only performed on active projects. A project becomes active when it is awarded to the contractor by the project owner, making it the ideal time to add the project to the WIP tracking system. A project is considered completed when the project owner grants final completion, and all receivables have been collected for the project.
To accurately perform WIP calculations, you need four core data points for each project:
- **Estimated Project Cost:** The expected cost of completing the project.
- **Actual Project Cost to Date:** The total cost incurred up to the current date.
- **Project Contract Price:** The agreed-upon price for the project.
- **Amount Billed to Project Owner to Date:** The total amount billed to the project owner up to the current date.
With these four data points, you can calculate the WIP for your project at any given time. The following calculations are involved in the WIP process:
- **(Actual Project Cost to Date) / (Estimated Project Cost) = Percent Project is Completed:** This calculates the percentage of the project that has been completed based on actual costs incurred relative to the estimated total cost.
- **(Percent Project is Completed) x (Project Contract Price) = Revenue Earned to Date:** This calculates the revenue that should have been recognized based on the percentage of completion and the contract price.
- **(Revenue Earned to Date) – (Amount Billed to Project Owner to Date) = Revenue Adjustment (i.e., WIP Adjustment):** This step involves determining whether there is an overbilling or an underbilling on the project.
Now, let’s explore examples of both an underbilling and an overbilling adjustment:
Suppose a construction project was estimated to cost $100,000 and, to date, the actual cost incurred is $80,000. The project contract price is $120,000, and the amount billed to the project owner is $70,000. Using the calculations above:
- Percent Project is Completed = ($80,000 / $100,000) = 80%
- Revenue Earned to Date = (80% x $120,000) = $96,000
- Revenue Adjustment (WIP Adjustment) = ($96,000 – $70,000) = $26,000
In this case, there is a positive revenue adjustment of $26,000, indicating an underbilling. This means that the project has earned $26,000 more than what has been billed to the project owner, and additional billing may be required to align the accounts correctly.
In another scenario, a different construction project had an estimated cost of $150,000, with actual costs incurred to date being $170,000. The project contract price is $120,000, and the amount billed to the project owner is $140,000. Using the calculations:
- Percent Project is Completed = ($170,000 / $150,000) = 113.33%
- Revenue Earned to Date = (113.33% x $120,000) = $136,000
- Revenue Adjustment (WIP Adjustment) = ($136,000 – $140,000) = -$4,000
Here, a negative revenue adjustment of -$4,000 indicates an overbilling. The project owner has been billed $4,000 more than the revenue that has been earned, and a credit or refund may be necessary to rectify this overbilling.
Fortunately, the process of calculating WIP can be straightforward and doesn’t require complex algorithms or calculus. Even small construction companies can benefit from the WIP process with minimal investment using common tools like Microsoft Excel or Google Sheets. Properly managing overbilling and underbilling adjustments is crucial for maintaining accurate financial records and ensuring fair financial practices in the construction industry.