How often has this happened to you: After what looks like a
really good month, you go out and buy an expensive piece of
equipment, like a truck. Then the following month is a really
bad one, and you wish you hadn't.
If this situation sounds familiar, it could be that what your
financial statements are telling you isn't exactly true. This
is a common occurrence for contractors who use the cash
accounting method. Switching to accrual (see "Accrual vs. Cash
Accounting: Why Bother?," Business, 10/04) will make your
financial statement more accurate by forcing costs to show up
on the books closer to when they are actually incurred. But
there's still a chance the profit-and-loss (P&L) statement
will be skewed, because of the way income is timed.
Timing of Costs vs. Income
With the accrual method, costs are entered on a regular basis.
Bills from vendors come in daily and payroll checks go out
weekly. So if you were to chart the cumulative costs on a job,
they would increase steadily until the end of the
However, your client billings are probably not that consistent.
Costs increase daily but the client is billed at set times
— weekly, biweekly, or often only once a month. As a
result, the profit on your income statement might look bad the
day before you invoice the client, but good the day after you
create the invoice.
The table "Costs and Income: Accrual vs. WIP Adjustment"
(below) presents the costs and income from a theoretical
construction job. The graph "Billing vs. Cost Over Time" (page
2) is based on the same job and illustrates the relationship
between billing and the costs incurred. The red line represents
cumu-lative costs, which go up steadily over time because the
contractor is using the accrual method of accounting. The blue
line represents cumulative billings; this line jumps up
intermittently, whenever the contractor bills the client. If
you invoice the client every other week, the billing line
changes every two weeks. The amount of gross profit can be
calculated at any point in time, but it will not be accurate
until the very end of the job. This is a problem, because if
you want to manage your business for profitability, you need to
be able to gauge how much profit you are really making at any
point in time.
Billing profit (strict accrual)
Earnings profit (adjusted for WIP)
(Overbilling) or underbilling
This data is from a theoretical
construction job with a total contract cost of $44,800. Note,
in Week 1, that based on the percent-complete calculation, the
builder has grossed $8,064. Although "underbilled," meaning the
builder doesn't have the money yet, the amount shows as a
positive number in the WIP adjustment. The information in the
top half of the chart comes straight out of the company's
books, which are kept with the accrual method. The bottom
section contains information calculated as part of the WIP
The blue line represents cumulative
billing and goes up only when an invoice is generated. The red
line represents cumulative costs for the job, which go up
steadily because the books are kept in accrual. The vertical
distance between the lines represents the amount of profit
(unadjusted) that exists at any point in time.
If you want your financial statement to accurately reflect the
amount of profit that is being earned, you have to perform a
"work in progress" (WIP) adjustment. This doesn't take long and
should happen at the end of every month, when you do a P&L
statement. The WIP adjustment increases the accuracy of the
statement by adjusting income up or down based on whether you
are ahead or behind with the billing.
underbilling. The WIP adjustment is similar to
percentage-completion billing. It's based on the idea that if
you've performed 50 percent of the work, then you've earned 50
percent of the income, even if you haven't billed the client
for that exact portion of the job. You are overbilled
if you have invoiced the client for more work than is actually
complete and underbilled if you have invoiced for
The WIP adjustment is a way to calculate how much you have
overbilled or underbilled on the job. Knowing this, you can
accurately calculate the amount of gross profit or loss that
exists at that point in time. There's no need to wait until the
end of a project to find out how well or how poorly you did.
Waiting might not be a problem if your jobs are only a few
weeks long, but it's a different story if you have multiple
projects that take months to complete and do not all end on the
same date. You may already have a general sense of where you
are with the billing, but the WIP adjustment is easy if you
keep your books on accrual (see "WIP Adjustment Formula,"
below). So why not put an actual number to it?
WIP Adjustment Formula
The formula to make a WIP adjustment is as follows:
% complete = costs incurred
total expected costs
% complete x contract price = earnings
earnings - client billings = overbillings or
Calculating the Adjustment
Here's an example of how the calculation would be performed,
based on the information in the "Cost and Income" chart on page
1. The job is four weeks old and you have spent $16,800 out of
a total expected cost of $28,000. This means the job is 60
percent ($16,800 / $28,000) complete.
Your contract with the client is for $44,800, so you have
earned $26,880 (.6 x $44,800).
Your cumulative billing for the job is $31,000, which means you
are $4,120 ($26,880 - $31,000) overbilled. If you did a P&L
statement for this job without making a WIP adjustment, it
would overstate your earnings by $4,120.
Percentage completion. It's
difficult to determine exactly what percent of the work is
complete, but you will have to do it if you want to make a WIP
The simplest way to determine percentage completion is to add
up all the costs incurred for the job and divide them by the
total current budget, including change orders. Admittedly, this
is an arbitrary way to ascertain the percentage of work
complete, but it's quick and it's the only method that can be
done just by looking at the books. It is important to
understand that this method works only if the estimate is
accurate and the budget is up to date. If the estimate is
seriously low, you could spend half of the budget and be
nowhere near to halfway done.
An alternative method is to look at what has been done on the
job and make an educated guess. If you think you have finished
40 percent of the work, call the job 40 percent complete. To be
on the safe side, you may want to guess low and call it 35
percent complete. You could guess for the entire job or break
it down and estimate what portion of the foundation, frame, and
other parts is complete. By prorating these numbers against the
budget, you could get a single number for the entire job. This
is more time-consuming than calculating from the books, but may
provide a better representation of the amount of work that is
The blue line represents the amount of
profit the P&L will show at any point in time based on the
idea that the contractor has earned only what he has billed.
The red line shows the amount of profit that has actually been
earned based on percentage completion. When the blue line is
above the red, the client has been overbilled.
Earnings. At the end of the
job, the amount you have billed the client will be the same as
the amount you have earned. But while the job is under way, the
amount that's been billed may bear little relationship to the
amount you have actually earned.
Actual earnings are calculated by multiplying percentage
completion by the total contract price (including change
orders). The resulting number will represent the total amount
of income you've earned on the job. For example, if you've
incurred 40 percent of the total expected costs, then you can
say you've earned 40 percent of the total contract. This may be
somewhat arbitrary, but it's the best you can do without
waiting till the job is done.
Adjustments for underbillings and
overbillings. Billing the client is a way to generate
cash flow and is unrelated to earnings. If you get ahead on the
billing, you will have more of the client's cash than you have
earned to date. If this happens, you will have a liability
called "overbillings." In most states, it's legal to be ahead
on customer payments. But if you were to walk off the job, you
would owe the customer the amount that was overbilled. It can
also go the other way: If you have underbilled the client, you
have created an asset called "underbillings."
If the client were to be overbilled by $5,000, you would adjust
the income down by the same amount on your P&L statement.
If the client was underbilled, you would adjust the income
Overbilling is of special concern because it can result in
showing too much income. Unless you are aware that this is
happening, you may be tempted to spend money you haven't
actually earned. Or you might think you are doing great on the
project and price the next job the same way.
The difference between billings and earnings over time is
illustrated by the chart "Cumulative Profit" (above). In the
first week of our theoretical job, you've incurred costs of
$5,040. If you haven't created an invoice, your income will be
zero. Does that mean you're $5,040 in the hole? Not really,
because if you do a WIP adjustment you will show $8,064 of
Here's how it would work. The costs to date are $5,040. If you
divide that number by the expected total cost of the project
(budgeted cost), you will get .18 ($5,040 / $28,000 = .18).
This means you have completed 18 percent of the work and earned
18 percent of the contract. Since the contract price is
$44,800, you can show income of $8,064 (.18 x $44,800). If you
subtract the expenses, you will show a gross profit of $3,024
($8,064 - $5,040).
Why Adjust the P&L?
You may be asking yourself why it's important to know any of
this. Here's the reason: Your financial statement is a tool for
managing your business. You wouldn't plumb a wall with an
improperly calibrated level, so why would you assess your
profitability with an unadjusted P&L statement?
If your company is really small, you might be able to keep
track of this in your head. But if you have three or four large
jobs going at the same time, you will not be able to determine
the collective profitability of those jobs without performing a
WIP adjustment. It would be different if all the jobs ended at
the same time, but if every project is at a different stage,
you will need to calculate how much you have overbilled or
underbilled on each one and adjust the P&L statement
There are many variables in construction, but the accuracy of
your financial statements should not be in doubt. By doing
regular WIP adjustments, you can be sure that if your profit
varies, it's not just a timing mistake. This allows you to make
decisions based on your accounting numbers, not just your gut
Leslie Shiner, M.B.A.,has more than 20 years of experience
working as a financial and management consultant for the
construction industry. She can be reached by e-mail at