Working with a Houston construction accounting firm can help you solve key challenges. I will take a bet and say that if you are a construction company looking for CPA you are being challenged with at least one of the issues I will be discussing in this article. I won’t be covering all challenges that I know face construction businesses, but I will be covering the main areas of interest which include reporting profitability, managing profitability, and tax planning and management.
Let’s jump right in.
Challenge #1: Getting A Clear Picture of Profitability
Being profitable isn’t a new idea for a construction business. However, what is unique to construction are concepts like retainage, project duration which impacts payment schedules, and accounting methods for reporting construction profit. The result of all of this are construction owners seldom relying on their internal financial reporting and using “paper napkin” methods to determine how they are doing. Because of some of the issues I mentioned and the consequences to financial reporting, owners doubt their numbers and over time lean towards not relying on the results being reported in their accounting systems.
In the small business world of construction, I see the disconnect between internal bookkeepers and construction company owners all the time. In some cases, this creates a hostile environment as both the owner and bookkeeper run out of solutions and communication breaks down. The owner intuitively knows that the numbers are not right. However, the bookkeeper feels like they are right because they have input all invoices and bills. The disconnect is due to how the construction company is reporting profit (including retainage), albeit the cash method, accrual method, or accrual plus percentage of completion method.
The decision on which accounting method to use—cash basis, accrual basis, or the percentage of completion method (often used with a Work in Progress or WIP adjustment in the construction industry)—depends on the specific financial goals, the nature of the business, and regulatory requirements.
(Here, I’ve added a detailed breakdown of each method’s advantages and potential use cases, as you provided.)
Cash Basis:
Pros
– Uncomplicated: This method is intuitive, recording revenue and expenses only upon cash transactions.
– Clear Cash Position: It offers an unambiguous view of the actual cash available.
Ideal for:
– Smaller enterprises or contractors with immediate payment structures and short-term projects.
– Entities seeking a straightforward accounting approach without the constraints of the Generally Accepted Accounting Principles (GAAP).
Accrual Basis:
Pros:
– Holistic Financial Picture: By aligning revenues with related expenses, it paints a truer image of an organization’s financial health.
– GAAP Alignment: It’s in line with GAAP, catering to businesses that produce financial statements for external parties like investors.
Ideal for:
– Bigger enterprises or those with intricate operations.
– Firms that extend credit or undertake prolonged projects.
– Entities obligated to follow GAAP
Percentage of Completion Method (complemented by WIP adjustment):
Pros:
– Steady Revenue Recognition: This method acknowledges revenue in tandem with project progression, ensuring consistent earnings representation for extended projects.
– Tax Strategy: By recognizing revenue consistently throughout a project’s duration, it can be advantageous for tax planning.
Ideal for:
– Construction entities or businesses engaged in long-haul projects with reliably estimable outcomes.
– Firms aiming to align their revenue and expenses with the actual project milestones.
From a financial standpoint, both the accrual method and the percentage of completion approach offer a comprehensive view of a firm’s genuine financial status, especially for those in long-term projects. Conversely, the cash basis can occasionally distort a company’s profitability, either by showcasing profits despite looming bills or the opposite. In my experience, owner’s want to see the percentage of completion approach whereas bookkeeper use a cash basis or accrual basis method of accounting.
It’s also worth noting that regulatory and tax factors can sway this choice. For instance, some bonding companies will require the use of the percentage of completion method.
Construction Profit Fluctuations
Profit will fluctuate throughout the life of a long-term project based on the method of accounting used.
Over the course of the project:
Cash Basis will show fluctuations in profit based on when payments are received.
Accrual Basis will show profit fluctuations based on when billing occurs and costs are incurred.
Percentage of Completion Method will show a more steady profit, closely aligned with the actual progress of the project.
Scenario:
Houston Construction Company Inc. has taken on a project worth $1.2 million, expected to last 12 months. The estimated total cost of the project is $1 million, aiming for a 20% gross profit margin. The project is billed in uneven amounts, and payments are received sporadically. Work progresses steadily at about 8.33% per month (100% ÷ 12 months).
Here’s a simplified monthly breakdown:
| Month | Costs Incurred | Billed to Client | Payments Received |
|---|---|---|---|
| 1 | $80,000 | $100,000 | $50,000 |
| 2 | $80,000 | $120,000 | $100,000 |
| 3 | $80,000 | $100,000 | $70,000 |
| … | … | … | … |
| 12 | $80,000 | $100,000 | $100,000 |
Profit Reporting:
1. Cash Basis:
Under this method, profit is calculated based on cash received minus costs paid each month.
For Month 1:
- Revenue: $50,000
- Expenses: $80,000
- Profit (Loss): -$30,000
2. Accrual Basis:
Under this method, profit is calculated based on amounts billed and costs incurred.
For Month 1:
- Revenue: $100,000
- Expenses: $80,000
- Profit: $20,000
3. Percentage of Completion Method:
Using this method, revenue is recognized based on the percentage of the project completed.
For Month 1:
- Percentage of Project Completed: 8.33%
- Revenue Recognized: $99,960 (8.33% of $1.2 million)
- Expenses: $80,000
- Profit: $19,960
This example illustrates how the choice of accounting method can lead to different monthly profit portrayals. The actual numbers and patterns will vary based on the specifics of billing, payment schedules, and work progress.
Let’s take a closer look at the different month profit portrayal, by looking at a month by month recap of the same project with some hypothetical scenarios:
Scenario Recap:
BuildItRight Inc. has a 12-month project worth $1 million. The estimated total cost is $800,000.
For simplicity:
- Costs are incurred evenly at $66,667 per month ($800,000 ÷ 12).
- Billing is spread evenly over 12 months at $83,333 per month ($1,000,000 ÷ 12).
- Payments are spread unevenly over the first six months, with the balance spread over the remaining months.
1. Cash Basis:
| Month | Costs Incurred | Billed | Payments Received | Profit/Loss | Net Profit % |
|---|---|---|---|---|---|
| 1 | $66,667 | $83,333 | $50,000 | -$16,667 | -33.33% |
| 2 | $66,667 | $83,333 | $100,000 | $33,333 | 33.33% |
| 3 | $66,667 | $83,333 | $70,000 | $3,333 | 4.76% |
| 4 | $66,667 | $83,333 | $40,000 | -$26,667 | -66.67% |
| 5 | $66,667 | $83,333 | $20,000 | -$46,667 | -233.33% |
| 6 | $66,667 | $83,333 | $20,000 | -$46,667 | -233.33% |
| 7 | $66,667 | $83,333 | $58,333 | -$8,334 | -14.29% |
| 8 | $66,667 | $83,333 | $58,333 | -$8,334 | -14.29% |
| 9 | $66,667 | $83,333 | $58,333 | -$8,334 | -14.29% |
| 10 | $66,667 | $83,333 | $58,333 | -$8,334 | -14.29% |
| 11 | $66,667 | $83,333 | $58,333 | -$8,334 | -14.29% |
| 12 | $66,667 | $83,333 | $58,333 | -$8,334 | -14.29% |
| Subtotals | $800,000 | $1,000,000 | $600,000 | -$200,000 | – |
2. Accrual Basis with Uneven Billings:
For this scenario, let’s assume the billings are front-loaded, with higher amounts in the earlier months and tapering off towards the end.
| Month | Costs Incurred | Billed | Earned Revenue | Profit/Loss | Net Profit % |
|---|---|---|---|---|---|
| 1 | $66,667 | $100,000 | $83,333 | $33,333 | 33.33% |
| 2 | $66,667 | $95,000 | $83,333 | $28,333 | 29.82% |
| 3 | $66,667 | $90,000 | $83,333 | $23,333 | 25.93% |
| 4 | $66,667 | $85,000 | $83,333 | $18,333 | 21.57% |
| 5 | $66,667 | $80,000 | $83,333 | $13,333 | 16.67% |
| 6 | $66,667 | $75,000 | $83,333 | $8,333 | 11.11% |
| 7 | $66,667 | $70,000 | $83,333 | $3,333 | 4.76% |
| 8 | $66,667 | $65,000 | $83,333 | -$1,667 | -2.56% |
| 9 | $66,667 | $60,000 | $83,333 | -$6,667 | -11.11% |
| 10 | $66,667 | $55,000 | $83,333 | -$11,667 | -21.21% |
| 11 | $66,667 | $50,000 | $83,333 | -$16,667 | -33.33% |
| 12 | $66,667 | $45,000 | $83,333 | -$21,667 | -48.15% |
| Subtotals | $800,000 | $870,000 | $1,000,000 | $70,000 | – |
3. Percentage of Completion Method:
| Month | Costs Incurred | Billed | Earned Revenue | Profit/Loss | Net Profit % |
|---|---|---|---|---|---|
| 1 | $66,667 | $83,333 | $83,333 | $16,666 | 20% |
| 2 | $66,667 | $83,333 | $166,666 | $33,333 | 20% |
| 3 | $66,667 | $83,333 | $250,000 | $50,000 | 20% |
| 4 | $66,667 | $83,333 | $333,333 | $66,666 | 20% |
| 5 | $66,667 | $83,333 | $416,666 | $83,333 | 20% |
| 6 | $66,667 | $83,333 | $500,000 | $100,000 | 20% |
| 7 | $66,667 | $83,333 | $583,333 | $116,666 | 20% |
| 8 | $66,667 | $83,333 | $666,666 | $133,333 | 20% |
| 9 | $66,667 | $83,333 | $750,000 | $150,000 | 20% |
| 10 | $66,667 | $83,333 | $833,333 | $166,666 | 20% |
| 11 | $66,667 | $83,333 | $916,666 | $183,333 | 20% |
| 12 | $66,667 | $83,333 | $1,000,000 | $200,000 | 20% |
| Subtotals | $800,000 | $1,000,000 | $1,000,000 | $200,000 | – |
Overview of the Construction Industry’s Unique Challenges in Reporting Profit
As you can see, getting a clear picture of a construction’s company profitability is more challenging than other industries. Not knowing how profitable you are leads to poor decisions that can result in financial problems for a construction company. In my experience, an accrual method with use of a percentage completion adjustment is ideal for any construction company that takes on jobs that last longer than 30 days.
Challenge #2: Managing Project Profitability
Another issue construction companies have is managing project profitability. The best way to depict the challenges and proposed solution for this situation is to go through another scenario. In this scenario, let’s assume my client has asked me to calculate how much they need to mark their projects up to hit a target net profit percentage of 18% for the year. Here are the additional relevant parameters:
| Parameter | Amount |
|---|---|
| Projected Revenue | $15,000,000 |
| Projected Gross Profit % | 18% |
| Projected Variable Cost | $12,300,000 |
| Projected Gross Profit | $2,700,000 |
| Additional Mark-Up | $- |
| Projected Fixed Cost | $1,440,000 |
| Project Net Profit | $1,260,000 |
| Target Net Profit $ | $2,700,000 |
| Profit Delta | $1,440,000 |
| Target Net Profit % | 18% |
| Projected Net Profit % | 8% |
Our aspirations are set high, with a target net profit margin of 18%. However, the current trajectory suggests a projected net profit margin of just 8% (18%-8%). This 10% gap is a stark reminder of the profitability challenges we face. To bridge this gap and achieve our desired margin, a mark-up of 27.60% is essential, especially if our sales projections is at $15,000,000.
It’s important to note that as projected annual revenue increases, then fixed cost is absorbed by additional jobs, and the mark-up percentage decreases consequently. This is because fixed costs, as the name suggests, remain constant regardless of the number of projects or the scale of operations. These can include expenses like rent, salaries of permanent staff, and equipment leases. When the revenue increases (due to more projects or larger projects), these fixed costs are spread out or “absorbed” over a larger revenue base. In simpler terms, the same fixed cost is distributed across more jobs, reducing the per-job impact of these costs.
Furthermore, mark-up is the percentage added to the cost of a job to determine its selling price, ensuring that all costs are covered and a profit is made. If fixed costs per job decrease (because they’re spread out over more jobs), then the amount you need to mark up (to cover costs and ensure profit) can be reduced. This is because a significant portion of the costs (the fixed costs) is now reduced on a per-job basis, allowing for a lower mark-up while still achieving the desired profit margins.
In essence, as the business scales and takes on more projects, increasing its annual revenue, it can benefit from economies of scale. The fixed costs get distributed over a larger set of projects, allowing the company to potentially offer more competitive pricing (due to a reduced mark-up) while still maintaining or even increasing profitability.
In my experience, construction companies tend to overlook the fixed cost absorption aspect and believe a target net profit margin can be hit by marking up the project based on variable cost alone. However, as you can see from this example… it’s unfortunately not that simple. Specifically, to calculate what your target mark-up is for a project, you need to know how much fixed costs that project will absorb which depends on projected sales.
Challenge #3: Tax Planning and Management
Tax planning for construction companies is challenging due to volatility of the industry and it’s profitability. A great year can turn bad quickly, and things can also turnaround quickly with a great job. This makes projecting taxes difficult for a construction company. Cash is king and the more so for a construction company as you are constantly dealing with macro risks as well as micro risks with respect to subcontractors and other parties involved in a project. In addition to the challenge of managing cash in light of tax obligations, determining what profit to estimate taxes on is also challenging in light of the different options discussed here in this post.
Generally, in the small business world, I advise clients to hold on to cash and to use tax planning and projections throughout the year as a thinking excercise. In situations, where confidence and certainty is high (if that even exists in the construction world) we may opt to go ahead and pay something in.
Given the unique challenges construction companies face, it’s essential to adopt tax strategies tailored to the industry’s nuances. Here are some considerations and approaches:
Leverage Tax Credits and Deductions: Construction companies often qualify for various tax credits and deductions, such as those related to energy-efficient construction practices or hiring from certain groups.
Utilize Tax-Advantaged Accounts: Consider using tax-advantaged accounts, like a Simplified Employee Pension (SEP) IRA or a 401(k), to defer taxes and benefit from potential tax deductions.
Stagger Income: If possible, stagger the recognition of income to avoid pushing the company into a higher tax bracket in a particularly good year. This can be achieved by timing the billing and collection processes.
Consider Different Entity Structures: Depending on the size and nature of the construction business, it might be beneficial to operate as an S Corporation, Limited Liability Company (LLC), or a Partnership. Each has its tax implications and benefits.
Tax planning for construction companies, while challenging, is not insurmountable. With a strategic approach, informed decisions, and regular consultations with tax professionals, construction businesses can navigate the complex tax landscape efficiently. The goal is not just compliance but also ensuring that the company retains as much of its hard-earned money as possible.
Conclusion:
The construction industry, with its unique financial landscape, demands a specialized approach to accounting, profitability management, and tax planning. Partnering with experts, like a specialized construction accounting firm such as JAG CPA & Co, can provide the insights and expertise needed to make informed decisions. As the industry continues to evolve, staying informed, proactive, and strategic will be the keys to sustained success.
Understanding the nuances of project profitability, especially in terms of fixed and variable costs, is crucial. As demonstrated, the absorption of fixed costs over a larger revenue base can lead to significant benefits in terms of pricing and profitability. This insight alone can be a game-changer for many construction businesses, allowing them to bid more competitively while safeguarding their profit margins.
Tax planning, another critical area, requires a proactive and informed approach. The volatile nature of the construction industry means that tax obligations can fluctuate dramatically. By leveraging available tax credits, deductions, and adopting strategic tax planning measures, construction companies can optimize their tax positions.
In essence, the challenges faced by construction companies in terms of accounting, profitability, and tax management are surmountable. With the right guidance, tools, and strategies, construction businesses can not only navigate these challenges but also thrive in the face of them. Partnering with experts, like a specialized construction accounting firm, can provide the insights and expertise needed to make informed decisions. As the industry continues to evolve, staying informed, proactive, and strategic will be the keys to sustained success.
Facing Construction Accounting Challenges? Let’s Solve Them Together!
Navigating the complexities of construction accounting can be daunting, but you don’t have to do it alone. At JAG CPA & Co, we specialize in addressing the unique financial challenges of the construction industry. Schedule a consultation with us today and let’s pave the way to your financial success.
About The Author
Joe is a Certified Public Accountant (C.P.A.) and a Certified Valuation Analyst (C.V.A.). Joe’s professional career in public accounting began in 2012 with one of the “Big 4” international accounting firms. Since 2012, the focus of his professional engagements has been primarily in the area of business tax planning, cash flow planning and management, business valuations, and small business financial consulting.
