Running a construction business efficiently requires more than just the ability to build, manage projects, and satisfy clients. A solid understanding of construction accounting is crucial for making informed financial decisions, ensuring profitability, and maintaining financial stability. This article aims to provide construction business owners with essential key terms and concepts in construction accounting to help them effectively manage their company’s finances.
1. Revenue and Revenue Recognition:
In construction accounting, revenue recognition refers to when and how revenue is recorded. Generally, revenue is recognized when it’s earned and realizable, which is typically when work is complete or when contractual milestones are met. However, construction projects often span over long periods, leading to the recognition of revenue based on the percentage of completion method or completed contract method.
2. Work in Progress (WIP) Reporting:
Work in Progress represents the value of incomplete construction projects at a specific period. The WIP report is critical to track costs, revenue, and profit for ongoing projects. Calculating the WIP entries requires considering the costs incurred, percentage of completion, and revenue recognized to determine the project’s estimated profitability. The WIP journal entries convert the company’s books to percent-complete accounting.
3. Overhead Costs:
Overhead costs encompass various expenses that are not directly tied to a specific project or task. Examples include rent, utilities, insurance, office supplies, and salaries of non-project-specific employees. Understanding and accurately allocating overhead costs is essential for determining the true markup needed for project and establishing profitable pricing structures.
4. Financial Ratios:
Financial ratios provide insights into a construction company’s financial health and performance. Some key ratios to consider include:
a. Profitability ratios: such as gross profit margin, net profit margin, and return on assets (ROA). These ratios help assess the overall profitability of the business.
b. Liquidity ratios: such as current ratio and quick ratio. These ratios evaluate a company’s ability to meet short-term obligations and its overall financial stability.
c. Efficiency ratios: such as accounts receivable turnover and inventory turnover. These ratios measure how efficiently a construction company utilizes its assets to generate revenue.
5. Job Costing:
Job costing is a method used to track and allocate costs to individual construction projects. It involves tracking direct costs (labor, materials, subcontractors) associated with a specific project. Effective job costing helps evaluate project profitability, determine potential budget deviations, and identify areas for cost optimization. Job costing should align with the estimate so that job profitability can be assessed.
Conclusion:
Understanding key terms and concepts in construction accounting is vital for construction business owners to make informed financial decisions and ensure profitability. By recognizing revenue and costs accurately, managing work in progress and analyzing financial ratios, construction companies can strengthen their financial management processes and achieve sustainable growth. Embracing these concepts and seeking professional expertise and support can lead to improved financial health and long-term success in the construction industry.
We cover key ratios in our Financial Metric Mastery class which can be purchased as part of the All Access library or stand-alone.