Contractors face many unforeseen issues that are often difficult to anticipate. Unexpected supply costs, changed orders, and unpaid accounts payable (AP) are all common causes of over- and under-billings.
Overbillings are listed on your balance sheet as an asset since the amount billed exceeds the cost incurred. However, overbilling decreases your current year-to-date profit.
Unapproved Change Orders
When construction contractors incur costs on jobs that need to be accounted for, it’s an unapproved change order. Whether or not this results from lax billing practices, cost overruns, management inefficiencies, or an unhealthy number of pending changes, the resulting over and under-billings can create financial reporting issues and raise red flags for lenders and sureties.
Contractors must choose accounting policies and procedures that reflect the underlying circumstances of each change order. Approved change orders that include scope and price may be recognized as contract revenue, adjusting incurred costs and total estimated costs and increasing the company’s gross profits.
However, a company’s estimate of contract profit should only be recognized for unpriced change orders if it is probable that the company will recover these costs. For these unpriced change orders, identifying the costs incurred as a contract asset will cause the company’s estimate of gross profit to decline.
Although carried as an asset on a balance sheet, a net job borrow figure can signify billing department problems, profit erosion not yet recognized, or unapproved change orders. It can also lead to cash flow problems, forcing contractors to finance projects rather than earn them.
Contractors can avoid job borrowing by regularly producing an over/under billing report and a work-in-progress (WIP) schedule. Access to this information allows companies to identify potential issues quickly, such as a high level of over-billing or a backlog of projects that still need to be fully billed.
A problem occurs if a company is overbilling so much that the year-to-date billings exceed the total estimated cash costs incurred and remaining contract balances to be collected. If the contractor robs Peter to pay Paul, it will need more funds left over to complete its remaining jobs and could be denied bonding capacity by a reputable surety.
Contractors aren’t perfect, so it’s not uncommon for their progress billing to be behind schedule. However, systemic underbilling from sluggish processes can create a cash flow issue. From a cash flow standpoint, contractors should “become whole” on a project when they catch up to where they should be on their billings (assuming no unapproved change orders are included in those costs).
A large amount of underbilling can send red flags to lenders as it demonstrates that a company is financially struggling or mismanaged. This can jeopardize a bond program.
Contractors can mitigate the risk of underbilling by implementing a robust project management system that utilizes automation tools while maintaining human oversight. This ensures meticulous work tracking and reduces the likelihood of missed tasks that can lead to overbilling. Regularly cross-referencing invoices with actual completed work will also nip overbilling in the bud. Using the percentage of completion method of accounting can also help, as it will demonstrate to third parties, such as lenders, exactly where your projects stand regarding build completion and revenue realization.
Many construction accounting software programs are tailored to the industry with features that help contractors meet specific business needs. For example, a contractor that uses time and materials billing methods can benefit from a feature that alerts them when their labor or overhead costs are close to exceeding their budgeted amounts. This can help ensure that the contractor stays within their client-approved price cap and allows them to change the bill amount if necessary. Additionally, some software offers the ability to calculate sales or use tax based on projects or localities to speed up client invoicing and compliance reporting.
Several construction-specific programs also allow users to track expenses by custom categories and compare estimates against actuals to identify over or under-spending patterns. They can also create progress-completion invoices based on bids or projections and automate the billing process. In addition, some software can print shipping labels or estimate freight costs to expedite shipments and reduce delays in the delivery process.