Keeping track of income and expenses for long-term construction projects can be overwhelming. Fortunately, the CFMA has recommended a method of accounting that makes this task much easier.
This method is known as the percentage of completion.
With over 8,200 members in the US and Canada, CFMA offers educational activities, publications, and networking. They are a reputable association that promotes best practices in financial management and works to meet the needs of construction financial experts.
In this article, we'll talk about what the percentage of completion method is, how it works, and a few examples of how this method is used in real life. By the end, you'll have a clear understanding of how this method can help you manage your finances with ease.
So, let's dive in!
In this article, you will learn about:
What Is the Percentage of Completion Method?
While WIP is a schedule, the percentage of completion method is a way to recognize revenue. Its job is to keep track of revenue for long-term projects based on how much work has been done during the period. Under the percentage of completion, contractors record recognized revenue that is earned regardless of the amount billed.
How to Calculate the Percentage of Completion - The Cost-to-Cost Method
The most common formula used to determine a project's percentage of completion is the "cost-to-cost" method. It involves comparing estimated and actual project costs.
Percentage of Completion Method Example
Job 1 Earned Revenue Calculation
For example, a project that has estimated costs of $700,000 has incurred $350,000 in costs so far. Dividing the costs ($350,000) into the total estimated costs ($700,000), you find that the project is 50% complete.
This means the contractor can recognize half of the total revenue for the project. If the contract is for $1,000,000, the contractor would record revenue of $500,000 for the period, which would be reflected in their income statement.
The Benefits and Challenges You May Encounter
Contractors must properly calculate work in progress (WIP) to achieve financial stability and stakeholder confidence. The percentage of completion (POC) is suggested for measuring WIP, but it is crucial to understand its benefits and drawbacks.
Benefits of the Percentage of Completion Method
1. More accurate financials: POC helps control overbilling and underbilling, ensuring profitability.
2. Improved financial statement accuracy: POC enhances financial statement credibility, transparency, and accuracy. This leads to investment opportunities and a stronger financial position.
3. Effective cash flow management: POC is effective in managing cash flow in long-term projects.
4. Consistent with GAAP: POC is GAAP-compliant, preventing financial and legal fines.
Challenges You May Encounter
1. Overbillings and Underbillings: The percentage of completion (POC) will show you if the project is overbilled or underbilled. Overbilling happens when the billed amount exceeds the revenue recognized. While underbilling occurs when the revenue recognized is more than the billed amount.
Consistent overbilling can make it challenging to cover remaining project costs.
Underbilling can lead to cash flow problems and make it challenging to meet financial obligations.
2. Change Orders: Changes can occur throughout the project. Therefore, it is crucial for contractors to include change orders as soon as they are approved.
Calculating the percentage complete can become complicated when change orders are included, but it is necessary to ensure accurate revenue recognition.
Overall, the POC method is a recommended approach for calculating WIP in construction projects, but it is important to be aware of the potential challenges and take proactive steps to manage them.
The percentage of completion method is widely accepted and effective for calculating WIP in the construction industry. Ready to take your construction business to the next level with accurate WIP reporting? The POC method is the way to go!
With CCA's expertise in bookkeeping and POC, you can expect enhanced financial accuracy and efficient cash flow management. Contact us today to see how we can improve your WIP reports!