5 Reasons Why Project Accounting Is Important
Updated: May 19, 2022
When the nature of your business is such that the delivery of your projects is quick (such as in a matter of days or weeks), accounting for this is generally fairly straight forward. Smaller projects start, they finish, and then they are billed, and the amount that is billed is the revenue for that project. In accounting-speak, we call that the Completed Contract Method of accounting for revenue. That is, the contract amount that is billed when the contract is complete, is the revenue that is recognized at the time. Typically, on smaller projects like this, costs are also recognized in the same period, and so the matching principal is usually met (the principal that expenses and associated revenues should be recognized in the same period).
That’s small projects, generally speaking. Enter longer term projects. These are projects that may extend for a number of months or years. For projects such as these, the importance of project accounting becomes crucial not only for success, but for the sake of cost control, cash flow management, and continuous improvement, which can have a significant impact over a longer period of time, across a number of projects. Project accounting dives into the specific budget lines of the project, looking at things such as original contract line items as well as change order line items, cash flow on the project, budget variances and changes in estimated profitability, and which specific budget line items are driving any one of these variances. In other words, if you want to have a good finger on the pulse of how a project is going, then project accounting is a very important function to add to your project toolbox.
Below are 5 benefits that project accounting can bring to your project:
1. Know your cash flow
I put this first, as cash flow is so critical in business, and it is one of the key challenges that contractors and trades in construction face as part of their business operations. If you do not have a good understanding of the cash flow on each project, you may find yourself in a position where the cash flow from one project begins to fund the negative cash flow of another. This is a dangerous place that you want to avoid.
Project accounting will help to ensure that you are billing each month to, at the very least (if possible), cover your cost for each budget line, which make up the schedule of values of your progress draw (monthly invoice on larger projects). Sometimes your customer or client may not allow billing on a particular budget line that you have costs for; particularly if it is for up-front costs for a line item that has no observable performance, such as materials in your shop that have not yet been installed on site. Sometimes the cash flow impact on this may be made up by billing more of another item, such as mobilization, travel, preconstruction, or other contingency amounts built into specific budget line items that may be billed earlier on in the project. For many projects, it’s normal for an engineer to review progress draws for scopes such as electrical and mechanical work, or for architects to review architectural scope progress draws, in order to certify that work is complete, and this quite often has a direct impact on what you can invoice for each month. So, knowing where your costs are coming from will help you be more informed on what you should be billing for each month. For those of you who work primarily on a cost-plus contract or time-and-material basis, while you don’t need to worry so much about an engineer or architect scaling back your invoice, you do still need to list out your specific costs in order to ensure you capture all of them to bill accordingly. Not capturing these costs may mean having to bill for them in the next billing period, which may mean fronting the cash in the meantime, as your vendor(s) will still expect to be paid on time, even if you missed including them in your progress draw.
2. Know what is driving your profit
If you are not tracking your project costs according to specific budget lines, you are leaving yourself to the mercy of “The Gap”; which is the hopeful positive difference between the project contract price and your costs at the end of the project. This approach is common, and it has a common enemy: creeping costs which decrease profits or even cause losses. While a project is underway, if you are finding that your projected profit is decreasing over time, but you are not tracking costs based on your budget, then it will be difficult to pinpoint the issue. We all know that when you are in the middle of an intense project, that is definitely not when you will have the time to start digging into where the creeping costs are coming from, and so this impacts your ability to make informed decisions based on the numbers (because the numbers tell the story!). If costs are tracked according to your budget, that is, they are allocated to appropriate budget lines, you will be able to pinpoint quite quickly where your profits may be eroding. Or, for that matter, you will also be able to pinpoint where they may be increasing, as you will want to find ways to enhance that outcome.
When coding your costs in your accounting system within a specific project, do your best to avoid dumping costs into the classic “catch-all” codes, such as other expenses, promotion, or cleaning, as the more you do this, the more you will lose the benefits of project cost accounting. Tracking these costs appropriately also helps better inform your budget for when you bid on similar projects in the future. If all of your labour was dumped into one labour budget line in the past, it will be difficult to know how much of that might have been employees versus temporary labour, or if the labour was heavier on self-performed activity in a particular scope of work, or perhaps if there were extenuating circumstances on the project that simply required more labour (such as increased continuous cleaning). If, when creating your estimate for a project you are bidding on, you simply use an amount that was dumped into a catch-all account, you may end up padding that line on the estimate a little more than it should be. When the spread on contract bids may differ by only a percentage point or less, the aggregate impact of this may be the difference between winning the contract or being too high. Project accounting helps you better understand your costs and what drives your profit, which better positions you to prepare competitive bids on future work. Garbage-in-garbage-out (GIGO) is the key concept here; the information you are able to use from your system is really only as good as how it was entered.
3. Know what is driving your revenue
At the end of the year, when your accountant does your year end, you may wonder why your revenue has changed, impacting your net income, and why there might suddenly be this large liability balance for deferred revenue that is now impacting financial ratios that are tied to lending covenants with your bank. Revenue recognition is the key here, and the recognition of revenue for long-term contracts is usually done either through the Completed Contract Method (discussed above) or the Percentage of Completion Method. For long-term construction projects, the Percentage of Completion Method is most commonly used. Briefly, this method consists of determining the percentage of completion of a project, very often based on the cost-to-cost method, and multiplying that percentage by the total contract value. This amount is the amount of revenue that can be recognized for the project. Therefore, if you have billed an amount greater than the amount that can be recognized for revenue on the project, you need to reduce your revenue by the difference, which will be a debit to revenue (decrease) and a credit to deferred revenue (increase). Here is a quick example:
Costs to date on project: $25,000
Total estimated costs for the project: $30,000
= 83.3% (percent complete)
Contract value: $45,000
x 83.3% = $37,500 revenue earned to date
Billings to date on project: $39,000
Deferred revenue: $1,500 ($39,000 - $37,500)
In the example above, there is an overbilling of $1,500, which is subtracted from your billings to arrive at earned revenue, and added to your liabilities as deferred revenue. You can imagine the impact that having adjustments like this may have on the overall revenue, and deferred revenue liability, if you have a dozen or more projects on the go at the time of your year end, and/or if the size of the projects are increased by orders of magnitude. Project accounting allows you to know if you are over or underbilled on an ongoing basis, for each of your projects, so you are aware of the impact this may have, at any given time, on your revenue and, at the end of the day, on your financial statements.
4. Know if you are on track
In maintaining a project budget, you can look at percent complete using the cost-to-cost method described above. Additionally, you could also look at the percent complete as a function of time. This is calculated by taking the number of days between the project start date and the current date, and dividing that amount by the total number of days in the project (project start date to substantial completion date). This gives you the percent complete for the duration of the project. Comparing this with the cost-based percent complete figure can sometimes provide helpful insights. For example, if your costs to date are showing you are 25% complete, and you are 75% through the duration of the project, it is possible that you may be facing a potential schedule constraint. If you do look at percent complete as a function of time, and compare that with cost-based calculations, be aware that the nature of the scope of work may not allow for meaningful interpretation of this analysis at any given time. For example, perhaps you are a mechanical contractor and you have a project with a lot of up-front costs for HVAC equipment, with trailing labour costs related to installation. In that case, your cost-to-cost percentage complete may be much higher than the duration percentage complete at the front end. Mobilization costs can also be high at times, which may push the cost-based percentage ahead of the duration-based percentage. So, while this can be an interesting metric, recognize that there are scope-specific factors that may cause a discrepancy between the percentage of completion calculations based on cost and duration. Eventually, however, these amounts converge near the completion of the project, and monitoring and understanding the relation between the two can be a helpful tool.
One of the important activities involved in project accounting includes updating the estimated costs to complete each line in the project budget, and this is often done by a project manager and/or a project accountant. Doing this on a regular basis, such as quarterly or monthly, allows you to get a regular snapshot of costs to date, budget variance, consider the estimated costs to complete and if there is a variance with the original estimate that may be impacting projected profitability, look at current cash flow and whether or not you are over or underbilled on the project, and then estimate projected billings on the project over the next number of months. These insights will help you forecast not only your profitability, but also your cash flow which, as discussed above, can often be a challenge when it comes to long-term projects. If you are forecasting a loss, or a cash constraint, knowing this in advance will provide you with more opportunity to mitigate this, either by finding cost savings elsewhere to address the loss, or by finding financing solutions, if necessary, to address a cash constraint. Conversely, if you are forecasting a larger profit than expected, or you are forecasting excess cash flows from what was initially anticipated, this will then allow you to look into ways to leverage this, such as capital expenditures that you had been considering, or short term investment solutions while you are holding the excess cash.
As you can see, there is a lot of value to investing resources into project accounting, if the nature of your business is longer term projects. If done effectively, the work in this area will help you to have an ongoing knowledge and awareness of how each of your projects are performing, which will better equip you to make timely decisions, manage your cash flow proactively, and avoid or mitigate forecasted constraints that may otherwise become emergencies if not addressed before they happen. A simple analogy may be the oil pressure sensor in your vehicle. This works continuously to monitor the pressure of the oil that allows your engine to run without seizing, much like cash allows your projects to continue without coming to a halt. If the oil pressure drops, the warning light comes on, indicating the need to address it. If you have a faulty oil pressure sensor, a faulty warning light, or you don’t pay attention to the warning light, eventually you run the risk of your engine seizing, and this then comes with costs and disruptions (vehicle failure has this odd way of happening at the most inconvenient time). The same can happen to a project and, in worst case scenarios, your business, if you do not have the mechanisms in place to monitor the profitability and cash flow of your projects. Having these systems in place allows you to spend less time jumping from one emergency to another, and direct more of your focus to the growth and continuous improvement of your business.
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Resources: Download a free project budget template