Construction is a complex and challenging industry with factors like labor and material shortages, local and state regulations, tax issues, and the overall economy impacting your company’s profitability. As the old saying goes, “every penny counts.” Having accurate construction accounting and financial management is vital.
However, accounting for construction companies isn’t the same as it is for other businesses. In this blog post, we’re explaining how construction accounting differs from traditional accounting, discussing some of the basic concepts you need to know.
Differences Between Construction and Traditional Accounting
Construction accounting shares many of the same principles as the accounting methods used in other industries, but it also involves some industry-specific challenges and concepts.
For example, construction companies want to make sure the projects they take on are profitable, which requires job costing accuracy. There may be a mix of one-off jobs, short-term jobs, long-term jobs, and jobs involving multiple sites.
Here are some of the ways construction accounting differs from traditional accounting.
Unlike businesses in other industries like manufacturing or retail, construction accounting generally focuses on custom projects. Each one must be managed individually with regard to profitability and cash flow.
When creating competitive quotes, consider each project’s specifications. For example, materials and labor costs can vary considerably depending on where the project is based and the type of construction.
2. Field and Mobile Work
In many industries, work is done at a fixed location, but businesses in the construction industry must manage their operations and accounting in the field. Labor and equipment are constantly on the move from site to site. This means you have to consider mobilization costs related to each job like transportation and insurance. It also means equipment and labor must be managed efficiently from job to job.
3. Irregular Costs
Indirect and continuously fluctuating costs can make it challenging to estimate construction job expenses. Over the life of an extensive project, the price of materials and labor can change considerably. Those fluctuations can be tough to predict.
Contractors can be especially vulnerable to changing costs because they lack the resources necessary to stockpile supplies. Even indirect costs, like insurance and overhead, can change throughout a long-term contract.
4. Flexible Contracts
Some construction contracts can span multiple accounting periods. Even smaller projects can last longer than intended due to issues related to materials acquisition, labor, and weather. To document cash flow and ensure sufficient income, contractors often must manage a schedule consisting of multiple payments and trigger dates or milestones.
5. Limited Sales
Most construction firms can only take on a limited number of projects each year. Bonding limitations and the amount of cash available to them can prevent construction companies from taking on additional jobs. Depending on the location, the work might be seasonal, which is even more limiting. Sales staff might be compensated differently, and any potential downtime of clients is also a consideration.
6. Change Orders
Unlike other industries, change orders are the norm in construction. If change orders aren’t handled quickly and efficiently, your company’s profits can suffer. It’s vital that you accurately consider how each change will impact the profitability of a project. Ideally, you should document each change order as it occurs to track its financial impact.
Basic Accounting Concepts for Construction Companies
Construction accounting is a unique type of financial management and bookkeeping. It is designed specifically to help contractors track each job and the potential impact on your company’s bottom-line results. Here are several basic accounting concepts that all construction companies should understand.
In general, each project acts as its own profit center, which is why construction companies use job costing. Job costing is the process of figuring out the total cost of completing a job to the stated specifications. Costs can be broken down into two categories: direct costs and indirect costs.
Direct costs include labor, material, subcontractor, and equipment costs, whereas indirect costs are not directly allocated to a particular project. Indirect costs include safety expenses, small tools, training, and general liability insurance.
Contract Revenue Recognition
How contractors recognize their revenue is another complex issue, mainly because of the long-term nature of many projects. There are two methods that contractors use most often. There are other methods but these are the most common.
- Percentage of completion method — The percentage of completion method (PCM) allows you to record revenue as it is earned over the life of a contract.
- Completed contract method — The completed contract method (CCM) allows you to recognize all revenue, costs, and profits only upon completion of a project.
Retainage refers to the portion of the project’s price that gets withheld for a specified period or until project completion. This practice provides you with a financial incentive to meet certain milestones. However, this practice can be inconvenient for subcontractors, as they will have to wait until the project’s completion to receive their share of the profits – yet another reason why managing cash flow is crucial.
In many industries, billing happens on a fixed schedule or at the time of sale. However, billing can be more complex in the construction industry. For example, the American Institute of Architects (AIA) method of billing is used in government-funded and commercial construction projects, where the contractor bills the client for the work completed each billing period.
There are also multiple contract methods that construction companies can utilize for each project.
- Fixed price — The parties agree on a fixed price at the start of the project, and no changes are possible.
- Time and materials — When a project’s scope can’t be determined upfront, time and materials billing might be used. This includes the cost of materials plus an agreed hourly labor rate.
- Unit price — The contractor charges a fixed price per unit, which might be a square foot or a roadway mile.
Wages paid in the construction industry can vary from those paid in other sectors. Here are some ways it may differ.
- Prevailing wage — With some public projects, contractors must pay the government-defined minimum wage to workers, which is called the “prevailing wage.”
- Union payroll — Many construction trades are unionized. Wages, benefits, and working conditions will depend on these agreements.
- Multi-state payroll — Some contractors have projects across multiple cities and states, which complicates payroll taxes and compliance with labor laws. The employer must comply with all federal, state, and local regulations.
- Weekly payroll — Payroll typically goes out weekly rather than on a bi-weekly or semi-monthly basis.
Why Your Construction Business Needs More Than a CPA
Running a construction company and serving the needs of your customers is challenging enough. Navigating the industry’s unique financial landscape on top of your daily responsibilities is a lot to handle, especially when you have major goals for growth. Outsourcing the financial side of your business is one way you can stay organized and focus on your goals.
At New Lyfe Accounting (NLA), we offer personalized financial services to clients in the commercial construction industry. With our extensive backgrounds in the industry, we’ve made construction accounting our sole focus. Our construction CFO services are our primary service. This is a high-level strategic partnership to help strengthen your business as you continue to grow. As supplementary services, we also offer bookkeeping, project accounting, and construction software solutions. Contact us to learn more about our services and how partnering with NLA can help your business succeed.