Welcome to Business and Finance for Non-Accountance. My name is John Haven and I've been an accounting professional for over 25 years in both private industry and academia. This podcast is for people who have no desire to become accountants and honestly good for you. The parties are terrible. But people who do want to understand financial statements well enough to use them in real life. Maybe you're taking a class and accounting feels like a foreign language. Maybe you've started a business and want to know if you're actually making money. Maybe you just got promoted and someone handed you a budget and a profit and lost statement and smiled at you like that was helpful. This is for you and yes, it's also for those of you who are dating because comparing financial statements before combining your lives is genuinely good due diligence. Love maybe you blind but your net worth doesn't have to be. We're going to call this episode building the numbers. Today we're going to talk about construction accounting which was actually requested by some of our audience. Which may be warm and fuzzy that people are actually listening to this. There is a joke in construction that goes something like this. How do you make a small fortune in construction? I'll start with a large one and everybody politely laughs. But if you spend any time around contractors, you know there's a real sting to this punchline. I've seen it happen. Companies that were busy, genuinely busy, work going on everywhere, cruise on three jobs at once and still somehow they end up broke. Or worse, don't find out their broke until it's way too late to do anything about it. So how does this happen? Not as a company not know they're losing money until the whole is too deep to climb out of. The answers almost live in accounting. Specifically, three areas that don't get near enough attention outside of the financial departments. Percentage of completion accounting or POC, time and equipment billing, also known as T&E, and contingency reserves. Today we're going to walk through Wall 3. We'll touch on a couple of other things. We are just going to skim through the surface, but this is going to take a little longer than usual. We could do deep dives into several of these topics and do a whole series just on construction accounting. I'll keep it to plain English and I'll use some real examples and I promise by the end of this, you'll understand why construction accounting is genuinely one of the hardest accounting disciplines there is. Not because the math is complicated. Because the rules are crazy, but because the judgment is truly complicated and requires a lot of honesty and there is a human element. To be successful in this, accounting and the operations leadership need to have honest conversations about what's going on in a timely manner. To be fair, you can substitute construction accounting with project accounting. If you work at Lockheed Martin where they develop and build new jets and missile systems, those are huge multi-year projects or Boeing building new aircraft and space systems. Alright, let's build something. Why construction accounting is its own animal? Let's start with a simple question. When does a business earn its money? For most businesses, this is simple. A restaurant earns its money when you eat the meal, a retailer earns it when you buy a shirt, a law firm earns it when the work is done and the invoice goes out. The transactions are clean, it happens, it's over. It doesn't even really matter if you're doing cash or a cruel accounting. This is when you earned it. It likely happened within a current period. It's not drug out across multiple accounting periods. It's easy. Now try applying that logic to a construction project. You sign a contract in January for a $30 million hospital expansion. The project will take two years. You've got crews mobilizing, equipment being delivered, subcontractors lining up. Money is flowing out the door from day one. You might even have money flowing out to buy materials weeks or even months before the first crews show up on the job site. So when did you earn the $30 million? When you sign the contract, when you finish the contract, or somewhere in the middle? It's not a trick question. It's one of the most consequential accounting questions in the entire industry. And there's two main schools of thought, the right one and the wrong one. Actually, the first one is called the completed contract. The simple idea, you don't recognize any revenue until the project's done. You finish, you hand over the keys, the certificate of occupancies generated, and you book the income. Clean and tidy. Almost completely useless for running a business unless you're building bird feeders and dog houses. Because you could have 200 people working flat out for 24 months. And your income statement would show nothing the entire time for revenue, just expenses. Your banker looks at your financials and thinks that you're running an extremely expensive hobby and not a business. And in reality, if you do these, it's going to be that small job. Otherwise, your business would be crushed from the cash flow management issue of going way too long. If you don't generate an invoice, you're not going to get paid and you're going to run out of cash before the job is done. The second method, the one used by both contractors, is called percentage completion or POC. And this is where the real action is. We're going to spend some time here because this method is elegant when it works, and it's an absolute disaster when it doesn't. The core idea is this. You earn revenue gradually as you do the work. You're not waiting for a ribbon cutting. You're recognizing income months to months and proportion to how far along the job actually is. Regardless of cash or cruel accounting, you're invoicing the customer each month for last months. Work. What costs actually hit the job? Sounds reasonable, right? It is reasonable. It's also depends on a chain of estimates and judgments that can go wrong in about a dozen different ways. Which honestly is what makes construction accounting so interesting. If you're the kind of person who finds accounting interesting, that is. If you're listening to this podcast, I'm going to assure you that you should at least find it useful. It is essential for project managers to understand POC accounting and the impact of their judgment on the overall finances of the job. Percentage a completion, the big one. All right, let's get into the mechanics just a little. I promise I'll keep it as painless as possible. The most common way to measure percentage of completion is called the cost to cost method. Here's how it works. Back to our $30 million contract. Your team estimates it will cost $24 million to complete the work. This leaves a $6 million expected profit, a 24% profit margin. Nice job with a nice profit margin, solid project. Now at the end of the first year, you've spent $12 million in costs. $12 million out of the $24 million. That's 50%, so you recognize 50% of your revenue. $15 million. Against the $12 million in costs, that leaves the $3 million in profit. Make sense. The math is clean. Everyone's happy. Merry Christmas. Happy holidays. Now let me introduce a small problem. What if the estimate was wrong? What if at the end of year one, you spent $12 million, but the job isn't actually 50% done? What if the concrete work ran over? What if you hit some unexpected site conditions, and you're really only 30% complete? What if the cost to finish isn't $12 million like you thought, but it's actually 16? Suddenly your estimate, a $24 million total cost, is closer to $28 million. Your total profit on the job just went down from $6 million to $2 million. So the job is still profitable overall, but you've already reported $3 million in profit in year one. That's a problem. Which means year two doesn't just look thin. It looks like a $1 million loss, even though the project itself is still in the black. This is some of the lurching corrections and finance that I'm talking about. The job doesn't become a disaster on its own, but the year two financial statements sure look like one. And your company is dealing with a $1 million loss to have to explain and overcome with other work for that year. This is what accounting calls a job going south. And here's the brutal part. The loss doesn't show up gradually. It shows up all at once. The moment someone does an honest, revised estimate of the cost to completion. One month you're profitable next month after a cost to completion review you're not. The financial statements lurch backwards. Once her to CFO describe it this way, percentage of completion is like driving by looking in the rear view mirror. The further you are from the last honest estimate, the more likely are to drive off a cliff. So get those estimates early and often.
often. That brings me to why I think this is the most underappreciated truth and construction accounting. The financial statements are only as honest as the estimates behind them. Think about who makes those estimates. It's your project managers, the operations people, smart people, experienced people, but people nonetheless who are under pressure to show a healthy job, who are, frankly, sometimes optimistic by nature. Because optimists are often great project managers. They push through problems, they motivate crews, they find solutions. I've sat in project review meetings where project manager was absolutely convinced that despite every trend line in the wrong direction, they were going to bring the job home on budget. And sometimes they're right. But when they're wrong and the accounting has to be following their, has been following their optimistic estimates for six months, the correction is ugly and hard to explain. The antidote is a culture where project managers and finance teams and accounting teams are actively challenging each other in an ongoing basis. The project manager knows the job. The accounting team knows the trends. Neither one should be able to tell a comfortable story without the other one asking hard questions. While the example talked about it in year one, at the very end when they sat down and figured it out, this should be a conversation every month. At the minimum, a hard conversation every quarter keeps the project on track and increases the likelihood of a good landing for every project. With a POC job, we should have a contingency fund for when things inevitably go wrong. We'll talk about this as a separate item later. With POC, you are the building owner as part of construction and you own all of the risks until you hand the project over to the owner. Just ask Boeing. Billions over budget on their fixed price contract for the Air Force's new tanker and the president's new airplane. They and the shareholders have to deal with it, not the government and the taxpayers. Overbuilding and underbuilding. This is another important concept. Overbuilding is when you've invoiced your customer more than your percentage of completion would actually justify if they asked you. Yes, this can be sticky. If the job is 30% complete but you've built 50% of the contract value, you've overbilled. Your cash position, however, looks fantastic, but you've essentially borrowed against work you haven't done yet. It's unearned revenue. If you don't finish the job, you owe that money back. It's sitting on your balance sheet as a liability, even if the cash looks sweet in your bank account. You may get a bad reputation by overbilling too much since you're taking advantage of your customer's balance sheet. You have an interest-free loan from your customer. They're not going to be happy about it. Underbuilding is the reverse. You've done more work than you've built for. Revenue you've earned is just sitting there unbilled and therefore uncollected and the cash collection cycle un-started. This can mask problems too because your margins look thinner than they really are. Until you've built, depending on the terms of your contract, it could be several months before the cash shows up. The job revenue less expenses look really profitable, but your business is cash starved and you can't continue to operate. This is essential, especially in a cruel accounting. The income statement shows the costs and with the contract terms in the markup, it's pulling through the revenue. The job on a POC job. The job looks profitable, but until someone builds the client, the accounts receivable never gets populated. And the customer's clock never starts ticking to get you paid. The joke I always make about overbilling and underbilling is this. Either one will kill you today, but both of them are the kind of things that you don't want to have to explain to your bank or an awkward time. T&E billing, where money gets lost. Let's talk about time and equipment billing or T&E for short. A lot of construction contracts are fixed price POC type contracts. You would agree to deliver a defined scope for a defined dollar amount. Honeywork doesn't fit that model. Emergency repairs, disaster response, early phase work before the full scope is known, change orders on complex projects where nobody really knows what something is going to cost until you really get into it and peel it back. These sound like government contracts. Basically, cost plus a margin. And you go until you spend the total amount and then you ask for more. Lockheed in the F-35 fighter and Boeing and the SLS rocket and Artemis space projects fit this. Billions and billions over cost, years behind schedule, and yet they're able to show profit to the shareholders because the government keeps giving them more money to finish the project. And for a penny and for a pound. In those situations, the owner would say, "Do the work and bill me your actual costs." And here's the reaction I get from most everyone when I first explain this. Oh, that sounds easy. Just track your spend, mark it up, and bill it. On the surface, sure, but really, it's not that much easier. But it does shift most of the project risk to the owner. If you get to the project cost cap and it's not done, the owner needs to come up with more money or you're going home and the project never gets finished. And they have nothing to show for their investment. There are two main permutations to T&E. One is true cost plus on an agreed market that covers all your overhead and profit. And you're going to have to defend your costs and potentially be audited by the customer. So in some cases, it'll be cost an overhead plus 10%, but they're going to drill in and understand your real costs. The other is a fully loaded rate that you may have been against other companies that covers your profit as well. There's pros and cons to boasts, but these are for later discussions. Just want you to know they exist. The labor burden problem. When you bill a worker's time on a T&E job, you're not just billing their hourly wage. You're billing the total cost to the company. And this includes things that you may not have thought about. What about the employer side payroll taxes? What about the worker's comfort insurance? What about general liability insurance? What about the health benefits of those employees? This cost goes up a lot. What about the retirement contributions? Are there union fringes? Paid time off, sick leave, etc. All these other costs. You may have to check the contract to see if these are all allowable costs or record, but they still need to be covered somewhere. By the time you added all up, we've created what's called a labor burden. And you're typically looking at a cost that's 35 to 50% higher than the base wage. Sometimes even more. The lower the paid, somebody is per hour, the higher the labor burden rate. So a worker making $30 an hour might actually cost you $45 an hour when you count for everything. If your billing rate is built on the wages alone, you're losing lots of money every single hour they work, quietly, invisibly, until someone runs the numbers and tries to figure out why the T&E job is not anywhere near as profitable as it should be. I knew a contractor who discovered this on a large emergency response project. They had 60 laborers on a site for three months. They'd been billing straight time because that's what somebody set up in the billing system years ago. It had never been questioned and revised. The un-recovered burden cost was in the hundreds of thousands of dollars. Gone. No way to go back and rebuild it. The contract was closed. This is not a bookkeeping error. This is a company changing mistake. We can do the same stupid things on equipment. Let's look at equipment rate. It has its own special brand to complexity. You have a piece of equipment on a T&E job. Let's say it's an excavator. The question is, what do you build per hour? There's three different ways to looking at this. Option one, your own cost. What it costs you to own the machine, the depreciation, the insurance, the maintenance, any associated financing costs. Repair history. This reflects what you actually spend to have this asset available for this job. But now you have to also figure out your utilization rate per unit of billing per day or per week. If you're only going to use it effectively half the year, you're going to have to charge twice as much to be able to cover the cost. If you have multiple excavators in your company, are you going to develop a rate on each individual piece of equipment or are you going to create a common rate across all of them? Some are going to be newer and have more cost but less maintenance expenses. Others will be quote unquote cheaper.
because they're more fully depreciated, and we're cheaper to buy to begin with. When your company bid the job six to nine months ago, it didn't necessarily know which one was gonna be on the job site. Option two, the market rental rate. What would it cost the owner to rent an equivalent machine from a third party equipment dealer? This is an external verifiable number and they certainly have the full cost built into it. Maybe even a little bit of profit built into it because that's what they do for a living. Option three, the replacement cost rate. What would it cost to replace this machine at today's prices spread over a useful life? Each of them is a legitimate methodology. Each one produces a different number. Beyond the rate question though, there's also the documentation problem. Equipment has to actually be tracked to be built. And on a busy job site, equipment tracking is nobody's favorite job. The operational takeaway is simple, even if the execution is hard. On a T&E job, your documentation system is your profit system. If you treat timekeeping and equipment logs as administrative overhead, as the knowing paperwork that you do after the real job, then you lose money, full stop. At this point, we have equipment rates and labor rates, but what about all the indirect costs of project management, safety, and so forth, that can't be charged directly to any specific job because they span multiple responsibilities? What about who's paying for all this S-GNA, the selling general administrative costs, back at the main office, last but not least? Where's the profit margins for the job? Depending on the contract, you may have a fully loaded rate for labor and equipment that includes everything, or you may have a cost plus with a profit margin added to it. But again, you would then have to defend your cost calculations to the customer. You can easily have a gross profit on a job showing 10%, but after coming in directs and S-GNAs, there's no profit. It's just keeping the crews busy until more profitable work is found. This is where the operating management team, understanding the financial statements really hits home. I've had to have this conversation with managers before. Managers thought they were winning bids at a 10% margin and doing great. Now they understand all we're doing is spending the hamster wheel faster, maybe keeping crews employed as a bridge to a more profitable job, but we're not making any money. Not updating equipment rates and overhead burden rates on the people can be catastrophic to the company. All right, let's put our toe in the water talking about contingency reserves. The cushion that can fool you. I wanna start with a confession. This topic generates the most confusion, the most arguments, and in my experience, the most awkward conversations at Project Closet. And it's most basic, contingency is money set aside for things that you expect to go wrong, but can't put your finger on it. Maybe it's adverse weather that does damage or delays projects, but meanwhile, you still have to pay for idle crews and people. Design changes from the owner usually goes under the topic we'll call change orders and we'll discuss them in depth at another time because those change orders are funded by the owner, not by us the builder. We may have to deal with material prices that spike when we bid the job and when the materials actually get delivered, things may change. I mean, just look at what's happening with tariffs and wars with the whole world, things happen. Sub-service conditions that turn out to be different from what the Geotechnical Report showed. Any kind of unforeseen anything. Every experienced contractor builds contingencies into their PSE estimates. If someone tells you they've priced a job with zero contingency, they're not being honest with you and they're trying to buy the job and hope nothing goes wrong. Hope, by the way, is not a strategy. Owners versus contractor contingency. Not all contingency is the same money. There is the owner contingency that I hinted at before, which funds the project's owners hold in their own reserves for changes that they might want to make or root risks on their side of the contract. We are just gonna talk about the contractor perspective here. So I wanted you to know the term, but we aren't gonna worry about this pot of gold. This is gonna cover things like a design change driven by the owner. The contractor contingency is ours. Funds the contractor builds into their own estimates for risks that are on our side of the ledger. This is our money for things we have to deal with, the weather, prices of materials, labor, war, et cetera. War, we may be able to charge back to the customer with an ex-sensitent circumstances, but not always. These are completely separate pots of money. They don't overlap, they do not share. I cannot tell you how many times I've seen a contractor burn through their own contingency and then look hopefully at the owner's contingency as if it was somehow available to them. The owner might not even make you aware of this pot of gold or how big it is. That's the owner's money for the owner's problems. I've had the experience of being both the owner and on the builder side. The accounting puzzle, from an accounting perspective, the contingency creates some genuine tricky questions. When you build contingency into your project budget, you have to decide, do I include it into my cost to completion estimate for percentage of completion purposes? If you include the contingency, let's say it's $300,000, you're treating it as a cost you expect to conserve and curve. Your total estimate cost is higher, your margins look thinner, and you're being conservative. If you get to the end of the job and you didn't need the contingency, that's $300 that flows through as additional profit at closeout, nice surprise, everybody looks like a hero. If you exclude the contingency from your estimates and show a higher profit early in the job, the margins look better on paper, but when you actually need the contingency, and statistically on a complex job, you will, your cost estimates have to be revised upwards constantly. And you're reporting reduced profits over and over again. No hero here, just as zero. Neither approach is technically wrong, but they produce very different financial pictures. Auditors will absolutely want to know what your contingency policy is, especially on bigger jobs. Banks will also ask you about it. There's a strong likelihood on complex jobs that there's gonna be unintended costs, and it's more consistent and easier to explain to have some contingency baked in and be excited about extra profit at the end. Trying to explain the ever-decreasing profit on a job is painful and challenging. In reality, if the contingency is built on qualified risks, we can actually release parts of the contingency as we go along with the project, and not always have to wait until the end. If a third of the contingency is associated with material cost variability, once the materials for the jobs are bought and delivered, we could actually release part of the contingency if we wanted to. Ah, the human behavior problem. If the project team knows there's contingency, they will most likely spend it, not maliciously, not through any one big decision, but through 100 small decisions over the life of the project. When someone says, "consciously or not," "Hey, we have contingency to cover that." The overtime to recover from a scheduled delay contingency. The extra material order to avoid potential shortage contingency. A slightly more expensive contractor who can start sooner contingency. Expodited freight to try to catch up and get the materials on the job site contingency. Each individual decision is defensible. Collectively, you arrive at project closeout with your contingency completely consumed. And hope that nothing unexpected actually happens because you have nothing left. The sophisticated response to this is to hold contingency above the project team level. The project manager manages to a budget that doesn't hold the full contingency. Senior leadership holds the reserve. To draw from it, you have to make a formal case. Here's what happens, here's why it's legitimate, and here's what it costs. As you can imagine, PMs don't love this. They feel like they're not being trusted, but what it actually does is make the contingency mean something. Every draw is deliberate, every draw is documented. At the end of the job, you have a clear record of how the reserve was used, invaluable.
and trying to do better estimates for jobs in the future. How all these things come together? I've walked through each of these three topics more or less separately. But in the real world, they don't operate in isolation. They're part of one interconnected system, and the failure modes stack on top of each other, and can be truly devastating. Two pictures, same outcome, different contract types. Back to that first hospital, fixed price contract, percentage of completion, cost risks that's entirely with the contractor. I'll remind you of the numbers. $30 million contract, $24 million estimate, $6 million profit. The job is moving, the PM is confident, and every month the cost of completion estimates look reasonable. But the PM is optimistic, a little more each month, and nobody on the finance side pushes back hard enough. Meanwhile, the contingency reserve is quietly getting nibbled away. A small scope creep here, and a subcontractor overage, and a weather delay that nobody formally flagged. Each draws defensible, collectively by the end of year one, the contingency is more than half gone, and the job is behind where the estimate says it is. The POC calculation has been recognizing revenue based on these optimistic estimates all along. The year end comes, and someone finally does an honest cost to completion analysis. Remaining contingency isn't enough to cover the gap. The total profit drops from 6 to 2 million, and since 3 million was already reported in year one, year two posts a $1 million loss. The hospital gets built, the contractor gets paid, but the financial tells a story that has bank asking uncomfortable questions. Under the disaster response repair, completely different animal. A storm has taken out a section of critical infrastructure, and the owner needs it fixed fast. There's no time to scope a fixed price contract, and crews mobilize within days on preset T&E contract rates. The owner carries the risk theoretically. Every legitimate hour and every legitimate equipment charge gets built. That's how the contractor is made whole. Except the work is chaotic. Time sheets are being filled out from memory, and indefensible at the end of the week. Equipment is moving from area to area, and nobody has time to log it properly and capture the hauling costs. The burden rates in the billing system haven't been updated for several years. Obviously the cost to health insurance and other things have gone up exponentially since it was last set. The time somebody sits down to recognize what was actually spent against what was actually built. There's a significant gap. Hours weren't captured. Equipment days weren't billed. The burden costs were chronically understated. By now the billing window on the T&E work is closing. The job is done. The invoices are out. The gap is done. The owner was supposed to carry the cost risk, but sloppy documentation meant the contractor absorbed most of it anyways. Two different contracts. Two different ways of allocating risk. Same result. Contractor ended up holding costs that they didn't plan for. On the hospital the risk was always theirs, and the estimates headed, hit it. On the disaster response the risk was supposed to be the owners, but the documentation discipline didn't enforce it. Neither of these is hypothetical. The patterns I've seen at different scales and different markets, more times that I'd like to count. Sometimes I've been the contractor. Sometimes I've been the builder. For the building owner. The contract doesn't save you. The method doesn't save you. What saves you is the discipline behind it. Honest estimates on fixed price work, airtight documentation on T&E work, and protected contingency on both. Without that discipline, the accounting will tell you a comfortable story right up until the moment that it can't lie to you anymore. So what can we actually do about it? So let me close with the practical stuff. When you're a project owner, a project manager, or a CFO, or just someone trying to understand why construction financials are so hard to read and manage, here's some things to consider. First, ask for the revised cost to complete regularly. Not the original estimate, the revised estimate based on what you know today. If you get a fast specific confident answer, that could be a good sign. If you get hesitation, vagueness, or we're tracking the budget without any supporting detail, that's a red flag worth pulling on. I'll tell you, I do this monthly, especially on big jobs. Second, on T&E jobs, don't let documentation slip. Review your time and equipment logs weekly, not at billing time. Revenue that isn't documented within a few days of being earned is revenue you may never collect. Set that expectation at the start of the job. Not after you've already lost the first month's worth of records. Review your costs for equipment and labor rates, at least annually. You've replaced an old piece of equipment with a much more expensive one. Pay rates have gone up with inflation and competitive craft labor market. Health insurance has certainly gone up. Was your utilization percentage of the equipment what you expected to drive your final race? There's lots of potential moving pieces that you need to validate in an ongoing basis. Third, treat contingency like a formal reserve with rules. Before the job starts, not during and not at closeout. Establish it, hopefully in writing. When we can draw the contingency, who approves it and how it gets documented. If you don't have the rules before the pressure gets turned on, you sure will enforce it later. And finally, and this is the big one. Recognize that construction accounting is a team sport. The finance team or the accounting team can't do this without accurate information from operations. Operations can't manage to the numbers without financial accounting, helping them understand what the numbers mean. The companies that get this right are the ones where the project manager and the CFO or controller are genuinely working together. Collegially challenging each other, trusting each other, and telling each other the truth, even when the truth is uncomfortable. It's a functional work marriage. That partnership, more than any software, any process, any accounting and methodologies, is what separates contractors who stay profitable from the ones who don't figure out their in trouble until it's too late. This is also where an accountant, you have the ability to really add considerable value to a company. It's a tangible expertise that AI will have a hard time automated. Thank you for spending time with me today on building the numbers. I'd love to hear from you what clicked, what didn't, and what you want me to cover next. Reach me at
[email protected]. At the top of the show, I told you the construction jokes start with a lot of fortune and with a small one. Here's the version nobody tells. Plenty of contractors do it the other way around. They start lean, they stay disciplined, and make the numbers tell the truth every single month. They revise their estimates regularly, they manage their documentation. The joke doesn't have to be about you, but the choice is made long before anyone's laughing. Until next time.
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