Avoid the Gross Profit Rollercoaster

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Podcast Interview Summary (or Read the Entire Transcript here)

The Three-legged Stool of Business

Every business has three essential tasks: 1. You’ve got to sell the work, 2. You’ve got to do the work, 3. You’ve got to keep score to see how well your work is doing.

The Importance of Accurate Accounting

You can’t wait until the end of the year to find out from your accountant if you made any money. You need to be doing your accounting regularly because if you aren’t pricing your work correctly or don’t understand your numbers, you could be losing money.

The Gross Profit Rollercoaster

Because of the way cash flow works, you can make all kinds of money one month (which can cause you to go out and spend that money), only to have things correct themselves the next month, and then you can end up in the hole.

Cash Basis vs. Accrual Basis Accounting

There is a big difference between Cash Basis and Accrual Basis accounting. Cash Basis recognizes income when cash is received and costs when money is paid, leading to significant swings in Gross Profit.

Challenges with Accrual Basis Accounting

Accrual Basis accounting recognizes income when invoiced and costs when expenses are incurred, which is more accurate than Cash Basis but still has challenges. For example, discrepancies can arise when you invoice ahead of incurring costs or vice versa.

Matching Concept

The Matching Concept is essential for understanding a business’s true financial picture. It involves aligning income and expenses properly so you know the real profit or loss at any given time.

Issues with Accrual Accounting

Even in Accrual accounting, mismatches occur due to factors like customer deposits, material deliveries, and differences in when you invoice and incur costs. These discrepancies can lead to irregular Gross Profit patterns.

Timely Reporting

It’s crucial for contractors to have accurate and timely financial reporting. Waiting until the end of the year for your CPA to assess your financial situation is not effective for managing and growing your business.

Adjustments

To address the Gross Profit Rollercoaster, adjustments need to be made to align income and costs accurately. These adjustments account for situations where invoices, bills, or payments are out of sync with job progress.

Relationships and Trends

Accounting is not just about numbers; it’s about understanding the relationships and trends within your financial data. Consistent, accurate reporting helps contractors make informed decisions.

The discussion underscores the importance of setting up the Chart of Accounts correctly, understanding the nuances of accounting methods, and actively managing financials to avoid rollercoaster-like swings in Gross Profit. Contractors are encouraged to focus on accurate accounting practices to gain better control over their businesses.

How to Overcome the Gross Profit Rollercoaster

Start with an Estimate

To overcome the Gross Profit Rollercoaster, we recommend starting a project with a detailed estimate of anticipated income and costs. This estimate serves as a baseline for tracking financial performance.

Adjusting Income and Costs

The next step is to adjust income and costs throughout a project’s duration to align with the estimated figures. This adjustment helps maintain a consistent Gross Profit percentage.

Overbilling and Underbilling

When you Invoice a customer before you’ve earned the income, it’s called “overbilling,” and the adjustment to income goes to an account called “Overbillings.” In other cases, you have not yet Invoiced the Customer for as much as you’ve earned (referred to as “underbilling”), and those adjustments to income go into an account called “Underbillings.”

Regular Monitoring

The article emphasizes the need for continuous monitoring of income and costs. It suggests revising estimates as needed and keeping them in sync with actual project progress.

Work in Progress (WIP) Adjustment

“Work in Progress Adjustment” is important – the process of modifying the estimate to maintain proportional income and costs.

Handling Changes in Costs

We advise adapting estimates in response to changes in costs, which may fluctuate due to factors like material price increases or decreases.

Monthly Adjustments

Regular Percentage of Completion adjustments are recommended as part of the monthly financial review process.

Monthly Financial Review

Monthly financial reviews are essential to identify any deviations from the estimated Gross Profit percentage and take corrective action.

Job Management

Effective job management involves constant monitoring and collaboration among team members to ensure that projects stay on track financially.

Investing in Training and Education

We recommend investing in training and education, both for yourself and team members, to ensure a better understanding of financial concepts and reports.

Software and Tools

Various tools and resources are offered through the Construction Accounting and Management Program (CAMP) to assist contractors in managing their finances effectively.

Importance of Financial Reporting

Consistent and accurate financial reporting, especially in construction accounting, is critical to making informed decisions and ensuring the business’s financial health.

Conclusion

This interview concludes by reinforcing the idea that understanding and effectively managing construction project finances is essential for long-term business success.

Overall, this interview provides valuable insights into managing construction project finances, specifically focusing on Gross Profit and the importance of maintaining a consistent Gross Profit percentage throughout the project’s life. It highlights the need for regular monitoring, adjustments, and education in financial management for contractors.