Or, “Are You Really Making Money, and If So, How Much?”

The Construction Industry has historically operated at one of the lowest profit margins in American Business. Because of these low profit margins, it’s critical that a contractor be able to adequately track, monitor and control his job costs. Even a few percentage points of the total job budget can make the difference between a successful or a losing bid, and a well-managed or a failing company.

It’s important that the accumulation of actual job costs correlates with the method used to produce the total job cost estimate. This enables you to accurately measure profitability as the job progresses, as well as adjust for overruns and unforeseen circumstances while there is still a chance of recapturing some or part of a loss. In addition, many contractors use accumulated job costs to determine the amount to bill for work completed–if costs are understated or not kept up to date, billings and cash flow may be negatively affected. Your accountant will rely on your job cost reporting in determining your tax liability, just as your banker or bonding agent will compare your financial performance to industry benchmarks. If you’re not properly classifying direct and indirect job costs, or if you’re unable to reconcile your job costs, you may end up overpaying your taxes, under- or over-bidding future work, or drawing unwarranted attention from the IRS or other financial institutions.

Finally, when it comes time to justify your costs (e.g, to support costs included in draws, time and materials or cost-plus contracts, or change orders/claims), it is critical that your method of cost accumulation be the same as that used to estimate and price the work. Otherwise, it may be impossible to collect for all costs incurred.

There are a number of methods contractors use to accumulate their job costs—smaller contractors may type descriptions and amounts into Excel spreadsheets, while relying on programs like Quicken, QuickBooks or Peachtree to keep track of their bills and their checkbook. However, it’s easy to outgrow these methods, and to lose control of the timeliness and accuracy of your information. It’s at that point that contractors will either adapt the job/project and item/classification features in a generic program to their business, or move to an integrated construction accounting and job cost system, where functions like accounting, document management, estimating, project management, subcontract control, etc., can all work together.

Regardless of whether you use spreadsheets, generic software or a construction package to manage your business, you still need to ensure that the numbers your computer provides you are good ones. This means that what we refer to as your subsidiary ledgers (accounts payable, job cost and accounts receivable are the three most important subsidiary ledgers) have to balance, or “tie,” to a General Ledger. This holds true whether all of your ledgers are in a single integrated package, or if, for example, your Job Cost ledger os in Excel spreadsheets, your Accounts Payable ledger is in QuickBooks Pro, and your General Ledger is maintained by your accountant.

What does that mean? Let’s take your Accounts Payable ledger as a simple example. You print an Accounts Payable report called “Open Payables by Job,” which lists the invoices you need to pay on each of your jobs as of a specified point in time (as well as retention payable, if your company uses retention). There will be a total for each job, a total for the “non-job” (e.g., overhead) invoices, and then a “Grand Total” for the report. You then compare this report to two other ledgers: the Job Cost Ledger and the General Ledger. The total for each job on your “Open Payables by Job” report should equal the “Amount Owed” value for each job in your Job Cost Ledger, and the Grand Total for the report should equal the number in your General Ledger Accounts Payable account(s).

Reconciling the Job Cost Ledger is less simple. You may have a single account in your General Ledger called “Work in Progress,” or you may have accounts for Labor, Material, Subcontract, Equipment, Payroll Burden, and Other. At any point in time you specify, if you print a Job Cost Ledger, the “Grand Total” for all your jobs should equal the “Work in Progress” value in your General Ledger. If you have several work in progress accounts, the totals by “Cost Type” (Labor, Material, etc.) in your Job Ledger should tie to the values of the corresponding General Ledger accounts.

There are other issues which can further complicate the Job Cost reconciliation process: if your company reports on a “percent complete” basis, there are values inside your General Ledger for “overbillings” and “underbillings” (deferred costs), which have to be tied to Job Cost. If some or all of your labor is self-performed, it’s important that labor burden (Payroll Taxes, Workers’ Compensation, Liability, etc.) be properly posted to the Job Cost Ledger. However, if your Payroll system (or Payroll Ledger) doesn’t provide a method to allocate the job-related labor burden to the “cost of construction” section of the General Ledger instead of the overhead section, your reporting will be inaccurate.

The goals of your Job Cost Ledger are to ensure that actual costs and estimated costs can be properly compared; to ensure that you bill for and collect on your costs, overhead and profit; and to allow you to compare your operating margins and overhead percentages with others in your industry segment. Reconciling your Job Costs ensures that numbers in your Job Cost Ledger are timely and accurate. Keep in mind that most integrated construction systems were designed with these goals in mind, so that you’ll get maximum accuracy reporting capabilities from your system, with minimal effort.

(Want to learn more about integrated construction software, and how D. Miller Associates can make it work for you? Call 800-895-1698 for more information today, or email info@dmillerassociates.com.)

Many smaller contractors, Fourth, contractors’ financial statements are subject to significant scrutiny by outside users, such as sureties and bankers, who often compare financial performance with industry benchmarks. If, for example, the contractor is including direct and/or indirect job costs in overhead rather than charging them to jobs, the contractor’s overhead will appear excessive.

Thus, how and what costs are included in the job cost and job estimate affect not only the amount of revenue recognition, but also cash flow (due to underbilling for work completed) and profitability (due to the inability to include all cost incurred in the performance of the work).

What Is Job Cost?

by Keith R. Fetridge

After 20 years of working with hundreds of different contractors, the one question I always hear is: “What should be charged to job cost? My controller tells me we should include X, Y, and Z in our job cost, but my project manager says that his former employer charged X, Y, Z, and the kitchen sink too. Who’s right?”

As you may have already surmised, there is no simple answer that will fit every contractor’s situation. The definitions and terminology vary within industry publications, and the application of what guidance does exist varies significantly between both CPAs and construction companies.

What does the applicable accounting literature say? The most current guidance comes from the AICPA’s Statement of Position (SOP) 81-1 “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.”

SOP 81-1 states that “contract costs should be accumulated in the same manner as inventory and charged to operations in the same period in which the associated contract revenue is recognized.” Contract costs include all direct labor, subcontract, and material costs, in addition to indirect costs that are identifiable and allocable to the construction contract. What SOP 81-1 does not clearly address is the types of costs that are included within indirect costs.

It’s Not as Simple as It Sounds

The difficulty in identifying and charging costs to jobs does not arise from identifying what direct costs should be allocated to job costs. The problems arise when contractors attempt to identify what indirect costs should be charged to a job and how those indirect costs should be allocated between their current jobs.

The issue of indirect costs lies with the term itself and how different people interpret it. For some, the term indirect cost means any cost not specifically identified to a particular project that must, therefore, be allocated according to a systematic methodology. To others, indirect costs include only overhead items, such as estimating, purchasing, etc., which are often referred to as job overhead.

For this discussion, I will use the second definition, which includes costs such as labor burden and equipment as direct costs and classifies costs such as general conditions, field overhead, and/or job overhead as indirect costs.

Why is it so important to know what costs belong to each job? The first and most important reason is that contract revenues earned for financial reporting purposes are generally computed based on the amount of contract costs incurred. That is, most contractors use the cost-to-cost method to determine the percentage of completion on individual jobs. As a result, the accumulation of actual job costs should correlate with the method used to derive the total job cost estimate. This enables the contractor to accurately measure profitability as the job progresses.

Second, many contractors use accumulated cost on jobs as a measure to determine what amount to bill; thus, if costs are understated, billings and cash flow may be negatively affected.

Third, when it comes time to prove a contractor’s cost (for purposes of supporting costs included in time and materials or cost-plus type contracts, or for purposes of documenting change orders or claims), it is critical that the contractor’s system of cost accumulation be the same as that used to estimate and price such work. Otherwise, it may be impossible to collect for all costs incurred.

Fourth, contractors’ financial statements are subject to significant scrutiny by outside users, such as sureties and bankers, who often compare financial performance with industry benchmarks. If, for example, the contractor is including direct and/or indirect job costs in overhead rather than charging them to jobs, the contractor’s overhead will appear excessive.

Direct Costs

Direct costs are relatively easy to identify and accumulate for most contractors. Direct costs can generally be defined as those elements of cost associated with the specific work to be put in place. The difficult aspect of identifying and allocating direct costs lies with the portion that must be accumulated in pools and allocated to job costs.

Some of the most commonly identifiable direct costs are:

Actual labor wages and related payroll taxes (FICA/Medicare, FUTA, and SUTA), fringe benefits (pension, health insurance, life and disability), and insurance (workers’ compensation and liability), etc.
Charges, fees, and assessments incurred in the performance of a specific contract, including taxes, freight, storage costs, etc.
Subcontractors’ costs.
Equipment (either owned or rented) used in the performance of the work. This includes both ownership and operating costs, such as depreciation, insurance, storage, taxes, licenses, maintenance, repairs, transportation, fuel, oil, tires, etc.
Other costs – bonds, permits, etc.

Indirect Costs

The identification, accumulation, and allocation of indirect costs is by far the most difficult aspect of job costing. Practice varies greatly between individual contractors depending on the size and type of work being performed. What determines if a particular cost should be classified as an indirect job cost or as a G&A cost? To make that determination, ask yourself the following questions:

1) Does the cost relate to the performance of a particular job in progress?

2) Does the cost relate directly to the contractor’s construction activities?

If the answer is “yes” to either of the questions, then the costs should generally be included as either direct or indirect job costs. If the costs are time-related, and do not relate to contracting activities, then they should be classified as overhead costs.

The types of costs that are typically included as indirect costs include:

Project management salaries
Estimating salaries and fringe benefits
Safety salaries and associated costs
Purchasing salaries
Contract administration salaries
Labor burden, including payroll taxes, fringe benefits, and insurance on the above salaries
General condition costs such as field offices, utilities, and security
Small tools, expendable supplies, and tools
Shop drawings and plans
Vehicle and communication costs
Engineering and architectural costs
Insurance – Builders’ Risk, Umbrella policies
Other costs associated with processing paperwork and/or accounting for the project

By their very nature, indirect costs require not only that you identify which costs fall into this classification, but also that you allocate these costs to individual contracts.

Cost Pools

Many costs in both the direct and indirect cost categories must be accumulated into separate cost pools and then allocated to the individual projects on some rational basis. For example, the cost of equipment storage, yard and/or shop facilities, or the cost of operating a separate contract administration or purchasing department cannot be specifically identified or costed to a particular project. But under our definition, the equipment costs would be classified as direct costs and the project administrative costs as indirect costs.

For these types of costs, the most common procedure used to allocate costs to individual projects is the use of a cost pool. Typically, contractors will accumulate costs into a number of different cost pools, such as:

Labor burden
Equipment ownership and operating costs
Shop and yard costs
Vehicle costs
Job management overhead costs

The development and use of cost pools requires the contractor to decide the following:

1) Which costs should be included as a job cost and in which pools should they be included?

2) How much of the cost should be included in the cost pool? In some cases, could the cost be allocated between job cost and overhead costs?

3) What method is most reasonable for allocating the cost to the jobs?

How you allocate indirect costs can vary depending on the type of work and amount of costs incurred. For example, a general contractor may choose to lump more costs together into one pool because they represent a very small percentage of total cost, while a subcontractor may use two or three separate cost pools for the same types of costs. What is most important is that the costs be accumulated and allocated to all jobs on a rational, consistent, and systematic basis over all years.

Some of the most common methods for allocating costs to jobs include methods based upon the number of labor or equipment hours incurred or the amount of labor, material, or equipment costs.

Costs accumulated in this pool can relate to both direct and indirect labor costs, but the method of accumulating and allocating the labor burden should be the same for both direct and indirect labor costs.

The sample labor burden calculation was developed using the percentage cost of each labor component to calculate the amount applied to each labor hour incurred. Another method used to develop and then allocate cost pools involves accumulating all the costs incurred in one reporting period (typically a month or year) and dividing that total cost by the allocating factor. For example, the total equipment cost pool would be divided by total anticipated equipment usage hours to obtain an hourly rate, which would be used to allocate costs to jobs based on the actual usage of equipment.

Cost pools, by their very nature, involve the use of estimates and, as such, contractors may find that the costs included in these pools are often over/underapplied to jobs. Depending on the reason for the over/underapplied amount and the amount of over/underapplied cost in relation to the total cost of the contracts, the contractor may decide to reallocate these costs to jobs or recognize the amount as a cost item.

Conclusion

Defining what costs should be included in job cost is a confusing area because contractors define direct and indirect costs differently and also use varying criteria for identifying which costs are considered indirect costs vs. overhead. The objectives which must be kept in mind when determining your company’s job costing procedures should include the ability to:

1) Obtain a high degree of comparability between actual costs and estimated costs.

2) Bill and collect for all your costs.

3) Compare operating margins and overhead percentages with others in your industry segment.

If you make decisions and set up your job cost accounting system with these considerations in mind, chances are you will have good answers to the question: “What should be charged to job cost?”

Keith R. Fetridge, CPA, is a Managing Partner and Director of the Construction Industry Service Group of Aronson, Fetridge & Weigle, in Rockville, Maryland (e-mail: kfetridge@afwcpa.com or phone: 301-231-6203). Keith has more than 20 years experience in financial management, tax, and business consulting for all types of contractors.

Keith is a member of the Greater Washington, DC Chapter of CFMA, as well as several other construction-industry associations. He is a frequent lecturer on many different management, tax, and financial topics. He is the author of over 100 articles on contractor management and a co-author of R.S. Mean’s Contractors Business Handbook, an editor and author of “The Contractor,” and a contributing editor to Construction Today.

Keith earned his BS degree in Accounting from the School of Management of Boston College in 1976 and has been practicing accounting in the Washington, DC area ever since. He is a licensed CPA in the state of Maryland.

UNDERSTANDING AND RECONCILING JOB COST