WIP & Percentage-of-Completion Schedules 101
A work in progress (WIP) schedule is an important tool for companies in the construction industry to monitor an individual project’s overall progress and profitability. A WIP schedule not only helps management track all current ongoing projects’ profitability metrics—such as total contract value, total costs incurred, estimated cost to complete and completion progress—it also can help third-party users determine a company’s overall profitability and liquidity by analyzing overbilling and underbilling on significant contracts.
The four basic elements necessary to prepare a WIP schedule are transaction price, costs incurred to date, estimated cost to complete and billings to date.
The transaction price represents the total contractual revenue the company expects to earn upon completing the contract and any adjustments for variable consideration. There are several different contract types, and some contracts may have elements of different types of contractual arrangements. Here are three common types of contractual arrangements:
- Lump sum
- Unit price
- Time and material
Lump sum is the most straightforward of the three and can carry additional risk for contractors, as the contractor will incur losses if cost overages occur. The lump-sum amount as agreed in the contract plus any change orders and variable consideration should be the transaction price for determining gross profit earned to date on the project. Change orders can present a challenge related to timing. When a project’s scope is increased, the additional work sometimes begins prior to the change order being officially approved and executed. This not only is a risk for the contractor operationally but also can distort profitability within the WIP schedule. If additional work is taken on without adjusting transaction price for the change order, additional costs will be incurred without a corresponding increase in transaction price. This will reduce profit margin on the project up until the change order is executed. Unapproved change orders should be carefully evaluated as part of the variable consideration that’s included in the transaction price.
In a unit price arrangement, the contractor is paid an agreed-upon price per unit of work completed. Unit price arrangements are often used when the project’s total scope isn’t fully known or if there are certain costs involved with the work that will likely be encountered but can’t be accurately estimated. To determine the total transaction price of a unit price contract, the contractor must have an accurate estimate of the total units that must be completed to fulfill the contract. At any point in time it’s estimable that more or fewer units must be completed to finish the contract, the contractor should incorporate that change in scope to both the transaction price and total estimated cost to complete.
Time and material contracts are often used when the project’s full scope isn’t known or easily estimated by either party. Under this arrangement, the contract owner bears virtually all contract risk. Any cost overages in a time and material contract will ultimately be billed to the contract owner. Time and material contracts also can represent difficulties when constructing a WIP schedule. Often, the total transaction price and total estimated cost to complete can’t be accurately determined. In this case, the contractor should determine its best estimate of what the total project cost will be at completion to determine the estimated cost to complete. Once this is determined, the transaction price would simply be the total cost plus a gross profit markup.
Another crucial factor in preparing a WIP schedule is accurately accumulating costs incurred on each individual project to determine the progress and also the earnings. The two most common problems in determining job costs incurred are job cost allocation and proper cutoff.
Allocation of job costs between projects is a complex subject. Some costs are much easier to allocate than others. For example, a purchased material that’s fully installed at a particular job site will be 100 percent allocated to that job only. However, certain construction costs can be potentially split between numerous projects in a given time period, such as labor costs and equipment usage. In addition, indirect costs, often referred to as “overhead,” also must be charged to each project based on a core cost factor such as total labor hours, total labor cost or simply total direct costs.
Cutoff of job costs is another crucial factor of having an accurate WIP schedule at a specific point in time. Costs recorded in the wrong period will have offsetting effects, making the earnings in both periods inaccurate.
Estimated Cost to Complete
Estimated cost to complete is a judgmental element of the WIP schedule and is determined based on management’s best estimate of each project’s future costs. The estimated cost to complete is what defines the expected total scope of the project in terms of the contractor’s cost. With the WIP schedule’s other elements being held constant, changing the total estimated cost to complete on a contract can have drastic effects on the percent completion of each job and, thus, the revenue recognized in each period. For example, imagine the two below scenarios where all factors except estimated cost to complete are the same. Changing the estimated cost to complete has a significant effect on percentage completion and can make an otherwise profitable contract into a contract that loses the contractor money:
To accurately estimate the cost to complete a contract, both operations and accounting should be involved. Project managers, engineers, estimators and project controllers generally will have the best knowledge of a project’s actual progress in terms of overall completion. This information also should be known by the accounting function, and regular communication is vital to have an accurate estimated cost to complete.
Although billings aren’t a factor for determining profitability, billings play a significant role in a company’s cash flow. Thus, it’s crucial that companies keep track of billings and make sure projects are being billed appropriately and timely. When considering billing as it relates to cash flow, construction companies should ask, “Who’s financing the project?” In a perfect world for construction companies, the customer would be fully financing the project, where billings would occur first and then project expenditures would follow. However, this is often easier said than done. Like other businesses that manage accounts payable and receivable, billing in the construction industry can be like a tug of war between companies to meet their cash flow needs.
Depending on each job’s progress compared to the timing of its billings, a project can be overbilled or underbilled. Underbilling a project results in a contract asset (costs and estimated earnings in excess of billings), while overbillings result in a contract liability (billings in excess of costs and estimated earnings). Once the transaction price, costs incurred to date and estimated cost to complete are properly determined, calculating contract assets or contract liabilities is fairly straightforward. The actual revenue earned to date on a project based on percentage of completion is compared to the total amount billed to date, and whichever is greater determines whether a contract asset or contract liability exists.
New Revenue Recognition Guidance
FASB published Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, on May 28, 2014. The new revenue recognition standard in ASU 2014-09 is primarily codified in FASB Accounting Standards Codification 606, and the effective date for nonpublic entities was for years beginning after December 15, 2018. The new guidance introduces a five-step model for recognizing revenue, and it requires entities to first identify the performance obligations in the contract and then allocate the transaction price to each one. Consequently, percentage of completion is applied to a performance obligation rather than a contract price.
In addition, the new revenue guidance also introduces the concept of “transfer of control” to determine when the revenue should be recognized—either at a “point in time” or “over time.” If certain conditions are met, revenue should be recognized over time, which is similar to using the percentage-of-completion method.
Another key change relates to the accounting when reasonably dependable estimates can’t be made at contract inception. Under current revenue guidance, companies are required to apply a completed contract method if they don’t meet the criteria for percentage of completion, and once the completed contract method is applied, the company can’t switch to the percentage of completion. This is no longer the case. Under the new revenue guidance, a company is required to recognize revenue to the extent costs are incurred until reasonable measurement of progress can be determined, as long as it expects to recover costs in accordance with the guidance; once reasonable measurement of progress can be determined, it’s required to recognize revenue over time.
Four crucial elements make up a WIP schedule: transaction price, costs incurred, estimated cost to complete and billings. Once these are accurately determined, a WIP schedule can be constructed that shows a true position of the company’s projects. Companies should pay significant attention to the changes and reporting requirements under the new revenue recognition guidance, as there could be changes to how companies should recognize revenue and measure progress toward completion. For more information, reach out to your BKD trusted advisor or use the Contact Us form below.