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GET PAID. The problems with WIP accounting in the construction industry

Does your role involve completing monthly revenue and Work In Progress (WIP), contract valuations, invoices and Application of Payment? Does it involve reviewing commercial performance, forecasting turnover and financial year gross margins?

The fact is if you are building new homes or working on a major engineering project and employ subcontractors, then your Work In Progress figure is most likely a LIABILITY. But usually builders and engineers rely on accountants to calculate their Work In Progress figure at the year end, and and many do not know how to calculate this number correctly. Accountants needed a way to value the finished goods that were not quite…well finished.

‘Work In Progress’ is an accounting method to value goods sitting in the production line which were no longer raw materials and where the production process has not yet finished meaning they could not be valued as finished goods.

The merits are obvious for the construction and engineering industry where prime contractors do not have to show a loss for the period until project completion where money is being spent on labour and materials, but no receipts had been recorded to offset the deficit. It also ensures that the client is directly funding the construction work, and that the contracting firm minimizes borrowing on behalf of the client.

So What’s the Problem For Builders & Engineering companies?

The problem with building companies for example is that they tend to ‘front load’ their jobs for cash flow and that builders use subcontractors for everything. Naturally there is a delay between work being completed and a subcontractor’s invoice becoming due.

The Result…is surplus cash! That’s great! So what’s the problem?

Many engineering companies and builders don’t understand where this cash has come from and mistake it for profit. This is a real issue. Some will spend it, and some will misinterpret it as margin and cut prices in order to win more contracts and cash flow their business.

The size of the problem or the implications for builders when this number is incorrectly calculated is not appreciated

Many auditors know costs may be stored in WIP longer than they should be, thereby avoiding depreciation until a later period. If so, reported profits are higher than should be the case. The Over/Under Billed Revenue accounts are Balance Sheet Accounts and they are often called either Billings in Excess of Costs (liability account that reflects over-billings) or Costs in Excess of Billings (asset account that reflects under-billings)

The construction work in progress account is a prime target of auditors

How to calculate WIP?

WIP identifies the value of construction projects which are currently being worked on by the construction firm. In order to properly account for each project, FOUR values are needed for each project at the end of any given month (or period):

By taking the Costs-To-Date divided by the Cost Estimate, the “percentage complete” for the project is calculated. For example:

We can sum up the elements in construction work in progress as follows:

What WIP doesn’t tell you…?

  • If you’re ahead or behind schedule,
  • If you’re over or underspent,
  • If you’ve spent money on the right thing,
  • If you’re getting value for money, or
  • If your problems are over or only just begun

 What’s the alternative?

Basing your application for payment on Earned Value Management (EVM) provides both the owner and the contractor with a method of controlling what items or materials have been provided by the contractor by looking at

  • How much work should be done? ~ Planned Value
  • How much work is done? ~ Earned Value
  • How much did it cost? ~ Actual Cost

For a project controls organization, Earned Value can provide valid benefits like the integration of work, schedule, and cost; early warning signals through Schedule Performance Index (SPI); Cost Performance Index (CPI); and an index-based method to forecast the final cost of the project.

The key is to develop a enterprise view of cost management definitions on basic terms like actuals costs and what is included (e.g. how are accruals to be treated?). In developing the Blue Print we use a Fish-Bone questionnaire as per the example below to specify a Project Controls and Cost Management solution: