Estimating the Percentage Complete
Typically, contractors use the percentage-of-completion (“POC”) method to account for long-term contracts. That method recognizes income as a contract progresses, in contrast to the completed contract method, which doesn’t recognize revenues or expenses until a project is substantially complete. Following is a simple example that illustrates the critical role CTC plays in measuring profitability.
Suppose a contractor enters into a contract to construct a commercial building. The contract price is $1 million and the contractor estimates its costs to be $900,000. At the end of year one, the contractor has incurred $300,000 in costs and believes its original cost estimate of $900,000 remains accurate—that is, its CTC is $600,000. Based on the costs incurred to date, the project is one-third complete, so the contractor’s first-year profit is $33,000 [$333,000 (33.3% of the contract price) - $300,000 in costs].
There are several steps contractors can take to ensure they prepare accurate CTCs, such as developing solid project budgets and labor schedules.
But what if productivity issues have substantially increased the contractor’s labor costs? Suppose that, assuming current productivity rates continue for the remainder of the project, its actual CTC is $700,000. This would reduce the POC to 30 percent, wiping out the contractor’s profits. In addition, it’s likely that the contractor would need to increase its labor costs down the road in order to meet the original target completion date, turning a profitable job into a loser.
Misjudging CTC Comes At a Steep Price
Failure to understand a project’s true CTC can cause a contractor to improperly recognize revenue, which in turn can lead to “profit fade.” If the contractor in the example above uses the inaccurate figure of $600,000 as its CTC, it will over-report its year-one profitability and experience significant profit fade in the project’s remaining years.
If, on the other hand, the contractor estimates CTC accurately, two important things will happen: First, more accurate, consistent reporting will inspire confidence on the part of banks and sureties. And second, it will provide an opportunity for the contractor to address its productivity issues or find other ways to reduce costs and boost its profitability.
There are several steps contractors can take to ensure they prepare accurate CTCs. These include:
- Developing solid project budgets and labor schedules (and updating them to reflect change orders and unforeseen developments),
- Implementing accurate systems for tracking and reporting productivity,
- Holding project managers accountable for monitoring a project’s financial performance,
- Accurately estimating the direct costs of all remaining work, and
- Meeting or beating the budget.
A Wise Investment
It pays to invest needed time and resources in developing accurate CTC estimates for your projects. The benefits include more accurate financial statements, stronger relationships with banks and sureties and higher, more consistent profits.
Seek the services of a legal or tax adviser before implementing any ideas contained in this blog. To reach a financial advisor at Lane Gorman Trubitt PLLC, call (214) 871.7500 or email firstname.lastname@example.org.