Zack Kelly is the founder of Home Builders Financial Partners, a construction-specific bookkeeping and accounting firm catering to high-end luxury custom home builders. He is an indisputable expert on construction finance, and he joined us on the podcast to talk through Work in Progress, or WIP.

What is Work in Progress (WIP) Reporting?

Work in Progress (WIP) reporting is a crucial financial tool used in the construction industry to track the progress and financial health of ongoing projects. It provides insights on three main aspects:

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1. Knowing How Much to Bill For: Determines the accurate billing amount based on the project's progress.
2. Managing Cash Flow: Helps in understanding the financial inflows and outflows to maintain a healthy cash flow.
3. Ensuring Financial Statements Are Correct: Adjusts revenue recognition to reflect the actual progress of projects.

1) Knowing How Much to Bill For

WIP reports help determine the accurate billing amount by using the percentage completion method. By calculating the percentage of project completion, builders can bill clients accurately, avoiding overbilling or underbilling.

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The percentage completion method involves calculating the proportion of the project that has been completed to date. This ensures that the billing aligns with the work done, providing transparency and accuracy in financial transactions. The most common way to calculate percentage completion is based on costs incurred divided by the total cost budget.

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Let's consider a construction project with a total cost budget of $1,000,000 and a total client budget of $1,200,000. By the end of the first quarter, $400,000 of costs have been incurred and you have collected $300,000 from your clients so far. How much

should you bill for?

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To calculate the % of completion:

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• Total cost budget: $1,000,000
• Total costs incurred: $400,000
• % complete = $400,000 / $1,000,000 = 40%

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To calculate the total amount of revenue you have earned:

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• Total client budget: $1,200,000
• % complete = 40%
• Total revenue earned: $1,200,000 * 40% = $480,000

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To calculate the amount you should bill for in this period:

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• Total earned revenue: $480,000
• Total collected from client to date: $300,000
• Total amount you should bill for: $480,000 - $300,000 = $180,000

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This would be the exact amount that you should bill for according to the % of completion method. However, at any given point, you will likely have collected more or less than you have earned. Let’s talk about what that means for cash flow in the section below.

2) Managing Cash Flow

WIP reporting helps in identifying whether you have billed more or less than the work completed, impacting future cash flow management.

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In the above example, you would have earned $480,000 and collected $300,000 prior to sending the client an invoice. In this scenario, prior to receiving the money from your client, you would be Under Billed.

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• If Earned Revenue > Amount Collected = Under Billed
• If Earned Revenue < Amount Collected = Over Billed

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Understanding whether a project is overbilled or underbilled is essential for maintaining a healthy cash flow. A good rule of thumb is that you should try to never be Under Billed, because this means that you are essentially fronting cash for your client by paying for project costs before they pay you. You’re acting as a bank for your client, but not collecting any interest!

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So that brings us to Over Billed. In general, it is fine to stay a little Over Billed, but if you are significantly Over Billed, it could get you into cash flow trouble as you progress on the project.

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In the above example, we assumed you had earned $480,000 and had collected $300,000. Let’s consider the following example where you’ve earned $480,000 but have already collected $700,000. This means you are $220,000 over billed.

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• Total cost budget: $1,000,000
• Total costs incurred: $400,000
• Total costs remaining: $600,000
• Total client budget: $1,200,000
• Total collected: $700,000
• Total billings remaining: $500,000

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What we see above is that you have $600,000 left to spend, but only $500,000 left to collect. That means that for the duration of this project, you are going to have a net cash outflow of negative $100,000.

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If you have the cash you’ve already collected still sitting in the bank, then you are fine. However, if you used that money to pay for costs on another project, you could be in upcoming cash flow trouble. This is why staying on top of how much you are over or under billed helps to understand cash flow management.

3) Ensuring Financial Statements Are Correct

While it’s common to be over or under billed, you will need to adjust your income statement every month to ensure that the revenue you are reporting is accurate.

Note: For tax purposes, the IRS requires large contractors (with average annual gross receipts over $10 million) to use the Percentage of Completion Method (PCM) for long-term contracts. Smaller contractors (with average annual gross receipts of $10 million or less) can often use the Completed Contract Method (CCM), which may not require monthly WIP adjustments.

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WIP Adjustment:

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• When overbilled in the month, the revenue is adjusted downwards to match the work completed.
• When underbilled in the month, the revenue is adjusted upwards to reflect the additional work completed but not yet billed.

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Numerical Example of Timing Adjustments: Consider a scenario where in one month you were overbilled by $50,000. You would need to adjust your revenue downwards by this amount to reflect the actual work completed. In the following month, suppose you were underbilled by $30,000. You would then adjust your revenue upwards by $30,000 to account for the work completed but not yet billed.

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• Month 1:
  • Overbilled: $50,000
  • Revenue Adjustment: -$50,000
• Month 2:
  • Underbilled: $30,000
  • Revenue Adjustment: +$30,000

These adjustments ensure that your financial statements accurately reflect the project's progress and the actual revenue earned, providing a true picture of your financial health.

Conclusion

Understanding Work in Progress (WIP) reporting is essential for builders to manage their projects effectively. By providing insights into billing accuracy, cash flow management, and financial statement accuracy, WIP reporting ensures that builders can maintain a healthy financial status and complete projects on time and within budget.

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As a final note, WIP is worthless if you don’t have accurate tracking of how much you’ve spent, how much you’ve billed for, what your current cost budget is, and what your current revenue budget is. Therefore, it’s important to have a good foundation to stay on top of these four numbers!