In this episode of Your Business Unleashed, we’ll discuss several ways to record and collect revenues that are commonly used in the construction and trades industries along with the benefits and pitfalls of each.
How a construction or trade company bills their customers and collects payments for its work are usually the first things that we fix with our new customers. Revenue recognition methods and collection policies in these companies often make the difference between a trades-based company that has cash and one that doesn’t. If you’re listening to this podcast and you own a construction or trades company, you very likely know that cash does not equal profit. The difference between profit and cash in the bank is all about the balance sheet. If you are accumulating accounts receivable and inventory, which can include work in process inventory, even if it’s not written onto the balance sheet, you are diminishing your company’s cashflow.
The goal of a well-run construction or trade company is not only to ensure that they’re profitable, but also to focus on reducing AR and inventory. High AR and inventory can often be fixed by changing how you bill your clients and your collection processes, which are commonly referred to as your revenue recognition model. It is important to note that these are billing methodologies, and this is different than pricing methodologies, which I covered in the last podcast. Okay, so let’s get into it.
So first, let’s talk about the completed contract method. This is very popular method of recognizing revenue in companies that work on short-term projects. Under this approach, a construction company recognizes revenue and profit only when the entire construction project is completed. Construction companies often require an upfront deposit to be paid in order to help with the cashflow concerns or if there’s a concern about the customer’s ability to pay on completion.
Let’s explore some benefits and pitfalls of the completed contract method. So, the benefits of this method is simple and straightforward, and billing occurs when the project is done. This dramatically simplifies accounting and financial reporting and the competency of the bookkeeper and other administration personnel required to account for it is reduced. There is also no need for estimates of project completion percentages or future costs, which can reduce the risk of errors and disputes. Generally, the timing and amount of revenue recognition is certain and clear, and it’s not tied to project progress or milestones. This makes it easier to predict cashflow and it simplifies budgeting.
A major drawback is that revenue and profit is recognized upon the project completion, which can make monthly financial performance appear lumpy, which may not show well in a financial report, which can negatively impact the company’s financial ratios, which can make it hard to secure financing without taking upfront deposits.
Construction companies may have trouble with cashflow as they’re not billing until the end of the project, after they have incurred the expenses. This constrained cashflow. Also, if the company’s collection policies are not solid, AR balances can accumulate, which also cripples cashflow. Using this method, there may be less incentive to spend money on proper project-based accounting leading to poor project cost control and unidentified cost overruns for long-term projects, recognizing all the revenue and profit upon completion may not accurately reflect the company’s performance over time and clients may prefer more frequent billing as it provides them with transparency and the ability to better budget for the project. The percentage of completion method of billing is one of the most widely used revenue recognition models in construction, particularly in projects that extend over a long time, often months or longer. Under this method, revenue and expenses are recognized as they occur and are directly tied to the percentage of work completed on the project, which is based on estimates prepared by at certain intervals.
The most common method of percentage of completion recognition is by comparing the actual cost incurred to date compared to the estimated total cost to complete it. Some of the benefits of the percentage of completion method is it reflects the revenue and profits over the life of the project based on the percentage of the work completed based on the revenues the expenses incurred to date. It provides a more accurate representation of the financial performance during long-term projects rather than at the end of it, and it aligns the matching principle as revenues are recognized as costs are incurred. Some of the pitfalls, of course, is it requires accurate and consistent tracking of project costs and progress. Data collection and sorting can be tough in the construction industry. And so this means it requires a high degree of accounting competence and good internal controls to ensure that all the costs are accumulated and recorded in real time.
Change orders and cost overruns need to be included and worked into the percentage of completion calculations in real-time. This can get complicated or the revenue recognition will be inaccurate. Another option with change orders and overruns is to communicate and bill these costs as they occur. Vendors and trades do not always submit their invoices on time, making it difficult to get a true estimate of actual and cost incurred to date. And revenue, of course, is an estimate and because the two previous factors I’ve mentioned can often result in estimation error, which can lead to restatements and recognizing revenue too early or in advance of sufficient cash receipts can lead to the company paying too much GST before it has to, which can also lead to cashflow issues. Alright, milestone billing is very common in the construction industry, particularly for the construction of new homes as most lenders require it as a condition of construction draw mortgages, it involves billing the client at a specific project, milestones or completion stages.
Here’s some of the advantages and pitfalls. So, milestone billing allows construction companies to receive payments periodically throughout the project, which helps with cash flows. It ensures a more steady income stream, and it makes it easier to prepare proactive projections and budgets. Billing at milestones aligns payments with project progress. Does the risk for a company, especially if a client’s financial situation changes during the project. Clients generally appreciate milestone billing because they see tangible progress and results as they make payments. This can enhance client satisfaction and trust. This is why lenders also want to see it is because it’s part of a typical construction draw mortgage and it’s all about trust in that scenario as well. With this model, a lender can have an inspector visit the site and write down the progress and the stage of construction and issue the next part of the loan. Milestone billing provides transparency to clients and banks.
They track the project and expenditures more easily, and if revenue is recognized as cash is received on a construction draw mortgage, the construction company has cash on hand to pay GST as the revenue is recognized. And this prevents a cash timing mismatch. Milestones make it easier to quote on various types of projects with unique characteristics and should make financial budgeting easier. Milestones make it easier to manage expenses because it creates points of accountability for all the trades during the build, bringing cost overages to the forefront faster and the company has the cash to pay these expenditures because they’re receiving the cash at the various stages.
What are the pitfalls? Well, managing multiple milestones on multiple projects requires a lot of administrative effort, gathering all expenses at a milestone and comparing them to budget. And pos can be time-consuming and project-based accounting needs to happen in real time for this billing to function properly.
This almost always requires dedicated resource to manage the flow of data and hold trades accountable in real time. Clients and lenders may dispute the completion of milestones leading to disagreements and payment delays. It is very important to have solid contracts with clear and precise milestones defined in them in order to prevent disputes. And if payment delays are prolonged, the construction company may face difficulties in covering ongoing project costs, potentially leading to project interruptions. And it is important to evenly space the milestones and to understand which phases the work will be the most expensive in order to plan out cash flows. To maximize these advantages, make sure you’ve got clearly defined contracts. Maintain open and clear communication, develop a robust invoicing and accounting system, and implement a payment schedule that aligns with the company’s cash flow needs.
Then there’s upfront billing. My favorite type of billing, and of course a customer’s least favorite is upfront billing.
This is also called upfront payment or payment in advance, and it involves requesting the client to pay some or all of the contract amount before the construction project begins. In certain cases, a construction company can ask a customer to pay budgeted costs up to a milestone, creating a hybrid between this method and milestone billing. Other times, a company asks their customers to pay a fixed amount at intervals that will last or reset when the cash runs out. Sometimes a company may ask for the entire payment upfront. This billing approach has its own set of benefits and pitfalls. Let’s get into them. So some of the benefits are obviously receiving full payment or partial payment upfront significantly improves a construction company’s cashflow. The immediate influx of funds can be used to cover initial project costs, purchase materials, and pay subcontractors and employees. This significantly reduces the company’s financial risk and increases their financial stability.
Planning for projects and investing in equipment and staff becomes a lot easier because it could be done with cash that’s in the bank, and this is a way of helping construction companies whether economic downturns. This method also reduces administrative burden as there’s generally less tasks associated with invoicing and payment tracking and collections, and clients who make upfront payments are often more committed to the project, which leads to a much smoother project execution. Some of the pitfalls, many clients are not comfortable with making a full or substantial payments upfront as they perceive it to be a significant financial risk. Most clients may prefer to pay as work progresses. This is because our customers may assume that there’s a risk that the construction company or trade may not perform the work as agreed upon once they have received the payment. This objection might be overcome by companies who have a slick onboarding process or great credibility in the market.
Bidding on construction projects is often quite competitive, and requesting a full upfront payment can make your bids less attractive compared to other contractors with more flexible payment terms. While receiving upfront payments is definitely advantageous for cash flows, we found that it often creates a false sense of success because the costs relating to the project have yet to be incurred. So there’s a buildup of cash at the company. It’s super important to proactively manage cash flow to ensure that the project isn’t disrupted, which can lead to legal and solvency issues. Some jurisdictions may have regulations or restrictions on the timing of upfront payments or the amount of upfront payments. It’s important to comply with these regulations and if a project cancelled early or experiences delays, the company might not have cash to satisfy refunds or to see the project through.
So construction and trade-based companies have a lot of options when it comes to revenue recognition. Accounting for the various options is complex, which is why many companies struggle to understand and manage their cashflow. For companies who have an excess of $5 million per year in revenues and several projects on the go at any given time, we almost always recommend the use of a fractional CFO to understand which options are best and assist in creating accounting controls and a reporting environment that makes tracking your revenue recognition policies easier.
Consistency is the key, as is financial accountability and clear communication with trades company officials and your customers.
Be sure to download “Better Tools”, our Construction Business Strategy Guide