In the intricate dance of cash flow and project management, "billings in excess of costs" play a pivotal role, particularly in sectors like construction where progress billing is the norm. According to a report by the Construction Financial Management Association (CFMA), it's not uncommon for contractors to bill up to 20% more than the work completed to date, a practice that helps manage the financial risks associated with large projects. This financial maneuver, while necessary for maintaining liquidity, translates into a liability on the balance sheet, reflecting unearned revenue that must be carefully tracked. As the CFMA outlines, recognizing revenue accurately is critical for financial reporting and compliance, ensuring that companies don't overstate their financial position. For businesses navigating this complex accounting challenge, understanding the implications of billings in excess of costs is essential for maintaining fiscal health and transparency.
One of the most common examples of how this term is used is found with the billing process used by many contractors. In this scenario, it is not unusual for a contractor to bill clients in advance for work that is contracted but has not yet been done. The understanding is that the work will be completed within a reasonable period of time. In the interim, the accounts receivable billed will be more than the actual revenues earned, and carried as a liability in the contractor’s financial records. As the work is finished and the revenues are considered earned, the amount decreases until the amount is no longer classed as a liability.
Providers sometimes use billings in excess of costs as a means of controlling expenses and avoiding the necessity of using credit or taking out loans in order to pay for materials needed up front. By securing some advance payments from customers, those funds can be used to cover all costs associated with the work, since the cash is in hand to pay for labor, materials, or any other task relevant to completing the job. When properly managed, this means that, once the project is complete, there are no lingering costs to be settled and the provider has in hand any profit that is generated above and beyond the job expenses.
While this practice is accepted in a number of industries, this approach does create the need to carefully manage the billing associated with each client in ways that would not be necessary if the billing took place at the time the money was actually earned. Care must be taken to track the progress of the work or the delivery of services so that the liability is accurately reduced. In addition, should the provider have several different projects taking place concurrently, it must avoid using funds carried as a liability to buy supplies for one job when in fact that revenue is associated with a different job. Failure to do so can quickly create a false image of what work has and has not been billed with a given job, creating issues for both the client and the provider.
What Causes Billings in Excess of Costs
In simple terms, having billings in excess of costs on a balance sheet simply means that the company has billed customers for work that hasn’t been completed yet. This should produce a net positive in cash flow, where the company has more working capital on hand than expenses.
The opposite situation is called costs in excess of billings. When this happens, it means work has been completed but not yet billed. This can produce a negative effect on cash flow, leaving the business without the money needed to pay suppliers, sub-contractors or employees.
Some industries purposely use billings in excess of costs to improve cash flow and reduce reliance on outside financing. Before being able to bill this way, contractors must persuade clients to sign a work contract for an agreed-upon amount.
What Billings in Excess of Costs Include
Many construction companies charge customers the full cost of a project upfront. This includes the costs of materials, labor, permits and other expenses.
It also includes project revenue, or profits for the business to take home from the job. When done right, there should be nothing to charge customers on project completion.
How To Calculate Billings in Excess of Costs
On a company’s balance sheet, the amount of revenue calculated with billings in excess of costs continually shifts as the project progresses. Many contractors that rely on this type of accounting utilize a percentage-based model to make accurate recordkeeping easier.
A monthly balance sheet should record the estimated project completion percentage based on work performed and work remaining. If a project is 40% complete, then 40% of the total billed amount would be considered as revenue, and 60% would constitute liability in accounting records. This percentage-based scale can be applied at whatever frequency profit-and-loss forms are normally created for the business.
In the following example, the customer has paid $300,000 in advance for a construction job. The project is slated to be completed in six months, and the contractor’s accounting records reflect monthly changes:
- Month one: Project completion is 10%. Current revenue from project is $30,000. Current liabilities are $270,000.
- Month two: Completion reaches 30%. Revenue for project is $90,000. Liabilities are $210,000.
- Month three: Project completion at 50%. Revenue set to $150,000. Liabilities also at $150,000.
- Month four: Completion is now 60%. Revenue at $180,000. Liabilities at $120,000.
- Month five: Completion reaches 80%. Revenue from project is $240,000. Ongoing liabilities are $60,000.
- Month six: Project completed. Revenue is fully entered on balance sheet. No liabilities recorded from project.
Keeping careful records is vital to ensure tax payments are calculated correctly, especially when a project begins in one tax year and ends in another. Any investors and lenders also want clear data regarding month-to-month project updates.
Why Contractors Should Be Careful With Billings in Excess of Costs
Using billings in excess of costs can provide ample capital for a project, but it also means that cash flow can drop dramatically once the project is complete. All of the revenue has been billed and earned, so until another project is secured, there's no source of further income to pay employees with.
Front-loading income in this way also means that contractors must have a clear idea of how much capital is required to complete the project. Otherwise, they may run out of funds for subcontractors and building materials near the end of the project.
Correctly using the billings in excess of costs method of accounting requires taking the time to painstakingly estimate project needs. Making mistakes can seriously harm a company's financial health, especially if work contracts don’t allow much wiggle room for adapting to market changes in materials costs.
