Every project starts with an estimate that attempts to predict the total Cost of labor and material needed to perform the work. With this number and the contract price, we can find the Original Estimate of Gross Profit. (Contract profits are always “gross” because overhead and other expenses have not yet been deducted.)
The same analysis can be performed during the life of the project to determine:
- if the contract is expected to produce a profit
- if the original project estimate was reasonably accurate in predicting the costs that are being incurred (and therefore the profit prediction is dependable)
- if field supervision and the labor force is as productive and efficient as expected
- if material costs are coming in as predicted
We use the original percentage of gross profit instead of the dollar amount so the contract performance can be compared over time, even if the contract dollar amount has changed by amendment.
A short form WIP may not state the Current Estimate of Total Costs, or the Current Estimated Profit, but you can calculate them.
Formula to find Current Estimated Percentage of Profit:
On the WIP schedule, do you see, or can you calculate, the Current Estimate of Total Costs to Complete? (Discussed in “2 of 4”)
Find it by adding the Costs Incurred to Date to the Current Estimate of Remaining Costs to Complete.
To calculate the current estimated profit %, subtract the Current Estimated Total Costs from the Current Contract Amount (gives you the expected profit in dollars), then divide the profit dollars into the contract amount to find the profit %. Try it on our sample contract.
Contract Price / Original % GP / Billed / Costs to Date / Remaining Costs
$1,100,000 / 10% / $550,000 / $350,000 / $700,000
Is the current estimated profit $50,000? Yes, it is!
To find the % divide $50,000 into $1,100,000 which gives you .045 or 4.5%.
This means that now, after this project has commenced, a profit that was projected to be 10% of the original contract amount has now deteriorated to 4.5% of the current contract amount. This is vital info for the contractor to have during the project. It shows a trend that must be controlled. Prompt action may prevent the project from producing a loss for the company or could even improve the final profit figure. The surety underwriter will monitor such projects, even if they are not bonded.
Critically Important: This analysis is impossible if the contractor fails to record the labor and material costs incurred specifically on each project. They must also make a CURRENT estimate of the remaining costs to complete. They cannot rely on the original estimate of costs and merely hope the profit will be there at the end.
Billings: Overbilled / Underbilled
Now let’s shift gears. The next point to determine is whether the project is billed ahead or behind the degree of completion. For example, the contractor’s office may be slow in processing the invoices to the project owner, so they may not have collected funds that are rightfully earned (they are Underbilled). Conversely, they may be billed beyond the degree of completion (they are Overbilled) and therefore have dollars in hand that are not yet earned. This is calculated in dollars by first comparing the % of completion to the % Billed to Date. Try it on our example contract.
Here are the questions:
- What was the % of completion?
- What dollar amount is that percentage of the current/revised contract amount? (This gives you the “correct” amount of billings at this stage in the project.)
- Are the actual Billings to Date more or less than this amount? Are they Underbilled or Overbilled, and by how much?
OK, what did you get?
- The % of completion is 33.3%
- Therefore the “correct” billings are $363,000
- If the actual billings are $550,000, the company is $187,000 Overbilled on this project.
They have succeeded in billing the client beyond their current degree of completion. This may not be bad if the contractor knows they are overbilled. Management should not be unpleasantly surprised when they are 100% billed but the work is still not complete (Yipes, no more money coming in! Who’s gonna pay for the labor and materials?)
Another issue: Overbillings can become a concern for the surety. Overbillings (money) may be diverted by the contractor into another project. In the event of contractor default and completion by the surety, this means there may be funds missing that rightfully belong in the project. This could increase the surety’s net loss.
Underbillings may indicate an intentional, conservative billing practice on the part of the contractor – leave money in the project and take it out at the end when successful completion is assured. If it is unintentional, they may be depriving themselves of earned profits that are currently needed.
Underbillings can also be an indication of poor management and / or administrative practices.
The point is that all these issues are important for the contractor and surety, and therefore, the agent.
Our last segment in this series will cover how all this affects the contractor’s financial statement. Important!
FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!
Call us with your next one.
Steve Golia, Marketing Mgr.: 856-304-7348
First Indemnity of America Ins. Co.
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