Introduction
All businesses have some form of accrual accounting system in place to track revenues and costs over time. A good accounting system is a necessary for the successful operation & existence of a business, and there are different options available to companies based on their size, revenue, or entity type. Many companies follow generally accepted accounting principles (GAAP) or other accounting rules, which helps to standardize tracking and allocation of different types of revenues, costs, assets, and liabilities.
Even with standards to follow, accounting systems often fall short of providing the necessary details of a construction company’s day-to-day operations due to manual data entry, data availability issues, or accounting reconciliation processes (typically done every few weeks or so). Even when you have timely, accurate revenue and cost data, your accounting system may be several weeks behind where you actually are on a project. Therefore, you might not be able to tell that you’re way over budget on an activity until it’s too late. You may be able to make the margin up somewhere else, but wouldn’t it be better to try to prevent the cost overrun in the first place?
Fortunately, there's a process that can help contractors overcome these deficiencies: Project Management Accounting.
Overview of Project Management Accounting
Project management accounting (PMA) helps construction companies get into the details of each project and develop the ability to closely inspect the operations of each project against the company as a whole in a timely manner. This level of project detail ultimately provides companies with a detailed understanding of project and company-wide profitability, cash flow, budgets & performance, and can lead to better estimating. Project management accounting is different but ultimately very similar to general accounting and GAAP regulations, but the information is collected in near real-time on each project, allowing you to gather data and derive far more insights into the overall financial health of each project and ultimately the construction company entirely.
Differences between PMA and GAAP Accounting
Let's explore the differences between PMA and GAAP accounting by thinking about the differences between a manufacturing operation and a construction project. In manufacturing, determining revenue and cost of goods sold (COGS) is usually straightforward, even for a business with multiple product lines and locations. There are clear fixed costs involved in managing a factory and warehouse. The inputs to the production process are clearly defined, the costs are easy to track, inventory is generally easy to determine, and revenue is simply dependent on the finished goods' price and the number of orders received. Evaluating the financial position of a company under this scenario is usually straightforward.
For a construction company, an individual project is its own profit center with variable costs of production, unpredictable change orders, inconsistent scopes of work, and other differences. This means that each project has a different COGS with respect to direct, indirect, and inventory costs. Projects have different durations and different payment terms, including nuances like retainage, that affect cash flow. Additionally, construction companies need to allocate overhead cost from supporting elements of the company like marketing, admin, and safety to specific projects. Understanding a construction company's financial position involves a more detailed, project-level analysis of these factors. This is why project management accounting is so important.
Elements of Project Management Accounting
Project management accounting requires coordination throughout the entire project, from pre-construction to completion. Typical pre-construction efforts for a construction company include estimating project cost and project activity costs along with allocating overhead and profit margin to the bid. After a project is awarded, the company takes the estimate and creates a project budget. A shortfall of using the accounting general ledger to understand project costs is that it lacks detailed tracking. Every accounting transaction that is lumped into a general ledger account is just dollars with no relationship to a project at this point that can be compared to a project budget.
For example, the payroll account does not distinguish between Office and Field employees. It doesn't necessarily know which project the cost relates to, and it certainly doesn't understand the specific activity the payroll expense relates to. All it shows is a lump sum of payroll expense over a given period, preventing the company from doing any detailed analysis into the labor cost required to complete a specific activity or job.
One of the key elements in a good project management accounting (PMA) system is the understanding and application of job cost and job activity costing for a project. There is a lot of accounting data that comes into a construction company for each project and capturing that information and visualizing it is the core of job costing.
Job costing is tracking specific costs incurred by a construction company and allocating them to an individual project. Tracking costs incurred during construction on a specific task is job or task activity costing. It is important to understand that these terms are again similar but different. Job cost can be considered the aggregation of all costs associated with the delivery of a project while job activity tracking is taking those job costs and breaking them down further by task for use in forecasting completion costs and ultimately profit/loss. These two detailed activities also flow into the estimating process during comparison of estimating workup and budget for the project.
Types of Job Costs
Job cost is comprised of overall labor, equipment, materials and overhead that is directly attributable to a project and can be aggregated to inspect the overall effort on a project from a very high viewpoint. A perspective here for understanding is that the project has its own general ledger accounting process providing for an independent COGS and profit center. It is not uncommon for companies to have an overall labor manhours budget, equipment budget, and project duration/general conditions budget versus actual or forecasted matrix to quickly investigate the performance or level of effort expended utilizing this rudimentary but project specific measurement.
Job cost should be broken down into three types of costs:
- Direct job cost: Job activity costing is tracking direct costs and allocating them to specific job performance activities. This level takes the equivalent section from an estimate with its budget and compares actual direct field costs to the estimate. Job costing activity is taking the project-specific general ledger and making it that much more detailed. Job costing activity depends on an accurate and easily used cost code process or job cost structure, which could look like:
Project 1540-01-A3, Baltic Improvements
Cost Code Division: 07-105 RCP Stormdrain, 36”
Budget
Costs
Difference
07-105-100: Labor
33,175 28,155 5,025
07-105-200: Equipment
42,381 45,685 (2,304)
07-105-300: Materials
78,000 77,000 1,000
For a more in-depth discussion of cost codes, see Smart Construction's Guide to Cost Codes
- Indirect job cost: There are job-specific costs that are not attributable to any one task for a project such as jobsite trailers, internet services, jobsite security, and permits. These types of items are usually treated in the general conditions of a project budget but can be separated out into other sections of the job cost budget structure depending on each company. These types of indirect support activity items should be measured in a project COGS, but many companies don't have the processes in place to account for these costs in the overall project cost.
- Overhead cost: Overhead cost is related to the function of the company-operations, marketing, finance, etc.. These costs need to be allocated to projects so that the company can get an accurate view of how project revenue is covering all costs, not just costs at the jobsite. Overhead may be a certain percentage allocation based on overall project size or revenue or percentage allocation of total manhours, depending on the company.
Benefits of Project Management Accounting
Unlike a typical manufacturer or retailer that makes a product, ships the product, invoices for the item, which is then reflected in the accounting system as an account receivable, construction contracts are frequently long or occur over numerous accounting periods, have inconsistent terms and conditions that affect invoicing, payment timing with retainage clauses, warranty items, and potential change order disputes that affect construction operations cash flow. Under the general accounting ledger process, most, if not all, of this relevant information is lost. The project management accounting process allows for the tracking of all this information separately for each project.
Job task costing activity at a detailed level gives construction companies the ability to track project budget vs. cost vs. progress and forecast completed activity costs across the entire project for each activity. This allows for a much more accurate depiction of a project’s overall financial situation with respect to performance or progress and financial outcome. This is also where job costing activity tracking information can flow back into estimating and project or performance management. Information is now available to identify performance or task trends and if estimating assumptions need adjustment.
Furthermore, there are other stakeholders that have an interest in the financial performance of construction operations, from surety companies to ownership, and the accurate tracking and understanding of each project’s cost structure and its final margin is of significant importance to all parties.
The project management accounting approach allows for this deep, granular inspection of a project. It should be updated month-to-month through forecasting or job cost adjustments for tasks that are exceeding the estimated budget along with tasks that are complete and may have come under budget at completion. Performing these adjustments month to month provides for an understanding and trend line for each project and the company overall. It is a far more powerful information process than a typical general accounting ledger can impart or convey to company operations & management.
Is each project profitable? Are we better at certain tasks or projects than others? What did we do wrong or right on this project? What will cash on hand balance potentially be in 180 days? Can we service our debt from a cash position? These types of questions can be answered through adopting a project management accounting approach.
It is a top to bottom project management process and takes time to develop, understand, refine, and embrace. This information is important to the general ledger of the company and should be the aggregation of all projects. This information affects the decision-making process on investment opportunities, equipment replacement and upgrade needs, borrowing costs to fund operations, and, the year-over-year company livelihood.
How Smart Construction Can Help
Smart Construction Field and Smart Construction Office help construction companies track activity and costs more efficiently and accurately. For example, contractors use Smart Construction Field to track employee time against specific activities. The timecard data from Smart Construction Field updates the schedule in Smart Construction Office at the end of each day, giving the project manager or owner critical data into the labor hours & cost on the project each day. The project manager can make critical decisions to avoid cost overruns and delays based on a better understanding of cost vs. budget from the bid. This availability of near real-time data helps contractors do project management accounting more quickly and accurately than with traditional methods like tracking manually in Excel.
Reach out to find out more about how we can help your company manage project costs more effectively with Smart Construction solutions.