Management Accounting

Back in 1987, when Maurice Forde, CR, of Forde Windows & Remodeling Inc., Northbrook, Ill., first launched his business, the nuances of accounting were not top of mind. Like all new remodelers, Forde was focused on selling jobs and making sure they were priced so he would ultimately make money, while also keeping an eye on expenses.

This is square one. And unless you were an exception to the rule or you hired an accountant on day one who was savvy in the ways of remodeling financial management, your books, like Forde’s, were originally kept only on a cash or straight accrual basis.

Cash accounting is the most basic method of accounting: All incoming funds are booked on a profit and loss (P&L) statement as income the moment they are received, and all expenses are listed as expenses only from the moment when checks are cut and monies are paid to cover invoices for everything from materials to labor.

In the first three years of his business, Forde admits that cash accounting and then a billings-based, straight accrual accounting method (more about this to come) left him wanting more from his first couple of accounting professionals. During this period, Forde relied on strong fundamentals in job-costing and pricing to get him through to the end of the year when the company’s books were closed and he could really look back and calculate the profitability of his company. This is because both methods of accounting he had used until that point cash and a billings-based, straight accrual method of accounting usually presented a distorted picture of profitability at all other given points during the year. These two methods of accounting are permissible for tax preparation purposes but did not provide much in the way of management decision making, often until well after the fact.

“Back then, I knew that cash goes in and cash goes out and hopefully you hold onto a little piece of it,” notes Forde. “I went through a couple of accountants who I was not happy with. At the same time, I was a member of NARI (The National Association of the Remodeling Industry), and I started talking to people and basically learned how to look at the reporting. There were some people who really knew the right kind of accounting and taught me how to look at these numbers and keep track of them.”

Flash forward to last month as Forde sat in his office on a Friday afternoon, clicking through reports generated by his bookkeeping software. From those reports, he had a firm grasp on the company’s overall profitability at that very moment. He also had a good understanding of the profitability on each of the company’s jobs-in-progress.

These reports were generated using an accrual-based accounting method where income and expenses are tracked based on the percentage of work on each job that is already completed, better known as percentage of completion accounting.

In part due to good decisions made from these reports over the past dozen years, last year his firm billed $1.5 million on a mix of jobs ranging from handyman, to exterior replacements to full service, and the company earned a very competitive level of profit on that work.

“I would say that it took until I was three years into the business to fully utilize [percentage of completion],” says Forde. “The biggest benefit is simply, knowing where you are.

“You can’t make any decisions that affect your business financially without knowing where your business is. If, for example, I was to look at my books today and see that I was losing a ton of money, I would have to make some decisions to do something. Conversely, if I look at my books today and I am making three times what I thought I would make at this time of the year, maybe I’ll make a different decision to go on vacation or whatever. But you can’t make decisions without the knowledge. Just knowing exactly where you are helps you plan for the future. And that is the biggest benefit.”

Three Types of Accrual Accounting
As Maurice Forde discovered early on in his business life, all accountants are not created equal. Remodeling companies, as distinct from other types of construction companies, have a unique set of needs to which an accountant must be sensitive.

For example, the percentage of completion method of accounting best serves the management needs of remodelers whose jobs frequently extend over longer periods of time — several weeks or months. Percentage of completion is not as helpful for specialty remodelers whose jobs are completed in a week. The time frame of the jobs involved is key to the choice of which accounting method provides the best information for management purposes.

Specialty remodelers whose jobs are consistently completed in a week or two would do fine managing with reports generated via a method of accrual-based accounting, referred to as the completed jobs. Under this method of accounting all income and all expenses related to a specific job are not booked until the job has been finished.

If the job lasts a week, the remodeler easily has enough information to check the profitability of his company in an ongoing manner. But for a remodeler with several long-time-frame jobs going at once, this method would leave him or her in the dark for long periods of time. For a remodeler like Forde with a mix of short and long time-frame jobs, percentage of completion accounting is the way to go.

A Simple Case Study
If Forde sells a $100,000 room addition job and the client gives Forde a check for the entire amount, under the cash method of accounting, his firm would enter that amount in their books as earned income on that day. But by using any one of the various accrual methods of accounting including percentage of completion, the same $100,000 deposit would be fully booked only after a delay of varying length. Under the completed job method, none of the deposit would be shown as income on the P&L statement until the job was 100 percent complete. Under the billings or straight accrual method of accounting, $100,000 could be kept as a liability on a deposit until the client is billed based on a prearranged draw schedule or whenever expenses come in and invoices are paid.

For example, if Forde used a billings reporting method and the first week he incurred expenses totaling $15,000, incurred overhead costs of $2,500, and according to schedule he invoiced the customer $50,000 that week, Forde may be left with an overly bright picture of his profitability. After Forde draws $50,000 from the deposit account, he would be looking at a snapshot gross profit of $35,000, and a net profit $32,500. Later in the job expenses could exceed the booked income and the gross- and net-profit pictures would be reversed. The result would be a consistently misleading platform from which to make near and long-term financial decisions.

That same $100,000 job under percentage of completion accounting would be handled with job costs firmly in mind. If Forde’s total job costs are $60,000 and during the first week $15,000 in expenses are paid, Forde would calculate that 25 percent of his is complete by dividing $15,000 into the overall expected cost of $60,000. He would then invoice the customer for 25 percent of the overall price and draw $25,000 out of the deposit account, leaving him with a much more accurate snapshot of his profitability at the end of that week. There would be $25,000 in income, minus $15,000 in expenses for a gross profit of $10,000, minus $2,500 in overhead for a net profit of $7,500. A comparison (below, left) reveals the differences in how the four accounting methods treat the same real-world situation.

Part of a Plan
Forde starts each with a plan that includes goals for total revenue, gross and net profit in dollar terms, and gross and net profit on a percentage basis. He breaks these goals down into quarterly and monthly targets, using history as a guide. For example, the first quarter represents not quite one quarter of his targets because these winter months are typically slower for a number of reasons: weather, post-holiday spending hiatus on the part of his customers, etc. Likewise, the second and third quarters are the busiest of the year and they account for the bulk of the year’s business. The fourth quarter picks up the remainder of the activity.

Each Saturday morning, Forde reviews the financial picture of his overall company on a job-by-job basis using reports generated with percentage of completion accounting. From this, he knows whether he will need to step up sales activity to meet revenue and profit goals for a given period or he can see if he is ahead of plan.

“What I see with a lot of young companies, and this may or may not be true, but they tend to have a focus on how much money they can bring in and not how much money they can make. The bigger the volume, the happier they are,” says Forde. “Often they are fooling themselves if they are not really tracking things. They just see that they are bringing in big numbers. So the first step is to try and start learning the numbers, how to read the numbers and mostly that comes from the job-cost part of it.

“Then, when you start using percentage of completion, you have to be realistic in knowing that you might get good news, or you might get bad news from the reports. In the end it is all good news, because you can make a change based on what you are seeing.” |

Editor’s Note: The genesis of this material was based on information gathered at presentations given by Steve Matlzman of SMA Consluting in Colton, Calif. and confirmed by a work published by Linda W. Case of Remodelers Advantage, Silver Spring, Md., The Remodelers Guide to Making and Managing Money. Go to www.smaconsulting.com and www.remodelersadvantage.com for further reading.

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