Understanding what the Work in Progress (WIP) Report is telling you is an important tool you can use to not only comprehend what is happening right now in your company but also what will happen in the near future.
The following will help unravel some tips to understanding the report and how it can be used for not only projecting but also measuring performance.
What is the required information and how does it calculate?
Most of us will see the following columns in a WIP Report:
· Contract amount (including all approved change orders)
· Estimated total cost (including the cost of all approved change orders)
· Cost to date
· Estimated total profit (represented as both a percentage and dollar value)
· Earned to date
· Percent complete
· Billed to date
· Over and under billings
· Contract balance
The WIP report uses the above information to calculate the revenue to be recognized on a project based on the Percentage of Completion Method of Accounting. This method, most often used for formal financial statement presentation, uses the percent complete (based on estimated cost to cost to date) to the billings to date – the result being an over or under billing. The following example demonstrates how the formula works:
Contract Price: $100,000
Estimated total cost: $80,000
Cost to date: $40,000
Billed to date: $35,000
In the above example, the percent complete is obtained by dividing the cost to date of $40,000 by the total estimated cost of $80,000 to arrive at 50% completion. The project has “earned to date” revenue of $100,000 x 50%, or $50,000; the billed to date is only $35,000, thus there is an under billing of $15,000.
The Company would have a current asset called costs in excess of billing of $15,000 and increase their revenue figure by the same amount. Overbillings (billings in excess of costs) are shown as current liabilities and revenue would be reduced by the same amount.
The above example shows why it is important that cost estimates are as accurate as possible as they directly affect the revenue the company will report. If the above project had a 10% margin (estimated cost of $90,000), then the result would be 45% complete ($40,000/$90,000) and an under billing of only $10,000.
Cost estimates should be reviewed monthly to ensure that any variances are accounted for as the project progresses. It is best practice to update these estimates as changes in the project become known – if you anticipate losing on a project you must report the entire loss as soon as it becomes known.
Year-end estimates are important as well. If the company is required to report their income on the percentage of completion method for income tax, the estimates need to be as accurate as possible so as to not have an assessment of look-back penalties. Additionally, performance bonuses may be paid out on the year end estimates and if there are significant changes in the first quarter of the subsequent year, they must be analyzed in detail.
What does this report tell me?
For starters, if this is an ongoing project in excess of six months or so, there may have been a change in the original projected margin and the current margin. Was the change due to a better margin on change orders or an increase in the productivity of the project manager or crew? If the expected margin has decreased, what are the possibilities it can be turned around before completion so we can at least make our original target?
The big tip here is the under billing. Under billings are indications of future cash flow pinches. If this project continues at this rate with billings behind costs, it will eventually strain the working capital of the company. Imagine if that underbilling was $1,500,000 instead of $15,000!
The results of this report may trigger further investigation. For example, this company historically has not had any significant under billings – in fact, the majority of their projects are overbilled. If we just look at billings and costs, it may be that there are costs that have been charged to this project in error – costs that belong on another project. In that case, once those costs have been moved, the percent complete will be reduced and possibly put the project back into an over billed situation.
The results of this report can be used by management to look at committed costs and accounts payable and compare them to accounts receivable, over/under billings and project cash flow requirements. The schedule of values and completion target dates can be used to project costs going out and a similar trend line can be used for collections.
The under billings should be communicated as soon as possible to the project management team so steps can be taken to turn them around within 30 days if at all possible. There may be a valid reason for the under billing – materials on site but not installed that could not be billed due to contract language. In those cases, care should be taken on future material orders to ensure that they can be installed by the billing cut-off date or postponed not to arrive until just after that date allowing another month for installation.
Finally, the contract balance in our example would be $50,000 – total contract less earned to date. This is known as “Backlog” and is a key number for management. It indicates how much the company has in future work and revenue and can be used to determine manpower needs for the coming months. It also is an indicator of whether management needs to be proactive in obtaining new projects sooner rather than later. Maintaining a consistent backlog allows the Company to retain valuable, trained employees rather than risk a layoff and rehire pattern.
The Work in Progress report contains vital information that can be used for projecting and determining performance, not only on a project management level, but project type, location, etc. This can assist management in determining which type of projects brings in the highest margins for the Company when bidding future projects.
The report is a valuable tool for management for cash flow forecasting. Addressing underbilling situations is paramount to maintaining positive cash flow positions on projects.