The Percentage of Completion (POC) accounting method is often used by construction companies to keep track of their projects. Many construction industry accounting professionals prefer the POC method over the Completed Contract Method because it provides a more realistic view of the company’s true financial status, especially on projects with extended timelines. This is accomplished because the POC method recognizes revenues and gross profit incrementally on a period-by-period basis, as opposed to the Completed Contract Method which only counts the revenue and profit in a lump sum when the project is completed.
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Why Is POC Better For Construction?
To illustrate the benefits of POC method accounting for construction projects, let’s look at XYZ, Inc.’s fictional Project 123 (below right). This table is a snapshot of Project 123 after 3 months of work on the project have been completed. As shown in the table, the original contract was for $500,000, and XYZ estimated their total costs on the project to be $400,000, generating an estimated $100,000 in gross profit. At some point since the beginning of work on the project, XYX signed a change order worth $45,000, bringing the total contract value up to $545,000. The estimated cost to complete the change order at $40,000, giving Project 123 an estimated total cost of $440,000. Also, this means that another $5,000 should drop to the bottom line, for a new total expected gross profit of $105,000.
Without the benefit of the POC accounting method, the owner of XYZ Inc might mistakenly believe that Project 123 is going to blow through all of their estimates and be hugely profitable. After all, during Period 3, XYZ only spent $25,000 but billed the customer $40,000. Since the project’s start, XYZ has spent just $60,000 while billing their client $120,000. You could see how XYZ’s owner might be thinking to himself, “cha-ching!” He originally thought that XZY was going to clear $100,000 (later revised upwards to $105,000), and here they are at the end of month 3, and they’ve already got $60,000 in the bank! According to this mistaken premise, the owner might assume that Project 123 is on track to blow the original gross profit estimates out of the water. Additionally, the owner might also incorrectly assume that Project 123 is at 22% completed based on billings to date ($120,000 / $540,000).
But, these would be a grave mistakes, because the percentage completed is not based on how much you’ve billed, it’s based on how much you’ve spent. That means that Project 123 isn’t 22% completed at the end of month 3; it’s actually just 13.6% completed.
This also means that at this point in the project, XYZ Inc. has overbilled their client on Project 123 by $45,880 (actual billings of $120,000 less the recognized revenue to date of $74,120). And furthermore, that $60,000 sitting in XYZ’s bank account? Only $14,120 of that is actually gross profit.
Further reading: What is Overbilling?
POC Accounting: Components & Calculations
Let’s take a quick look at the financial components that make up the POC method, and how each is calculated:
Percentage Completed for the Period =
Period Costs / Estimated Total Project Costs
Percentage Completed to Date =
Total Costs to Date / Estimated Total Project Costs
Recognized Revenue for the Period =
Period Percentage Completed * Total Project Revenue
Recognized Revenue for the Project to Date =
Project Percentage Completed * Total Project Revenue
Gross Profit for the Period =
Period Recognized Revenue – Period Actual Costs
Gross Profit for the Project To Date =
Recognized Revenue to Date – Estimated Total Project Costs
Now, from a cash flow perspective, overbilling on a construction project can be a very good thing. In this example, XYZ Inc. has over $45,000 of their customer’s cash sitting in their bank account, before they’ve actually completed the work to “earn” it. Therefore, if a business emergency comes up for XYZ that’s requires an immediate cash infusion to fix, well guess what: as long as that emergency costs less than $46,000, XYZ doesn’t have to borrow any money, because it’s already covered with the cash they’ve got sitting in the bank, thanks to the healthy overbilling on the project to date.
Further reading about the construction industry’s cash demands:
But this can lead to huge financial problems if a company mistakenly believes that the extra cash sitting in the bank account is earned profit (or free cash flow), instead of the end result of a significant overbilling. That’s because, over the course of the project, the costs are going to catch up to the billings, and this can lead to a situation where a construction company “runs out of billing on a project.” In this scenario, the company has already billed most or all of the project’s total contract value before they actually completed the work on the contract. And so, they have to incur costs (incur costs = spend cash) to finish their work without the benefit of any more cash coming in (since they already billed for the full amount of the contract). If they didn’t save some of that cash generated through the overbilling at the beginning of the project to fund their expenses at the end of the project, then they could have a serious financial situation on the hands – specifically, a “cash crunch.”
The POC method allows construction companies a much more realistic view of their project finances and progress. It also enables construction companies to better manage overbillings (and underbillings) along with their overall project cashflow. If used correctly and conservatively, the POC method should be a tremendously valuable tool to help keep their project finances – and the overall financial health of the entire company – on track.