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MODULE 6

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MODULE 6

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  1. MODULE 6 CONSTRUCTION ACCOUNTING INTRODUCTION TO COST

  2. WHAT ARE COSTS? For economists, costs are the way we measure the amount of resources used to produce goods and services. These costs can be measured in units of money ($), physical force (amp.), energy (kwh.), time (hr.) etc. $ The more resources we use, the higher the cost. But the shape of the function depends on the kind of input we are using and its supply. INPUT EXAMPLES OF INPUTS: Materials, Human resources (labor), Support services (overhead), Equipment use (depreciation). Accountants use monetary units.

  3. HOW DO ACCOUNTANTS DEFINE COST? “Costs” are the resources a contractor acquires and expends as it works on a project. As the work is completed (this month, next month, the month after, etc.) we recognize these costs on our internal progress reports. As the periods of time go by, we also recognize them as charges against revenues in the period when we did the work: “Cost of Construction.” This goes on our external income statement. So, for our internal decision making we look at the work done, and compare this with our plans. And for external reporting we look at the time period when we did the work. And remember: costs are not the same as expenses!

  4. PERSPECTIVES ON CONSTRUCTION JOB WIN CONTRACT CONTROL: FINISH (USAGE, COSTS, (PAYMENT) SUBCONTRACTORS, SAFETY, RISKS) COMPANY CO-ORDINATION: BIDDING, PURCHASING, TRAINING, SCHEDULING FINANCIAL REPORTS: FOR BORROWING, TAX SAVING, INSURING, BONDING, TAX PAYING

  5. MAIN INPUTS TO BUILDING PROCESS • Materials Direct and • Labor traceable: • Subcontractors “500” accounts • Construction overhead Indirect: “600” accounts • (These become the contractor’s Cost of Construction) • - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - • Administrative and selling • expenses “700” accounts • (These become the contractor’s Operating Expenses for the year)

  6. INFORMATION FLOW MASTER BUDGET FUTURE ESTIMATES JOB “A” RECORD JOB REGISTER JOB “B” RECORD JOB “C” RECORD WEEK: MATERIALS LABOR SUBCONTR. OVERHEAD FINANCIAL REPORTING PERIOD EXPENSES DEFERRED EXPENSES

  7. PLANNING AND CONTROL CYCLE In Process • Budgeting • Material and labor • Cash Cost Control Scheduling Internal Cost Reports Finish line Planning (rough estimates) External Financial Reports start New Project

  8. WHAT IS INVENTORY? • Every material and supply that we purchase. They remain • a part of inventory until the contractor bills for work done • (cost of construction or cost of sales). • Any other costs related to completing a building project, • including labor and overhead. • BUT—some contractors treat all these building inputs as • cost of construction immediately, and calculate their • inventory balance at the end of the year. • Some contractors keep a central inventory (warehoused), • which is released to job sites through requisitions. Others • order and have materials sent directly to job sites. AVERAGE DAYS # DAYS / INVENTORY OF INVENTORY IN PERIOD / TURNOVER INVENTORY TURNOVER = Cost of construction / end. inventory

  9. FLOW OF LABOR COST INFORMATION BUDGET Master budget, hires, etc. Plans SCHEDULE Original or revised JOB RECORD Actual work, use of inputs Actions COST AND PROFIT REPORTS Ledger, balance sheet, income statement, income tax return

  10. DOCUMENT FLOW FOR LABOR JOB ORDER JOB BUDGET JOB CARD (TIME CARD) PAYROLL REGISTER FINANCIAL STATEMENTS External reports EMPLOYEE RECORD CHECK REGISTER (Payroll) PAYROLL TAXES PAYCHECK WITH STATEMENT

  11. ACCOUNTING FOR LABOR COSTS It is not just a report of work done and payments made. Other analyses can be done: a) How much time was spent on chargeable activities? b) How much time was paid at standard rates? c) How did our performance compare with our budget? EMPLOYER’S PAYROLL RESPONSIBILITIES • Deduct some taxes and premiums from employees’ gross. • (Examples: withheld income tax, FICA, contributions to • health and pension plans, contributions to life insurance) • 2. Calculate employer’s liabilities based on gross payroll totals. • (Examples: FICA, federal and state unemployment insurance, • worker compensation fund, contributions to health and • pension plans, contributions to life insurance)

  12. SCHEDULING A PROJECT * Some work must be finished (roofing) before other work can start (flooring, drywalls). * Workers have to be available and materials ordered. * A system of accounts and a control system should be in place. * Subcontractors have to be paid and their work completed. * We have to maintain cash balances at all times. * We should be able to meet or beat deadlines without taking extraordinary measures. KINDS OF PROJECT REPORTS GENERATED * Budgets and schedules prepared in advance. * Schedule of values (draw report) at stages of the project’s completion. Contractor can compare actual achievements with planned achievements. * Reports of work achieved. * Final summary report of revenues and costs, both actual and budgeted.

  13. DOES ALL COST ADD VALUE TO OUR PROJECTS? • Lost work time (workers must be paid) • Storage of materials until ready for use • Inspections by contractor personnel

  14. EXAMPLES OF STANDARDS • How much flour in a loaf of bread? • 5-7 cups (good standard?) 2. How many yards of fiberglass in a boat? We expect to use 255.39 square yards. (improvement?) 3. How many hours of study a week for this course? (That depends on the outcome we want!)

  15. MODULE 7 CONSTRUCTION ACCOUNTING OVERHEAD AND OTHER COST ISSUES

  16. CONTRACTING COSTS We have a good idea of the materials and labor costs for this building. But when something is used at more than one job, we have a harder time deciding the cost incurred here. That cost is indirect, and we call it job-related overhead.

  17. VARIABLE COSTS AND FIXED EXPENSES Some of our expenses increase as our work inputs increase. Most of these are directly involved in building, but not all (non-building examples: selling, rentals, maintenance) Other expenses (administrative, taxes, security) have little relationship to building activity. Many of these are set for a period of time (fixed expenses). But they can be changed at any time. - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - COSTS OF DEFECTIVE WORK AND REWORK • Should we treat them as variable or fixed expenses? • They are certainly direct because we can trace them. • They are certainly not fixed because we don’t budget them. • They do not add any value to the building. • Put them in special category for the business (“Cost of • defective work”) because they are avoidable.

  18. CONTROL OF VARIABLE COSTS Operating Expenses _________________________________________ = Revenues An indicator of efficiency (and the inverse of this ratio indicates productivity) One reading of efficiency for a single month: useful Ratio Readings for many months: trend data (much more useful) Months Example using data from March to May 2000: $15,500 / $117,000 = 0.132 (13.2% cost control or 1:7.5 productivity) April to June 2000 (there was a slight drop) $16,700 / $122,000 = 0.137 (13.7% cost control or 1:7.3 productivity)

  19. HOW TO ASSIGN OVERHEAD These indirect or fixed costs benefit projects but cannot be assigned easily to those projects. Still, we are expected to assign them, to show that they will be recovered. Find the activity that drives the cost, that is the reason for the cost (examples: small tools used on projects, office personnel dedicating time to specific projects). If there is no clear activity, then assign the costs with great care. GENERAL OVERHEAD FORMULA 1. Estimate total overhead cost for the year. 2. Choose a measure of input that is present in all our projects. Examples: total of labor hours, labor dollars, direct costs, square feet of construction, etc. 3. Divide #1/#2 to calculate a unit overhead cost. 4. Assign overhead to projects based on number of those units (labor hours, etc.) used in the job.

  20. CALCULATING AND ASSIGNING OVERHEAD * Estimate total overhead for year (example: $480,000) * Estimate total usage of a common job input (example: 120,000 labor hours on all jobs) * Calculate unit overhead cost: $480,000/120,000 = $4.00 assigned for each labor hour budgeted. * Calculate total overhead for a job: $4.00 per hour * 10,500 hours = $42,000. ANNUALIZE ALL OVERHEAD – DON’T OVERPRICE JOBS! The project uses 10,500 hours during a 2 month “down” period, when nothing else is happening. Should we take all the overhead for those 2 months and assign it to the project? $480,000/12 = $40,000 per month * 2 months = $80,000 overhead If we do that, the cost of the project rises and we may lose the bid.. So: assign the overhead evenly to all projects. Calculate a unit cost for each labor hour, or calculate a percentage of total overhead for this job: 10,500 / 120,000 = 0.0875 * $480,000 = $42,000.

  21. INCLUDE OVERHEAD IN OUR BID? If it is related to the construction work, yes! All of these (vehicle maintenance, supervisor salaries, storage) are spent during the building process. If it is related to selling and administration, then I say no! These have almost nothing to do with the building process, and there’s no good way to estimate it on each job. “But governments require us to account for all overhead in our bids!” (They do it because they want to know if we can recover all our expenses and stay functioning.) So go ahead and include administrative expenses, but just remember that we won’t get an accurate cost picture for our internal decision making.

  22. COST VARIANCES These are deviations from our cost budget. If our costs are higher than the budget, the variance is “unfavorable.” (You know, gotta cut costs!) If our costs are lower than budget, that’s “favorable.” The variance could be due to a change in price. Examples: We spend more for the materials or pay our workers more than we planned. Or it could be due to a change in inputs. Examples: We used more materials than we were supposed to, or the workers took longer to do the job. Example: Budget calls for 100 hours @ $25 per hour, or a total of $2,500. We actually spent $2,625 because the job took a total of 105 hours. So the overrun of $125 was due entirely to the extra time spent.

  23. PAYROLL • Contractors have these responsibilities for their • employees. • Withhold from employee gross wages the income • tax liability (based on the W-4 form). • 2. Deduct from employee gross wages the Social • Security (6.2%) and Medicare (1.45%) co-payments. • Deduct from employee gross wages any health plan • or pension plan co-payments. • Match the employee Social Security (6.2%) and • Medicare (1.45%) co-payments from company cash. • 5. Pay from the company’s cash flow all premiums for • state and federal unemployment insurance and • worker comp insurance. • 6. Match the health plan and pension plan payments.

  24. MODULE 8 CONSTRUCTION ACCOUNTING *ACCOUNTING FOR EQUIPMENT *BREAK-EVEN ANALYSIS

  25. LONG-LIVED (FIXED) ASSETS * Examples: buildings, machinery, vehicles * Used in the production of goods and services * Long useful life (several years) * Replaced on schedule * Depreciated (charged to expenses) over their useful life, using an acceptable method CONTROL RECORDS FOR LONG-LIVED ASSETS * Acquisition and replacement plan * Individual identification (serial numbers) * Maintenance and usage * Depreciation policy and records TO CALCULATE DEPRECIATION: * Original acquisition price * Estimated useful life (or MACRS category) * Disposal (salvage) value

  26. MAINTENANCE RECORD • Date acquired ____________ • Maintenance required: • __________________________ • __________________________ Name ___________________ Make & Model _____________ Serial No. ________________

  27. EQUIPMENT RECORDS EQUIPMENT PLAN JOB RECORD ACQUISITION / RENT EQUIPMENT RECORD (IDENTIFICATION) EQUIPMENT USAGE MAINTENANCE RECORD DEPRECIATION FOR EXTERNAL REPORTING

  28. HOW TO DEPRECIATE? ACCELERATE! CHARGE MORE IN THE EARLY YEARS! CHARGE THE SAME IN EACH YEAR! DO A STRAIGHT LINE! FOLLOW THE IRS RULES! [MACRS]

  29. DEPRECIATION STEPS Calculate: *Acquisition cost *Years of useful life *Residual (salvage) value Decide on the depreciation method: *Straight-line method *Accelerated method *IRS depreciation schedule A contractor can use one depreciation method on its financial statements and another on its tax return.

  30. STRAIGHT-LINE METHOD The same amount of depreciation expense in every year of useful life. Example: Machine costs $26,000, useful life of 5 years, residual value of $1,000. So total depreciation expense will be $26,000 – 1,000 = $25,000. And depreciation per year will be $25,000 / 5 years = $5,000.

  31. DOUBLE DECLINING-BALANCE METHOD This is the most popular accelerated method of depreciation. Multiplies the book value of the equipment times twice the straight-line rate. Returns to straight-line rate in the last 2 years. Example: Machine costs $26,000, with useful life of 5 years and residual value of $1,000. Again, total depreciation expense will be $25,000 but the annual expense will be greater in the first year and less at the end.

  32. MACRS (Modified AcceleratedCost Recovery System) -- IRS This is the rate usually used on income tax returns. It states a different rate each year, and multiplies it against the full value of the asset. Notice that it includes an extra year, and there is always a residual value of zero. Each kind of fixed asset belongs to a different class. This is the five-year class.

  33. BUSINESS DECISIONS -- EQUIPMENT To rent the equipment or to purchase it? Here is what the accountant will tell us. But we have other reasons for our decision, too. How much will we use it? When will we use it? If we purchase it, we will have an asset that we depreciate each year. We may also have a liability if we are using a financing lease. If we rent it or lease it under an operating lease, we have rental expense only. There is no effect on the balance sheet. If we purchase it, we will have depreciation expense on that asset. If we rent or lease it under an operating lease, we have rental expense only. In either case, there will be construction overhead costs. If we purchase it, it gives us a depreciation deduction on our taxes. If we rent or lease it under an operating lease, it gives us an expense deduction. If we purchase it, we are the ones in control of the expense deduction. If we rent or lease it under an operating lease, the supplier sets the price.

  34. PERFORMANCE RATIOS Return on equity: (In terms of the owners’ investment) Net Income / Total Shareholders’ Equity (example: $125,000 / $625,000 = 20.0%) - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Return on assets: (In terms of all the resources being used) Net Income / Total Assets (example: $125,000 / $1,000,000 = 12.5%) Drawback: All these figures come from transactions in the distant past, and they are not adjusted for price inflation.

  35. WAYS TO INCREASE PROFITS We could: Increase total sales (by lowering prices) – But if we do that, ______________________________ Increase gross profit (by buying larger quantities, working on bigger jobs, skipping government contracts) – But if we do that, _____________________________ Lower our operating expenses (crack the whip, subcontract, rent) – but if we do that, ______________________________

  36. BREAK-EVEN ANALYSIS The break-even point is the level of activity that yields zero profit. At that point the company’s revenues are equal to its expenses. To put it another way, at that point the company’s gross profit is equal to its operating expenses. There are several ways to calculate the break-even point. Here we will divide operating expenses by the gross profit margin. Example: A contractor earns a gross profit of $200,000 on its completed work of $2,000,000. That is a gross profit margin of 10.0%. Now suppose it has great ambitions and expects to spend $320,000 on its front office and promotional work. What level of revenue does it need to have? Just calculate: $320,000 / 0.10 = $3,200,000.

  37. USING BREAK-EVEN ANALYSISTO PRICE OUR BIDS Implications of each alternative Firm considering submitting a bid Alternative 1 Alternative 2 Alternative 3 Bid high Bid low Don’t bid (poor shot) (good chance) $230,000 $200,000 (180,000) (180,000) (40,000) (40,000) (40,000) $10,000 $(20,000) $(40,000) $50,000 $20,000 $0 Bid Direct Costs Fixed Costs Gross Profit Net Contribution To Overhead

  38. MODULE 9 CONSTRUCTION ACCOUNTING *PRODUCTIVITY ISSUES *COMPANY VALUATION *BANK RECONCILIATION

  39. PERIODIC REPORTING * Report at uniform intervals determined in advance. * Comparing most recent period with similar period last year, and year to date with similar time period last year. * Use level of analysis (job, subsection, week/month) that allows further investigation. * Study only significant deviations from our plan. * Allow for seasonal swings and for expected changes in activity levels: flexible budgeting. WARNING SIGNALS * Change in labor rates (are we using proper skill levels?) * Change in inventory levels (overbuying?) * Change in productivity levels (according to plan?) * Cost overruns on current projects. * Efficiency of labor (how much time is chargeable?)

  40. PRODUCTIVITY Productivity is equivalent to the following ratio: Value of outputs / Value of inputs Productivity increases if: * inputs are reduced * outputs are increased Example: Amount of concrete laid by worker in one hour (cubic yards) Standard rate: 100 cu. yd. per hour Labor productivity = Rate of work * no. of hours Work done: 2450 cu. yd. In 25 hours Do we have Improvement or Inefficiency?

  41. PRODUCTIVITY VS. COSTSIN CONTRACTING Construction costs increase 2-6% per year Construction productivity improves 0.8% per year 1975 1997 Bid estimates remain unchanged because of strong competition among contractors. Profitability of contract work declines every year. 1975 1997

  42. HOW TIME IS SPENT ON THE JOB SITE In an 8-hour day per cent time Productive work 50 4.0 hours Waiting on resource 14 67 min. Waiting on assignment 7 33 min. Materials handling 6 30 min. Waiting on instructions 5 24 min. Late / inaccurate info. 5 24 min. Accidents 3 14 min. Punch list 3 14 min. Wastage and theft 3 14 min. Substance abuse 2 10 min. Re-do 2 10 min.

  43. HOW CHANGES IN PRODUCTIVITY CAN IMPACT A CONTRACTOR’S PROFITS Components of the bid: Field Labor Cost 40% $ 400,000 Material Cost 35% 350,000 Equipment Cost 7% 70,000 Job Overhead 8% 80,000 Admin. Overhead 8% 80,000 Profit margin 2% 20,000 Total bid 100% $1,000,000 What if labor productivity improves by 5%? Then field labor cost is reduced by 5% of $400,000. We save $20,000, and now our profit is $40,000 or double the estimate. If labor productivity falls by 5%, we lose $20,000 and only break even.

  44. TEN STEP PROGRAM TOINCREASE PRODUCTIVITY • Planning prior to start of construction. • Implementing personnel management procedures. • Planning and scheduling. • Materials management. • Implementing an emphasis on cost and risk. • Implementing TQM philosophy. • Improving safety. • Improving equipment productivity. • Communications, recordkeeping, job cost system. • Quality and pride in work. The ten steps have more to do with planning and creating a culture of improvement, than they do with measuring the improvement. That’s because the measurements will take care of themselves.

  45. THE “MORE” MANAGEMENT APPROACH One way to emphasize cost and risk: Measurement of productivity (How much time is it actually taking us?) (Where is the waste occurring?) Opportunity for improvement (Suggestions for how could we do it better?) Risk emphasis (How much variability in the process?) (How easy to predict the result of our intervention?) Evaluate cost (Do we know what it’s costing us now?) (Can we calculate what the improvements will cost us?

  46. VALUATION OF A COMPANY If we have an offer to sell our contracting company, or if we have to sell it to pay inheritance tax. We could multiply the company’s net income by its price-earnings ratio. But what if we’re a private co.? The economists recommend calculating the present value of the company’s future cash flows. So how do we estimate those future cash flows? * The company’s past results (if the future will not get any better). * The company’s future results (if it will grow). But discount those future cash flows! * Liquidation value (if we’re going to close down and sell off the parts).

  47. PUTTING A VALUE ON A COMPANY If we’re over the hill, use PAST PROFITS. If the best is yet to come, use FUTURE PROFITS. If we don’t have a clue, use THIS YEAR’S PROFIT. If it’s all over, use TOTAL VALUE OF ASSETS. If price inflation is high, calculate present value. Example: Estimate of $100,000 profit per year for 8 years Cost of borrowing: 7% per year Present value factor: 6.00 Value of the company: $600,000

  48. ESTIMATING CASH FLOWS • Make an estimate of the expected net income per year. • (It could be increasing if the company is growing.) • An average of the last five years. • The result for the last two years or the latest year. • The projected result for the next 3-5 years, discounted • to allow for price inflation. • Then multiply this estimate by the number of years we will • earn this income. If the contractor has been in business for • several years and has a good profit history during that time, • we may estimate more time than if it is a start-up company • or if it has a spotty profit history. • Example: • We estimate net income of $350,000 per year for the next • 7 years, stated in present value terms. • The value of the contractor would be $350,000 * 7 = $2,450,000. • Since we are working with a long period of time, we may • assume that net income will be equal to cash flow.

  49. CONTROL OF PETTY CASH FUNDS * Always replenish from deposited bank funds. * Use for company business only, documented daily. * Account for these funds as Miscellaneous expenses. * Use voucher system (not IOU’s) for all withdrawals. Withdrawals should be compared with actual cash balance. PARTS OF A CASH FLOW STATEMENT * Operating cash flows (results of ordinary business) * Investing cash flows (buying and selling company property) * Financing cash flows (raising shareholder capital, borrowing)

  50. CASH IS A VITAL RESOURCE We have an independent source of verification of our cash balance (the bank) The checking accounts may clear rapidly (Code 21) but not instantaneously So: some events do not appear in bank statement and some events are not recorded on our books. Bank Reconciliation: adjusts bank statement and company books to include all events transpired.