Every year many of the largest surety losses in the country are caused by a lack of quality internal controls. This can take many forms and affect companies both large and small. Billing practices are just one of those controls. Unfortunately, it’s one of the biggest areas of improvement for the industry as well. Managing billings can make or break a contractor and bond companies understand that. First, if your company does not have a system that can show you how over/under billed you are, you need to immediately upgrade your internal accounting system. This is a frequent problem I see with growing contractors. There are many great affordable construction accounting software programs available. QuickBooks is a fantastic system for many businesses, but I have yet to see it produce good statements for contractors. Good contractors need sophisticated cost and reporting systems. It may seem like you have more pressing needs for your capital but this is one of the best investments you firm can make.
Costs and Estimated Earnings in Excess of Billings on Uncompleted Contracts
This long statement above or something close to it should show up as a current asset on your company balance sheet. Usually these are referred to as “Underbillings” for short. Your accounting software should calculate your underbillings for you. You may also use the work-in-process form on our Resources Page. In short, an underbilling on a project is when the Costs for the project plus the Estimated Earnings on the project are more than the Billings for the project or (Cost + Estimated Earning>Billings).
Underbillings show up as a current asset because you have done work (incurred cost) for which you have not billed. The logical thinking is that you should be able to bill for that work in the future and convert it to accounts receivable or cash. On paper it sounds like a great thing. Unfortunately, few things scare bond companies more than underbillings. The reality is that large underbillings are usually one of two things. They are a loss that the contractor hasn’t recognized or a poor billing practice.
- Losses – One of the easiest ways for a contractor to lose money or worse, is to perform work for which they can’t get paid. Often to please a good client or to avoid delays, good contractors agree verbally to contract changes. They go out and perform work, incur the cost and try to get the change order signed later. NEVER, EVER do this. Take my word for this, it will come back to haunt you at some point. ALWAYS get a signed change order before doing any work that is not in your contract. Unfortunately, these unsigned change order often show up as underbillings. The contractor can’t bill for the work until the change order is signed. The second scenario is one in which the contractor had poor estimates in their work. For example, a dirt contractor may run into unforeseen rock or water. Their contract may not allow them to pass these costs onto the Owner, so they are stuck in underbillings. Bonds companies are wise to these things and will ask a lot of questions regarding your underbillings. They may discount them completely if they are not satisfied with your answers or if it’s not quickly billed.
- Bad Billing Practices – Construction is a very cash intensive business and the companies that fail are the ones that run out. Even with great billing practices, the collection cycle is usually long so why would you not want to bill for work you’ve performed. In many cases, once you miss a month’s billings, you can’t bill for another whole month and then must wait for collections. As such, bond companies are nervous about companies who routinely have large underbillings. A better practice would be to get out in front of the money and be slightly overbilled.
Are Underbillings Always Bad?
Sometimes there are good reasons for being underbilled. Let’s say for example that the job calls for purchasing special equipment and that equipment can’t be billed for until it’s started at the end of a project. This may be a legitimate reason. Just make sure your bond company isn’t surprised. Another thing to keep an eye on is how your underbillings stack up to your cash, assets and equity. If your overall underbillings make up a small portion of your assets, your bond company is less likely to be concerned. If they make up all your assets, you may be looking for a new bond company. Finally, stay on top of underbillings. If you have a history of quickly billings and collecting underbillings, you are likely to get a lot more leeway. If the same underbillings stay on your books month after month, your bond company is going to question the collectability of that work.
Billings in Excess of Costs and Estimated Earnings on Uncompleted Contracts
Of course, the opposite of underbillings is the statement that appears above. We simply refer to these as, “Overbillings”. In short, an overbilling on a project is when Costs for the project plus the Estimated Earnings on the project are less than the Billings for the project or (Cost + Estimated Earning<Billings). Whereas underbillings show up as a current asset on your company’s balance sheet, overbillings show up as a current liability. The logic is that you have already billed for work you haven’t performed. At some point, you will have to perform that work and incur the costs. Although it’s a currently liability, bond companies look at some overbilling as a good practice, especially early in a job. Wise contractors will try to stay ahead of the money and add some additional cost into mobilization and other costs to get them started off in front.
Too much in overbillings can be problematic as well though. Sureties will get very concerned if a contractor has billed more than the remain gross profit in the project. This is referred to a “pure job-borrow.” This is a dangerous road as you will now have to steal from another project to finish this one and is often a sign of cash flow problems.
Another overbilling consideration will be cash and receivables. Because the work will still need to be performed without additional billings, your company will have to fund those costs from somewhere. The bond company will want to make sure you have the adequate cash and liquidity necessary without having to take it from another project.
Understanding under and over billings is not only vital to keeping your bond capacity, it may just keep your construction company in business. Make sure you keep a watchful eye on all your projects and billing practices. Contact us if you need help. We help contractors of all sizes and want to be your bond broker for life!