Profit Fade
“Profit Fade” occurs when jobs close with lower gross profits than was originally estimated. This often occurs when companies do not maintain Work in Progress Reports (W.I.P.s). The W.I.P. is a tool that shows estimated gross profits for each project, allowing staff to address potential issues, save anticipated profits on the current jobs, and estimate future jobs correctly.
Underwriters who approve bonding, loans, and credit lines must rely upon the contractor’s ability to estimate correctly. As a result, they spend a great deal of time analyzing the contractor’s financial statements. Maintaining accurate W.I.P. reports allows managers and creditors to analyze a contractor’s estimating capabilities by performing a “fade analysis”. This analysis is calculated by comparing the final cost of completed contracts with the original estimate used for financial reporting. If profit fades occur consistently, underwriters will lose confidence in the contractor’s ability to estimate. This in turn can lead to lower bonding capacity and/or denial of credit lines.
The Work-In-Progress Schedule
The primary function of this schedule is to determine revenue and gross profit under the percentage-of-completion method. Following each accounting period, the schedule should be updated to include the gross contract amount, the total cost incurred-to-date, and the estimated total cost of the contract (which is the most critical). These amounts should be tracked for each contract individually, and include any approved change orders signed after the reporting date.
To prepare the schedule, the contractor needs collaboration between those responsible for project management and those responsible for accounting.. Without consistent communication from managers in the field, the finance department will have difficulty accurately estimating the completion costs. Specifically, the W.I.P. record of costs incurred-to-date should be consistent with job cost reports in the accounting system. If project managers are not maintaining an accurate accounts payable system for job costs, errors may arise in the calculations.
The external CPA is an excellent resource for analyzing and maintaining accurate W.I.P. reports. Many clients ask us to assist them with profit fade analyses on closed contracts, and we frequently review the accuracy of the reports prior to their release to third parties. We also review other calculations, such as the financial impact of backlog projections.
In working with our clients, we have seen the benefits of accurate W.I.P. reporting first hand. Bond underwriters and creditors perform calculations such as the fade analysis at least annually, and excessive or consistent profit fades could restrict bonding and financing capacity. We have also seen situations where overly optimistic estimates of gross profit helped cause a fade. Cases such as these not only undermine the credibility of the contractor’s estimating process, but they also result in accelerated income tax on profits that were never realized.
Even small contractors without bonding concerns should perform these calculations. Small contractors may eventually need to look for bonding or financing as they expand, and proactively maintaining accurate W.I.P.s may help them later on. Beyond that consideration, the W.I.P. report is the most accurate measure of job profitability. It helps companies adapt to potential problems on individual jobs, and it records an accurate performance history, which helps the contractor price future projects more accurately.
We are only a phone call away if you have questions or need assistance your financial reporting.
Christopher T. Marrie, CPA, Principal
cmarrie@hbkcpa.com | 239-263-2111
