Construction accounting brings a different set of rules when compared to more traditional styles of accounting. The perfect example of this is percentage of completion.
Whether you rely on recognizing revenue through percentage of completion or not, understanding the fundamentals of this process is vital to ensure that when you do encounter this method, you have the knowledge needed to ensure accurate billing, tax reporting, cash flow management and overall job performance.
In this article, we will break down percentage of completion in construction, looking at calculations, examples, scenarios, and everything contractors need to know to understand this foundational construction accounting method better.
What is the percentage of completion method?
Percentage of completion (POC) is an accounting method used to recognize revenues and expenses based on the percent of work done. In essence, costs and revenues are determined by how far along you are on the job.
- Revenue = (% of work completed in a period of time) * Total contract value
When specific milestones are hit, bills are expected to be paid. For example, a contractor may quote a job for $100,000, billed on a percent completion at the end of each month.
At the end of the first month, with project completion at 20%, an invoice reflecting 20% of the total ($20,000) will be sent.
By nature, percentage of completion allows project managers to accurately evaluate projects for each individual phase of a project. This helps to identify operational bottlenecks such as cash flow issues or labor inefficiencies, clearly showing cash requirements throughout the job.
Moreover, contractors won’t have to wait till the end of a project to receive payments. Meaning they have more leeway with their cash.
As a result, percentage of completion is both popular and effective for long-term contracts. In addition, it’s compatible with generally accepted accounting principles (GAAP), as these principles require that you recognize revenue in the period it was earned.
It’s important to take regular looks at how work projects are going. Keeping a close eye on job progress – month by month – helps those in charge of the money to make sure everything is in line. The goal is to verify that financial statements accurately back up real performance to date.
Progressing through a job can often feel like the last half of a tightly contested NFL game. Using the percentage of completion method, it’s almost as if you have a scoreboard to keep track of all the progress made so far. Each phase of the job is a possession, and the project timeline is like the game clock. This standardized approach of POC keeps you in the know so you can quickly tell where you stand in any given quarter and what adjustments need to be made before you head into the next one.
How to calculate the percentage of completion
There are three primary ways to calculate percentage of completion. They are:
- Cost-to-cost
- Efforts-expended
- Units-of-delivery
Before we dive into each method, contractors will need a few key pieces of information to get started. These are:
- Cost-to-date: Total amount already spent
- Total estimated costs: Sometimes referred to as “cost-to-completion”—this reflects the total amount you expect to spend by the end of the current period
- Contract price: Amount you are charging the project owner
You should carefully track these numbers and be able to source them quickly. If not, here is your reminder to do so. Use construction management software to ensure you can quickly and reliably pull up these numbers when you need them most.
With this information in hand, let’s take an individual look at three different methods contractors can use to calculate percentage of completion.
Cost-to-cost
Once you know your cost-to-date and cost-to-completion, you can plug those numbers into the basic formula below:
- Percentage of completion = Cost-to-date / Cost-to-completion
- Example
$40,000 / $120,000 = .33
The above example shows this project is 33% complete, given the cost-to-date and cost-to-completion.
To take it a step further, you’ll now be able to calculate and recognize the revenue to date based on the completion percentage we just calculated. In essence, we are matching revenue with expenses here.
Let’s say the total contract amount is $1,000,000. From here, we can plug the percentage of completion and total contract amount into the following formula:
- Revenue to date = Percentage of completion * Total contract price
- Example
33% * $1,000,000 = $330,000
Efforts-expended
This method is typically based on labor hours, materials used, or machine hours. For example, suppose you estimate that a project will take 10,000 labor hours to complete, and you’ve already clocked 6,000 labor hours to date. In that case, you can divide these two numbers and then multiply that number by 100 to get a percentage of completion.
- % Completion = (Labor hours to date / Total estimated labor hours) x 100
- Example
(6,000 / 10,000) * 100 = .6 or 60%
Units-of-delivery
This method is best used for construction projects in which you, as the contractor, must deliver several identical services or end products. In other words, any time the contract can be split into a specific number of identical deliverables, such as identical pieces of furniture, the units-of-delivery method can be used to identify percentage of completion.
For example, if a contractor is to deliver 50 units and 10 units have been completed, the project would be 20% complete.
- Percentage of completion = Units to date / Total units agreed to deliver
- Example
10 / 50 = .2 (20%)
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Percentage of completion example
With a basic understanding of the three most common methods, let’s look at a detailed percentage of completion example using the cost-to-cost method.
For this example, let’s assume that a contractor was awarded a contract with a total value of $1,000,000 to be completed in three years. In the table below, we have broken out this project to display the following:
- Contract price: this number will not change and should reflect the total contract value of the contract
- Costs incurred in current period: actual costs incurred during the contract year
Estimated costs yet to be incurred: a fluctuating number representing an estimate of costs for the next contract year. This number will likely change depending on progress made, market factors, and issues with project execution
| Contract year | 2023 | 2024 | 2025 |
| Contract price | $1,000,000 | $1,000,000 | $1,000,000 |
| Costs incurred in current period | $258,000 | $220,000 | $170,000 |
| Estimated costs yet to be incurred | $400,000 | $190,00 | $0 |
Notice the $0 at the bottom right of the table. We put $0 here as we expect the project to be completed at this point. Meaning that, theoretically, there should be no additional costs remaining.
From here we can use the template below to plug in the above numbers to determine percentage complete for each year along with the revenue generated:
| Contract year | 2023 | 2024 | 2025 |
| Contract price | $1,000,000 | $1,000,000 | $1,000,000 |
| Costs incurred in current period | $258,000 | $220,000 | $170,000 |
| Cost to date | $258,000 | $478,000 | $648,000 |
| Estimated costs yet to be incurred: | $400,000 | $190,000 | $0 |
| Total estimated costs | $658,000 | $668,000 | $648,000 |
| % complete | 39% | 71.50% | 100% |
| Revenue to date | $392,097 | $715,000 | $1,000,000 |
Calculations:
- Revenue to date = % complete * Contract price
- Cost to date = Cost to date from previous year + Costs incurred in current period
- % complete = Cost to date / Total estimated costs
Percentage of completion accounting
The IRS requires accrual accounting for long-term projects. As a result percentage of completion is almost always the best route to take, with two significant exceptions.
The first exception is determined by:
- Size of the job: Construction contracts that can be completed in two years or less.
- Size of the contractor: Contractors with no more than $25 million in gross receipts over the last three years.
The second concerns home builders:
- If a contract is expected to have 80% or more of estimated total costs attributed to home construction, they are eligible for exemption from IRS regulations.
Outside of these exemptions, the IRS typically requires the use of percentage of completion for large contractors working on projects spanning two or more years. With that said, some exemptions exist for large contractors; however, any change in accounting methods will likely require the approval of the IRS. For more information, contractors can review IRS code 460.
Risks of using the percentage completion method
The advantages of percentage of completion for contractors are clear; you don’t have to wait until the end of the project to receive payment, and it gives a clear snapshot of job progress (not to mention that you may have no other choice but to use POC to appease the IRS). But what about the disadvantages?
Results are based on estimates
You may have noticed in the provided example that percentage of completion is calculated using total estimated costs. Since this method relies on estimates, the door is wide open for inaccuracies and skewed profit calculations if your estimating system is flawed.
If your estimates are wildly inaccurate, numbers will skew, resulting in a barrage of adjustments.
Too many adjustments won’t look good to other project stakeholders or the IRS. For this reason, POC requires a high degree of due diligence from the contractor. They must ensure they have a system that can reasonably estimate profitability, job costs, and progress. As a business owner, you must know how to do this or hire someone who does.
Beware of overbilling or underbilling
Overbilling and underbilling are two thorns in the side of the percentage of completion method. This is because revenue and expenses can be tricky for contractors to get right, especially on long-term projects. When revenue figures don’t quite match up with what’s already been billed, it can result in major cash flow problems. These problems are mostly caused by excessive over or underbilling.
When the amount you bill exceeds the amount you bring in—you’re overbilling. Keep an eye on this. If it happens too often, you’ll have a plethora of cash flow issues, making it hard to cover costs down the stretch of the project. In contrast, when your billing is consistently below what you bring in—you’re underbilling, resulting in just as many cash flow issues from a P&L that reflects too little profit.
Take note of these billing differences by taking advantage of WIP reports. When you notice discrepancies, ensure your accountant is aware so they can record them as journal entries. This is the only way to make the necessary adjustments to ensure that income statements accurately reflect what’s been calculated through the percentage-of-completion method. Additionally, contractors need to revise their estimates anytime changes occur. This ensures your accounting calculations’ accuracy and helps avoid further cash flow challenges.
Change orders
Change orders are a necessary evil for most projects. But when it comes to the percentage of completion method, they can be even more of a hassle. Failure to properly handle change orders can make calculating POC an absolute nightmare. When using POC, contractors have a duty to account for change orders as soon as they are approved. This is vital since income recognition is based on each project’s completion percentage.
When change orders are approved, you must adjust estimates, revise budgets, and alter your numbers immediately. You want to always be on top of your revised estimates to ensure your accounting calculations stay accurate and consistent.
Percentage of completion & progress billing with Knowify
It’s no secret that progress billing can be truly daunting. Staying on top of it can be an immense challenge, especially when dealing with large projects, various phases, and change orders.
Don’t make this more complicated than it has to be by using spreadsheets to keep tabs on billing. Let’s face it; they’re outdated and not suitable for contractors looking to grow. Knowify delivered a better way with our robust set of construction accounting tools.
With Knowify, contractors can do the following:
- Create progress invoices quickly and easily
- Send customers clear, easy-to-understand invoices
- Track payments and accounts receivable aging
To see how Knowify can simplify your progress billing, schedule a 30-minute demo with one of our experts today!
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