Understanding Work in Progress (WIP) and How to Track it.
Running a profitable remodeling business is a constant juggling act of balancing the money coming in on each project versus the money going out to ensure that each job is properly funded and profitable.
Tracking project progress in real-time is incredibly important because consistent overbilling on your projects can give you a false sense of profitability. In contrast, underbilling can leave you tight on cash and scrambling to pay for materials and labor as your project progresses.
Those spikes and crashes in your remodeling company's cash flow can be the result of:
Incorrectly estimating jobs
Not using change orders
Not billing clients regularly
Paying out trades quicker than you're collecting revenue
Not tracking work in progress
I often talk about how to properly estimate projects to ensure they are profitable and why you should be using change orders to avoid eating costs by reconciling cost overruns.
Right now want to focus on how not tracking work in progress can negatively impact your company's financial stability and impede the overall progress of your growth goals.
What is Work in Progress
In its simplest form, Work in Progress (WIP) is a financial tracking tool that helps you see if your projects are properly funded or if you're headed toward a cash crunch.
It tracks how much money you have earned to date on a remodeling job compared to how much you've spent on it.
It's like a game of "tug of war." On one side, you have receivables (money in); on the other, you have payables (money out).
For example, let's say you book a $100K remodeling project with a 20% (or $20K) deposit. That $20K is considered deferred revenue because even though you've collected it, you haven't earned it yet.
The mistake many remodelers make with deposits is adding them to their revenue numbers, which gives them a false sense of security about their financial picture.
Why Tracking Work in Progress is Important
To ensure your remodeling business is running profitably and you're not feeling a cash crunch anywhere during the project timeline, you need to find that balance between how often you're collecting money from clients and paying out money to vendors and trades.
From the example above, if you spend that $20k on raw materials or labor for another project instead of keeping it aside for the intended job, you're going to hit a financial wall because that money you're taking isn't yours yet.
When it comes time to pay for materials, trades, and vendors for that original project, you won't have those funds available.
You won't have contributed to your overhead or profit during the project's progress, leaving you scrambling to get another deposit or draw from another job to cover your monthly overhead bills, pay your team members, and keep your operations rolling.
It's like borrowing money from your Visa to pay off your MasterCard. Eventually, those funds run out, and the accumulated interest breaks you financially.
With WIP project tracking, you will be able to manage your cash flow better and measure profitability, showing you if you're pricing your jobs properly.
Accounts Receivables & Client Deposits
In order to understand the importance of work in progress, you need to start at the beginning of the project timeline and the construction deposit you secure upfront.
Construction deposits hold a time and a place in your schedule for a project and are a guarantee that you will be able to cover the project's final costs. This means that you shouldn't be accounting for it the same way you do for progress payments during a project.
Again, looking at the example above, we've taken $20,000 as a deposit on this $100,000 project. That money should be applied to the project's final invoice(s) and not used for upfront expenses or another project's expenses.
This means the deposit isn't counted as revenue on the accounting side and shouldn't land on your Profit and Loss Statement yet.
Instead, it's placed on the Balance Sheet and held as a liability to the company, and is brought onto the revenue side at the project's end to settle the final invoice(s).
This method might differ from how you're operating right now, but it's critical for scaling any remodeling or custom home-building company. As you grow, you need to ensure you're balancing these two things:
Your financial risk of paying for committed costs on a project should the project go south.
Your ongoing cash flow to ensure you are always holding the right amount of cash to offset your weekly or bi-weekly revolving receivables.
Managing Work in Progress Flow
One of the fundamental keys to running a successful and profitable construction business is to ensure that you have a systemized workflow for financial inputs and outputs. Because when you're knee-deep in a project, money starts flowing in and out of the business at a rapid pace - and you want to ensure that it's coming in faster than it's going out.
Whether you are using a fixed-cost or cost-plus billing approach, you should be billing your clients on a schedule-based approach and not by project milestones.
Milestone-Based Billing
Milestone invoicing in a residential construction project refers to a payment system based on predetermined large milestones or major stages of completion. Milestone invoicing ensures that payments are made as specific project milestones are achieved. These milestones typically include significant phases such as the completion of the foundation, framing, rough-ins, drywall, and finishing.
This invoicing method aims to provide transparency and accountability, allowing homeowners to track progress and make payments based on tangible deliverables. However, it doesn't always work that smoothly, and a homeowner will often withhold a remodeler's payment based on an outstanding item within a large milestone.
This can shift your focus away from the project at hand to the project that's closer to the next draw. Meaning you might be far away from the next draw on Project A, but you need to cover payroll, so you divert your team and resources to Project B, which is closer to the next draw.
Working like this puts your jobs, client relationships, and business at risk, which is why milestone-based billing is never a recommended invoicing process.
Bank Loans and Billing Schedules
If you are working on projects funded through a bank loan, you will likely encounter a variation of the milestone approach where the bank will break down the project into smaller milestones and payout corresponding percentages based on the successful completion of each milestone. In recent years, many lenders have moved further away from large phase milestone draws to help builders properly cash flow a project between stages of completion.
Unfortunately, the approach still has its drawbacks. Very often, the percentages the bank will assign don't quite correspond with the estimate you've provided the client, as they tend to use benchmark ratios instead of matching your estimate.
For example, they might pay 2-3% for windows and doors, whereas you might install a nanowall system or high-efficiency triple-pane passive house units. These costs might account for more than 2-3% of the project's estimate, leaving you short on cash and running in a deficit.
In this scenario, it's advisable to speak with the banking institution to see how flexible their lending terms will be, then decide if you want to enter into the project where you're operating in a deficit.
Schedule-Based Billing
In contrast, a schedule-based billing system is a payment structure where invoices are generated, and payments are made based on a predetermined schedule rather than specific milestones. The construction contract details the schedule specifying the billing intervals, such as weekly or bi-weekly periods.
Each interval corresponds to a billing cycle, and the invoice is generated accordingly. This type of billing system is particularly useful when a project will have a longer duration or when progress cannot be easily measured by clear milestones. It provides a predictable and regular cash flow for both the homeowner and the contractor, ensuring that payments are made consistently throughout the project's timeline.
How to Apply Schedule-based Billing to Cost Plus and Fixed Cost
If you're a cost-plus remodeling contractor, you're likely already using this billing format for costs expended to date.
If you're a fixed-cost remodeler, you would divide the total project cost by the total number of billing periods for the project's duration.
For example,
Sample Project Budget = $100,000
Deposit Amount = $20,000
____________________________
Progress Billings = $80,000
Let's say the project duration is ten weeks and that we are going to bill bi-weekly:
$80,000 / 5 bi-weekly payments = $16,000/bi-weekly billing period.
In your contract, you would provide this clause to explain how you bill in your "Cost of Work" section. You would then indicate the payments and specific billing dates the client would agree upon and accept when signing.
Paying out Trades & Vendors
Now let's shift our focus to the other side of the tug-of-war rope; payables.
Many construction company owners believe paying trades right away is the best way to strengthen their relationship with their partners. And while this is true to some extent, there's another thing to consider for your cash flow and the part you play in helping your trade partners better manage their cash flow.
By setting up a systemized approach for your financial relationship with your trade partners, you're actually helping them to improve their own cash flow systems in their businesses, which can directly impact your ability to confidently work with them, knowing they aren't funding other work with your payments.
Milestone vs. Schedule Approach to Payouts
When it comes to our cash flow, remember that we want to collect money a bit faster than we pay it out. So if you are invoicing clients on a weekly basis, then pay out your trade partners on a bi-weekly basis.
A simple way to implement this is to issue cheques every other week or choose the same dates each month (the 1st and 15th are recommended) to do a bi-monthly cheque run.
Then disclose this invoicing and payout process to your trade partners when you hire them by including it in your Trade Partner Agreement or on a purchase order. If you're not using either a Trade Partner Agreement or a Purchase Order in your residential construction business, click here to learn more about how we can help you get started.
For regular trade partners on your roster that you've worked with for a long time, give them sufficient notice that you plan to change your process for invoicing and payouts. However, avoid disrupting any current projects by trying to make that change happen immediately.
Systemizing financial processes like client billings and trade partner payouts helps manage your cash flow and are critical steps to ensure that, as you scale your business and step back from the day-to-day management, the project managers you hire can execute independently.
Calculating Work in Progress
Starting to track work in progress is easier than you think. Click below to download a simple template you can use right now.
Here are the numbers you'll need each for each current project each time you update this worksheet:
Updated total targeted revenue number, including your original contract price, plus any completed change orders. Be sure to remove the deposit amount from this number before entering it.
Your current "Billed to Date" from your Quickbooks account. Don't include unbilled actual costs, just the total amount you've invoiced your clients.
Your actual costs to date. This is all of the expenses up until the current moment you are creating this update.
Cost to completion. This is where most people can get off track as they start estimating the amounts left instead of having a systemized approach to generating this automatically. The BUILD AND PROFIT SYSTEM uses the invoices and expenses you enter to automatically generate a report showing the exact cost to completion based solely on accurate data without human interpretation or adjustments.
Updating your WIP template as you create your scheduled client invoices helps ensure you're being as accurate as possible in evaluating your under or overbilling position.
Underbilled vs. Overbilled: Which is Better?
The simple answer is that, ideally, you want to be just a little bit overbilled. Being overbilled means you have enough cash for upcoming expenses and are ahead of upcoming production expenses, so you shouldn't be short on cash during the project.
But you don't want to be too overbilled, which can cause you to think you have more money than you do and overspend on overhead expenses or use funds from one project to cover another. Being too overbilled often masks your true profitability because your bank account always has money… until it doesn't.
A simple way to track your under-or-overbilled status is to use something called "Quick Ratio."
Quick Ratio is your current assets divided by your current liabilities, both of which can be found on your balance sheet. In order for these figures to be accurate, you'll need to ensure you're using accounting software like Quickbooks and that your Accounts Receivables and Accounts Payables reports are updated regularly.
The target range for Quick Ratio is between 1 and 2. If you're below one, you are largely underbilled on projects and need to take steps to course correct so that one sideways job doesn't have lasting financial impacts on your business. If you're over 2, then you are largely overbilled.
Advanced Tracking: Income Statement Adjustments
If you're just getting started tracking work in progress, I don't advise you to make income statement adjustments. But if you've been tracking work in progress for a while and want to take this to the next level, consider this.
In our coaching practice, we evaluate our client's income statements monthly and always need to ensure that the work-in-progress part of the equation has been factored into the data. Otherwise, we are measuring apples to oranges, making it difficult to accurately assess the business's financial information.
Generally speaking, most advice on the internet will advise you to estimate the percentage of completion when it comes to making calculations for work in progress. The problem with this approach is that it allows for human interpretation and estimation, leading to inconsistent and inaccurate data and, eventually, poor business decisions.
It is important to note that implementing income statement adjustments for work in progress requires a solid understanding of accounting principles and practices, and it is recommended to have your CPA be the one to make these adjustments to ensure a consistent and mathematical approach versus a judgment approach.
How to Get Started Tracking WIP
Adjust your client billing schedules in every contract moving forward to bring in money weekly.
Institute a revised payout schedule to bi-monthly so you stay slightly over-billed on projects.
Don't categorize deposits as revenue; have your bookkeeper or CPA move client deposits to a liability account on the balance sheet. Don't worry if that doesn't make sense to you - it will to them, I promise.
Be consistent with your weekly invoicing schedule and update the Work in Progress template each time.
Tracking WIP correctly means accurately calculating your Cost to Completion, not taking your brain's "best guess." The BUILD AND PROFIT SYSTEM teaches you how to do this with the exact system, step-by-step instructions, and one-on-one support.
Understanding and applying the concepts of WIP tracking can be confusing, and it might feel overwhelming, but the alternative is being unprofitable - or potentially bankrupt.
Work-in-progress tracking is essential for providing real-time visibility into your revenue and actual costs on each project so that you can ensure they are properly funded and that you are pricing your work properly.
If you're constantly borrowing from one project to pay for another and you're ready to make a change in your remodeling, custom home building, or specialty trade business, the BUILD AND PROFIT SYSTEM can teach you the benefits of using systems thinking to track project progress in real-time and help you run more efficiently and profitably.
