Work in Progress (WIP) Accounting Principles: A Subcontractor's Guide to Healthy Financials

The hardest part of being a subcontractor is building a profitable business. The already-low profit margins can quickly disappear due to improper time estimates and fluctuating materials costs. Plus, you typically have to buy all the materials, hire the team, and complete a significant portion of the work before you can ever submit a payment application. 

With cash flowing so slowly, accurate work-in-progress (WIP) accounting is key to keeping your construction company financially healthy. 

If you’re new to WIP reports (or your current WIP accounting processes aren’t working well), you’re in the right place. This article will offer a comprehensive roadmap to WIP accounting, including:

• Explanation of WIP accounting
• Benefits of WIP accounting principles
• Components of a WIP report
• How to calculate work in progress
• Common mistakes in WIP accounting
• Best practices in WIP accounting
• Projecting the highs and lows in your cash flow

What WIP Accounting Is and Why It’s Important 

Work-in-progress accounting is an accounting method specific to the construction industry. It tracks costs—like labor, materials, and other direct or indirect expenses—and revenue at regular project intervals.

WIP reports calculate ongoing project details to reveal if the project is on-budget or off-budget and if it’s been overbilled or underbilled. They can play a critical role in keeping projects profitable and obtaining an accurate picture of the company’s financial health. 

If you have yet to get started with WIP accounting, or your WIP processes aren’t very rigorous, you might be struggling with inaccurate financial reports and encountering some profitability issues. 

Benefits of Healthy WIP Accounting Principles

If you run accounting for a subcontracting company, you’re probably familiar with this scenario.

A project starts off with 15% profit margins. Everything seems to move along just fine, with no red flags. Then, when you tally up all the payroll reports, payments to lower-tier subs, and materials invoices, you discover a net profit of pennies. Or worse, the project sunk into the red. 

WIP accounting can prevent all that—and then some. In fact, healthy WIP accounting principles can offer several key benefits:  

1. Track the financial health of each project: WIP reports will help you identify potential issues before they spiral so you can keep projects on track. For example, it can help spot gross margin slippage early on and alert project managers that they need to course correct. 
2. Help manage and control costs: By comparing work completed to the budget spent, you’ll be the first to know if project expenses are running too high. For instance, if the team has only completed 25% of the work but used up 40% of project labor budgets, you can proactively request the sourcing team to find ways to reel in costs. 
3. Comply with contracts and pay app requirements: If you want to get paid on time, payment applications must be 100% accurate and comply with all contract requirements. WIP reports help ensure that invoices align with work completed, reducing the risk of pay apps getting kicked back to you.
4. Increase future profitability: WIP reports systematically account for project-related costs and revenue. This gives you a clear picture of which projects are most profitable, enabling you to spot trends about the types of projects that are best for the business. 

Components of a WIP Report

WIP reports combine information from the field, sales, and the back office. To create these reports, you’ll also pull data from the original contract, project managers, and your accounting system to create them. 

Gathering all the necessary information upfront is key. Here’s what you’ll need:  

• From the original contract: some text
  • Job number and name
  • Total contract value
  • Original estimated costs (including change orders)
• From project managers:some text
  • Total costs to date 
  • Revised estimate costs
• From A/R records:some text
  • Actual billings to date

How to Calculate Work in Progress

These inputs will let you calculate the percentage of work completed, earned revenue, and any overbilled or underbilled amounts. 

1. Calculating Percentage of Work Completed

This is a simple calculation of the project’s actual costs to date divided by the revised estimated costs. 

Actual Costs to Date➗Estimated Costs 🟰 Percentage of Work Completed

2. Calculating Earned Revenue

It takes two steps to come up with your earned revenue figure.

Step 1. Contract Amount ➖ Revised Estimated Costs 🟰 Estimated Profit

Step 2. Percentage of Work Completed ✖ Estimated Profit 🟰 Earned Revenue

3. Calculating Overbilled or Underbilled Amount

In a perfect world, your total billed to date matches your earned revenue exactly. But it’s possible that you’ve over- or under-billed somewhere along the way. The last WIP calculation will help you set your records straight.

Total Billed➖Total Costs to Date➖Estimated Revenue = Over/Underbilled Amount

• If the result is zero, congrats—your billing is on track.
• If the result is a positive number, this is your overbilled amount.
• If the result is a negative number, this is your underbilled amount. 

Be sure to rectify any over- and under-billings per your established accounting procedures. This will ensure that your WIP reporting accurately reflects the true financial status of each project. 

Common Mistakes in WIP Accounting

As with most financial reports, the outputs are only as good as your inputs and processes. A few common issues can wreck your WIP reporting. 

• Incomplete or inaccurate data: Human error is the biggest culprit of mistakes in financial reports. From striking the wrong digit to accidentally keying in an extra zero, inaccurate data will wreck your WIP reports. 

• Poor tracking of expenses and costs: Getting proof of expenses from project managers can be a struggle. But if they don’t submit all the purchase orders in a given period, you won’t have an up-to-date view of expenses. 
• Miscalculating the percentage of work completed: The entire WIP report hinges on accurate calculations of how much work has been completed. If team members in the field give you inaccurate costs or estimates, your completion percentage will be wrong. 
• Not revising estimates: If the field team isn’t revising estimates to reflect changes in scope, schedules, or costs, your actual-to-projected costs ratio may appear to be higher than it actually is.   
• Irregular reporting: Preparing WIP reports at inconsistent intervals makes it difficult to identify trends. You simply won’t get the same level of insight if you only do your reporting every few months. 
• Failure to address overbilling or underbilling discrepancies: You can’t calculate overbilling as extra profit just like you can’t chuck underbilling up as a loss. You have to address these discrepancies. Failure to do so puts future payments at risk. 

Best Practices for WIP Accounting

Getting the most out of your WIP report starts with a few proven WIP accounting principles. 

1. Better Cost Tracking 

Everyone in the business needs to be on board with tracking expenses. You shouldn’t have to hound project managers, purchasing teams, field supervisors, or anyone else for receipts at the end of the month. The more diligently people track expenses related to specific projects, the easier it will be for you to accurately total costs to date when it comes time to run your WIP report.  

2. Automated Data Entry 

Since manual data entry errors are one of the most common mistakes in WIP reports, it stands to reason that automating data entry will result in more accurate (and faster) reports. If you’re looking for a new construction accounting software to streamline your reporting processes, we recommend these options. 

3. Monitoring Project Progression 

Tracking actual work finished is the clearest way to report on project progress, versus only monitoring labor hours. Be sure your calculated percentage of work completed lines up with how much of the project laborers have finished. The last thing you want is to accrue 100% of your estimated labor hours, and the work only be 80% done. 

4. Communicating with Project Managers

Data is great, but nothing can tell you more about what’s happening with a project than the project managers (PMs). Establish tight relationships and regular syncs with your PMs; they have the most accurate pulse on what’s happening in the field.

5. Prompt Invoicing

Synchronizing your WIP reporting and invoicing schedules can help keep your totals on track. If you run your WIP before invoicing, you should always wind up with an underbilled amount that reflects the total you should invoice for the next time. Just be sure to submit pay apps according to the schedule outlined in the original contract.

Projecting the Highs and Lows in Your Cash Flow

Accountants at hundreds of subcontractors are getting loads of value by pairing healthy WIP accounting principles with billing and cash flow forecasting software. Tools like Siteline give you more visibility into cash flow and backlog by collating traditionally siloed data into easy-to-read visual reports. 

You can use it to forecast project billing along a front-loaded bell, standard bell, or flat curve and revise projections as the project progresses. It can even project payment dates and deliver cash forecasts by week across all projects. If you’ve longed for a tool that can warn you of potential dips in cash flow well in advance so you can proactively adjust, request a demo of Siteline.