There is always more than one road to get you to your destination, but one of those roads is usually better than the others. It's the same with accounting. All three main methods — cash, accrual, percent complete — will get you to the same cumulative gross profit, but according to Judith Miller, an Orinda, Calif.–based consultant, businesses evolve from cash to percent complete as they grow in sophistication.
“The cash basis is typically the method people start with,” Miller says. With cash, Miller explains, a client's check becomes income only when you actually make the deposit, regardless of whether the job has started or is already completed. Similarly, expenses are not recorded until vendors are paid. The danger is that a contractor will spend money that's in the bank without recognizing that it's already committed to something else.
“The second level of sophistication,” Miller says, “is accrual accounting. It recognizes income when the invoice is sent, regardless of when the client pays.” Similarly, expenses are posted when you receive a vendor's bill, even if it sits in accounts payable for a month.
Nancy Schmeltzer, operations manager for McCutcheon Construction, Berkeley, Calif., likes the ability to realize income early. “It allows for a more immediate cash flow projection even though we might not have the money in our hands.”
Percent complete is Miller's third level of sophistication. You only earn money for work that has actually been completed, plus your built-in gross profit.
“Percent of completion keeps it very clear whether you're ahead of or behind your homeowners,” says Patti Oehmke, an owner of SEI Design/Build, Vienna, Va. She learned the system, she says, by “making mistakes and having to dig for why the numbers didn't work.” She cautions that an owner must understand the method and shouldn't just rely on an accountant. “If a business owner hires someone who doesn't know it properly, he'll never understand what his business is doing.”
The chart above is based on a completed job with $70,000 in direct costs and $100,000 in client payments posted over a six-month period. Unlike accountants who think of gross profit on a monthly basis, remodelers care about how gross profit is affected by accumulating revenue and expenses. In every case, the chart shows that the accumulated gross profit at the end of the project is 30%. But monthly “snapshots” of accumulated gross profit can be very different depending on the accounting method used. Gross profit under the cash and accrual methods fluctuates wildly month to month, and is always underestimated. (More dangerous is a front-loaded draw schedule, which would over-estimate gross profit until the end of the job.) Only the percent complete method provides a consistently accurate picture of gross profit at every stage of the job's progress.