As the end of the year approaches, it’s a good time to take a look at where your company stands overall. Did you have a profitable year or was it a bad one? Soon, you will have to create a profit and loss statement (P&L) to answer that question. You want to know, and Uncle Sam needs to know. And you don’t want to pay any more taxes than you must.
Taxes not withstanding, it is important for you to be able to create a financial statement that truly represents how much profit you’ve earned. And the only way to do that is to adjust your numbers to reflect the actual income you have earned this year, instead of the amount of money you’ve collected or the dollars that you’ve invoiced. To do this, you need to understand and create a WIP adjustment.
WIP it Good
WIP stands for Work in Process. It is an adjustment you make to correct any misrepresentations caused by overbilling or underbilling a job. In last month’s article, I discussed the Matching Principle, an accounting term which states that the income and expense you see on your P&L should be as a result of the same activity. To determine how much you are overbilled or underbilled, you need to look at the WIP formula:
Cost-to-Date ÷ Budgeted Cost = % Complete x Contract = Earnings – Billings = (Over)/Under
In essence, you want to use the costs you’ve already incurred on a job to determine what percent complete you are on the job. That percentage of costs can then be used to “match” the percentage of the contract that you can show on your P&L statement.
For example, let’s say you are in the middle of a contract that you sold for $182,000 and that you estimated would cost $140,000. That represents a 30% markup, or a 23% gross margin. As you come to the end of the year, you look at the P&L for the job and see that you’ve spent $40,000. That means you have spent 29% of the budget for the job. Assuming that the budget was correct, you should have completed about 29% of the project. Therefore, you can show 29% of the contract on your P&L.
Cost-to-Date ÷ Budgeted Cost = % Complete x Contract = Earnings
$40,000 ÷ $140,000 = 29% x $182,000 = $52,000
Overbilled or Underbilled?
Your P&L statement should show $52,000 of income for this job. But what if you’ve invoiced for $75,000? Then you are really showing too much profit — $23,000 too much. You earned $52,000 and show $75,000; you are, in essence, overbilled on the job by $23,000.
Earnings – Billings = (Over)/Under
$52,000 – $75,000 = ($23,000)
As I discussed last month, the problem with not making any adjustment for this situation is that if you show too much profit, you might make purchases or pay bonuses on money you haven’t really earned, or you may even pay too much in taxes.
You need to reduce your income by $23,000 and show that money as a liability. Because you have overbilled, you actually owe the customer $23,000 more work.
The numbers can also go in the other direction. You could be in a situation where your P&L actually shows too little income. For example, on the same job as above, what if you’ve only invoiced the customer for $45,000. You know you should invoice soon, but you haven’t gotten around to it.
Earnings – Billings = (Over)/Under
$52,000 – $45,000 = $7,000
In this case, you are missing out on $7,000 profit that you’ve actually earned. To correct for this, you will need to add more dollars to your income.
Know Where You Stand
The most interesting part about WIP-adjusted P&L statements is that they can then truly help you manage your company. You can see if the gross margin is consistent across time and across jobs. If we compare the two examples above, you’ll see that after we make the WIP adjustment, the total income and the gross profit are the same with both examples.
Income $ 75,000 $45,000
WIP Adjustment $(23,000) $ 7,000
Total Income $ 52,000 $52,000
COGS $ 40,000 $40,000
Gross Profit $ 12,000 $12,000
By making an adjustment to the P&L statement, you can see where you ended up this year. Then you can start next year knowing that your numbers represent the actual activity for 2009. In an uncertain economy, it’s important to know where you stand. And that any profit you show is profit you’ve actually earned!