A recent discovery within a client’s file reminded me of how often I encounter similar errors that stem from a focus on process or procedure without adequately conveying the intended purpose of the action.
Companies seeking to improve the accuracy of their financial statements often utilize WIP (Work in Progress) adjustments. The intention is to counteract incoming dollars that are counted as income but as yet have no offsetting costs. The typical example of this would be receiving an “at signing” payment of $50,000 on a job that isn’t scheduled to begin until the following month. Including that payment as income in the current month skews the income (and, accordingly, the gross profit and margin) for that month.
In a perfect world, all jobs a) are sold with a consistent markup; b) produced reasonably closely to estimated costs and schedule; and c) invoiced in accordance with the Matching Principle (see definition, calculation and example here).
Under these conditions, the achieved gross margin should remain fairly consistent between reporting periods (months), as depicted in Example A:
But it's not always like this. Since we all know it’s more important for cash flow to bill early, bill often (BEBO), most contractors who are selling fixed-contract price work will front-load the payment schedule. This practice can skew the numbers significantly depending on how many invoices vs. job costs are dated within a given period. It is not unusual to see something closer to Example B:
The Purpose of WIP
Work in Progress (WIP) adjustments are used to correct this situation by adding or deducting “income” to eliminate unearned income. Therefore, once the WIP has been entered, one would expect there would be far smaller changes in margin value among the reporting periods. In other words, the P&L would look more like Example A.
Blindly Following a Process can Obscure the Purpose
When a client reports that they are performing monthly WIP adjustments, and I check out their P&L by month with margin, and I see something close to Example B, I can be pretty sure that the WIP adjustments are not performing their intended purpose. If I dig back far enough, the cause is almost always an emphasis on process without explaining purpose. The bookkeeper generally says something like, “That’s how I was trained to do it” or “That’s the way the last bookkeeper did it.” Without understanding the purpose of a procedure, there’s no easy way to know if the process is achieving its intended purpose.
WIP adjustments are often derived from spreadsheet calculators that are quite complex. If your company is going through the month-end process and still getting results like Example B above, it may be time to review the purpose of WIP, examine the steps of the current process, and identify where things are going awry. If the purpose isn’t being fulfilled, what’s the point?
