Overbilling and underbilling in construction, with a worked example

Tue, 25 Jul 2017 23:40:23 +0000

Overbilling is when a contractor bills for labor and materials before the work is complete. Underbilling is the reverse: the contractor has done work it has not yet billed. Both are measured against the same yardstick, which is the revenue a job has earned to date under the percentage of completion method. On a work-in-progress (WIP) schedule, overbillings appear as “billings in excess of costs and estimated earnings,” and underbillings appear as “costs and estimated earnings in excess of billings.”

This post explains how the earned figure is computed, works through a $2 million job, and shows how a change in the cost estimate moves the result. It replaces two short posts from July 2017, one on each term. For the full monthly schedule with several jobs, see how to build a work-in-progress schedule from job cost.

How earned revenue is computed

Most contractors measure completion with the cost-to-cost method. The share of the job that is complete equals the cost incurred to date divided by the current estimate of total cost. Earned revenue to date is that share multiplied by the contract price.

The federal tax regulations describe the same calculation. Under 26 CFR 1.460-4, the “completion factor” is the ratio of contract costs incurred through the end of the year to the estimated total contract costs, and cumulative gross receipts equal the completion factor multiplied by the total contract price.

Once earned revenue is known, compare it with billings to date:

If billings to date are greater than earned revenue, the difference is an overbilling.
If earned revenue is greater than billings to date, the difference is an underbilling.

An overbilling means the customer has paid for work the contractor still owes, so it sits on the balance sheet as a liability. An underbilling is work the contractor has performed and can still bill, so it sits as an asset.

A worked example

The figures below are hypothetical. Take a contract with these terms:

Contract price: $2,000,000
Estimated total cost: $1,600,000, which leaves an estimated gross profit of $400,000
Cost incurred to date: $640,000

The job is 40% complete, because $640,000 divided by $1,600,000 is 0.40. Earned revenue to date is 40% of $2,000,000, or $800,000. Gross profit earned to date is $800,000 minus $640,000, or $160,000.

If the contractor has billed $950,000 so far, it is overbilled by $150,000. If it has billed $700,000, it is underbilled by $100,000.

When the estimate changes

The cost estimate drives the whole calculation, so a revised estimate changes the over or under figure even when no new cost or billing has posted.

Suppose the project manager raises the estimated total cost from $1,600,000 to $1,700,000 because of a concrete overrun. Cost to date is still $640,000.

Percent complete falls to 37.6%, which is $640,000 divided by $1,700,000.
Earned revenue falls to about $752,900.
With $950,000 billed, the overbilling grows from $150,000 to about $197,100.
Estimated gross profit on the job drops from $400,000 to $300,000.

An overbilling that grows while costs and billings stay flat usually means an estimate went up. Review the estimate-to-complete on each job before reading the WIP schedule, because a stale estimate shows a healthier position than the job has.

Why contractors overbill

Overbilling is a common way to improve cash flow, particularly with clients that pay late. Billing ahead of the work gives the contractor cash to run the job, start new work before payment arrives, and handle an unexpected problem.

The cost is that the cash belongs to work not yet performed. If an overbilled job’s cash is spent on other projects, the contractor can run short of money to finish the original job and have to fund the remainder from elsewhere in the business. A company-wide overbilling total that rises faster than backlog can be a sign of this.

Why underbillings appear

Underbillings should be rare. They usually come from a dispute between the amount owed and the work performed, an unapproved change order that has cost but no billing, or an invoice that was never sent. Bill as soon as work is complete, under the agreed terms and any approved change orders. An underbilling that persists on a job for several months often means unbillable cost, such as rework, and the estimate should be checked.

The tax side

For federal income tax, 26 U.S.C. 460 requires the percentage of completion method for long-term contracts. A long-term contract is one for building, installation or construction that is not completed within the tax year in which it was entered into.

Section 460(e) exempts residential construction contracts. It also exempts other construction contracts that the contractor expects, when the contract is signed, to complete within two years, if the contractor meets the gross receipts test of section 448(c) for that year. IRS Publication 538, in its January 2022 revision, describes that test as average annual gross receipts of $26 million or less over the three prior tax years, indexed for inflation. The figure for the current tax year could not be verified from that publication.

Book and tax results can differ, so confirm the method for each contract with your CPA.

How to track this on your jobs

A WIP schedule needs four input columns per job: contract price including approved change orders, estimated total cost, cost to date, and billed to date. In Excel or Power BI, add three computed columns:

Percent complete = cost to date / estimated total cost
Earned revenue = percent complete × contract price
Over (under) billing = billed to date − earned revenue

A positive result is an overbilling and a negative result is an underbilling. Add the job-level results across all open jobs to get the company totals for the balance sheet. Run the schedule at each month-end close, and keep the prior month’s figures beside the current ones so a change in estimate on any job shows up right away. For a related calculation that also uses receipts averaged over several years, see how to compute average annual receipts for the SBA size standard.

Accounting | Construction Metrics