A recent discovery within a client’s file reminded me of how often I encounter errors that stem from a focus on process or procedure without adequately conveying the intended purpose of the action. Let me explain.
Companies seeking to improve the accuracy of their financial statements often make WIP (work in progress) adjustments. The intention is to counteract incoming dollars that are counted as income but as yet have no offsetting costs. A 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, if jobs are (a) sold with a consistent markup, (b) produced reasonably closely to estimated costs and schedule, and (c) invoiced in accordance with the matching principle (see “The Matching Principle”), then the achieved gross margin should remain fairly consistent between reporting periods (months).
P&L With Margin, Example A
But, since we all know it’s more important for cash flow to BEBO (bill early, bill often), most contractors who are selling fixed- or contract-price work front-load the payment schedule. This practice can skew the numbers significantly depending on how many invoices vs. job costs are included within a given period. It is not unusual to see something close to Example A (below).
P&L With Margin, Example B
Now look at Example B (above). The purpose of WIP is 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.
When a client reports that they are performing monthly WIP adjustments, and their P&L by month with margin looks similar 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 understanding 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.” She or he dutifully continues to perform what can amount to an arduous amount of work at the end of each month, but may never use appropriate reports to monitor the results.
Many companies review their P&L by running a single month, or a year-to-date, or possibly a comparison between a given period in the current year compared with a similar period in the previous year rather than running a trended P&L. This is generated by simply asking for the date range displayed by month. Users may benefit from a year-to-date P&L or (even better) a 12-month-to-date range. It’s only then that the results of the WIP (or whatever else is being analyzed) can be seen easily. If your software permits you to easily display it, by all means add the achieved gross profit margin on a month-to-month basis. Without understanding the purpose of a procedure, there’s no easy way to check the results to confirm that the process is achieving the 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?