Accounting 101: Understanding the Numbers Behind Your Construction Business
Accounting is often called the language of business, and that is especially true in construction. But construction has its own terminology and financial nuances, and understanding them can make it easier to see what your numbers are really telling you.
At MyBuilderCPA, we know that most builders don't struggle because they're bad at business. They struggle because the financial language doesn't always match how construction actually works. Understanding the basics of construction accounting can help you better understand your financials and make more informed decisions.
Start With the Profit and Loss
The profit and loss statement, or P&L, is one of the most important reports for understanding how your business is performing over a period of time. You can use it to look at a specific month, a quarter, a year, or multiple years to compare your business performance.
One of the first terms you'll encounter is revenue. QuickBooks Online may label this section as "income," but in accounting terminology, revenue refers to the gross amount coming into the business before costs are deducted.
Next is cost of goods sold, which builders may also refer to as job costs, cost of sales, or direct construction costs. These are the time, materials, and labor that can be allocated to specific jobs.
Understanding Gross Profit
Once you understand revenue and job costs, you can understand gross profit.
Gross profit is your revenue minus your job costs. It tells you whether your jobs are profitable before your overhead is considered.
This distinction is important because if you're already losing money at the gross profit level, your overhead expenses will only make the situation worse. Looking at gross profit gives you a clearer picture of how the actual construction work is performing.
Markup and Margin Are Different
Markup and margin are not the same thing.
Markup is how much you add to your cost to arrive at your price. Margin is what you keep after the job is completed.
This distinction matters because a builder may mark up costs by a certain percentage, but that doesn't necessarily mean the same percentage will become the final margin. Warranty claims, rework, and other costs that cannot be billed can reduce the margin on a project.
Understanding the difference between markup and margin is an important part of understanding construction profitability.
Don't Forget About Overhead
Below your cost of goods sold, you'll find expenses, which generally represent your overhead, the costs associated with running the business that cannot be allocated to a specific job.
This can include the costs of keeping your office operating, attracting new clients, and other expenses necessary to run the business.
It's helpful to distinguish costs from expenses. Costs are tied to building homes and activities that can be connected to generating profit, while expenses are more closely associated with operating the business itself.
Revenue, Profit, and Cash Are Not the Same
Another important accounting concept for builders is understanding that cash is not the same thing as profit.
A business can be profitable without having cash available, and it can have cash without being profitable. Your P&L shows activity over a period of time, but it does not tell you how much money is currently in your bank account.
That's where the balance sheet provides a different perspective. Unlike the P&L, which looks at activity over a period, the balance sheet provides a financial snapshot of the company as of a specific date.
Understanding Your Balance Sheet
The balance sheet is organized around the accounting equation: Assets = Liabilities + Equity
Assets represent what the business owns, including bank accounts, accounts receivable, inventory, and fixed assets.
Liabilities represent what the business owes to others, including accounts payable, credit cards, payroll liabilities, and long-term loans.
Equity represents the owner's interest in the business and can include contributions, distributions, and retained earnings.
Understanding these categories helps you see not just how your business performed, but where it stands financially at a particular point in time.
Accounts Receivable and Accounts Payable
Two other important terms for builders are accounts receivable (AR) and accounts payable (AP).
Accounts receivable represents invoices you've generated for clients that have not yet been paid. Your AR aging report can show you who owes you money and how long those amounts have been outstanding.
Accounts payable, on the other hand, represents money your business owes to subcontractors and vendors. Your AP aging report provides a view of those outstanding obligations.
It's important to record these transactions correctly. A bill is something you enter when you plan to pay later, while an expense generally represents something that has already been paid. Keeping this distinction clear helps your financial reports accurately reflect what is happening in your business.
What About Deposits and Retainage?
Construction accounting also includes terms that may not be as familiar to business owners.
Retainage is money that has been earned but held back until the job is complete. It is generally treated as part of accounts receivable.
Customer deposits are different. When a homeowner pays you upfront, that money is generally a liability because you still owe something in exchange for it. As the obligation is satisfied, the deposit can be released from the liability.
Understanding how these transactions affect your financial statements helps ensure that your reports provide a more accurate picture of the business.
Cash Flow Tells Another Part of the Story
The statement of cash flows can be one of the more difficult financial reports to understand. In QuickBooks, it uses the indirect method, starting with net income and accounting for changes in balance sheet accounts to arrive at cash at the end of the period.
While the report can help explain changes in cash, it isn't necessarily the best starting point for planning your future cash needs. For cash flow planning, a simple spreadsheet forecasting upcoming cash coming in and going out can be a useful tool.
Keep Your Accounting Simple and Useful
You don't need to understand every accounting concept to run a successful construction business. What you do need is a working understanding of the language used in your financials.
Knowing the difference between revenue and job costs, gross profit and net income, markup and margin, assets and liabilities, and accounts receivable and accounts payable gives you a stronger foundation for understanding your business.
The goal isn't to become an accountant. It's to understand what your numbers are telling you.
At MyBuilderCPA, we're proud to help construction business owners understand their financials and use that information to make better decisions. Once you understand the language, your financial reports become much easier to interpret, and the rest of construction accounting starts to make more sense.
Comments