This is a good article for our construction clients on why sureties are so focused on bid spreads and how much you bid as compared with your peers. Specifically, bidding too low. Although it's great that you got the job, the surety will want to be sure that you have plenty of margin built into that bid. Most of our bond clients are for construction - surety bonds (whether it be construction bonds, bid bonds, or performance bonds). For our clients, this can be some good information and help you plan for the upcoming year or two.
Underbilling: Why Your Surety Has Concerns — and You Should, Too
Underbilling occurs when work you’ve completed hasn’t been billed or costs you’ve incurred haven’t been reimbursed. Nearly every contractor has some underbilling from time to time. But underbilling can hurt your cash flow and eat into your profits. Worst case: You may actually lose money on a job if you never receive payment for underbilled labor, services or material.
From an accounting standpoint, underbilling is the cost and profit earned on a lump-sum construction project that has been incurred within a billing cycle but has not been billed. For example, a contractor completes 90% of a construction project but only bills for 70% of the overall contract. That’s a 20% underbilling.
There was a time when underbilling was thought to be a good thing, better than overbilling. But today, it is generally recognized that underbilling can be a cash-flow problem.
Common reasons for underbilling
There are many reasons why you might see underbilling on a job. Here are some of the most common:
Billing cycle/timing issues. Underbilling can occur when a contractor misses its billing cycle. A project manager may fall behind in his monthly submittals. That would cause an underbilling for that cycle. Typically, these kinds of timing issues work themselves out once submittals are back on track.
Under-estimated project costs. Project costs that exceed the total contract cost can be a reason for underbilling. It’s always a good idea to re-estimate costs as the work progresses. Otherwise, you may find yourself understating costs and overstating revenue and profit, which could lead to cash-flow problems and profit fade. If you don’t discover the underbilling until the end of the job, you may have to put money back into the project to complete it.
Unapproved or disputed change orders. This is a common reason for underbilling. Contractors perform work that hasn’t been approved by the owner, running the risk of not getting paid. You should always submit change orders and get sign-offs before starting work.
Stored material that can’t be billed. A contractor might purchase the material needed for a project but can’t bill for it until it’s been placed and/or inspected, and approved to make sure it performs as expected. Unless the owner allows for storage on site, this is an underbilled cost.
Tracking underbilling trends
Underbilling trends tell a lot about a contractor’s management, internal procedures and style. Analyzing the underbilling progression in semi-annual or quarterly work-in-progress (WIP) reports can help spot potential problems. It’s critical to track job vitals from one WIP to the next. Are underbillings increasing or decreasing? Has the contract price changed? What’s the impact on gross profit (GP)?
Let’s say a contractor has a $100,000 job, and the 3/31 WIP shows the job is 25% complete, underbillings are $30,000 and GP is $20,000. At 6/30, the job is 70% complete, underbillings have decreased to $20,000 and GP has dipped to $15,000. At 9/30, the job is 98% complete, underbillings remain at $20,000 and GP is still $15,000.
In this example, the 6/30 WIP is cause for questioning. Underbillings decreased $10,000 and GP declined $5,000. Why? Maybe the contractor and the owner worked out $10,000 in underbillings, but the contractor had to write down $5,000 in profit. At 98% completion, the contractor is still showing $20,000 in underbillings. The project is basically done, so those underbillings are suspect. It’s possible that an underwriter may delete $20,000 from working capital until the contractor confirms collection. If the underbillings aren’t collected, the contractor actually loses the remaining GP of $15,000 and has to put $5,000 back into the job.
Whenever a job is over 90% complete and has underbillings, your surety company will likely have questions. Those underbillings may represent a significant portion of the GP earned and cost needed to complete the job. If they aren’t collected, the working capital, cash-flow statement, and profit and loss statement may all be overstated. Underwriters will defer these areas of their financial analysis until the underbillings are fully vetted.
3 steps you can take to eliminate underbilling
Too much underbilling can hurt your business and jeopardize your approval for bonding. Here are three things you should do to stop the cash-flow drain that comes from underbilling:
Make sure your project managers get their submittals in on time. A delay in billing means your company is incurring costs but not getting paid.
Do several takeoffs during the course of a job to prevent surprises at the end. Re-estimate labor and material so you can stay on top of costs.
Communicate regularly with the owner. Everything should be documented, with a clear understanding of work expectations and sign-off procedures for change orders. Performing unapproved work is a serious risk.
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