Managing finances effectively is critical for the success of any construction business. One significant challenge that contractors face is understanding the balance between overbilling and underbilling. But what exactly do these terms mean, and why do they play such an important role in a construction company's financial health? In this article, we’ll explore overbilling vs. underbilling, highlight the impacts each can have on your business, and discuss how to find the right balance for optimal construction success.
What is Overbilling in Construction?
Overbilling occurs when a contractor bills for work that is ahead of the actual progress on a project. This means that the invoice exceeds the cost incurred at that point in time. For example, if a contractor has completed 20% of the work but bills for 30%, the difference is classified as overbilling.
Contractors might overbill to:
Enhance cash flow: By billing ahead, construction companies can cover upcoming expenses, such as payroll and material purchases, more easily.
Create a financial buffer: Overbilling provides a cushion that can safeguard against project delays or unexpected costs.
However, while overbilling can help optimize cash flow, it comes with risks.
Risks of Overbilling
Financial Misrepresentation: Overbilling distorts a company’s financial reporting, making it difficult to assess actual progress and revenue.
Client Trust Issues: Billing clients for work not yet performed may lead to disputes or a loss of trust.
Compliance Concerns: Repeated overbilling may raise legal and regulatory red flags, impacting long-term business relationships.
What is Underbilling in Construction?
On the other hand, underbilling occurs when a contractor bills for less than the cost of the work completed at that time. For example, if a contractor has completed 30% of the project but only bills for 20%, this results in underbilling.
Underbilling can stem from:
Poor tracking of progress: If construction bookkeeping practices are weak, underbilling can go unnoticed.
Delays in submitting invoices: Administrative backlogs or delays in creating billing statements can lead to underbilling.
Client requests: Sometimes, clients may ask for smaller invoices to manage their cash flow.
Risks of Underbilling
Cash Flow Problems: Underbilling leads to less cash coming into the company, potentially jeopardizing daily operations.
Financial Strain: When too much work is completed without equivalent billing, the contractor’s financials can appear weaker, impacting financial health.
Project Delays: Limited cash flow can result in delayed procurement of materials or payment to subcontractors, further delaying the project.
The Balance Between Overbilling and Underbilling
Achieving a balance between overbilled vs underbilled is vital for maintaining construction financial health. Here’s how to strike the perfect balance:
1. Monitor Project Progress Closely
Regularly track the progress of your project to ensure billing aligns with actual work completed. Use detailed job cost reports to assess whether billing in excess of costs or underbilling is occurring.
2. Use Accurate Construction Accounting Systems
Implementing advanced construction accounting software helps automate billing based on actual work progress. Systems like QuickBooks, Sage 100 Contractor, or JobTread can offer better control over construction payment schedules and financial tracking.
3. Set Clear Payment Schedules
Establishing transparent payment schedules ensures clients are aware of how much they will be billed and when. This can prevent disputes over billing issues and maintain trust.
4. Conduct Regular Financial Reviews
Regular reviews of financial reporting can reveal discrepancies between billed amounts and costs incurred. Collaborating with construction bookkeeping services can streamline this underbillings and overbillings process.
5. Train Your Team
Ensure that your project managers and accounting team understand the significance of balanced billing and know how to monitor it. Workshops on best practices for billing can prevent underbilling or overbilling in construction.
Examples of Overbilling and Underbilling
Example of Overbilling:
A construction company begins a project worth $500,000 and completes 25% of it. However, they bill for 40%, collecting $200,000 instead of $125,000. Although this helps immediate cash flow, it skews their financial statements.
Example of Underbilling:
A contractor completes 50% of a $600,000 project but only bills for 30%, leaving them with $180,000 in invoices instead of $300,000. This causes a cash flow strain that hampers their ability to continue purchasing necessary materials or paying labor costs.
How Overbilling & Underbilling Affect Your Financial Statements
The impacts of overbilling and underbilling extend beyond cash flow and can significantly affect your financial statements, such as the balance sheet and income statement. When overbilling occurs, the company's financials may show inflated assets and revenue figures. This can create a misleading picture of profitability and financial health, making it seem as if the company is in a stronger position than it actually is. For example, overbilling can temporarily boost the accounts receivable and falsely elevate net income, complicating future project evaluations and financial planning.
Conversely, underbilling results in understated revenue and accounts receivable. This can make a company appear less profitable, weakening key financial ratios like the current ratio and quick ratio, and potentially harming relationships with lenders and investors. Additionally, underbilling affects the balance sheet by increasing work-in-progress (WIP) costs without matching revenue, skewing the company’s working capital. In the long run, these issues can lead to financial strain, make securing new projects or financing more difficult, and ultimately hinder the growth of the business.
Actionable Tips for Contractors
Leverage Technology: Utilize project management tools and construction accounting software to automate billing and track project progress accurately.
Partner with Bookkeeping Services: Hiring an outsourced construction bookkeeping service can help ensure your billing aligns with project milestones.
Audit Your Billing Practices: Regular audits help identify billing discrepancies and correct them before they become larger issues.
CCA - Your Solution for Construction Billing Issues
Balancing overbilling and underbilling is essential for your company’s financial health. At Construction Cost Accounting (CCA), we understand that accurately aligning your billing with project progress is more than just a good practice—it’s a critical aspect of maintaining strong cash flow and credible financial reporting. Let us take the burden of financial management off your shoulders and empower your business with reliable, expert-backed bookkeeping services.
