This month we switch to a not so interesting but necessary and important accounting topic, the dreaded Work in Progress (WIP). This article will show how WIP can be easy and more importantly, very useful.
WIP in a project environment can be messy, difficult, and time-consuming to nail down, however once set up will produce great results.
Different approaches can be used:
Understanding true profit for a project business can be difficult, because project costs can incur months before invoicing.
Let's look at the Profit and Loss (P&L) accounts for the ‘Sprawling Global Project Company Ltd'. They spend $5,000 on Project X in one month and invoice $10,000 in the next month.
Month 1 Month 2 Revenue (Sales)Sales 0 $10,000 Direct (Project) Costs $5,000 0 Gross Profit (Sales - Costs) $(5,000) $10,000
It's not possible to understand a true profit for each month by reading the P&L. Understanding company profitability for multiple projects, with extended execution times, progress (milestone) payments and deposits, especially if they cross over financial years, is very difficult, because costs do not match revenue in the same accounting period.
For this reason, major international accounting standards such as GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) have cost-matching principles, mandating companies report costs at the same time as the revenues they are related to. Using this principle, Mr. Been, SGPC Ltd.'s CFO, can report results in one of two ways,
1. Defer cost reporting to the same time-period as the invoice. Use this if most invoicing is done after the costs are incurred.
Cost Recognition Method Month 1 Month 2 Revenue (Sales)Sales 0 $10,000 Direct (Project) Costs $5,000 Gross Profit (Sales - Costs) $5,000
2. Defer reporting of revenue if most of your invoicing - deposits and progress payments, are invoiced before costs are incurred. Larger project companies with conservative accounting will use this method.
Cautionary tale: the collapse of Enron, $60 Bn of assets and the dissolution of, at that time, a tier-one accounting practice, Arthur Andersen, was triggered by the opposite (fraudulent) practice of recognising all the revenue for new long-term contracts immediately on their P&L, before any milestone invoicing. It was done to overstate profitability and boost share price. Cost mismatching was not the best idea.
Mr Been says,
“Cost matching is all very well in theory, but figuring all this out every month is cruel and an unusual punishment, which will take three weeks to finish. We have 50 projects in progress, material, and labour costs to add up, and all to be matched with progress payments differing by project.”
Now, enter WIP as the solution to Mr Been's problem. He sets up WIP, as a current asset in Xero, transfers all direct costs (Cost of Goods Sold: COGS) for the month to WIP, as one journal entry, and sets it to auto-reverse on the first of the next month. Voila! In the example above, the $5,000 costs move to month two on the P&L. Month one now shows $5,000 on the Balance Sheet, where the costs have been ‘parked' for that month.
As a bonus, management, and Scrooge McBanker, SGPC Ltd.'s financier, both relax because management sees the true project profitability. Scrooge sees SGPC has future cash and profit coming in month two and he will be able to pay the exorbitant overdraft charges.
Mr Been now realises he still has the problem of adding all the different costs and progress invoices to arrive at an accurate WIP figure, without the manual nightmare. He turns to the ‘Percentage of Cost Complete' (POCC) principle to calculate WIP. Milestone invoicing for each project in progress can be matched to costs as below,
Total Project Y Revenue = $100,000
Invoiced to date = $40,000 = 40% of total revenue
Total planned Cost = $50,000
Cost incurred to date = $30,000 = 60% of planned cost
WIP = Costs in excess of matched invoicing = (60% - 40%) *Planned Cost = 20%*$50,000 = $10,000
Next, Mr Been runs a WIP report in Tidy. There are two WIP reports (provisioned to your site on request), OS01B Accounting WIP POCCR, for deferred revenue recognition, and OS01C Accounting WIP % Cost for deferred cost recognition.
Since Mr Been is using deferred cost WIP, he runs OS01C, which spits out a WIP of $10,000 for project X, plus a WIP for all the other 49 projects in progress. In Xero he enters a manual journal using the total to debit WIP and credit COGS. A month-end obstacle course is reduced to 10 minutes.
But what if invoicing lags cost for some projects, and leads costs for others (because of deposits and milestone invoices)? No problem, the total WIP reflects the correct mix.
Edward Fyvie, principal of 5e Management Services, provides consulting services to SME businesses in five main areas: Customers, Effective Strategy, Innovation, Productivity and Sales M&A Advisory, Board Advisory, Effective technology, analysis and business planning.
