Step-by-Step Accounting for a Small Business in Construction
Accounting for building in a small construction company is similar to the accounting for other manufacturing processes. Because construction companies often complete jobs that are quite different from one another, these companies use a technique called job-order costing. Understanding the steps to apply job-order costing to your construction company can help ensure that your financial records are as sound as the structures you are building.
When starting a construction project, often the first step is to purchase materials. Materials purchases are recorded with a debit to the raw materials inventory account and a credit to the accounts payable or cash account. Note that this entry reflects only the purchase of materials. Furthermore, debits and credits to the company's inventory accounts do not have to be made on the basis of the actual flow of inventory. Companies may choose to physically move inventory in and out of raw materials on a first-in, first-out basis, but account for this movement on a last-in, first-out basis. Decisions about inventory cost flows have important implications for financial reporting and tax liability for small businesses
Direct materials, or those materials that are easily traced to jobs and cost-effective to account for on a unit basis, are accounted for with a debit to the work-in-process inventory account and a credit to the raw materials inventory account. Indirect materials, which are any materials that are not easily traced to jobs or that are not cost-effective to account for on a unit basis, are treated as overhead costs. When these items are moved into production, a debit is made to the manufacturing overhead account and a credit is made to raw materials inventory.
Because construction companies do not usually incur labor costs until employees begin work, the accounting for labor costs is less complicated than the accounting for materials costs. Direct labor, wages and benefits paid to employees on individual jobs are accounted for with a debit to work-in-process inventory and a credit to wages payable. Indirect labor, like indirect materials, is accounted for as an overhead cost. Therefore, when a company incurs indirect labor costs, it would debit the manufacturing overhead account and credit the wages-payable account.
In addition to materials and labor costs, construction companies often incur other overhead costs related to insurance, tool rental, depreciation, utilities costs and other costs of doing business. When these costs are incurred, they should be accounted for with a debit to the manufacturing overhead account. The credit for the entry depends on the overhead cost incurred. For costs that are owed on account, the correct credit is accounts payable. If the cost was paid in cash, then the appropriate credit is the company's cash account. Lastly, because depreciation does not involve a cash outflow or the company owing a balance to another company, the credit is made to the accumulated-depreciation account. This appropriately reflects the use of the asset in the construction process.
Because overhead costs are not able to be easily traced to individual projects, these costs must be allocated to jobs. This allocation is made based upon a predetermined rate. Owners should estimate the total expected overhead cost at the beginning of the year and determine an appropriate method to allocate this overhead to jobs. For example, if the manager determines that direct labor hours are closely associated with the amount of overhead incurred on a job, she may determine that this is the best way to allocate these costs. This is called the allocation base. In that case, the manager would divide the estimated overhead for the year by the estimated direct labor hours to be used in the same year. This figure is called the predetermined overhead rate.
Construction company accountants use the predetermined overhead rate to apply overhead to jobs. When the job is complete, the accountant multiplies the predetermined overhead rate by the number of units in the allocation base that are used by the job. This number is the amount of overhead applied to the job and is entered into the financial statements with a debit to work-in-process inventory and a credit to manufacturing overhead.
Completed jobs no longer represent "work in process" and must be moved into the finished goods inventory account. For a construction company, the names of the accounts may seem strange, but the concept is the same. At job completion, a debit is made to the finished-goods account and a credit is made to the work-in-process inventory account. The amount of the entry is the company's cost to complete the construction process.
Lastly, the company receives payment from a customer. While the recognition of revenue on long-term construction projects can be complex, the rules are simpler for smaller construction projects. When title transfers to the customer, a debit is made to the "cost of goods sold" account and a credit is made to the "finished goods inventory" account for the cost of the job. At the same time, the sales price is credited to the sales account and debited to the accounts receivable or cash account. The difference in the two figures is the margin on the project.