Part 3: What is the WIP telling us?
Updated: Aug 23, 2022
Let's talk about the what the WIP report is doing!
A few background items to address here before we get going. There's a method to recognize revenues on long term contracts (projects lasting more than 1 year to complete) known as the percentage of completion method. Fancy way of saying recognize profit on a job EVENLY throughout the duration of the project. All this means is that there's something else driving how you're able to recognize revenue other than your progress billings; costs and estimated gross profit.
The magic formula for recognizing revenue (or at least one way to look at it).
Revenues Earned = C/ (1-GP%)
C= Cost to date
GP%= gross profit percentage
Fortunately we have the WIP template do all of the calculations for you in this step (under column G).
Notice that nothing about billings is mentioned in the above formula. All this is saying is that regardless of what billing activity there is, this is the amount of revenue you can recognize. I like looking at the revenues earned calculation this way because I think it's the most intuitive way to understand it. If your gross profit is 15% and your costs are say $100, you're saying that $100 is 85% (1 minus 15%) of your revenues ($100/85%).
Now comes the time when we factor in billings.
If your billed to date is greater than the above calculation, you have an overbilling for the difference between the two. If your billed to date is less than the above calculation, you have an underbilling for the difference. Overbillings are liabilities and underbillings are assets. The over and under billings are what smooth out profit recognition EVENLY throughout the duration of the job. So there you have it folks!
BUT WAIT! Not all jobs are expected to be profitable.
When you are expecting a loss on a job, you have to recognize the entire loss the year it becomes evident. This means that you can't recognize a portion of the loss as you've been recognizing a portion of profits. There are different ways to present this but for simplicity's sake you can run it through your WIP report. Don't worry the WIP template will take care of it.
Calculate your current period revenues and costs by simply reducing the revenues earned and cost to date by the previous periods revenues earned and cost to date on that contract.
Now that we've discussed the general concepts of the WIP report, we can move on to the analysis of the calculations and what to look out for. See you soon!