The term underbilled sounds simple enough. When you have more costs on a job than you have billings, there's an underbilling and the difference between what you billed and your costs on the job is the underbilling...not so fast.
When you have more costs on a job than you have billings, you're definitely underbilled, but the underbilling doesn't equal the difference between costs and billings.
Think of underbillings as an amount that's fronted to you by the magic of accounting.
You've incurred costs on a job in progress but didn't bill the project owner or general contractor (GC) by period/year end. Tough luck, you're left with a loss, or are you? Fortunately for you, WIP comes along and fronts you the revenue to bump up your gross profit for the period/year to match the estimate. Yes! Based on accounting standards, you're entitled to recognize revenue even though there were no progress billings. But there is a catch.
When you bill the project owner or GC you record revenue and an asset (accounts receivable). With underbillings, you record revenue too, but instead of recording a receivable, you record an underbilling. This underbilling is a placeholder that says "hey I didn't get a chance to send an invoice, but I'm good for it, just look at my estimated gross profit. I'm going to make X% gross profit on this job". It can do wonders for your income statement and balance sheet, but you have to remember one thing. Everyone is expecting that to turn into a receivable that will lead to the collection of cash, and that doesn't always happen. This is the reason why sureties get uneasy with high underbillings. It's a phantom asset that's based on your estimates. If you keep saying "I'm good for it, I'm good for it" and aren't, those are underbillings become as useless as a post it that says "I owe you". Sureties stop caring become even more fixated on your cash position. Poor estimating can lead to inflated underbillings, which can eventually turn into substantial losses.
So how do you calculate underbillings? Example time!
Assume the following fact pattern:
Contract Price: $100,000
Estimated Total Cost: $70,000
Gross Profit %: 30%
Cost to Date: $45,000
Billings to Date: $35,000
Billings to date less Costs to date: $(10,000)
Gross Profit % on activity: (29)% (($10,000) / 35,000)
X= Total gross revenues
1) (X - 45,000) / X = 30%
2) X - 45,000 = .30X
3) .70X= 45,000
4) X= 64,286
Check: (64,286 - 45,000) / 64,286 = 30%
Now onto the underbilling!
Underbilling: 64,286 - 35,000 = $29,286
To summarize, you billed out $35,000, which wasn't enough considering your expected gross profit of 30% on the project, so the WIP formula "fronts" you $29,286 in revenues to balance out your gross profit.
Thanks for tuning in!
-Ara