Why do contracts have those long expensive tails that reduce their profitability so much right at the end?
All contractors that I have spoken with knows exactly what I am talking about, in your mind that contract is already done and dusted, your focus is on the next project and suddenly this thing liberty you from behind with unexpected costs and effort. It happens with construction contracts, maintenance and service contracts and even some manufacturing and purchase orders.
The secret to prevent this from happening lies with your accountant and not with your project manager – the guys/gals with the thick glasses and dark suits captured the solution in IFRS 15 of the International Financial Reporting Standards.
Let me explain how it works in very practical terms – it is a complex topic but so important in securing a sustainable organisation.
When you land a contract or purchase order you need to forecast your income and expenses for the total job and throughout the execution of the job you need to update that forecast on a regular basis. You do this by looking at what you have spent (external as well as internal costs) and forecast what you still need to spend right to the end – the total of these costs give you the Cost at Completion – do the same with Revenue and you can determine your Profit at Completion as well as your Profit at Completion percentage.
You will notice that I use the word forecast and not budget in the below paragraph, a budget shows expected activities – life as we want it to be. A forecast shows life as it is probably going to be – this is normally a moving target, hence the need for regular updates.
You also then use the actual spent costs as a percentage of the Cost at Completion to calculate the percentage completion of your contract – that is right, you do not use the amount of Revenue you have invoiced or money you have received, you use the amount of costs you have incurred.
You now, at regular intervals throughout the contract, have a number of data points – let’s list them:
- Total expected revenue for the contract
- Total expected costs of the contract
- Total expected profit and profit % of the contract
- Actual spent costs to date
- Actual invoiced revenue to date
- Profit and profit % to date – calculated by deducting actual spend to date from actual invoiced revenue to date
- Completion % – based on the spent to date as a % of total expected costs.
As a manager or leader of your organisation you can now immediately see if there is going to be a problem at the end of the contract. All you need to do is to compare the profit % to date with the total profit percentage at completion of the contract.
If your profit % to date exceeds the total expected profit % of the contract then you have recognised revenue and profit that has not fell due yet and you can expect a nasty surprise as the contract carries on. Save enough of that revenue in your advances received account so that the profit to date percentage match the total expected profit percentage and you will be fine throughout the contract.
If your profit percentage to date is less than your total expected profit % then you can sleep better at night as the contract is not the disaster you thought it was – you are ahead with your expenses and you can accrue some revenue that you still need to invoice the customer.