Your neighborhood ice cream shoppe no doubt operates under a simple fixed price, point-of-sale billing method. Construction companies don't have it so easy.
Because of the project-based, decentralized nature of construction work, contractors need to use various billing methods. Let's review the five most common in case you might be overlooking an approach that could better suit your business needs.
Sometimes known as fixed price, lump sum billing sets a single cost for an entire project based on a detailed estimate. This method works well for jobs with clearly defined scopes when there are no anticipated fluctuations in labor or materials costs. Finishing early or underbudget can heighten profit margin, but you also run the risk of paying out of pocket for cost overruns.
If you typically use lump sum billing, read through each contract carefully to determine whether it allows for contingencies because of unforeseen events. Also, you can ask for payment in advance, on project completion or through scheduled installments. Typical installment approaches include:
Advanced billing: This gives you access to the funds needed to buy materials, pay subcontractors and vendors, and mobilize on the job site before construction starts.
Arrears billing: This approach involves sending an invoice after work is complete. Doing so means you must pay out of pocket to mobilize and complete construction — all the while trusting that the project owner won't reject your work or delay/deny payment after completion. As you're likely aware, arrears billing works best for smaller, short-term jobs for trusted customers.
Progress billing: This can happen on a percentage-of-completion basis with retainage withheld. You follow a payment schedule, billing the owner when designated project milestones are met. It's typically used for long-term projects with larger budgets. When using progress billing, ensure the payment schedule is clearly spelled out in the contract.
READ MORE: Construction Accounting: How to Determine the Best Method
Cost plus billing includes the total project cost plus a fee for profit. The project cost includes direct costs (such as labor, materials and equipment) as well as indirect/overhead costs such as travel mileage, insurance and administrative expenses.
On top of that, contractors generally apply a flat fee or charge a percentage of overall costs incurred, allowing for the fee to escalate when job costs rise. A good approach for projects with largely undefined scopes, this billing method allows for change orders and rising materials prices without cutting into profit margins. Some owners might place a cap on total project costs in the contract.
Time and Materials
Time and materials billing bases the contract price on an hourly or daily labor rate plus the cost of materials used. Under this method, you'll generally need to apply a standard markup for both the labor and materials/equipment components to account for overhead costs and build in a profit percentage.
Time and materials billing is a sound method for projects with undefined scopes or deadlines. The contract should allow for change orders and, ideally, offer a bonus for early completion to keep crews working efficiently.
Under a unit-price contract, you bill a customer at a fixed price per "unit." The project is divided into blocks or segments (units), with the number of blocks undefined at the beginning of the job.
This is an especially common billing method among heavy-highway and utility construction companies taking on projects with repetitive work that can easily be priced out as units. It's a good approach when you can't estimate with certainty the project's schedule or scope.
The unit price method also provides leeway for tacking on additional work and materials, which can result in production quantities higher than estimated. To avoid losing money, it's critical to estimate the unit pricing correctly.
READ MORE: Revenue Recognition in Construction: How to Choose the Right Method
AIA Progress Billing
This common construction billing method uses American Institute of Architects (AIA) standardized forms for progress billing. The contractor invoices the customer based on the percentage of work completed for that billing period.
You can use costs, units or labor hours to calculate the percentage of the project that's complete. Although widely used for long-term projects, AIA forms can be costly to use and customize. You must ensure any changes made won't lead to legal compliance issues.
A Common Thread
Running through all five of the billing methods described above is a common thread: the need for accurate, detailed estimates and good project record keeping. With these in place, you can provide the documentation needed to increase the likelihood that you'll get paid on time and with minimal conflicts.
We can assess your billing methods and help you better organize your financial information for best results. Please contact us for personalized assistance.