When part of last year's profit was an estimate
Any business billing work in stages carries estimates in its earnings. Here is the test a buyer runs on them.
A buyer is paying for future cash flow. Your past results are the evidence he uses to judge what that cash flow will be and how steady it is. That is the basis of the price, whatever the industry.
What is different for a company that bills work in stages — contractors, installers, custom manufacturers, anyone whose jobs run for months — is how much work it takes to confirm that the past results were measured correctly. If you report on percentage of completion, part of every year's profit was estimated rather than earned, and the work-in-process schedule is where those estimates sit.
Where the estimate enters your profit
On an open job, you count the costs you have spent so far, divide by what you expect the whole job to cost, and that fraction is how complete the job is. Apply it to the contract value and you have the revenue you can report. Anything above your costs is reported profit.
Every number in that calculation is a fact except one. What you expect the whole job to cost is a judgment you make. For jobs still open at year end, that judgment decided how much profit the year showed. Once a job finishes, its real margin is known, so over a few years these differences even out. The year most likely to be off is the most recent one, which is usually the year being priced.
The test a buyer runs
It is called profit fade, and if you carry bonding, your bonding agent already watches for it. Take jobs that finished, and compare the margin each one carried while it was open against the margin it actually closed at.
A $2.4M job, expected to cost $2.0M, with $1.5M spent, is 75% done and shows $300,000 of profit. If finishing takes another $700,000 instead of $500,000, that job closes nearer $136,000.
One job like that is normal. The same pattern across many jobs says two things: profit in those years was reported high, and the company's estimating is less accurate than the schedule suggests.
What it changes
The first point adjusts the earnings a buyer works from. The second affects how much he trusts them, which shows up in what he offers and in how much of it he is willing to pay at closing.
Separately, and later in the process, over-billings, under-billings and retainage get settled in the working capital adjustment at closing. That moves cash at close rather than the price.
A Straight Answer
Your earnings set the price. The WIP schedule decides whether those earnings get taken at face value. A company whose jobs finish close to where they were bid does not have to argue for its numbers.
That record is made up of jobs already closed, so it cannot be changed now. It can be changed going forward, and it starts changing the month somebody reviews the estimates on a schedule instead of at the end.
BuiltEquity is a sell-side brokerage for trades and field-service companies. Nothing here is accounting advice. Your CPA is the authority on your books.