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What Are Underbillings? The Definition in Construction
Underbilling occurs when costs have not yet been billed or reimbursed. The accounting method most commonly used by contractors to report earnings is the percentage of completion (POC) method. A project’s revenue is calculated using the contract price and the percentage of completion and very rarely matches the amount billed. The difference between the two is either an underbilling or an overbilling.
POC accounting determines the percentage of work on a project completed as of a particular date, based on the costs incurred to that point as a percentage of the total estimated costs for the project. For example, when a contractor reports having incurred 50% of total project costs but has billed only 35% of the total contract price, there is an underbilling of 15% of the contract price.
Why Does Underbilling Occur?
Underbilling is fairly common. Underbilling of costs typically is the result of:
- Slow billing that occurs when a contractor misses its billing cycle and monthly submittals are not made on time
- Actual costs exceeding the total contract cost due to cost underestimation, resulting in overstating revenue and profits
- Unapproved or disputed change orders being included in the contract price
- Profit fade that has not yet been recognized in the estimated costs to complete the project
- Stored material that can’t be billed until it has been inspected and approved
Underbilling becomes a problem when it negatively impacts cash flow or becomes an issue with construction bond underwriters or lenders.
Best Practices for Avoiding Underbilling
When underbilling is the result of submittals not made on time, getting them back on track should solve the underbilling problem. Missing the billing cycle frequently can raise underwriting concerns about a contractor’s management ability.
Cost underestimation is best addressed by periodically re-estimating costs as work on a project progresses. If underbilling is not recognized early, you could end up putting money into the project to bring it to completion.
Be particularly wary of unauthorized change orders. Never perform work that the project owner has not approved, or you might not get paid for it. Such problems can be avoided by being clear on the procedures for obtaining approval of change orders and communicating regularly with the project owner.
Underbillings and its Effect on Construction Bonds
Underbilling is fairly common, but that doesn’t mean it should not be avoided. As noted earlier, underbillings can be detrimental to a contractor’s cash flow. Additionally, underbillings are likely to raise some issues with the construction bond underwriters, particularly when a job is more than 90% complete and the underbillings represent a significant chunk of the gross profit earned and cost to complete the job. Should the underbillings not be collected, the working capital, cashflow statement, and profit-and-loss statement may be overstated. Repeated underbillings can threaten a contractor’s ability to get approved for a construction bond.
From an underwriting perspective, the main concern is the risk to the party guaranteeing payment and performance bonds (known as the bond’s “surety”). In approving a construction bond applicant, the surety is agreeing to extend credit to the contractor (the bond’s “principal”) for the purpose of paying valid claims against the bond. The project owner (the bond’s “obligee”) can file a claim against the principal’s performance bond for project noncompletion, and suppliers and subcontractors can file against the payment bond if not paid according to the terms of their contract.
The surety will honor its guarantee by paying the claimant directly, creating a debt the principal must repay or face legal action by the surety. While the principal is legally obligated to repay the surety in such cases, that may be easier said than done if the principal lacks the necessary capital or ends up declaring bankruptcy. So it’s easy to understand why the underwriters assess every bond application carefully to determine the risk of claims being incurred and the risk of the surety not being repaid for the debt created by paying claims on the principal’s behalf.
A history of repeated underbillings and gross profits below what was originally estimated can call a contractor’s management practices and financial stability into question. At the least, the elevated risk can result in a high bond premium rate. In the worst-case scenario, it could make it difficult or impossible for the contractor to obtain the necessary construction bonds.
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