Balancing Construction Accounting Data Specificity
Where some developers may aggressively shoot from the hip regarding their decision making, others may become mired in analysis paralysis. While the former may have lax accounting controls over their construction costs, the latter may be obsessed with a granularity of construction data that is impractical. How should a developer strike the right balance to understand its construction costs without missing the forest from the trees?
As we have stated before, the key to any business being successful is having a profitable product one can produce repeatedly. This key concept, aside from all others, ensures a business that can both continue and have the potential to grow. Many boutique developers do not emphasize this as a key concept, and thus lurch from one project to the next. While there are opportunities for continuous improvement in the financing or approval process which may make for them a core competency, if a developer finds its projects consistently delivering a similar product, they should consider employing processes and procedures to further refine that repetition and lead to a cycle of ever-increasing efficiency. Doing so will help develop additional core competencies that may serve as a competitive advantage, yielding accelerated growth.
Before we dive in, it is important to dispel the notion that construction is a highly commoditized industry. While several material components are commodities, the industry is anything but. It is not uncommon to look at standout examples of superior cost efficiency (like Walmart, Costco or Amazon) and conclude that within the construction industry, if we can just find the right general contractor or subcontractor who is the most cost optimized, we will obtain the lowest price. This is incorrect. The industry is populated by hundreds of small businesses in a given market, each of which makes very different decisions about their price and whether they will even accept the job. One subcontractor may have provided you an amazingly “below market” number on your prior project, but when time comes to bid your next one will give you a very high price. This could be because they have taken on too many jobs and will provide a price as a courtesy but are only really interested if they can make a huge profit. It could also be that the general contractor’s project manager upset them or made unreasonable demands on them for that last project, and they are reluctant to work with them again. The industry tends to be a round robin of relationships, with an organic assessment of past performance, relative value (for both sides of the transaction) and personal affinity. Therefore, isolating construction costs in the same way you might a stock price in a highly efficient market with millions of transactions is an unachievable goal. Therefore, while data is important, a developer may be infected with an unhealthy obsession to obtain data so granular it would be counterproductive to their aim of delivering on deals and achieving results for its investors.
Too Little
Often developers focus their general ledger on the soft costs with which they are most familiar but treat construction costs as a black hole into which the general contractor fills in the number. As we have discussed in prior articles, a project’s hard costs are, on average, around 70-80% of total cost of the project. Therefore, treating the construction portion of the project budget as just a number to be plugged into the proforma from the general contractor evades obtaining a level of specificity that can provide insights to the developer. We have also seen developer clients who would try to shoe-horn their construction costs into five or six very broad cost codes (earthwork, vertical costs, amenities, etc.) which had imperfect corollaries from the construction budget and likely led to data corruption rather than any consistent insight. While we do not advocate for hyper granularity, if your accounting system currently forces the construction cost data to be tracked in this manner, your accounting and construction departments will feud continuously over accuracy, transparency and payment approval.
Too Much
When developers, and/or their CFOs, finance or accounting departments, feel that they receive too little data from their general contractor or their owner’s representative to make informed decisions, this may drive them to an obsession of believing that if they had all the data of their general contractors and subcontractors (or to internalize construction) that they would finally understand their true costs. While understandable, this instinct should be tempered by an understanding of the source of this desire and why it is nearly always impractical to obtain.
First, a developer’s tax accountant will desire yet another breakdown of the data for the purposes of calculating depreciation. In real estate, depreciation allows property owners to deduct the cost of buildings and certain improvements over time, based on the asset’s useful life as defined by the IRS. Depreciation serves as a useful offset to profits to reduce tax exposure. The key IRS rules around depreciating construction materials and components hinge on whether the constructed components are classified as:
Real property (part of the building structure, depreciated over 27.5 years for residential or 39 years for commercial), or
Personal property (movable or not integral to the building, eligible for shorter lives such as 5, 7, or 15 years).
Common construction materials/components and their typical depreciation schedules under the Modified Accelerated Cost Recovery System (MACRS) is currently defined as follows:
Shorter-Lived Assets (5-15 years)
Carpet: 5 years (classified as personal property, not part of the structural floor)
Appliances (e.g., stoves, refrigerators): 5 years
Cabinetry (movable or tenant-installed): 5 years
Landscaping: 15 years
Parking lot paving (site improvements): 15 years
Longer-Lived Structural Components (27.5 or 39 years)
HVAC systems: 27.5 years (residential) or 39 years (commercial)
Plumbing systems (e.g., pipes, drains): same as building
Electrical systems: same as building
Roofs, windows, doors: same as building
While it may seem simple enough to obtain separate cost data from the general contractor for these key material components vs. the labor and overhead employed to install them (which cannot be depreciated) this is easier said than done. There is often a misconception that the general contractor receives the breakdown of materials, labor, overhead and other costs from subcontractors or suppliers.
Second, aside from the need for accurate tax reporting, a case is often made that this data would enable more sophisticated analysis by the developer that would provide a competitive advantage (such as comparing material costs against available indexes). Unfortunately, this is not the case. Unless the general contractor has specifically instructed its subcontractors to provide this breakdown, they will most likely not receive it. The only reason the general contractor would do so is if they feel they can buy the material separately and pass on (or absorb) the markup. However, in so doing the general contractor then accepts responsibility for material coordination for that subcontractor which invariably leads to increased management oversight (which also has a cost). Regardless, some subcontractors will only provide a single number for both material and labor.
Therefore, the pursuit of this level of granularity is often impractical to obtain.
Well then, what data can we get?
Assuming the developer has elected for a GMP contract, then they are likely receiving a level of detail that is sufficiently granular. However, if they are not utilizing some system by which that information is digitized, then they may not have easy visibility to this data. Even under lump sum and other common contracts, the two most critical sources of data are generally shared with the developer. These consist of the bid sheet (during the bidding phase) and the G702/703.
The bid sheet is a matrix the general contractor will generate to display all bids received and what combinations of subcontractors results in the lowest overall cost. It should be noted that while in an ideal world, all subcontractor and supplier bids would be able to be compared apples to apples, the more complex the construction type, the more unlikely this is to occur. While the data will confirm to the developer that the general contractor has selected the most cost efficient combination of subcontractors and suppliers (and if not, the developer is well within their right to receive a suitable explanation, e.g. the low cost leader included unacceptable exceptions in their bid, they have a poor track record or add undue risk based on the general contractor’s experience, etc.), little more information may be gleaned other than that the average market price for any portion of the work is more than the price on which the general contractor sets the budget at construction start.
The G702/703 is the standardized method for submission of, and documentation of, monthly payment applications against the budget established by the contract. Thus, it documents percentage of work complete and change orders during the course of construction. While the G702/703 often does provide more granularity than the top line budget, these breakdowns (while sometimes including material and labor breakdowns when those materials are purchased separately or need to be staged earlier in the construction process) should primarily be based on phasing of work. For instance, plumbing work typically occurs in three phases at different times: undergrounds, rough in and trim. When properly optimized, the G702/703 payment subcategories should align with the schedule to ensure subcontractors or suppliers are paid promptly for work performed, but also only for work performed. This relationship between schedule and payment is further discussed below.
Both of these data sources are likely shared by the general contractor in some manner. However, it is very common, unless the developer has established otherwise by contract with the general contractor, that both are shared as a paper handout at OAC meetings or (in the case of the bid sheet) as an excel file by email. While they may not be submitted digitally and easily analyzed, they are often within the possession of the developer’s staff or consultants. Therefore, establishing a workflow (ideally digital) where this information can be seamlessly transferred into a system which “talks” directly to the accounting system is ideal.
Industry Standards for Establishing a Cost Accounting Structure
The best practice for a developer building a consistent general ledger for construction would be to use one of the two Construction Specification Institute’s MasterFormats.
CSI 16 Division vs. 50 Division Version
The graphic below provides a decent summary of the difference between the two. Generally speaking, the 1995 format still remains more commonly used in the industry. Additionally, the 2004 format significantly expands building systems, which is likely less relevant unless the developer focuses on projects with more of these components.
As a broad structure for construction related costs, this system should serve as a logical method for tracking of construction costs within a developer’s general ledger. This structure will also be useful for the developer to evaluate the bid spread which the general contractor should be required to share with the developer under most AIA contracts (understanding bidding is discussed further here)
Regardless of the format used, these division categories can be further broken down into several subcategories for added specificity. Whether or not the general contractor utilizes further granularity within each major subcontract line item is best left to them as any attempt by the developer to impose more granular detail will likely be inconsistently followed if working with more than a single general contractor. The general contractor may elect, depending upon the subcontractor, to break their line item down further into a labor/material split or divide between rough and finish work. While a data driven developer might want to have all that information for every subcontract line item, obtaining it consistently is impractical. Why? There are two reasons why obtaining a precise split between material and labor is likely futile. First, even if you can get two general contractors to agree to use the same MasterFormat for their reporting, and even if they are building nearly identical projects, the detailed ledger both will generate will never be identical. There is just too much subjectivity available to the general contractor to ensure consistency between how each firm will use the system. Second, even despite providing robust bid instructions in advance, subcontractors may or may not provide the data in a version either the general contractor or developer may desire. A classic example of this is one might want to understand the breakdown between material and labor. However, subcontractors will often balk at providing information in this way unless the subcontractor plans to invoice separately, often in advance, for materials (this especially true the busier the subcontractors are as they will not take the extra time to provide specificity or may even pass on bidding altogether if they feel the general contractor is asking too much).
Leveraging Cost Data for Optimal Schedule
Although the developer may be unable to obtain all the granularity it desires due to the constraints discussed above, if the developer is requiring their general contractor to follow the scheduling (or reporting) requirements under the Clear Flow Matrix structure, the general contractor must work with their subcontractor to break down their contract into amounts aligned with each work phase (Ideally by week and by work area). While this may seem laborious at the start of a project, this is the most critical and powerful way to align financial benefit with schedule. Additionally, ensuring that the pay application is structured in this manner will make payment authorizations far simpler in the field than is the norm.
Typically, the developer (or their representative), the contractor and the architect will meet monthly during the course of construction at the OAC meeting prescribed by contract. Projects which do not utilize a CFM type cost breakdown in the pay application rely on a % of work complete approximated based on a brief visual inspection in the field. In so many OAC’s we have attended, this is often a complete guessing game. A subcontractor will push for as much as they can possibly invoice and may submit that their work is 83.7% complete. The general contractor will likely push back, resulting in 82.4% being submitted on the draft pay application. The developer’s representative will then likely push back further, if they believe it is reasonable, settling on 81.3%. Who is correct? Who knows. The elegance of the CFM scheduling system when tied to contracts and billing is that one can state definitively what work is complete and what work is not. And we would submit that, outside any agreement with a subcontractor (at the general contractor’s discretion) to pay for stored on-site materials, a subcontractor should be paid 100% for work fully completed in an area and not be paid for incomplete work. In other words, since the last pay application, it is evident that the drywaller has completed the second floor east and third floor east as the painter has been able to move into each area. While they have started work on the third floor west, the work is not yet complete and no portion of it should be invoiced on the pay application and that it is only fair that they should be paid promptly and in full for the second floor east and third floor east.
Many general contractors intuitively subdivide subcontracted costs into phasing that make sense, even without strictly adhering to the Clear Flow Matrix. This is because it is intuitive that if they are building a 10-story building, and they plan to have subcontractors completing their work one floor at a time, they will at a minimum divide the total contract amount into 10 line items corresponding to each floor. Therefore, even if a developer neither mandates CFM by contract nor requests it be adhered to, there is a natural inclination to structure the G702/703 in this manner. A slight nudge may be all that is required to ensure the pay application is structured to follow subdivisions which align with a regular weekly schedule, and this is certainly of advantage to the developer.
Properly Assessing Variances to Budget
In addition to properly structuring the starting budget, understanding variances is another important vital cost data source that must be captured to truly understand construction cost data. First, let's establish that the true price of any construction project is never known until construction concludes and all change orders are reconciled, hence our dim view of hard bidding (which tends to establish a rosier starting price, but the true price of the project is only known after all the change orders are submitted to ensure the GC or subcontractors obtain what they believe to be fair compensation). Admittedly, in an ideal world a general contractor would deliver exactly on budget with no changes, however, in all our years we have never seen this accomplished.
In our experience, many who come up through the world of general contracting, while understanding the structure of a budget and the need to stay within budget, often fail to understand the purpose for variance reporting. To be clear, while not all developers employ variance reporting, this can be a critical management tool when one’s business model is based in producing a consistent product and repetition. One often hears, even high-level executives with that general contracting background lament that if only they were allowed to modify certain line items in the budget, those items would no longer be overbudget and answering questions on variances would not be necessary. If there are individuals like this within your organization, additional training on the purpose of variance reporting may be required. Ultimately, variance reporting is meant to identify which line items ultimately cost more than originally anticipated. And while team members should be encouraged to manage to the bottom line (savings in one area can offset those in another), this is irrelevant for the type of insights one hopes to gather from a clear understanding from where budgetary misses came. With any well-developed construction budget, there will always be line-item misses (both positive and negative) which ultimately one hopes will balance. However, this is never guaranteed, and allowing managers to modify their original budget to fit reality erases the very data which will help lead to insights to help better plan future projects. What is more important is having a system in place to track the root cause of the variance and to establish levels of delegated authority to expedite the approval of change orders (which are variances to budget) quickly. For more detail on this, see here.
Just Right (Optimal Data Granularity)
After all the above discussion, we recommend that developers do the following to ensure optimal system set up, transparency, clarity and expeditious approval of construction payments:
Select either the 16 or 50 division CSI format as the basis for your internal accounting system, do not include sub or sub-subcategories. It is recommended to select the format after consulting with frequently used general contractors on the structure they utilize for optimal transparency.
Establish ratios of material vs. labor/overhead on key subcontractor costs via survey. This can be done through a documented audit of select subcontracts from prior projects, it being easier to obtain the breakdown from subcontractors who have already performed work and were pleased with their profit rather than trying to force every bidding subcontractor to provide this breakdown upfront. Establish a process to survey a select number of subcontracts every couple of years and adjust the ratios if needed (likely major adjustment will not be needed).
Select a project management system that has a cost accounting module and that can tie into your accounting system. Procore is an industry leader, but there are many others.
Establish a process for identifying root causes of change orders that can be tracked, summarized and later analyzed.
Establish a process for providing delegated authority so that small change orders can be approved quickly at a low level and large change orders are seen and approved by more experienced decision makers.
Tracking this data should provide sufficient granularity to understand what is really going on throughout the construction process, ensure proper controls and enable analysis of future deals based upon historical data.
If a developer is interested in indexing their construction budgets to inflation, we have a proprietary tool here to help with that.
