I realize that contractors don’t like me harping about knowing their numbers, and contractors as a whole don’t like accounting and bookkeeping. I also recognize I must sound like a broken record. However, 90 percent of the financial problems we see with contractors have something to do with numbers and usually involve poor financial information. I am dedicating this article to helping contractors understand why this problem exists and how to combat it. First, let’s discuss some causes of this problem prior to offering some ideas on how to fix it.
Causes of the Problem
- A “leave it up to the accountant” attitude. Many contractors simply delegate financial tallying to the CPA who handles payroll and taxes. The problem is the accountant is merely acting as a scorekeeper and makes no decisions regarding the business. This would be like a basketball coach having to go to the scorekeeper once a month to determine what plays to run.
- Tallying records for taxes, not cost analysis. If you don’t record information in a format that matches how you estimate and do jobs, it will not be helpful. Taxes are calculated on the bottom line. While the profit total may be the same, quick and accurate financial analysis is impossible if accounts are not set up in a logical format. Frequently, contractors will fax us a10-page statement and say they don’t understand it. I write on the top that I don’t understand it either and fax it back. Since you must go to the trouble and expense to tabulate data for taxes, it makes sense to compile the information in a useful format.
- Records that are too complicated. In his book, Thinking, Fast and Slow, Daniel Kahnema discusses how the brain has two systems: System 1 operates from recall quickly and automatically, while System 2 handles more complex information. As I read the book, I realized looking at these two brain systems can help explain why some people have difficulty grasping financial information.
Try the following exercise. Take the numbers below and add one to each digit to come up with the next number series. Here are a couple of examples of the process:
- When adding 1 to each digit of 16, the new number is 27(1 plus 1 is 2, 6 plus 1 is 7).
- When adding 1 to each digit of 253, the new number is 364(2 plus 1 is 3, 5 plus 1 is 6, and 3 plus 1 is 4).
Now treat the following numbers as an exercise and follow the system above to calculate the next number as fast as you can. Simply repeat each answer quickly and then go to the next.
I bet as the numbers get longer, it gets harder to concentrate and do it. That is because your brain can’t merely answer the problem from short-term recall as the complexity of the problem increases.
Herein lies the problem: contractors are busy. Frequently, financial information is not laid out in a simple format, and it is hard to concentrate and follow through. Rather than dig deeper into the complex numbers and figure it out, contractors often just move on to one of the many tasks that are always nagging them. So here are some simple guidelines to help you get a better handle on the numbers.
Fixing the Problem
- Set a specific time and date each month for reviewing financial information. Performing tasks that require concentration also requires scheduling. Turn off your cell phone and e-mail, and spend some time working on it. It takes a while to get into the “slow brain” transitions necessary to handle complex information.
- Have an agenda of what to cover. Review your profit and loss statement and balance sheet in an accrual format. Even though your CPA and the IRS may accept a cash format, I believe you should never use a cash format, as it is not an accurate reflection of your current financial position. Also, review accounts payable (what you owe people) and accounts receivable (what people owe you). To see where you are, compare it to the previous month and past year.
- Close out the month. To the bookkeeper, closing out the month means the checkbook balanced, but that is not enough. Try to bill everything as close as possible. Even if you don’t do jobs in progress, try to post part of the sales so you have the job billed in your accounting records. Record materials in the month they are used, even if you have not paid the bill yet.
- Set your statement up in a simple-to-read format. Use the same titles and logic you would use to bid a job. This will help you quickly understand the numbers. Of course, this example has arbitrary numbers, but in its simplest format, an operating statement would look something like Figure 1.
The detail in Figure 1 is not enough for financial analysis, but you can have multiple accounts under each of these categories. Use the totals and logic to help see what is going on in the business. In the above example, labor is 24 percent of sales ($120,000 divided by $500,000). If labor is 40 percent of sales this month, something is wrong.
Possibly a job has not been billed, you have a losing job or something unusual is going on. In the above example, gross profit before variable overhead was 40 percent ($200,000 divided by $500,000). If it is only 25 percent this month, what is wrong? Do you have a job that was a big loser, or has something not been billed? Variable overhead is normally 4 percent, but suppose year to date it is 8 percent. What is wrong? Is someone stealing gas? Have gas prices increased, or are your trucks getting old and requiring too much maintenance? By keeping things simple and matching your accounting logic to your job logic, you know where you are and what is going on. By using your records, you will also have better records.
Keep score in a format that makes sense to you.