The Pros and Cons of Overbilling

Overbilling can be good for your cashflow, but it can also potentially cause problems if used in the wrong way. This week, we’re breaking down the pros and cons of overbilling, and how to overbill without setting yourself up for future headaches and issues with your bond underwriter.

Topics we cover in this episode include:

• What is overbilling?
• What scenarios may result in overbilling?
• When does overbilling become a bad thing and how do bond underwriters look at it?
• How human error can lead to overbilling

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Wade Carpenter, CPA, CGMA | CarpenterCPAs.com
Stephen Brown, Bonding Expert | SuretyAnswers.com

TRANSCRIPT

[00:00:00] Wade Carpenter: Welcome to the Contractor Success Forum. In this episode we are talking about overbilling, which is a great thing for cashflow if you’ve been acting as a bank for your customer. But there are potential drawbacks and we will kick around the pros and cons today. So if that’s of interest, stick around. Let’s get into it.

If you’re new here, I’m Wade Carpenter with Carpenter Company CPAs. Here with me is my cohost, Stephen Brown with McDaniel Whitley Bonding and Insurance.

Stephen, what is over billing? What are we talking about today?

[00:00:33] Stephen Brown: Well, overbilling is a very interesting thing to bond underwriters and I’m in the surety business, Wade. Overbilling brings up so many different questions when it’s being reviewed. I mean, on the one hand, if you can be overbilled and get paid early and get ahead of the game when you know that the payments are notoriously slow, that’s a good thing.

But if you over bill and you get a bunch of cash in and use that to pay for other projects that aren’t performing as well, the term we use is robbing Peter to pay Paul. And your term as an accountant would probably be job borrow, but that’s a term that the underwriters use too, job borrow.

So in other words, you’re taking money on one job and spending it on another that you’re losing money on, and at some point it catches up. So that’s the scary part of overbilling.

What is overbilling?

[00:01:25] Wade Carpenter: I think we just need to define that, and I think everybody generally knows what we’re talking about, but overbilling is where you billed ahead on a job. Say you’re 50% complete, but you billed 70% of the job. And there’s reasons for that.

There’s, especially with Covid, a lot of the the supply chain got messed up and a lot of people had to go order materials and if their properly showing stored materials right, that’s fine. But if not, it can look like to a bonding company, some people are borrowing to pay for the last job with the current job.

[00:01:59] Stephen Brown: Mm-hmm.

[00:02:00] Wade Carpenter: And it becomes a vicious cycle. I think that was your concern in talking about this, was it not?

[00:02:05] Stephen Brown: Yes, it was. It clearly shows up on financial statements billings and excess of cost. And that’s a counter asset. So that shows up as a liability, right, Wade?

[00:02:17] Wade Carpenter: Right.

[00:02:18] Stephen Brown: And it’s all designed to even things out. Your cost for this, you billed this.

What scenarios may result in overbilling?

[00:02:23] Stephen Brown: So in an overbilling situation, or billings in excess of cost, accounting term, what scenarios might arise that there would be an overbilling?

[00:02:34] Wade Carpenter: I guess that’s where I could get into some stories. I used to do a lot of utility contractors, and if they were buying pipe, that can be hundreds of thousands of dollars. And I’ve had some where they would buy the pipe up front for the job, and they would be able to bill for the stored materials, but really shouldn’t be able to bill for their profit on stuff like that. And if you show it properly on a financial statement, that can explain it.

I have a, they do about 150 million a year. They have one division that does schools that’s 120 million a year. And they’re a May year end. And obviously for schools, they do a lot of the building when the kids are out of school, right?

So, these people have gotten known for doing quality work, but these school boards apparently take off in the summer. And for them to get paid, they have to go ahead and bill upfront for these jobs. And they actually go ahead and pay them upfront. So on these audited financial statements, believe it or not, some years we were showing $12 million overbilled on a May statement.

[00:03:39] Stephen Brown: Oh wow.

[00:03:39] Wade Carpenter: 12 million is a lot of money, but they can burn off a lot of that in two months time. But we had to explain to the bonding companies like, yeah, no, they’re not really borrowing from Peter to pay Paul in this case. They had solid equity and stuff like that. But in that situation, you can understand it.

When you start borrowing and billing ahead and your owner doesn’t know, and you really are floating, we all want to stop being the bank for our customers, but there’s a point where it becomes a problem, right?

[00:04:08] Stephen Brown: It does, especially if your mindset as a contractor is to try to hard cash, ’cause you know you’re in trouble.

[00:04:14] Wade Carpenter: Yeah. Hoarding cash is one thing, but again, I see it where people will bill on the next job, and then, I think from the bonding company, obviously you’re worried about you borrow from the job and then something happens to that contractor and they skip out and they’ve taken all the money and then you’ve gotta finish it, and there’s no cash left in the job to do it.

[00:04:34] Stephen Brown: Right. And I’m not saying that frontloading a job isn’t a good business practice, but that’s usually in a situation where you have upfront costs where you make your main profit. For example you’re a general contractor and you’re building a building and you can do all the dirt and concrete, for example. So that’s getting in early and getting things done, getting the foundation done, you can do it with your own forces and you can front load the cost of that.

Other situations as a subcontractor, a demolition contractor on a project as a sub would be paid first and maybe interior finish contractor would be paid last in the project. So you have to always think about whether the money’s gonna be there to pay you as you bill as well. So overbilling is not bad, and overbilling is not good. What is it?

When does overbilling become a bad thing and how do bond underwriters look at it?

[00:05:24] Wade Carpenter: There is a point where it can be too much. And I know we were just talking about a situation you had where you were kicking around with an underwriter, and I know I’ve got some measures that I looked at. From a underwriter standpoint, I know you used to do underwriting for bonds as well, how do you look at it?

[00:05:40] Stephen Brown: They generally, if their contractor is doing it and they traditionally hold Profit on their jobs, then they’re for it. They’re like if you can do it, why not? Why not take someone else’s money and make interest on it?

[00:05:54] Wade Carpenter: Right.

[00:05:55] Stephen Brown: That’s their thought. But if that contractor has a tradition of profit fades, which means the profit that they originally estimated on the job versus where it is now, and they see a lot of over billings, they get concerned.

[00:06:08] Wade Carpenter: Right. When I look at a contractor, one of the measures we have is look at overbilling as a percentage of revenue. Are there other tests and things like that you look at or your underwriters look at that are saying, is–

[00:06:23] Stephen Brown: I think that’s a key performance indicator for, that’s a good one.

Your over billings to your equity can tell you a lot. So let’s just take a ratio number of over billings to equity that might be a concern to you or to a bonding company. It would be in a situation where you have a higher number. So the closer to one, if it was over one, it would be terrifying, right?

[00:06:49] Wade Carpenter: Oh, of course. Yeah. If it’s more than usually 20, 30%, then people start getting nervous.

[00:06:54] Stephen Brown: Yeah, so, a three over 10 ratio, so to speak. Right?

[00:06:58] Wade Carpenter: Yeah. Something like that. But as far as the way I would look at it, if you can explain it and exactly the same thing you said in that situation. The contractor that I was talking about that got $12 million overbilled, they actually tried to be conservative on their jobs because they were also on percentage of completion for tax purposes.

So obviously they tried to go the other way and the bonding company loved it, because number one we’re being conservative. They knew exactly why they were getting overbilled. Otherwise as a percentage, they still had some equity there, but it was a scary thing. It was like hey, we’re $12 million cash up front, which is great, but they’ve got a lot of stuff out there that they gotta complete to finish that out.

[00:07:42] Stephen Brown: I can just tell you, especially during Covid, it was absolutely crazy how much we were insuring as an insurance agent stored properties for contractors. Amazing amounts of stored properties. So everybody was freaking out over the delivery of their materials and snatching ’em up. Pipe salesmen other folks were trying to take care of their best customers during this short term nightmare.

So if you didn’t have that kind of relationship built up it was really hurting you financially. Or if your project manager forgot to order the materials till after the job started. That turned into a nightmare for a lot of our customers.

[00:08:22] Wade Carpenter: Right.

[00:08:22] Stephen Brown: That type of scenario.

How human error can lead to overbilling

[00:08:24] Stephen Brown: So what about change orders being unrecorded? Human errors, miscommunication. What kind of examples might lead to overbilling from a human fault standpoint?

[00:08:36] Wade Carpenter: As you said, change orders is a great example because if you have a unapproved change order that’s not put into the job, it can also look like you’re way overbilled when you may be, maybe you’re not as overbilled or not overbilled at all, but you’ve got a huge change order that just hasn’t been signed and approved.

That’s not supposed to go on the financial statement yet, but until you got a signed change order, you may have to go and explain that to your bond agent so that they can take that to the underwriter.

There could be several other things that, as I said, that one with pipe, I saw a lot. During Covid, some of my electrical contractors, the electrical stuff can be very expensive and some of the one’s doing, whether they were doing commercial jobs or residential jobs, they were having to order electrical parts anywhere they could get them. And so it became a huge problem.

But on stored materials, as I said before, a lot of people just throw that into their the percent complete and don’t back out the stored materials. And if you look at the AIA billing form, they do have a thing where it says plus, subtracting out the stored materials and then adding them back in.

 So if you start recognizing profit based on stuff that you’ve got stored materials on, it can definitely look like it’s overbilled even when it’s really not. Does that make sense?

[00:09:59] Stephen Brown: Yeah, it makes sense. And I guess from a general contractor’s point of view, if you’ve bonded your subcontractors back and they wanna overbill and the owner’s willing to pay, why not? Why not make your sub happy? But in a situation where the billings don’t justify the amount of work that’s been performed that’s just usually thrown out, isn’t it?

[00:10:21] Wade Carpenter: Yeah. And again, we also see sometimes that contractors unfortunately don’t have really good job costing records. And as much as we try to get good percent complete, a lot of these guys really are not tracking that very well. If they’re not tracking their job costs, they really, they have some kind of gut feel for how they’re doing, they have a gut feel like I’m 70% done, but they’ve really only got 50% of the costs in.

Then it really can look very distorted if you’ve got somebody that can’t bid as well. And I think you also see that what you brought up before in, looking back at are these jobs having fades from one year to the next.

[00:11:03] Stephen Brown: Yeah I had a customer once that went to an auction and went crazy and he felt like he was getting fabulous deals on this equipment and he bought a whole lot of it. And he was over billing like crazy to help finance that equipment. And his logic was, well I’ll only be using it on these jobs.

[00:11:20] Wade Carpenter: Oh yeah.

[00:11:21] Stephen Brown: It was a mess with the accountant to figure out. But so there’s a lot of reason for overbilling.

[00:11:25] Wade Carpenter: That just brings back another story to me.

[00:11:28] Stephen Brown: Oh. All right. Go ahead.

[00:11:28] Wade Carpenter: So I had another grading contractor, this was back before 2008, was doing a large project with a Walmart shopping center, the whole development. Their grading part of it was over a 20 million job. And it was a point where all the other contractors had no work in, 2008, 9, 10, after that. All this equipment got dumped on the market and he had it in his brain that, hey, I can get this stuff cheap and I’ve got this one job that’ll carry me through and everything else is gonna be hunky dory.

And so he bought all this equipment, he was actually charging it to the job and they let him. And a lot of this stuff came out later, but you know, after that job was done and when that equipment sits idle, that is a cashflow killer. Because he still had payments on it.

And he kept justifying that, hey, my monthly payment is not as much as the rent would be. So he justified it in his mind. But once you’re thinking about insuring those and maintaining that heavy equipment, that can add up pretty quickly.

[00:12:32] Stephen Brown: Yeah, I’m sure his bonding agent, underwriter, weren’t too pleased with it. First of all, bonding underwriters don’t look at equipment for what they bond you for. They look at working capital cash. And so he is gonna show that he lost money on that. But look, I have a lot of equipment. But then you’ve also depreciated it half off the books the first year or as fast as you can, hopefully.

So you get in kind of an upside down situation, and the answer to the bond underwriter, oh, you did that? Why did you do that? It was a great deal. And you honestly thought this job could pay for all of this equipment or just the equipment rental cost would be half based on your notes? Anyway, I can’t imagine all the questions they had.

[00:13:20] Wade Carpenter: They did. And actually again, some of these stories from 2008 still resonate in my mind. But that contractor unfortunately, he was doing 50, 60 million. He did not survive. He thought he had this $20 million job and it was gonna carry him through. And when all that came to an end, he came to an end, unfortunately.

[00:13:39] Stephen Brown: So he should have been concentrating on what all along to survive? In retrospect.

[00:13:44] Wade Carpenter: I think that may lead into the next episode we’re gonna do on, pricing properly and knowing your job cost and overhead, because that’s a constant problem with contractors. And they, even if they are doing some kind of job costing they never understand what their overhead is.

They never seem to get that number to their estimator or whoever’s estimating the job. Or they’re trying to get the job and they cut the price or whatever, but they don’t understand the factors that go into bidding a job. I see it all the time and there is a happy medium between, we gotta get some work to survive, but if you’re gonna put yourself in bankruptcy because you’re underbidding it– I’ve got some stories there. I don’t wanna launch into those.

[00:14:29] Stephen Brown: Let’s go. Let’s roll on into our next podcast. I think we’ve touched pros and cons of overbilling adequately. Have we missed anything, Wade?

[00:14:38] Wade Carpenter: No not that I can think of.

[00:14:40] Stephen Brown: Kind of summarizing, overbilling good, overbilling bad. What’s the answer? The answer is overbilling is good when you know what you’re doing and you’re strategic about it. Overbilling is bad when you’re looking at as an option to solve other problems that you have.

How’s that Wade?

[00:14:59] Wade Carpenter: That sounds great. That’s a great summary of it. Okay. Thank you all for listening to the Contractor Success Forum. If you’re listening on a podcast somewhere, check out the show notes at Contractor Success Forum dot com or the Carpenter CPA’s YouTube channel. Consider subscribing to this channel. Follow us each week, and we will look forward to seeing you on the next show.