Last week we talked about the need for accurate records, especially when it comes to your finances.
A bookkeeper can help bring clarity to an otherwise fuzzy history of your finances. This is a key position in the business and should not be left to an overworked and poorly trained “office worker.” These people are often incredibly skilled in a number of areas that are part of running a business. Bookkeeping is not one of those areas. A bookkeeper understands the importance of what they are doing and has a sense of why it is important to keep records. In short, they see the bigger financial picture.
The chart of accounts, a fancy way to catalog your business expenses, is the structure on which the books are built, like the superstructure of a tower.
Only you can decide how to record your expenses, but there are a few steps to keep in mind if you go this route.
STEP 1: Project Costs
The first step in creating an effective chart of accounts is to separate out project costs. I should note that accounting for projects is often referred to as COGS (cost of goods sold) or COS (cost of service). You can certainly Google these definitions. The cost of “goods” and “services” are the contract work you do. It is important to keep your project costs, labor and materials, separate from your operating costs.
Often contractors lump all project costs together, which is a mistake. Each project is like a mini-business that must be profitable if the company is to be profitable. You can not know that unless those costs are separated. We will get into how you can do that in a few weeks, but first it’s important to understand the why.
More on the why below.
STEP 2: Operating Expenses
Step two in creating an effective chart of accounts is to compile your operating costs. How much does it cost to keep your business running? Do you get paid a salary even if your team is not in the field?
This is also where your general liability, umbrella and auto insurance come in. At some point we can allocate these costs to your projects, but not until you have built the financial structure and project base to allocate them to your projects. If you are paying for insurance on a per project basis, I would strongly advise you to talk to your insurance broker because it is incredibly expensive. It is much more cost effective to take out an annual policy.
Let us keep it simple for now and let it flow into your operating costs.
STEP 3: Liabilities
Step three is about gathering all the debts you have. These could be lines of credit, equipment loans or back taxes.
STEP 4: Assets
Step four is to compile any assets you may have. These include equipment and/or vehicles. This is not about the equipment loan; that’s at the top of the liabilities (step 3). This is about the value of the assets. If you were to sell them now, how much would you get for them? Be conservative here.
STEP 5: Equity
Step five is often underdeveloped for smaller contracting businesses. It should not be the main focus, but becomes more important as your financial plan begins to come together. Your equity (or property) is the money left over after all expenses and liabilities have been paid.
In other words, it’s what your business is worth when you subtract liabilities from the value of your assets and contracts (in some cases, your contracts can be considered assets, too! “Contract financing” is the most common case. If you have a contract with the city, state or federal government, it is considered an asset. More on this in the coming weeks).
Now that we have explained where you should put all your financial data, it is important to know that WHY this is important.
In step one, I suggested separating project costs from operating costs, but also separating projects. This way you can see where you are losing money on certain projects. Is it typically in the materials or in the labor? Was it just on one project or is there a trend?
This is the start of a solid project management system that drives production on your projects so you can optimize your labor spend. It also helps you break down material costs so you can more systematically track where, how and when materials are arriving on your projects.
The point here is to become less reactive and more proactive. That’s possible with project management.
Step two is one of the most important numbers you need to determine your labor price. Your labor price is the price you charge for sending employees. If you do not know how much it costs to keep the lights on, how are you going to get to the higher levels of financial wealth, like equity?
You need to know how much it costs to run your business. Once you have an idea of the cost, you can start making strategic decisions about where to trim fat, especially if you know how it will affect your projects and the future of the business.
Once you have a clear picture of your liabilities, step three is very important. To get a handle on your debt, you need to be able to look at it with a clear eye. Some debts are better than others. Debt for growth is good. Debt to help you out of a cash flow crisis may not be wise, especially if obscurity and extremely high operating costs are the reason you have gotten this far. If you do not understand what got you to where you are now, you’ll likely end up in the same situation again, just with a little more debt in the account.
Steps four and five are very helpful. They are a little more advanced than this basic look at breaking down your chart of accounts. Until you are ready to start down the amortization path (which is a helpful tool), you should stick with steps 1-3, familiarize yourself with them, and then start with steps four and five.
All of these steps will give you the information you need:
- Whether or not you are losing money on your projects and where.
- How much it will cost to run your business, which is essential to setting your working price.
- When you will be debt free.
Now that you have a clear picture of why a chart of accounts is essential to growing your business, I hope you will consider hiring a professional accountant to help you create a framework for organizing your business. They may have their opinion for how to set up the Chart, but it’s important to keep the structure aligned with what reporting information is vital to you and for contractors it tends to be:
- Project Costs (Labor & Materials)
- Operating Expense
- Debt & Liabilities
Next week we’ll break down Labor Rates and how to build them.
If you’d like to have a conversation about how we can help you build a contracting business that’s ready to scale, schedule a meeting with us!