October 4, 2023

The Impact of Overbilling in Construction Bond Programs

Construction contracts often require contractors to procure bid, performance and payment bonds. These bonding requirements often are a condition to receive a contractor's license. A cost-to-complete or backlog schedule is an important tool used by surety companies during underwriting to determine a contractor's open single job and aggregate bonding capacity. This is usually reviewed via a contractor's work-in-progress report.

Overbillings are a Sign of Cash Flow Issues
Construction projects often require a significant upfront investment in equipment, materials, and labor. It's no secret that cash flow can be tight in the industry, and if a contractor needs to be more careful about managing project costs and change orders throughout a build, they can quickly run into issues. While some overbilling is typical, significant amounts can create a cash flow issue for contractors that need to be more careful. This is because the profit and loss statement (P&L) will appear to have lots of money in the bank, which could lead to them 'borrowing' from future projects or spending on other expenses too soon.

The best way to avoid this issue is by having strong accounting and financial teams that closely monitor project costs, progress, and billings and structuring project billings with micro-milestones to maintain a consistent influx of cash. This will help mitigate the impact of the construction industry's notoriously slow payment cycles.

Overbillings are a Sign of Job Borrowing
Contractors can find themselves in a situation where their costs to date on a project exceed the amount of revenue recognized to date on that same job. This is a common issue in industries with slow payment turnarounds, like construction. The solution to this problem is a well-managed Work in Progress (WIP) report that ensures current cost accrual is kept on par with billings. Significant overbilling can lead to a scenario known as job borrow, where the contractor has billed revenues that they will not have the ability to bill again once the contract is completed. This liability on the balance sheet can put your company at risk of future cash flow problems.

Even though the contractors are frontloading their jobs, this may not be a good idea for long projects. Significant overbilling could lead to a snowball effect where the contractor has to use the money from new jobs to cover the costs of jobs still being worked on, ultimately depleting their working capital.

Overbillings are a Sign of Subcontractor Issues
Clearly articulating project scope, changes, and agreements helps reduce misunderstandings that often lead to overbilling. Robust project management systems that utilize automation tools with human oversight ensure meticulous tracking, curbing overbilling. Regular reconciliations that cross-reference invoices with actual completed work also help to keep tabs on progress, catching discrepancies early and eliminating overbilling before it can become problematic. While fraudulent overbilling schemes can be extremely damaging, some overbilling is common for construction contractors with slow-payment clients who want to stay ahead of the project cash runway.

However, significant overbilling can indicate a contractor is using profits from one job to fund losses on another, which can raise red flags with contract surety bonding companies. It is also important to understand the difference between overbilling and underbilling when using a percentage of completion project accounting since both can occur on projects with extended timelines. Underbillings, referred to as Costs over Billings on Uncompleted Contracts, are an asset on the balance sheet because the contractor has yet to earn the revenue but will do so at some point.

Overbillings are a Sign of Payment Issues
Overbilling occurs when the contractor invoices their customer for work completed before it is complete. This is a common construction industry practice as contractors often front load (bill higher upfront) contracts in anticipation of slow payment cycles, and it can be a useful tool for keeping cash flow stable throughout the project. The issue arises when overbilling is extensive, particularly on long projects.

A significant overbilling can cause a contractor to face job borrowing, where the estimated cost to finish the contract exceeds available cash. This is a critical issue that must be addressed. A best practice for construction companies is to stay slightly ahead of billings on all projects. This is usually achieved through a WIP schedule matching invoice and cost accounting with actual construction progress. However, a significant amount of overbilling can indicate future payment problems and should be brought to the attention of your contract surety underwriter.

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