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Underbilling in Construction: How to Capture Missing Revenue & Protect Cash Flow

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Last Updated Mar 21, 2024

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Effective money management in construction projects is as essential as overseeing the construction work itself. Amid allocating, spending, and monitoring financial resources, underbilling is a common but often neglected issue with significant repercussions. 

In this article, we dive into the difference between underbilling and overbilling, examine the impacts of underbilling — and explore strategies to prevent underbilling on projects.  

Table of contents

What is underbilling?

Underbilling, or "costs in excess of billing," occurs when the invoiced amount for completed work is less than the earned amount based on the project's progress. This leads to a revenue shortfall, adversely affecting cash flow and potentially the ability to fund ongoing and future initiatives.

In the immediate term, underbilling strains cash resources, jeopardizing the ability to meet financial obligations such as payments to suppliers, subcontractors, and employees. If persistent, it may signal poor project management or financial instability, affecting the firm's creditworthiness and ability to secure financing.

Underbilling also affects the accuracy of financial reports. For companies that employ the percentage of completion method for revenue recognition, it can skew the perceived financial health of a project, potentially leading to strategic errors based on inaccurate financial data.

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Underbilling vs. Overbilling

Accurate billing is vital for maintaining healthy cash flows and transparent client relationships in the construction sector. Underbilling and overbilling — or "billings in excess of cost" — are two prevalent issues that each carry specific implications for project management and financial transparency.

UnderbillingOverbilling
DefinitionBilling the client for less than the work completed and materials supplied.Billing the client for more than the work completed and materials supplied.
Financial ImpactCan lead to cash flow issues due to a temporary shortfall in revenue.May improve short-term cash flow but can lead to future cash flow issues when the work needs to be completed without corresponding payments.
Client RelationshipsMay initially build trust due to perceived affordability, yet could lead to future disputes or doubts about project management upon uncovering consistent underbilling.May cause trust issues or disputes over billing accuracy, potentially harming long-term relationships.
Project ManagementSuggests possible issues with project management, estimating, or financial controls.May indicate aggressive financial management or an attempt to front-load project revenue.
Financial ReportingAffects the accuracy of financial reporting and may distort the financial health of a project, especially if revenue recognition is based on the percentage of completion method.Leads to a potentially misleading financial statement that overstates the project's progress and financial position, requiring adjustments in future reporting periods.
ExampleA general contractor completes the foundational work as well as some early-stage structural work but bills only for the foundational work due to administrative oversight, leading to underbilling.As stipulated in the contract, the client agrees to cover 50% of the general contractor’s mobilization costs upfront, resulting in overbilling before the project breaks ground.

Both underbilling and overbilling present challenges in construction accounting and project management, impacting cash flow, client trust and financial transparency in different ways. Accurate billing, aligned with the actual progress and costs of a project, is critical to maintaining financial integrity, ensuring client satisfaction and supporting the sustainable growth of a construction business. 

Identifying Causes of Underbilling

Underbilling in the construction industry can arise from a variety of operational and contractual challenges. Understanding the root causes is essential for addressing and preventing this issue.

Inaccurate Costs-to-Date

One of the most common reasons for underbilling is the difficulty in accurately identifying or approving the costs incurred up to a certain point in the project. This challenge can stem from several factors, including inadequate tracking systems, complex project requirements or delays in receiving or processing information around project costs. 

Ineffective cost reporting plays a significant role here. When project managers or accounting teams cannot promptly or accurately account for the costs incurred, the billing submitted to clients may not reflect the actual work completed and materials supplied, resulting in underbilling.

Lack of Authority or Leverage to Bill

In some instances, contractual terms or compliance requirements may limit a firm’s ability to bill for the full extent of the work completed. This situation can occur if the contract stipulates specific milestones or conditions that must be met before billing can occur, or if there are regulatory or client-imposed compliance issues that affect the timing and amount of billing. Without the leverage to bill according to the work completed, construction firms may find themselves underbilling as a default consequence of contractual constraints.

Some examples include:

  • Milestone-based billing contracts: Unable to bill for work that's completed but hasn't reached the next milestone as defined by the contract
  • Compliance with safety regulations: Delays in billing due to awaiting mandatory safety inspections or certifications
  • Client-imposed conditions around subcontractors: Restrictions on billing due to subcontractors not having specific types of insurance coverage required by the client
  • Retainage clauses: Systematic underbilling as a result of contracts that withhold retainage, a percentage of payment until project completion
  • Change order disputes: Delays in billing for additional change order work needed beyond the original scope due to disputes over scope, cost or necessity

Legal disputes between the contracting parties can also lead to underbilling. When there are disagreements over the scope of work, the quality of services provided, or the terms of the contract, construction companies may hesitate to bill for the full amount of work completed to avoid exacerbating the dispute. In these cases, underbilling becomes a byproduct of the effort to mitigate legal risks and maintain a working relationship with the client until the dispute is resolved.

Repercussions of Underbilling

For construction companies, underbilling can have profound short-term and long-term financial consequences, influencing everything from project timelines to client relationships and the sustainability of the company.

Short-Term Underbilling Issues

In the short term, underbilling can lead to immediate cash flow problems. As revenue falls short of the progress of the project, companies may struggle to cover their operational costs. This situation can result in delayed payments to subcontractors and suppliers, leading to strained relationships and potential delays in project completion. The inability to procure materials or pay workers on time can stall construction, affecting project timelines and damaging client relationships.

The necessity of diverting funds from other areas of the business to cover shortfalls creates a ripple effect, leading to missed opportunities for discounts or early payment incentives that could have improved profitability or sped up project completion times. Moreover, securing external financing — such as lines of credit — to cover cash flow gaps introduces additional costs due to interest payments.

Long-Term Underbilling Issues

Long-term effects of underbilling can be severe. If underbilling is consistent, it may be perceived by lenders, surety underwriters and investors as a sign of poor financial management, making it more difficult and expensive for a company to obtain credit or bonds in the future. This can raise the cost of doing business — and potentially lead to higher project costs.

Sustained underbilling also impacts financial reporting and earnings, as it underrepresents revenue, leading to a distorted financial picture of the company. It can affect strategic decision-making, where a company might forego opportunities or expansion due to an apparently weaker financial position.

The most dire long-term consequence is the potential for business failure. If a company consistently spends more than it earns and cannot bridge the gap, it risks falling into a cycle of debt — eroding profit margins and potentially leading to insolvency. This threat is particularly acute for firms reliant on a few sizable projects, where underbilling on one project can lead to the company's inability to pay staff or cover expenses, causing the business to collapse.

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Strategies to Avoid Underbilling

As construction firms navigate the complexities of project billing, adopting a suite of proactive measures can transform maintaining billing accuracy from a time-consuming challenge into a barometer of operational performance. Here are some essential strategies designed to fortify billing practices and avoid underbilling.

Implement robust project management tools.

Comprehensive project management software is designed to seamlessly integrate critical features such as time tracking, cost management and billing, facilitating a holistic view of project progress in real-time. This integration ensures that every hour of labor and every unit of materials is meticulously tracked and accurately billed, significantly minimizing the risk of underbilling. By offering a granular insight into project accounting and operations, these platforms empower companies to make informed decisions, enhance accountability and improve financial outcomes by ensuring that all billable work is promptly and accurately reflected in invoices to clients.

Cross-reference job costs through regular reviews.

Regular audits of job costs are essential in identifying discrepancies between the work done and the amounts billed. By cross-referencing your project management software's data with actual job costs, you can catch instances of underbilling early on. This practice ensures that all expenses, from labor to materials, are accurately captured and accounted for in your billing.

Adopting a thorough approach to auditing and cross-referencing job costs accomplishes more than just comprehensive expense tracking—it reinforces a culture of precision and accuracy within billing processes. Steering clear of careless billing habits and rigorously validating each cost against job cost audits minimizes the likelihood of underbilling. This careful scrutiny ensures every expense is precisely documented and included in invoices, thus preserving the financial health of your projects.

Leverage cash flow projections.

Accurate cash flow projections are vital in managing the financial health of construction projects. These projections should factor in expected payments based on completed work, allowing you to anticipate and address potential underbilling issues. By regularly updating your projections with actual job progress and billing, you maintain a clear picture of your financial status and can make informed decisions.

These projections, when aligned with the draw schedule, take into account expected payments for work completed, thereby equipping construction firms with the ability to foresee and rectify potential underbilling scenarios. Regularly refining these projections with real-time data on job progress and billing enhances overall financial clarity, empowering decision-making that keeps projects in a stable financial position.

This approach acts as a critical defense against spiraling into a negative cash position, where expenses outpace the project's income. Such imbalance forces a company to seek funds externally to cover costs — options that often come with their own set of challenges and additional expenses. Borrowing from financial institutions, for example, introduces the cost of capital, necessitating repayment with interest. This can temporarily bridge the gap, yet it eats into the project’s profitability, potentially diminishing it to zero (or resulting in a loss) over time.

Furthermore, the reliance on internal funds to offset underbilling can lead to missed opportunities. Cash on hand in construction is a powerful tool for negotiating discounts or pushing for faster completion times, providing tangible benefits that extend beyond mere financial metrics. 

However, the biggest risk lies in the potential long-term repercussions of mismanaged cash flow. The inability to cover costs due to underbilling can trap a business in a dangerous cycle of increasing debt, dwindling or negative margins and, in extreme scenarios, lead to a firm’s failure. Construction companies that are heavily reliant on a single project are particularly vulnerable, as underbilling can cause an inability to pay staff or cover expenses, ultimately resulting in the collapse of the business.

Cash flow projection acts not only as a mechanism for financial forecasting but as a crucial safeguard of project and overall firm financial stability. 

Conduct an earned value analysis.

Another strategy in preventing underbilling in construction projects is the use of Earned Value Analysis (EVA). This systematic approach combines scope, schedule and cost in a single integrated system to provide accurate snapshots of project performance and progress. By employing EVA, construction firms can gain early insights into cost variances and performance trends that might lead to underbilling, enabling the precise matching of work completed to the corresponding billing amount. 

Ensure costs are posted to the correct job promptly.

The prompt and precise assignment of costs to the correct job and corresponding cost codes is essential for preventing underbilling. Delays or inaccuracies in allocating costs, whether due to oversight in job costing or misapplication of cost codes, can result in billing discrepancies, leaving some incurred costs unreflected in invoices. 

By implementing a comprehensive tracking system that supports real-time cost allocation and integrates job costing with detailed cost codes, ensures that every expense — categorized accurately by its type and related project — is billed promptly and precisely. This level of detail not only streamlines the billing process but also enhances the accuracy of financial reporting and analysis, safeguarding against the potential of underbilling.

Understand the contract terms and conditions thoroughly.

An understanding of the contract's billing provisions is key to preventing underbilling, specifically knowing precisely when and what to invoice — including milestones reached, materials used, labor expended, or other billable elements. 

A thorough grasp of the contract ensures optimal use of all billing opportunities offered by the contract. This prevents underbilling that might arise from overlooking details or misinterpreting the contract's terms. Moreover, familiarizing yourself with the entirety of the contract allows for proactive planning and management of the project's financials, further safeguarding against potential revenue loss.

The Importance of Addressing Underbilling

Proper invoicing for completed work and supplied materials leads to healthier cash flow, credibility with clients and financial institutions, and informed decision-making based on accurate financial data. Effectively managing underbilling is essential for a firm's sustainability and growth, ensuring financial stability and positioning the company for success in the dynamic construction industry.

Categories:

Financial Management

Written by

TJ Forbes

12 articles

TJ Forbes is a Senior Solutions Engineer at Procore, specializing in financials products, analytics, ERP integrations, workflows, reporting and accounting solutions. He previously worked as a financial manager and project accountant for Stiles, a commercial real estate firm in Ft. Lauderdale. TJ holds a Masters in Financial Management from Southern Adventist University.

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Taylor Riso

38 articles

Taylor Riso is a marketing professional with more than 10 years of experience in the construction industry. Skilled in content development and marketing strategies, she leverages her diverse experience to help professionals in the built environment. She currently resides in Portland, Oregon.

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