Using Cost Codes In Construction Accounting
What Are Cost Codes?
Put simply, cost codes are numeric codes that represent the different inputs (costs) that go into a project. Whether that be equipment, materials, labor, or some other element. Cost codes are useful because they allow you to track and analyze costs on a more granular level both during and after a project: For billing purposes, to demystify 'where the money went' and to identify areas for improving profitability.
Let’s say, for example, you have a crew working on replacing a damaged roof on a residential home. You can use cost codes for the materials you will use, such as shingles and nails. You can also include various cost codes for the type of labor the employees are performing at different times throughout their shifts (e.g setup, tiling, cleanup). Finally, you may also want to include cost codes for any additional equipment you purchase.
Each element or aspect of a particular project's costs can have its own unique cost code. However it is also easy to go overboard with this as you can imagine, so we'll touch on some practical guidelines to implementing them later on.
Why It´s Important to Use Cost Codes in Construction Accounting
The main reason for using cost codes in your accounting practice is that using them will help clarify exactly how much you have spent on a project. Understanding your costs is crucial to ensuring you are charging your client the correct amount based on what you have spent to complete a job, and crucially that you are not losing money on certain jobs through costs you are not seeing.
Cost codes are used in accounting departments in most businesses. However, they are especially important for the construction business. If you’re running a burger restaurant for example, it’s easy to split your material costs out into buns, beef, toppings, condiments, staff hours etc. While the prices of those materials may go up and down, and the quantities may even vary according to menu item, the inputs for each final product are pretty well defined, in other words the thing you sell has some very well defined fixed costs. The cheeseburger is going to be the same from client to client. Flipping the burger and slicing the tomato and lettuce will always be more or less the same process.
In construction however, the amount for each input is going to vary based on the size of the job and the conditions. The costs incurred in erecting even the same type of building may vary greatly from project to project. Perhaps one requires different foundation work based on the lay of the land, or clients may have more complex specifications that require an unforeseen amount of man hours to complete, throwing off your schedule on that and other jobs.
With that in mind, it then becomes quite clear how using cost codes can provide you a framework to more clearly 'extract' your true costs from project to project on a much more granular level than if you were simply tracking them from a very broad level (ie wage bill, overall material costs). This is crucial to ensure correct billing for current and future projects, but also to identify what types of projects may be consistently proving to be more or less profitable.
Let's look at what some cost codes might look like in practice:
We can see here that in this company's particular setup, they have identified what some of their major activites are, ie Foundation and Excavation, and assigned sub items within those codes that match ie 100s for Excavation, 200s for Foundation. We'll talk more about some effective patterns you can implement in the best practices section later on.
The system they have used here is a fairly common pattern, however you can also use libraries of predefined cost codes such as CSI Masterformat. Using an industry standard cost code library can be handy for compatibility in reporting between yourself and other companies you may be working with.
Let's Expand On The Specific Benefits Of Using Cost Codes
Ensure you are billing correctly
This is the most obvious advantage to using cost codes in your construction accounting. Making sure you have your costs clear will ensure you are charging your clients correctly in a way that is both fair to them and, critically, profitable for you. Too many companies fail because they take on a lot of unprofitable jobs (naturally thinking more work is always a good thing), or they can't identify and minimise what costs are eating into all their profits consistently.
When working on larger projects and over many billing periods, using cost codes will allow you to make more accurate cost predictions for each phase of the project and include this in your Work in Progress Schedule (WIP). This will allow you to identify where underbilling or overbilling may be either happening unintentionally or intentionally, not just at the end of the project but along the way as well.
Ensure you are on budget
The above advantage of using cost codes in your construction accounting ties directly to the second advantage of using them. Cost codes will help you see if you are meeting the expected costs from your WIP as you reach the Percentage of Completion (POC) for each billing cycle. This will not only help you keep track of your progress during the job but also help you plan more accurately for projects of a similar nature in the future.
Give more accurate quotes on jobs
It’s never fun when you go over budget on a job and are forced to debate whether to go hat in hand and ask the client for more money or eat the extra costs yourself. Even worse is losing out on a job entirely because someone else underbid you. By analyzing cost codes from previous projects and ensuring you are using them when planning the new one, you should be able to have a clearer picture of your estimated costs. This will lead to better quotes on projects. Better bid accuracy not only protects you from losing out on a job but will also lead to happier clients and more referrals for future jobs.
Determine how you could be more efficient
Using cost codes in your construction accounting will also allow you to see where you may be able to cut costs while at the same time maintain quality. Perhaps prices for a common material have increased recently. If there is an acceptable alternative on the market, you may be able to save by switching.
Likewise, you may be able to weed out some of your inefficiencies, whether it be with equipment, materials, or labor. For example, is there a team from your crew that consistently seems to take longer than expected to complete their tasks? Are they taking an extended lunch break on the sly? Well, if you’re not splitting different parts of the labor into cost codes, it will be a lot harder to spot this.
Protect yourself from fraud and embezzlement
This can be something of a balancing act, because what you're trying to do here is improve visibility, so you have to make sure you are not making your accounting system so complicated that things can get buried. However generally speaking, these issues are more likely to raise eyebrows and alert you to inconsistencies when people are attempting to hide them under particular cost codes, simply because the discrepancies would appear more glaring, rather than among the total cost of a project.
Best Practices for Using Cost Codes in Construction Accounting
If no two four-story office buildings are the same, then neither are the ways two construction companies use their cost codes. Still, there are a number of best practices that will help ensure you are getting the most out of your cost costs and taking full advantage of the benefits discussed above.
Use the right number of cost codes for your business
There is no one size fits all number, but we would recommend experimenting to find a quantity of cost codes that makes sense for your business. It is probably not worth having costs codes for every material you have ever used, but materials that are commonly used in most of your projects and represent major costs are likely worth having separate cost codes for.
How far you really need to drill down in your cost codes is also debatable. Simplifying and being practical here is helpful. For example, having a cost code for every size nail you use is likely going to drive your accountants and project managers crazy. It will also increase the chance for mistakes when someone enters the wrong code or hasn’t properly updated the price. Having an endless list of cost codes also makes it more difficult to get quick and useful insights. It shouldn’t take hours of analysis for the project manager to see and understand if the costs are on track or if there is anything that seems out of order.
Of course, using too few cost codes won’t allow you to glean any useful insights either. Therefore, your firm’s ideal number of cost codes will vary. For larger firms doing entire building projects, splitting your cost codes out into the major aspects of a project is probably a good idea. For example, if you are constructing an office building, you may want to have a category for electrical and cost codes for wiring, outlets, and labor, for example. Drilling all the way down to different size wires and types of outlets may not be worth it.
Another good suggestion to keep things simple is to include everything that you contract out as just a single code. For example, if you hire out the electrical, just have one code for that. On the other hand, if you are the firm being contracted to do the electrical work and that is your firm’s specialty, it may be worth doing the drilling down of different size wires and types of outlets since you are likely to get some valuable insight for your more specialized, smaller-scale work.
Make sure everyone in your team is on the same page
In addition to finding the sweet spot between detail and simplicity, it’s important to make sure everyone in your firm is on the same page with your cost codes. It doesn’t matter how great of a job the accountants have done creating the system if project managers in the field don’t use them correctly. You will require time for the accounting team to reconcile and verify things, undermining the goal of increased efficiency that has you using cost codes in the first place.
A good suggestion here is to include all stakeholders in the cost codes creation process. This will ensure everyone is not only on the same page, but also that they understand the process and have a chance to offer their insights on what should and should not be included. Inclusion is the key to harmony and will lead to a company where everyone is working towards a common goal.
Create a logical structure
In addition to including everyone in the creation of the cost codes, it’s important to follow a logical structure. This will help you make sense of your costs as well as make it easier for everyone to enter and track them correctly during the course of a job. One good suggestion here is to format your cost codes according to the order you complete tasks in as part of the construction project. For example, you could progress from excavation, to foundation, to framing, to roofing in an order that follows how you will go about the build itself.
In addition to a logical order, leave yourself space between codes to drill down in future updates. See the example above. If you make a category code for excavation as 100, you could drill down to a further subcategory of excavating equipment as 110, then again to 111 for a backhoe and 112 for a bulldozer. In other cases, you may want to use larger digit codes or a singular code per category, using a dash before the individual cost codes. It’s also a good idea to leave space for any future additions should you need them. Having a logical system will not only make it easier for everyone to use and understand but will also cut down on project proposal preparation time. Your project planner will be able to quickly put together an estimate without having to look up codes in a complicated and nonsensical system.
IMPORTANT - Make sure your costs code values are updated regularly
There may be no more important best practice than this one. Costs for inputs can fluctuate due to supply and demand, and you don’t want to be using inaccurate prices. If you do, your costs will be incorrect and you may very well end up losing money by underbilling your client. While special conditions like shortages may require more frequent updates, a good practice is to set your purchase managers the task of updating cost codes quarterly or monthly. Make it a routine practice, like doing inventory. This will help ensure costs codes are up to date and your reported expenses for a build are representative of their true costs.
In conclusion, using cost codes in your firm’s accounting is a basic best practice that will allow you to accurately understand where your are spending, be more efficient, and ultimately, ensure you are making fair money for your hard work. While it may take some time initially to create your cost codes, having the right balance between simplicity and detail will be worthwhile in the end, and having a practice everyone can use effectively will ensure you take full advantage of this.
We hope you found this guide useful. This is a resource we will continue to update and build on over time, so please let us know in the comments below if there are things you feel we should add. Thanks.