179. WIPAA, The Builder's Blindspot With Andy Skarda

Welcome to another episode of Professional Builder Secrets. We recorded this one live at the International Builder show in Las Vegas, but the content is still highly relevant for builders around the world. Today I talked with APB's head coach Andy Scarter about the WIPA calculation work in progress, accounting adjustment. We talk about what WIPA is, the financial risks that builders face if they don't track WIPA accurately, and how WIPA can affect your cash flow, your profitability and and your decision making. It's a very important episode and I.

Hope you enjoy it.

This episode of Professional Builder Secrets is brought to you by Apparatus Contractor Services. Apparatus provides full scope end to end QuickBooks, Precision Construction accounting and CFO services for residential builders. If you feel like you can't completely trust your weekly and monthly financial reports or you feel like you're flying blind and Apparatus Root will rebuild and operate your QuickBooks accounting system and give you precision construction accounting capability you can trust. Learn more@apparatusteam.com or on the APB Rewards Partner Directory.

In the manufacturing world, work in progress is an asset. All right? You've taken raw materials, you've added a process to it. In your manufacturing, it's worth more because of what you've done. It's always an asset, it's never a liability. In a building company that is running cash flow positive work in progress that has not yet been invoiced is a liability. So we mustn't bash the accountants too hard. In most cases, if they're not experienced in working with residential home builders, they won't even realize that this situation exists. Most accountants are not trained to understand the nuances of the building industry.

Here we go. Andy Scara, Professional Builder Secrets Live day three of ibs. Plenty of energy today.

There we go. Full of beans.

Full of beans. Full of beans.

Young man, how you doing?

How are you?

Better for seeing you. Yeah, same to you.

For anyone close by, any builders close by, this is a really important topic today.

This is maybe the most important topic we've spoken about on, on this series.

I think so. So do you want to tell me what we're talking about, Andy?

I hope we talking about the work in progress accounting adjustment because otherwise I'm.

Going to be very embarrassed.

How does he not bleed?

I don't know.

Will, tell me. How does he not bleed? That's, that's.

It was good entertainment though.

It was absolutely fantastic.

Very good entertainment. So talk to me. Work in progress accounting adjustment. Maybe take it a step back. What is work in progress?

So obviously every, every builder, well hopefully every builder is constantly busy building homes or remodeling homes, depending on which part of the industry they're in. That brings with it an impact on cash flow and profitability. Obviously at certain times in that build the builder is extended because he's buying materials, he's paying for labor and subcontractors ahead of being paid. And then obviously it swings around, the money comes in and now he's recovered. Hopefully everything that he has outlaid plus a bit more, and now he starts on the next stage of the build. So the work that's in progress, what we're looking at here is making sure that as that process is happening, he is 100% across the profitability of each of the jobs. And then obviously because of that, across the company.

Okay, what does the work in progress, accounting adjustment refer to then?

All right, so here we dive into some numbers. If you were to talk to an accountant or a bookkeeper and say to them what is the arithmetic definition or formula that is used to determine profits? They will tell you it is income minus expenditure. And that sounds pretty simple. I mean, that is in any accounting course you do, that's going to be what you learn. Income minus expenditure equals profit. In virtually every other business. In fact, I think in every other business that formula works perfectly all the time because the cycle of particularly the expenditure side of the business is generally very predictable. In the building industry, unfortunately, you're dealing with people where administrative skills is not necessarily their strong point. So you end up with, for example, a really, really good plumber who's the best plumber in your city. But he does his invoicing on a Sunday afternoon when he remembers if he's got the time. All right, so now let's go back to that arithmetic equation. Let's say we have a builder who. Let's not use a plumber, let's use a concreter because that's easier to work with. He's laying a slab. He knows that when he costed the job, the slab was going to cost the client $100,000. And he knows that he's been quoted $75,000 by the concreter to lay that slab. The slab gets laid, he invoices the client the $100,000 that he's entitled to do because this is a good client. In our example, the client pays him immediately. So now we have income of $100,000. The concreter is very busy. He's a one man band. He's running around laying slabs all over the city. It takes him two weeks to Send the invoice. But now we get to the end of the month before that invoice arrives. So let's go back to our equation. Income, $100,000. Expenditure, zero profit, $100,000.

Yeah, okay, I guess.

All right, Exactly. So now what happens is, what does the builder do? Let's make the example even more spicy. Happens to be financial year end, okay? So he sends his books off to his accountant, the guy with the glasses and the tie, and he does the normal equation that an accountant is going to do. What does this client's income mean? $100,000. What's the expenditure been? Zero. He issues a statement to the builder that says, you made $100,000 profit. What does a builder do? Drives down to the Dodge dealership, buys himself a new ram, goes straight from there down to the local boatyard, picks up a stainless steel trailer and a new bass boat, and he goes fishing. And while he's fishing, ding, you've got mail. And he picks up his phone, and there's the email invoice from the concreter for $75,000. How much money do you think the boat company's going to give him back for his secondhand boat and trailer? Do you think the Dodge dealership is going to take that Ram back? No. This builder's in a world of pain. He did nothing wrong. His accountant told him he made $100,000 profits. But actually, if you go back to what the reality is, when he did the quote, he had a 25% margin on this particular deal. He should have known that only $25,000 of that amount of 100 was actually his to do something with. But it's easy when I'm giving you an example where there's one job and it's one stage. If you think about a builder who's got 10 houses under construction, they're each at a different stage. To track exactly how much money that's coming in is yours and how much you've got to keep is extremely difficult. And that's why we made it easier by coming up with the work in progress accounting adjustment, which is designed to help the builder understand which money is his and therefore part of that equation. Because the truth is, in that equation, the hundred thousand dollars should never have gone in. Only 25,000 should have gone in. Then he would have been okay.

Yeah, because if you're doing 10 houses and had 10 examples of that, I mean, that's $750,000.

There you go. That's the amount of exactly liability right there. Yeah. And the Biggest problem really in the whole story with this thing is not so much the reality of it, but the fact that I would go as far as saying 90% of builders that haven't worked with the APB don't even know they've got a problem.

And their accountants don't know.

Well, their accountants don't even know. Exactly. Exactly.

Why is that? Why did the accountants get to the end of the year and think that a hundred thousand dollars is profit?

Because most accountants are trained in a manufacturing business model. And in fact, that makes it even worse because in the manufacturing world, work in progress is an asset. All right? You've taken raw materials, you've added a process to it in your manufacturing, it's worth more because of what you've done. It's always an asset. It's never a liability. In a building company that is running cash flow, positive work in progress that has not yet been invoiced is a liability. So we mustn't bash the accountants too hard. In most cases, if they're not experienced in working with residential home builders, they won't even realize that this situation exists. And if they, the danger is if they treat the builder's books the same way as they treat other people they do the books for, the builder's going to end up in trouble because he's naturally going to trust an accountant. So, and, and of course, we haven't got to the tax side of this thing yet, but, but that's the fundamental reason most accountants are not trained to understand the nuances of the building industry.

Before we dive into the taxes and the solutions and everything like that, can you go a bit deeper on what implications there could be for a builder that doesn't track their whipper accurately?

Okay, so the biggest problem they've got is their profitability numbers are always going to be wrong. I mean, I can, I can come up with a fancier word than that, you know, inaccurate, blah, blah, blah. Bottom line is any builder that is not doing a monthly work in progress accounting adjustment will not have profitability figures that are accurate. The repercussion of that is if he doesn't know what his profitability actually is, he's going to make decisions based on what he thinks it is that are going to then get himself deeper into trouble. So, I mean, I could go on for an hour on what could go wrong, but that's the fundamental problem, a misunderstanding of what the actual profitability is. Month to month results in decisions being made that are just going to get him deeper and deeper into Trouble.

You can go a bit deeper if you want. We don't have quiet on him an hour.

No, I mean, if you think about what are those decisions I gave you, the extreme stupidity of going and buying a new truck and a boat. But he may well invest in extra materials because he feels like he's got a lot of extra money or marketing.

Or any of those things.

Exactly. Incur costs that actually he can't afford. And the net result then is when those invoices arrive, when it comes home to roost. He's now got to try and find money from somewhere. What does that mean? He goes and gets a loan and now he's even in a deeper problem because now he's got to service the debt as well, which is just. That's just compounding the problem.

Some of the examples you gave in our cash flow discussion yesterday around you get to Thursday, it's payroll day, and you don't have enough money to pay your staff. I mean, that's the extent side of it. Right.

And I mean I, I always feel for the builders because most of the guys we talk to take looking after their team extremely seriously and they will pay everybody else before they pay themselves. So when things start to get tight, he's working 60 hours a week and he's not getting paid. And he's got to somehow support his family and keep this business going. Again, he's done nothing wrong in terms of working hard and all of those good things. He just doesn't understand what the numbers are. And because of that he's making bad decisions.

Maybe we could dive a bit further into the cash flow situation and how. I guess not tracking WIPA or not understanding your WIPA can impact cash flow throughout the year.

Well, I mean, cash flow is tied directly to profitability. Now, I mean, we've had the cash flow discussion in its kind of specific form, but if you think about it, go back to my extreme example, we should never be putting the hundred thousand dollars in that example into the equation. We should be putting 25 in there. As soon as you put $25,000 into the equation, everything else makes sense. So when we talk about cash flow, what he's got to understand is his starting point on cash flow is 25,000, not 100. And the only way he's going to know that is if he's tracking his combined WIPA across every job, irrespective of where that job happens to be. So if he starts the discussion at 25k, he's in a place where he can actually now plan his cash flow. The tool that we give our builders to track cash flow includes wipa. So what it's actually doing is it's saying, and wipa, of course, is the APB abbreviation for the work in progress accounting adjustment. And maybe while I'm clarifying that I should just dive down a side road. We don't want to confuse work in progress with work in progress accounting adjustment. It's why we add the two A's on the end. Most accountants are pretty good at tracking work in progress. And when we get into the discussion on taxation, that becomes a far bigger piece of the discussion. But builders need to understand the difference between work in progress and work in progress accounting adjustment. Back to cash flow. Start the equation with $25,000. Start planning your cash flow around what is your money, not the money that's in your bank account. And everything else downstream of that is going to smoke fluidly, which is Vegas Day three. Speak for smoke. Flow smoothly. We can't even talk anymore. This is really bad.

Yesterday you spoke about having 12 months of cash reserves as well.

If you are in a position like.

That, which is a strong position for a building company, how does that impact your decisions around wipa?

It won't really, because it's kind of the end of the process. But you are never going to get there without implementing WIPA at the beginning of the process. You. Because if you remember where that discussion went yesterday, what we're saying was you first gotta get to the place where you're managing your cash flow so that it's positive. And when it is positive that you have more cash available than what you need to run the business, that's the point at which you can start to build those reserves. So if you're not doing WIPA at all, or accurately or regularly, every month, come what may, and making sure that the relevant journal entries are happening, if you're not doing that, you're never going to get to the place where the money that you think is yours is actually available to build those reserves.

Yeah, well, you might look at your bank account and think, I've got 12 months of reserves, but 85% needs to go to someone else.

There you go. And I mean, if you did that, actually you'd be doing yourself a favor because if you took 85% of it and stuck it in another account as your reserve, what's going to happen? Which, in fact, you've just inadvertently explained what WIPA does, what wipa, it doesn't move the money to a different account, but what it says is it might as well be in another account. It's not yours to spend.

It probably. It could be or should be. Maybe you've got your reserves, you've got your. And then you've got.

Absolutely. A lot of, a lot of our bigger clients do exactly that. Whatever their WIPA provision is, they will put that aside into a different account and then they pay their subcontractors and their suppliers out of that account.

So let's dive practically into how a builder can implement WIPA tracking into their business.

There's an easy way and a hard way. Which would you like first?

About 15 minutes worth.

All right, so let's go easy way, join the apb, do the training on wipa, use the calculator that we've created, implement WIPA tomorrow, implement WIPA yesterday. That's the easy way. The difficult way, you'd have to devise your own calculator that would allow you to separate whose money, every dollar that comes through the door. How much of this is mine and how much of this do I have to keep available? And I mean, let's be honest, we're really talking about builders whose primary function is to build. They don't really want to be in a place where every single day they're trying to track every single dollar to make sure that they don't spend somebody else's money. From the way we look at it, it really becomes critical at the point, point where you're calculating profitability. So it's not a, it's not a major administrative task during the month. You can literally do it on the last day of the month when your books are about to close for that month. As long as your data is up to date at that point, the calculator will tell you exactly what your wiper liability.

So the setup itself is a bit of work, but once you've got that.

Setup in place, I mean, again, not making this. Join the apb. Join the apb. For those people that do the training and use the calculator, it's a 20 minute setup.

It depends how complex. I mean, you got 10, 20 jobs on the go. It could be complexity to it.

The data that you're putting in there is really simple. We want to know what was your original budget to build, what did you quote the client and have there been any revisions to that through variations or change orders? That's 50%. Everybody knows what, what the contract value is to the clients. They can go to the estimating software and see what the budget to build is. The other two Pieces are how much have you invoiced your client of that total amount? And how much have you been invoiced of the total amount of the budget to build? And what we're looking at is the discrepancy between if you've invoiced 50% of the revenue from the job, you should have made allowance for 50% of the budget to build. If you haven't received 50% worth of invoices, what WIPA will do is say, let's keep it simple. Million dollar job, we halfway through $500,000 invoice to the client against a budget to build of 750,000, we should have invoices of 375. Let's assume we've got invoices of 300. What WIPA will do for you is say you've only got 300. You should have had 375. I'm taking $75,000 and out of your profit calculation and then it allows you to calculate that profit correctly. So literally when we create that, that calculator, there's 50 jobs in it. If it took you two minutes, a minute per job to put in the contract price and the budget to build, literally under an hour to set it up, and then 30 to 40 minutes once a month when your bookkeeper has closed off the month.

What if a builder goes through this process? They get the WIPA calculator, they plug all their numbers in, and it's not a good look. They've got not enough money in the bank that's going to cover anywhere near the amount of outstanding invoices they're going to have coming in. What would you recommend they do at that point?

Increase their margins?

That can be a longer game though, right?

Oh, it's a long game, there's no doubt about it. But the problem, and I think we discussed this yesterday, any builder that is trading in a situation where he's unable to settle his current invoices is trading in liquidation in most countries where I think people would be listening to this podcast, that's illegal and that's. You're facing a jail term if that gets uncovered. Now, we started this talking about the fact that most builders are unaware that this problem even exists. The reality of this is a lot of builders may be in this situation inadvertently. They didn't do it deliberately. They didn't even know it was happening. So. But what do we need to do? If you find yourself in that situation, what you've got to do straight away is work out just how much Brown Smelly stuff you're in and then come up with a plan again. We're going back to cash flow planning. If I plan my cash flow correctly, I cut everything else to the bone for six months. I push up my margins so that the new jobs coming in are giving me that little bit of extra headroom. You can turn it round relatively quickly, maybe four to six months, to get back to a place where you can now cover your WIPA liability. And then from there onwards, because you've implemented it, it's now going to work for you, it's now going to be positive, and from there on, it'll be a lot simpler.

You mentioned getting a loan earlier, and I got the feeling that that was not something we want to recommend.

No.

Is there ever a situation where a builder needs to take that step?

Well, from a straightforward business perspective, if they're at desperation level and there's no other alternative, you might have to do that. But to be honest, you would still then want to be setting up your cash flow plan or your fixed expense plan to now cover the overhead of the loan repayment in order to now. I mean, that might be a quick fix for somebody in a dire situation, but the truth is most builders would be able to trade their way back into a positive situation.

So we're getting more cash in the business, Correct?

Yeah. We mustn't forget to talk about tax.

Let's do it now then.

All right. So why I want to raise tax is quite simply that in again, in most of the countries where people will be listening to this podcast, the tax law is actually advantageous to the builder from a tax perspective, but extremely dis. Is that a word? Disadvantageous? Unadvantageous. As I said, day three Ibs. The tax law does not work well for a builder 12 months of the year. And what we're really talking about here is the difference between management accounting and tax accounting. Okay, so what does the tax law say? The tax law in all four of the major countries that we work in says for tax purposes, the builder's income, their revenue will be based on the completion rate of their jobs, the completion percentage of their jobs. The tax law allows that to be calculated by. Not on the revenue you have received, but based on the invoices you have received from your suppliers and your subcontractors. So go back to our earlier example. You've actually invoiced the client for 50% of the contract price they've paid you. When it comes to tax purposes, if you've only received 30% of the invoices. The tax authorities will ignore anything above 30% of what you've received for tax purposes. Now this is where the disconnect comes in. You've actually got 50% of the money in your bank account. But from a tax perspective, they're going to assess your tax liability as if you had 30%. Now anybody understanding the fundamentals of accounting is going to realize that If I chop 20% out of your revenue, I'm not changing what your actual costs are at that point. That has an immediate, immediate effect on your gross margin and that is a ripple effect onto your net margin. We don't want those kind of calculations being done during the year on a month to month basis because they're going to distort the figures. And as we said earlier, any distortion in the data is going to make the decisions you make more difficult. But for tax purposes, that is what the tax authorities require your accountant to do. So what we want builders to do is to run management accounting where they are using WIPA during the year to calculate their profitability accurately every month. And then once a year, when their accountant goes to do their tax liability, they would use what we call wipra, which is the work in progress revenue adjustment. The beauty again for all of our members is we automatically include a slave WIPRA calculator. With the WIPA calculator, they only have to fill in wipa. It automatically populates wipra. And at the end of the year when their accountant comes back and says, let's do your taxes, they've got the basis of the calculation done already. It's a simple way of doing it.

So what does the WIPRA calculation do? Does it actually reduce the revenue amount? Is that what you're saying?

Essentially what it's doing is instead of calculating percentage complete on the invoices that the builder has sent to the client, it calculates the percentage complete on the invoices the builder has received from their suppliers and subcontractors. That's the primary difference between the two.

Have we missed anything else?

Look, I mean it's. I sadly call this the cancer of the building industry. More builders go bankrupt out of a misunderstanding or a lack of understanding of this particular subject than from any other. Because when it goes wrong, it goes wrong very quickly. Builders can go for years never knowing they've got a problem because as long as they've got work coming in and they're cash flow positive, it's like a rug over the pile of dirt. You don't see the dirt because there's enough of a rug of ongoing work to cover it. But when that work dries up. It's why we had so many failures in Covid, because as long as people were working, they could cover it and keep ahead of it. Soon as that stops quickly, quickly problems. So please, builders get to understand wipa. Implement it. Run it every month, please. Plus the journal entries. Make sure your profit and loss statement is accurate. Make your decisions off accurate information, and none of these horrible consequences we've spoken about will happen to you.

Sounds good. Let's leave it there, Andy.

Let's leave it there.

Thanks for coming on the show.

It's a great pleasure. Thank you for having me. Again.

Again.