WIP accounting refers to the practice of tracking work-in-progress (WIP) inventory for the purposes of GAAP compliance or financial management. It’s an essential tool for project-based businesses, such as those in the construction industry.
If your company frequently accepts long-term contracts, here’s what you should know about WIP accounting, including what WIP is, why it matters and how to calculate it. We’ll also explore how it affects your financial statements and some common WIP accounting mistakes to avoid.
What Is Work in Progress Accounting?
Work-in-progress accounting involves tracking the value of products in the middle of being made ready for sale. In other words, it’s the process of capturing the costs tied up in partially finished work, also known as works in progress or WIP inventory.
WIP accounting is most relevant in industries where projects take a longer time to complete. Construction and consulting are the quintessential examples, as engagements frequently span multiple years.
What Is WIP Inventory?
WIP inventory is the core subject of WIP accounting, referring to the portion of your business’ inventory that has been partially completed but isn’t yet ready for sale. It’s the middle stage of development that falls between raw materials and finished goods.
More specifically, WIP inventory contains all of the direct costs you’ve incurred in order to make progress on preparing the product. That may include the cost of direct materials, direct labor and an allocation of manufacturing overhead.
For example, imagine a client hires your construction company to build a multi-family building, which you expect to take between 18 and 36 months. Once you break ground, you should initially consider all expenses related to the project WIP inventory.
Why WIP Accounting Matters
WIP accounting is essential for compliance with GAAP, especially revenue recognition standards and the matching principle. These require you to record revenues when you earn them—not collect them—and record expenses in the same period as the revenues they helped generate.
WIP accounting is necessary to create an accurate balance sheet and income statement. Without it, you may end up misrepresenting your financial position and performance to external stakeholders, like lenders and investors.
Even if you aren’t subject to GAAP, WIP accounting is invaluable in industries like construction, consulting and creative services. It can have a significant impact on your profitability, helping organize the two main aspects of cash flow management:
- Billing: By tracking the percentage of work completed with WIP accounting, you can invoice clients in line with your actual progress on the project. This helps prevent overbilling and underbilling, both of which can cause cash flow issues.
- Budgeting: WIP accounting helps you compare your budget usage to your actual progress. That lets you identify potential cost overruns early, so you can adjust your resource allocation to protect profit margins and avoid cash shortfalls.
Without accurate WIP data to inform your billing and budgeting decisions, cash flow management becomes much more challenging. You may find out too late that you’re grossly over budget, or end up short on cash despite being profitable on paper.
How to Calculate Work in Progress
WIP accounting starts with a simple formula:
Work in Progress = Direct Materials + Direct Labor + Allocated Overhead
Here’s what each of those variables means:
- Direct materials: These are the raw physical inputs that go into your project. In construction, that might include the cost of concrete, bricks or lumber.
- Direct labor: This refers to the wages or payments you make to the people actively working on the project or assembling the product.
- Allocated overhead: This is the portion of your company’s indirect production costs that you allocate to the project. For example, that might include a percentage of your equipment depreciation and utilities.
Adding these together is how you calculate the value of work performed to date on an unfinished project, also known as WIP inventory.
In practice, one of the most significant benefits of tracking WIP is in using it to recognize revenue and expenses using the percentage of completion method. It’s a popular option in industries where long-term contracts are common, such as construction.
Here are the other formulas involved:
Percentage of Work Completed = WIP Inventory ÷ Total Estimated Costs
Earned Revenue = Percentage of Work Completed x Total Contract Value
Next, let’s look at an example to demonstrate how this all comes together.
WIP Accounting Example
Imagine you own a construction company, and a client hires you to build them a single-family home for $2.5 million. You estimate the project will take two years and approximately $2 million to complete.
At the end of the first year, your WIP accounting team has tracked the following:
- Direct materials: $350,000
- Direct labor: $250,000
- Allocated overhead: $100,000
- Billings to date: $1 million
Let’s use that information to determine how much revenue you should recognize at the end of the first year using the percentage of completion method. The first step is to calculate work in progress:
WIP = $350,000 + $250,000 + $100,000 = $700,000
With that, we can determine the percentage of work you’ve completed to date.
Percentage of Work Completed = $700,000 ÷ $2.5 million = 35%
Finally, we can multiply that percentage by your total contract value of $2.5 million to determine your earned revenue at the end of the year:
Earned Revenue = 35% x $2.5 million = $875,000
In practice, it’s also a good idea to determine how much you’ve overbilled or underbilled the client, which should inform your future cash management decisions. To do that, simply subtract earned revenue from billings to date:
$1 million billed to date – $875,000 earned revenue = $125,000
Since the amount is positive, you’ve billed more than you should have for the percent of work completed to date. In other words, you’ve overbilled the client by $125,000.
How WIP Affects Financial Statements
WIP accounting requires the use of two unique accounts. The first is an asset account for your WIP, or the costs you’ve incurred on a project to date. The second is a contra-asset account to record your billings for the project.
In the construction industry, these accounts are often named “Construction in Progress” and “Billings on Construction in Progress,” respectively. They offset each other on the balance sheet, with the net result reflecting your overbilled or underbilled amount.
Let’s use the numbers from our previous example to show how the journal entries might look. For simplicity’s sake, we’ll assume all parties paid for everything in cash.
| Journal Entry #1: Record WIP for project costs incurred to date | ||
| Account | Debit | Credit |
| Construction in Progress | $700,000 | |
| Cash | $700,00 | |
| Journal Entry #2: Record billings to date | ||
| Account | Debit | Credit |
| Cash | $1,000,000 | |
| Billings on Construction in Progress | $1,000,000 | |
| Journal Entry #3: Recognize earned revenue and matching expenses | ||
| Account | Debit | Credit |
| Cost of Goods Sold | $700,000 | |
| Revenue | $875,000 | |
| Construction in Progress* | $175,000 | |
| *Note: This is a plug that equals your gross profit to date. It’s debited to Construction in Progress to ensure the account reflects the total value of work completed—not just costs incurred. In this case, you’ve built 35% of a home valued at $2.5 million, so your Construction in Progress account should have a total balance of $875,000. | ||
The final result of these journal entries is to show $875,000 of revenue and $700,000 of costs on the income statement. This aligns with the GAAP requirements to recognize revenue when earned and deduct related expenses at the same time.
The entries also create an $875,000 debit balance in the Construction in Progress account and a $1 million credit balance in the Billings on Construction in Progress account. These net to a $125,000 credit on the balance sheet, reflecting overbillings.
You would show that credit balance as a liability since it represents unearned revenue.
Common WIP Accounting Mistakes to Avoid
WIP accounting may seem straightforward in theory, but it can quickly become complex in practice. Cost estimates are never perfectly accurate, and project scopes often change multiple times before completion.
Given these realities, here are some of the most significant pitfalls to be aware of:
- Underestimating project costs: It’s tempting to bid low to win more projects, but if your initial cost estimates are too optimistic, your percentage of completion calculations will be inflated. That can cause you to recognize too much revenue early on, forcing you to adjust profits downward later.
- Treating overbillings as profit: Recording overbillings as profit violates GAAP and creates a misleading picture of your financial health. It can also cause a dangerous cash shortage later on in the project when your billings slow down, but expenses continue.
- Failing to account for change orders: Change orders are almost inevitable in industries like construction and consulting. If you don’t update your WIP accounting to reflect changes in scope, budget or timeline, your revenue recognition will quickly fall out of sync with reality.
If you’re having trouble managing WIP accounting on top of your other responsibilities, consider hiring a CPA. They can help you navigate the relevant accounting standards and optimize your systems for liquidity and profitability.
Get WIP Accounting Help With Paro
WIP accounting is essential for GAAP compliance, playing a critical role in revenue recognition and expense matching. It’s also invaluable for profitability and cash flow management, helping to inform your billing and budgeting decisions.
A fractional controller can provide the expert accounting help you need at a fraction of the cost of a full-time professional. To connect with a WIP accounting expert, schedule a free consultation to learn more about Paro’s accounting services.
