Definition of project revenues for service companies

The current accounting and cost accounting standards are still geared towards manufacturing companies. They cannot or can only be applied to project-oriented service providers. The following article therefore examines aspects of the balance sheet and short-term income statement from the perspective of service providers. In this context, the correct delimitation of project revenues plays a central role.

The Sulzer site in Winterthur shows the post-industrial structural change in prototypical form. Where diesel engines and entire locomotives were once manufactured, today you can find architectural and engineering offices, software and IT companies, graphic design studios and PR agencies. However, the established accounting and cost accounting standards have not yet understood this step from an industrial company to a service company. They pay little attention to the needs of service providers who handle projects on behalf of customers.

For example, Swiss GAAP FER 22 lists as “typical long-term contracts” primarily “mechanical and plant construction, power plant construction and the individual production of unit contracts (e.g. aircraft, locomotives, housing developments)”. It is only in second place that the standard states that long-term contracts “also” exist in the service sector. In other words, locomotives are still being built in Swiss GAAP FER, and the timetable software has fallen behind. The following article therefore considers problems and solutions for the creation of a short-term income statement for project-oriented service providers.

The relevant KPIs for the balance sheet of a service company differ substantially from the key values of a manufacturing company. The national and international accounting standard-setters do not allow the activation of the actual asset of a service provider, the know-how of its employees: such a company does not own expensive production resources, and therefore in many cases its fixed assets only include the IT infrastructure. In such cases, the assets side of the balance sheet consist mostly of cash, receivables from customers, and ongoing projects. This aspect limits or makes borrowing more expensive, because banks do not invest in a company’s working capital. This leads to the rule of thumb that service providers should be primarily equity-funded.

As a rule, capital turnover is less relevant for service providers than for manufacturing companies, so they can focus their controlling on profitability, i.e. on the margins from the income statement. The balance sheet must then be viewed primarily from the perspective of liquidity. The percentage of work that has not yet been invoiced should be kept as low as possible, which requires prompt invoicing. In the case of fixed prices, appropriate advance payment plans make sense, and receivables should be handled consistently. This counteracts an above-average commitment in working capital.

In the income statement, more than 80% of the income from projects is compared to the salaries of the employees (and the costs of the freelancers). However, the ongoing projects are usually not completed on an accrual basis (e.g. for monthly financial statements). This results in a major challenge for accounting: it has to correctly evaluate ongoing projects or “work started” at a given reporting date. Effective controlling therefore presupposes for a service provider active in the project business the correct determination of project revenues.

Of particular importance are project delimitations, i.e. the limitation of hours, turnover and income for certain periods. Such project delimitations are necessary, inter alia:

• to be able to present the profit and loss situation correctly (principle of accrual in the case of monthly, quarterly or annual financial statements),
• to identify possible project risks at an early stage,
• to record potential risks in the books at an early stage (integral risk management),
• to determine “correct” project margins in ongoing projects.

In principle, two different methods are now available for the period-specific determination of project turnover:

• In the input-oriented method, the degree of completion is calculated on the basis of the quantity of inputs, in the case of project service providers usually on the basis of the number of hours worked. Calculating the ratio between the number of hours worked and the total hours to be worked gives the degree of completion (PoC).
• In the output-oriented method, the ratio between the output already delivered and the total output to be delivered is calculated to determine the degree of completion. This is possible, for example, on the basis of a detailed specification and a Work Breakdown Structure (WBS).

Because the output-oriented method does not take into account uneconomical service delivery (i.e. additional expenditure, budget overruns, etc.), it is preferable for accounting purposes. In practice, however, the input-oriented method is practically always the prevailing method, as it is easier to implement and all projects can be treated exactly the same. The responsible project managers have to “only” periodically estimate the remaining time expenditure in this method.

Project managers often argue against the output-oriented method that the degree of completion cannot be estimated in this form. This has to be countered by the fact that a similar estimation had to be made for the preparation of offers and the uncertainties in an ongoing project should decrease rather than increase.

The systematic determination of project boundaries therefore places high demands on the organization, processes and systems of a company. In practice, therefore, it is advisable to use an integrated enterprise resource planning (ERP) system without these requirements being difficult to master. Such software solutions enable simple residual or total estimates of all projects or budget items, including subprojects or parts of a work breakdown structure. Integrated ERP systems also enable a simple and timely calculation of the previous hours per employee and project, which is central to the calculation of the Percentage of Completion.

Whether projects in service companies generate profits or cause losses often depends on how well a project leader manages his projects. A regular estimation of the remaining costs forces a project leader to (also) deal with the questions of profitability. In addition, care should be taken that the individual estimates of the remaining costs and the degree of completion are available later and can be evaluated (e.g. graphically) over time. Controlling can thus identify projects where the completion rate has remained constant at 90% for several months, for example, or where the remaining working hours are decreasing faster than the remaining effort. The estimates of a project leader and the systematic evaluation by controlling can thus provide important KPIs for assessing and controlling projects or their management. In this way, problems can be identified early and their subsequent costs reduced.

In addition to these “hard facts,” cultural aspects must be taken into account. The early and honest discussion of problems in projects and their financial consequences presupposes an open risk culture. The interaction between the project leader and controlling is central here. The project leader must be able to face potential budget surpluses without fear at an early stage of the project and must also be able to communicate them. Successful controlling therefore depends on a constructive and fear-free handling of risks ? This is the only way to identify risks at an early stage and take corrective action in good time. Too little importance is attached to such “soft facts”.

In addition to organisational and technical measures such as a functioning ERP system, the “human factor” is crucial to the success of a company. Little has changed since the heyday of the Swiss mechanical engineering industry, even though the former factory halls are now used by modern service companies.

Mr. Claudio Pietra, MD, managing director Vertec group (www.vertec.com)
Mr. Marco Pizzorusso, CFO Zühlke group (www.zuehlke.com)