Defining WIP
Work in Progress or WIP refers to the value of work started but not yet completed. WIP carries significant implications for business valuation and operational management.
WIP is used by businesses that have long term contracts and use project billing. These are generally construction or manufacturing businesses but can also be used by businesses offering services under long term contracts such as software developers, lawyers, engineering and architectural consultancies.
WIP is represented as a current asset on a business’ balance sheet. It is created through the allocation of costs incurred through project execution. Representing a pipeline of work, long-term contracts often have targets that measure progress. These can be represented as deliverables or percentage completion objectives. Prior to meeting the target, the business incurs costs related to the project. This is WIP and the value is related to the cost incurred. Costs can include direct costs, like materials and labour, and indirect costs such as a percentage of overhead expenses.
For the prospective buyer, WIP represents past and future cash flows. The buyer can associate historical cash flows incurred in the performance of the long-term contracts. Since the buyer will be taking over the projects, they can identify the future revenue associated with WIP.
Valuation Implications of WIP
The presence of WIP in a business significantly influences its valuation through associated risks. WIP affects the business valuation as it represents ongoing business, thereby reducing risk associated with future revenue. Since WIP provides an assessment of risk, understanding it has significant purchase and sale implications.
Buyers may see WIP as a risk, for they will be assuming a potentially onerous contract. A buyer may perceive WIP as a risk to the timely and on-budget execution of the contract. Conversely, the seller will argue for risk mitigation, recognizing WIP represents potential future profits. Buyers should carefully review WIP to quantify their risk. Understanding the nature and reliability of the cost estimates and the potential for successful completion are necessary to assess the true value of WIP.
Commercial Building Construction
Cordy’s Construction Ltd. (“Cordy’s”) wins a contract to build a commercial building. The total construction cost is $5 million. Cordy’s agrees to complete the building within 24 months. There are milestones for the laying of the foundation, the completion of the structural framework, coating the exterior, finishing the interior and final inspection.
Initial Stages
Cordy’s begins excavating the property and building the foundation for the building. The costs incurred during this phase include labour, materials and equipment rental. Cordy’s also allocates a percentage of indirect or overhead costs like management costs and insurance.
These initial costs are recorded as WIP as the project is started but not completed. At this stage, let’s say WIP balance is $500,000.Midpoint
As the project progresses, additional costs are incurred for the framework, the exterior cladding, finishing the electrical and plumbing installation, etc.
Every month, Cordy’s updates its WIP account as new costs are incurred. After 12 months, the value of WIP might increase to $2.5 million, reflecting one half of the project’s completion.
Billing and Revenue Recognition
Cordy’s bills the client 20% of the total contract amount once every milestone is reached. For example, Cordy’s bills the client for $1 million upon the completion of the foundation.
The amount billed is recognized as revenue and the corresponding portion of WIP is transferred out of WIP to reflect that this part of the project is completed.Project Completion
Upon receipt of the final inspection, the entire WIP value is moved out as the project is fully billed to the client. If the final WIP value is $4.5 million, it indicates the total cost incurred on the project and the profit on the project is $500,000.
Operational Benefits of WIP
Improved financial visibility on costs incurred during the completion of the project affects future financial performance. Using accurate cost tracking, Cordy’s can more effectively monitor its performance and progress toward completing its milestones. If project costs start to climb unexpectedly, Cordy’s can correct its course, making changes to the project or the contract.
Using the visibility into past projects for future cost projections produces better management decisions. Cordy’s can identify potential risks in project execution early on giving early warning markers for management decisions. This can then help Cordy’s prevent cost overruns.
Analysis of WIP provides better support when bidding on contracts for projects with long timelines. Cordy’s can analyze past projects costs for better pricing accuracy for long-term contracts, resulting in greater profitability.
Conclusion
Business valuation involves the estimate of the quantity and probability of future cash flows. Businesses reporting WIP have more accurate expectations of future revenue and tighter controls on costs. Businesses like Cordy’s benefit from analysis of past project costs to competitively bid on future projects. Cordy’s wins more projects and is more profitable than its competitors. These two operational properties reduce operational performance risk and decreases profitability risk. Reducing risk yields higher valuations.
Upon a proposed sale of Cordy’s, the buyer can assess the nature and reliability of the cost estimates and the potential for successful completion of projects through analysis of WIP. Cordy’s can illustrate its success in competitive bids. Cordy’s can argue that the project pipeline reduces the risk of future revenue.Optimize Your Business Valuation and Efficiency with Troy Valuations
Interested in learning more about how Work in Progress can enhance your business valuation and operational efficiency? Contact Troy Valuations today for a comprehensive consultation and take the first step towards optimizing your long-term project management strategies.