07.26.2007 — Measuring profitability for a custom retailer is especially important because the typical “flags” you expect from a normal retail business are not present.

Most entrepreneurs use cash flow as their primary performance indicator. If you can’t pay your bills, then you are probably not making enough money to cover your expenses and, therefore, are not making a profit.

This method, however, rarely works for custom contracting. Client deposits confuse the profit picture and require a different financial measurement tool.

Typically, custom dealers don’t put client deposits in a separate escrow account. Instead, they use the money to operate the business.

As your business grows, client deposits also grow. With them, business owners basically have access to interest-free loans and, therefore, good cash flow. Problems occur, however, when business slows down and client deposits stop coming. That’s when profits are necessary to finance business operations.

If the profits aren’t there, the business will fail.

Cash and Accrual Accounting Shortfalls

Every custom dealer and retailer needs good financial tools to measure and calculate performance and profitability. If you use cash or accrual accounting methods for accounting statements, you may not be painting a true picture of your business.

With a cash-based method, you report deposits as income and expenses as they are paid. Therefore, when you receive large deposits, you get a false sense of profitable revenue since you don’t pay for the ordered equipment until at least a month after you have invoiced.

With an accrual method, you report the income when the invoice is generated and the expense when you receive the invoice, not when the invoice is paid. Nevertheless, neither method can properly track what is happening with client deposits.

Proper tracking requires additional information about your percentage of completion on each project. This tracking is done with a third accounting model—the work-in-progress method.

Work-in-Progress Benefits

Work-in-progress accounting, also called the “job completion method,” looks at the percentage of completion of a job and uses this percentage to recognize income. For cost, you take that same percentage and apply it to the estimated total cost of the job.

The following chart shows examples of these three accounting methods: cash, accrual and work-in-progress. This example shows a $100,000 installation with a 30 percent deposit of $30,000.

As you can see, the cash method gives a very inflated profit picture. Even the accrual method is misleading with profits being higher than they actually are at this point in time. The work-in-progress method, however, gives the most accurate view of the profitability at this specific point in time.

In this example, if we say that we will have a total cost of $60,000 for this job and we have a work in-progress cost to this point of $12,000, we calculate the percentage of cost against total cost ($12,000 is 20 percent of the total job cost).

To compute the percentage of receipts for work-in-progress, we would take this 20 percent figure and apply it against the total job price ($100,000) to show this $20,000 as our receipts for this job. The excess dollars received ($30,000 deposit less the 20 percent of work in progress) is shown as excess receipts.

A work-in-progress report defines receipts (or revenue) with regard to costs and, therefore, is a better reflection of your profitability at any given point in time.

Jonathan Knapp is president of Simply Reliable Software, which provides all-in-one software solutions for custom installers. He can be reached by telephone at 617-731-0113, ext. 101 or by e-mail at .