What Is Underbilling in Construction?

In an industry where profit margins are usually thin and cash flow is crucial, construction businesses can’t afford to let any revenue slip away. Unfortunately, that happens more than it should—and underbilling is a key reason. Inadvertently charging clients less than they owe might not always be a big deal; firms can easily rectify a small, isolated case of underbilling in the next billing cycle. Sometimes, however, underbilling is a symptom of serious underlying issues that can threaten a business’s long-term financial stability.

What Is Underbilling?

Underbilling, also known as “costs in excess of billing,” occurs when a company charges customers less than they owe based on the goods and/or services they have received. It is a common issue in construction and other industries that rely on the percentage of completion method (PCM) of accounting for revenue recognition. Under PCM, companies recognize revenue for the amount of work they’ve performed so far on a project, usually based on the costs they have incurred by a specified date. Then they bill the customer accordingly. When the bill does not reflect the full amount of work completed, that is underbilling.

Key Takeaways

• In underbilling, less money is flowing into the company than out of it.
• When a firm underbills, it may not be able to pay suppliers, subcontractors, or employees on time.
• Companies that underbill can develop a reputation as being difficult to work with.
• Chronic underbilling can make it difficult for construction firms to obtain surety bonds.
• Companies can identify underbilling early on by regularly auditing their projects.

Underbilling Explained

Underbilling can be represented as a dollar figure or a percentage of the total project cost. For example, using PCM accounting, a contractor that has completed 20% of a $10 million project would bill the client for $2 million (20% of $10 million). If the firm bills only $1.5 million, it has underbilled by $500,000, or 5% of the total project cost.

Some types of underbilling work themselves out over time with negligible effect. Say a contractor’s billing cycle simply lags behind its project milestones. That will cause short-term cash flow issues, but—assuming nothing else goes awry—the company would end up billing and receiving payment for the entire project once it is completed. Other underbilling instances, however, may not come to such neat resolutions. In the case of undocumented change orders a customer might never have to pay for extra costs associated with work they didn’t approve. The end result would be a financial loss for the contractor.

Either way, chronic underbilling is often a sign of bigger financial problems. It may indicate poor accounting management or a penchant for errors in manual processes. For that reason, underbilling can make it more difficult for construction firms to obtain the surety bonds they rely on to ensure timely payments and financial stability. It also hurts a company’s cash flow and makes it harder to fund future projects.

Underbilling vs. Overbilling

As the words imply, overbilling is the opposite of underbilling. It happens when a company charges a customer more than it should for the goods and services provided. Both underbilling and overbilling can stem from poor accounting and project management practices, incorrect estimates and calculations, or undocumented change orders.

Unlike underbilling, overbilling is sometimes an intentional act. Construction projects have significant upfront costs, and contractors might consider overbilling early in a project’s billing cycle to alleviate some of the cash-flow burden they experience. In these cases, they must clearly communicate with customers to avoid billing disputes and other misunderstandings. At the opposite extreme, overbilling can be deliberate financial fraud.

Risks of Underbilling

Left unaddressed, underbilling can have long-term negative effects on a company’s cash flow—not to mention its relationships with customers and partners. Contractors and other construction companies that regularly underbill may struggle to fund new projects or find themselves in violation of government regulations.

• Impacts on Cash Flow

  Strong cash managementis essential in the construction industry because profit margins are often thin and upfront costs are high. An instance of underbilling, no matter how small, typically means the firm has billed for less than it has spent on a project to date. As these underbillings add up and cash flow moves from positive to negative, it can affect a firm’s ability to pay for future work—and even force it to delay or cancel upcoming projects. If the firm needs to seek loans or other outside financing to meet short-term cash obligations, the accompanying interest payments and fees will put additional pressure on its long-term finances.

• Legal Risks

  Underbilling opens the door to legal trouble in several different ways. When contractors have to overbill late in a project to compensate for earlier underbillings, the resulting confusion may end up in billing disputes and eventual legal action. Additionally, because chronic underbilling is often a sign of fiscal mismanagement, it can put firms on the radar of tax authorities and financial regulators. A common scenario is that underbilling results in inaccurate financial reports and firms incorrectly filing their taxes based on those reports.

  In addition, the cash flow strain caused by underbilling may drive contractors to take shortcuts in other areas of their business, which can also lead to legal problems.

• Reputational Harm

  Underbilling may not seem like a bad thing for customers. After all, who doesn’t like paying less than they expected? But, eventually, contractors that underbill will have to overbill to make up the difference. And that usually doesn’t sit so well with clients—especially when they don’t see it coming.

  Plus, when a firm has cash flow issues because of underbilling, it may not be able to pay its suppliers, subcontractors, or employees in a timely manner. Over time, the firm will likely develop a reputation as a company that’s difficult for customers to work with and for subcontractors to work for.

Potential Causes of Underbilling

Underbilling often results from challenges specific to the construction industry and its project-based nature. Recognizing these causes is the first step to preventing them. Here are some of the most common reasons for underbilling.

• Miscommunication: Failure to notify a client about changes to the scope of a project or its cost can result in underbilling. Miscalculated project costs and undocumented change orders (both described below) are two of the biggest examples of miscommunication. Other examples include internal miscommunication between departments of the construction firm, such as when a field team doesn’t properly communicate changes or progress to the accounting department. Unclear contract terms and poor communication with subcontractors can also lead to misunderstandings and underbilling.
• Miscalculating project costs: Underbilling often happens when a contractor underestimates the cost of a project and bills accordingly. Improperly calculating a project’s completion percentage, then billing for less work than has actually been done, is another common cause of underbilling.
• Performing undocumented change orders: Unexpected issues, such as unforeseen site conditions or supply shortages, are typical during construction projects. When contractors perform extra work to address these issues without documenting them in a change order and securing client approval, it can lead to underbilling. Customers may not have to pay for additional work they haven’t signed off on.
• Paying vendors for work not yet completed: Construction firms sometimes pay their subcontractors in advance, before their work is complete. Doing so creates an underbilling situation where the contractor has incurred a cost but can’t invoice for it because the work isn’t finished.
• Delays in the billing cycle: Despite the importance of billing to a company’s financial health, it often falls to the wayside for busy contractors and small construction firms without dedicated accounting resources. These delays can lead to underbilling in project-based accounting because work completed between billing cycles may be overlooked or inaccurately recorded when invoices are finally prepared.
• Underestimating storage costs: Contractors often face unexpected storage expenses. For example, a firm may be contractually unable to invoice for materials they’ve purchased until those materials have been inspected and approved for use. In the meantime, they have to store those materials and incur the related costs. In addition, storage costs can rise due to project delays, bulk purchases, scope changes, or logistical issues that increase costs beyond what was accounted for in initial estimates.

How to Identify Underbilling

Underbilling can go undetected for months; by the time it’s found, it can have significant, irreversible ramifications. Construction companies can identify underbilling early on by regularly auditing their projects to ensure that the amount of work completed and the amount of work billed for are aligned.

Companies should first check that their work-in-progress reports which track the costs incurred for partially completed projects, and their project management systems, which track the status of those projects, are up to date and accurate. It’s also important to validate the information in those systems through on-site inspections. Then firms should compare that data with actual expenses and invoices to spot cases where they haven’t billed for all of the work they have performed.

Other approaches to identifying underbilling include analyzing billing-to-completion ratios, reviewing unbilled receivables, conducting periodic reconciliations of costs and billings, monitoring project profit margins, and performing regular variance analyses These methods can help spot discrepancies that may indicate underbilling before it becomes a significant issue.

Tips to Avoid Underbilling

Of course, it’s even better to avoid underbilling in the first place. With a more proactive approach—plus attention to detail, automated processes, and clear communication—construction firms can be sure that they account for every dollar they earn. These five tips provide practical strategies for preventing underbilling.

1. Use regular cash flow projections: Cash flow forecasting helps firms identify and prevent underbilling by estimating the amount of cash flowing into and out of the business during a specific future period. It’s tricky to make accurate predictions, but regular reviews of project progress and sent invoices can help. If new cash flow projections are lower than expected, underbilling may be to blame.
2. Regularly audit job costs: While overall project audits identify ongoing underbilling, specific audits of job costs can help prevent it altogether. Before sending any invoice, firms should review and double-check the accuracy of all expenses (labor, supplies, etc.) related to the work being billed. This helps ensure that the amount of work invoiced matches the amount of work completed—the key to successful project-based billing.
3. Thoroughly review contract terms and conditions: Construction contracts spell out a project’s milestones and other details, such as what materials should be used. Firms should always review these documents before sending invoices to make sure they are correctly billing for completed work and approved materials, as defined in the contract.
4. Remove bottlenecks that cause delays in cost allocation: Cost allocation—assigning indirect expenses to specific tasks—is a particular challenge in construction, where so many costs are shared across a firm’s multiple projects. Firms should determine their allocation method in advance to avoid manual calculations that can lead to underbilling.
5. Require all change orders be documented: Requiring all change orders to be documented and approved by the client eliminates confusion around new work that needs to be performed and how much that work will cost. Doing so helps firms accurately account for all completed tasks.

Specialized Accounting Software Enhances Project Visibility

Construction is a tough enough business without having to worry about lost revenue from underbilling. A unified system for project management and accounting can help contractors and other firms estimate, allocate, and track costs more accurately. NetSuite’s construction enterprise resource planning (ERP) system automates these tasks and is built to support the industry’s unique project-based requirements. For example, the cloud-based solution includes automated billing capabilities that help prevent delays in the billing cycle by generating invoices based on project milestones, time and materials, or other predefined criteria.

NetSuite’s real-time project tracking and reporting features give construction firms better visibility into their work in progress, making it easier to identify potential underbilling before it becomes a serious issue. Teams can monitor project costs, completion percentages, and billing status from a centralized dashboard. Additionally, NetSuite’s change-order management functionality helps prevent underbilling from undocumented changes by automating the process of creating, tracking, and approving change orders. The system can automatically update project costs and billing schedules when change orders are approved, reducing the risk of miscommunication between field teams and accounting staff.

Underbilling can have serious consequences for contractors and construction firms. Companies can avoid underbilling by conducting regular accounting and project audits, accurately tracking their costs, and maintaining clear communication with clients. Firms that take these proactive steps to avoid underbilling will not only improve their short-term cash flow but also build healthier businesses for the long term.

Underbilling FAQs

What is an example of underbilling?

An example of underbilling is if a construction firm has completed 50% of a project but has billed the customer for only 35% of the total contracted cost. In this case, the construction firm has underbilled by 15%.

Is underbilling considered an asset?

Yes, underbilling is considered an asset on a balance sheet—usually listed as “Costs and Estimated Earnings in Excess of Billings” or “Unbilled Receivables”—because it represents money owed to a contractor or construction firm for work completed. Overbilling, on the other hand, is considered a liability on a balance sheet.

What is the underbillings-to-equity ratio?

Underbillings-to-equity is a ratio that compares a contractor’s unbilled work and excess costs (costs incurred on a project that exceed the amount that can be billed to the client at that point in time, based on the terms of the contract) to its net worth. To calculate the ratio, add total unbilled work to excess costs and then divide the sum by total net worth. This metric is used to assess a contractor’s financial health and potential risk.