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DSO and DPO – What’s the Difference?

Gary Dwyer
GaryDwyer
Product Director
BST Global
Analyzing Days Sales Outstanding (DSO) and Days Payable Outstanding (DPO) can improve one very important financial metric for your AEC firm: cashflow. What It Is Before I get into how to calculate DSO and DPO, and how the resulting value of each impacts your firm’s cashflow, let’s do a quick refresher on their definitions: Days Sales Outstanding shows how well your firm is managing its accounts receivable by measuring how long it takes to collect payments owed to your firm. Days Payable Outstanding shows how well your firm is managing its accounts payable by measuring the average number of days it takes you to pay vendors. In short, DSO helps your firm see how long it’s taking to collect outstanding payments, and DPO helps your firm see how long it’s taking to pay outstanding bills. And while they address different areas, the information derived from each are equally as important. Now that you’re caught up on what DSO and DPO means, let’s look at the formula for each. How to Calculate DSO Credit SalesA purchase made that does not require the payment to be made in full at the time of purchase. The full amount can be paid at some point in the future or smaller regular payments can be made over a period of time. DSO is calculated by dividing your accounts receivable during a particular time period by the value of your credit sales during that same time period, and then multiplying the result by the number of days in the period. Here’s a quick example: Receivables: $2,000,000 Credit Sales: $2,800,000 Days in Period: 91 days DSO Calculation: ($2,000,000 / $2,800,000) x 91 days = 65 days Your firm should be aiming to have as low of a DSO value as possible because it indicates that you’re doing an excellent job of collecting outstanding debts. A range between the lower 50’s to upper 80’s is a typical value for most AEC firms. But once values start creeping over the upper 80’s, this should be a clear red flag to your firm. How to Calculate DPO DPO is calculated by dividing your average accounts payable by your daily cost of sales (also sometimes referred to as cost of goods sold or COGS). For example: Payables: $250,000 Cost of Sales: $1,250,000 DPO Calculation: $250,000 / ($1,250,000 / 365 days) = 73 days Unlike DSO, you want your DPO value to be higher because it means you can keep cash within your firm for longer. In this case, a range from the mid 60’s to more than 100 would be typical for most AEC firms. DSO and DPO Target Values But having a low DSO value, or a high DPO value, doesn’t give you the whole story. The target values for any firm are influenced by several factors, such as: what industry your firm is in, the type of projects your firm works on, whether that work is public or private, whether your firm is working as a general contractor or a sub-contractor, etc. So, what may be a target value for one architecture, engineering, or environmental consulting (AEC) firm, may be different for another. For example, if your firm does more private than public work, then the DSO target may be higher as you have room to negotiate more favorable progress payments (e.g. get advance payments), which helps reduce your firm’s DSO. But as you calculate your firm’s DSO and DPO values, keep in mind that while a single value is an important indicator to start paying closer attention, the benefit really comes from tracking these values over time. These values cannot be changed overnight – there are processes that need to be put in place and tested in order to see those values start to come down or go up. Depending on which direction the trend moves, it will have a positive or a negative impact on your firm’s available working capital – which is why these calculations are so important to understand. More on this in the next section. Why It’s Important Monitoring the trend of DSO and DPO values provides an insight into how your AEC firm manages its cash. Let’s see just how a positive or negative trend can have an impact. First off, an increase in your firm’s DSO means you’re financing clients by carrying their debt on your books – this results in a negative impact on your firm’s cash flow since it’s taking longer to collect those payments. Pay When PaidA contractual clause that stipulates that a contractor is obligated to pay its subcontractors upon receipt of payment from the owner. The same impact on your firm’s cash flow happens if your DPO is declining – meaning, cash may be going out sooner than it needs to be. This can be improved by making sure your firm negotiates more favorable payment terms with vendors and pays vendors according to those terms (not paying them earlier than what’s in the agreement), or it can even adopt a Pay When Paid strategy with vendors. Conversely, a reduction in your firm’s DSO, and an increase in DPO, will lead to improved cash flow for your business. As your firm starts collecting payments more quickly and takes longer to make payments (within reason, of course – you don’t want to ruin the relationship with your vendors!), the amount of cash coming in will exceed the amount going out. Even the smallest improvements in these factors can have an impact on the amount of working capital your firm has at a given time – so don’t take these lightly, make them a priority. Conclusion DSO and DPO are useful formulas for analyzing your firm’s processes (i.e. billing, collections, and payment processes) and can play a direct role in the effectiveness of your cash cycle. Given the significant role cash plays in successfully running a business, monitoring your DSO and DPO values can help your firm find ways to collect on outstanding bills as quickly as possible, while also watching outflows of cash for vendor payments. Want to learn other helpful calculations to keep your firm’s finances in check? Check out The Ultimate ERP Glossary for AEC Firms, where you’ll learn 150 terms (along with a whole range of AEC related formulas) that cover the entire project lifecycle. Download your free copy by clicking below! DOWNLOAD GLOSSARY NOW

Cash vs. Accrual vs. Work in Progress Accounting: Which is Best for AEC Firms?

Evelyn March
EvelynMarch
Group Director
BST Global
Cash basis and accrual basis are two different methods of accounting. Each method tells a different story about revenue, but neither method gives the whole story – that's where the work in progress (WIP) method comes in. It’s an important question: which accounting method is most effective at providing insight into your firm’s revenue? Some say accrual basis accounting is more effective than cash basis accounting. But many times, if architecture, engineering, and environmental consulting (AEC) firms only leverage accrual basis accounting, they miss out on an even deeper level of insight of revenue that can only be achieved with the accrual based WIP method. While each method provides a snapshot of your AEC firm’s income, the WIP method provides the most accurate representation. The impact of this? Your team is able to get a clearer picture of your firm’s revenue journey. Before we dive into how WIP gives the level of revenue insight your AEC firms needs to be successful, let’s review the more commonly used cash and accrual basis accounting methods first. Cash Basis Accounting The end goal of any profitable business is to monitor cash flow. That’s why for the cash basis method of accounting, income is booked when money is received, and expenses are booked when money is paid. In other words, items are booked when money changes hands. While this makes the value of your firm’s revenue extremely accurate, it can also paint a misleading picture. If a large sum of revenue is received and recorded before bills are paid, your firm may falsely appear more profitable, as assets will be greater than liabilities. Of course, the reverse is also true. If a firm pays for expenses prior to receiving the money and recording this revenue, it can make a company look like it’s headed in the wrong direction. In this case, your balance sheet would show the value of your firm’s liabilities as greater than the value of its assets. Accrual Basis Accounting While cash basis accounting records the actual movement of cash, accrual basis allows for the prediction of revenue. With this method, if an invoice is received for completed services (expenses), or a bill is submitted to a customer (revenue), both are booked at that point to predict future revenue and expenses. So, while items are booked when money changes hands with cash basis, items are booked when an invoice passes hands with accrual basis. This prediction allows you to see the cash flow that’s already in motion once an invoice is sent – but what if you could predict revenue even before invoices are sent to the client? That would be the holy grail of data analysis. And yes, it’s possible… if your enterprise resource planning (ERP) software can calculate WIP. Work in Progress What is WIP? Accrual-based WIP is the value of work completed, but not yet billed. Since there are parameters that determine the contractual amount that you can bill, what if you used those parameters to figure out the value of work before you billed it? This additional layer of accrual allows you to book the revenue that comes from work completed in the month it occurred. By booking revenue at this point in time, it provides the truest picture of your firm’s forecasted income. Let’s explore this concept a little further. Since the accrual method means you book expenses when your firm receives an invoice or timesheet, you have a clear picture of your cost for a given month. No matter which accrual method you choose (accrual basis or accrual-based WIP), your expenses will always be booked in the month it occurred – this will not change. But with WIP, you have an additional option for booking revenue: your AEC firm can now book revenue in the month work was completed. We know it takes money to make money, so booking your revenue in the same month that you booked your expenses gives the truest picture of your firm’s financial standing. But by taking it a step further with the WIP method, the WIP value on your financial reports will show the value of work before you bill it in the future. So, how is this added benefit helpful to your AEC firm? We’ll take a look at that next. The Revenue Story with WIP In a scenario where WIP is not used, and expenses are booked in a given month yet billed months later, your picture of expenses versus revenue is skewed. The month of the expenses would appear with no offset of revenue, and when the invoice is sent, the revenue would appear with no offset of expenses. Because these values were booked in two separate time periods, it would be challenging to make the connection of how much expense it took to earn the amount invoiced. On the other hand, if the WIP method were used, you would accurately depict the revenue earned in the same month the expenses were booked. Seeing that this value was booked as WIP, it alerts you that this is your future billing amount. Are you starting to see the extra layer of analysis your firm would receive? Because WIP is a statement of what you expect to bill in the future, when an invoice is sent, that value is offset from the WIP account. By booking that value in WIP, you are now able to evaluate how long it took from completing the work to billing it. That same principle applies when cash is received. Noting the date of the invoice, and the date that cash was received, it shows how long it took for a client to make a payment. Thus, WIP gives you a complete timeline from work completed to billing, and then from billing to cash collected. Here’s another way to look at it: Say your team completed work in January. According to the WIP method, you would book that work in January. Then, if you were to review your firm’s WIP balance (reminder: this is work you’ve completed, but are waiting to bill) in March and saw there was a balance for WIP that was booked in January, this would immediately alert you that the work completed in January had not been invoiced yet as of March. Your firm can now proactively review WIP and give attention to projects that have fallen behind in invoicing, thus, having a positive impact on your firm’s cash flow. Conclusion While your AEC firm can choose to use any of the three accounting methods, it’s important to understand the added benefit of WIP in its ability to enable your firm to proactively analyze and maximize its profits. By incorporating WIP into your accounting practices, it opens communication between your Finance and Project Management team to discuss the time lapse between work completed and work billed. Opening this dialogue allows the project team to join in the ownership of a healthy cash flow and also aids in the dialogue with your clients as you manage the time from billing to payment. Want to learn other important AEC industry terms? We’ve created a glossary packed with 150 terms that covers the entire project lifecycle, all in the context of an ERP solution. Get your own free copy of The Ultimate ERP Glossary for AEC Firms by using the link below! DOWNLOAD GLOSSARY NOW