Construction Accounting Article -
Going, Going, Gone …
Catch Profit Fade Before it Lowers the Curtain on Your Bottom Line

Target Audience: Construction Industry Professionals, Contractors, Construction Business Owners, Construction Accountant Interest, Profit Fading Interest, Job Bid Fluctuation Prevention Interest, Best Billing Practices Interest

It’s an all-too-familiar story: XYZ Construction had a job that wouldn’t end. The contract was nearly complete, but the costs kept accruing as last-minute changes added up. By the time the work was finished, any hope of a profit was finished, too.

The fictitious XYZ fell victim to a very real, and potentially disabling, financial predicament called “profit fade.” It occurs when a job fails to go as planned, and your carefully estimated profit margin shrinks to nothing — or less.

In an industry that isn’t known for high profit margins to begin with, profit fade can be a deadly threat. Fortunately, there are ways to catch it.

Know Your Enemy

As every contractor knows, the profit you calculate when bidding a job can fluctuate dramatically as work progresses. For every phase you finish under budget, there’s an unexpected problem waiting to wipe out the savings. If you want to end at the top of the arc, you need to stay on top of each project’s swings.

Every significant cost increase should be accompanied by a change order that increases the value of the contract. If it isn’t, determine why. Was your initial estimate off? Or have you done extra work that wasn’t covered by a change order? In either case, you’re headed for profit fade, and you should find ways to get the job back on revenue-friendly status.

Watch Your Back

In addition to monitoring works in progress, study your estimating and profit histories. Review some good jobs and some that didn’t work out so well to determine where the jobs didn’t meet budgets and whether expenses were allocated properly.

Discuss with your job supervisors whether the assumptions you used in estimating the projects were valid. Did you, for example, realistically calculate the number of bricks your crews could lay in a day? Were your average labor costs accurate?

Also consider direct and indirect costs, and compare your estimates on jobs that lost money to those you used on profitable projects. Then use the results to improve your estimating procedures on future projects. If, for example, projects were delayed because you expected your project manager to obtain final foundation design approvals and shop drawings while also getting the job under way, you may need to revisit your staffing estimates.

Look, too, at whether certain owners cost you money. If one owner consistently moved walls or added doors, you may want to be sure any future contracts with that owner include very specific language regarding scope and specification changes, change orders and schedule revisions.

Perform as Planned

Before work begins, understand fully what you’ve contracted to do. Contract language is often unclear, resulting in differences in interpretations that can disrupt and delay projects. A careful review of your contracts at the start and the subsequent clarifications that are needed can help prevent disruption and delay.

Also make sure your project managers understand the contract language fully. Meet with them before every project to discuss not only the contractual provisions for scope of work and change orders, but also what you bid and why. If your managers don’t know how much you allocated for materials, and how you arrived at that number, they can’t reasonably be expected to meet your budget.

As work progresses, meet with your project managers regularly to make sure they are comparing their actual costs to the bid cost amounts. If a problem arises, they can address it immediately. They should also note the reason for the issue. If you’re typically plagued by weather delays during a certain time of year, you may need to build a little more time into your bids. If a supplier or subcontractor is always late, you may need to find other sources for those materials or services.

If there’s a problem, remember that your leverage is strongest before the project is finished. Owners need your help to meet their goals, and they may be more amenable to approving change orders while you’re still on the job. If you wait until the project is done, remember: Owners have use of the facility and may not have released your retainage. In other words, they’re holding all the cards.

Plan to Succeed

It’s a rare construction project that goes as planned from start to finish. But, if your profit routinely runs out before you’ve completed the final punch list, you have a problem.
To keep profits on a solid footing, constantly review your practices and procedures in order to identify any weaknesses and correct them immediately. You can’t predict every problem, but you don’t have to let profit fade lower the curtain on your bottom line, either.

Sidebar: Why Sureties Care About Profit Fade

Protecting your company from profit fade (see main article) can protect your bonding capacity as well. Sureties get nervous when you don’t make as much money as you expect, so review your projection methods regularly to ensure you’re getting the best possible results.

In addition, you may want to hold off adjusting costs until the job is well over half complete. You may, for example, score a great deal on concrete early in the project, but your savings could easily be offset by a later increase in fuel or labor costs. Don’t change your original estimates until you know for sure.

Last, sureties look at your billing practices. If you’re billing some projects early to compensate for profit fade on others, your standing could go down.
Above all, sureties value honest, consistent information. Don’t do anything that might imply — even slightly — that you’re being dishonest.

Find out how our expertise in construction accounting can add value to your business. Email us or call us at 1 (888) 875-9770.

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