Understanding profit dynamics — and how they vary between different types of construction projects — is vital for maximizing profitability and customer satisfaction
Don't let profits pass you by. Although this may seem like obvious advice, many people establish a specific routine when it comes to selling and managing a particular type of project in the construction industry. When they're faced with selling or building another type, they often don't consider the different profit dynamics and end up leaving crucial profit dollars behind.
Profit dynamics aren't hard to manage once the basics are understood, which is the goal of this article. To help you lay a solid financial foundation, first we'll cover the customer satisfaction equation and how profitability plays into it. Then, we'll move onto the basics of a profit & loss (P&L) financial statement, including the differences between gross and net profit. From there, we'll explore the profit dynamics for different types of construction contracts.
The customer satisfaction equation
Most people instinctively get this equation (customer satisfaction = perceived value - customer cost), and usually try to create customer satisfaction by cutting the cost to the customer. What they don't realize is that this mind-set hurts profitability, directly limiting their ability to continue doing this in the future.
Consider the price of fuel, for example. People typically don't perceive the value of gasoline to be $5 per gallon, so they grumble whenever they buy gas. This leads to the blame game. In this case, it's the “big oil” companies that are at fault. The focus becomes how much profit these companies must be earning.
Rarely can a company cut costs enough to make the customer happy while maintaining a viable business. In this example, if every oil company refunded 100% of its profits, it would only change the price of gasoline by a few percentage points. In reality, people don't perceive much difference between $4.90 and $5.00 per gallon, so they'd still be unhappy.
The P&L statement is a summary of all revenue and costs for a specific period of time. It is one of the core financial statements that indicates the financial status of a company. The top three numbers in the Figure (click here to see Figure) are based on a specific project. These are the numbers most often discussed, but only show a partial picture. Not surprisingly, they can often lead to misconceptions about the profit dynamics of different projects. After the top three line items, two major costs need to be factored into the profit equation: indirect job costs and overhead. In the end, the number leftover is net profit or bottom line. Ultimately, this is the number that really matters.
Each company will have a slightly different way of defining the differences between direct job costs, indirect job costs, and overhead. To fully understand the impact your project-level decisions have on the bottom line, you'll need to have an understanding of how your project impacts all three of these cost items.
Gross profit versus net profit
Two factors are typically discussed when it comes to profitability: revenue and/or gross profit. Revenue or top-line is the easiest to talk about, is the same across all companies, carries the most bragging rights, and is what all of the “top contractor” lists measure.
If there is any focus inside the organization on discussing profitability, it's usually at the job level and is about gross profit. This number (shown as a percentage) varies widely between companies, depending on how each company classifies costs as direct, indirect, or overhead. Trying to compare gross profit numbers between companies — or even different project types — is useless without a deeper understanding of how costs are classified. What really makes a difference is how all of these numbers work together to create the net profit or bottom line, as is evidenced in the following examples:
Projects that are paperwork intensive, requiring a lot of change orders and time and material (T&M) billings, will use more overhead in the way of accounts receivable, administrative, and contract administration costs, thereby lowering the project's impact on the bottom line.
A project with a quick schedule and lump sum with few changes, on the other hand, will have a much lower impact on overhead costs. Therefore, it will have an increased positive impact on the bottom line.
Warehouse, purchasing, and delivery costs are typically considered indirect or overhead costs. A foreman who plans poorly, or a job requiring many changes, will drive these costs up quicker than a job only requiring weekly material orders.
Typically, as project sizes decrease down to the point of service, projects have a higher impact on indirect and overhead costs. It costs practically the same to write a $50,000 purchase order as it does a $500 one — or to produce a $100,000 invoice compared to a $1,000 one. The smaller the project, the higher the gross margin must be to maintain a similar net profit.
Why profitability is good
Many people have a skewed view of business profits, which is largely due to the nature of many media messages and general misunderstandings about the intricacies of operating a business. Operating a construction business encompasses a myriad of challenges, including unforeseen problems, bad estimates, cyclical business cycles, and a difficult labor market.
Additionally, with today's tight credit market, many developers and project owners are either filing bankruptcy or are slow on payment. These same credit conditions are also hindering your ability to obtain credit — at a time when you need it most. Only by having a consistent, appropriate level of profitability can you invest in your business and grow through both good and bad economic times. Consider the areas a business invests profits in. What happens when profitability is inconsistent?
It's critical for you to heavily invest in recruiting and training, especially with today's tight labor market. These investments allow you to compete on price and project delivery.
Construction companies tend to have cyclical work cycles. During downtimes (i.e., winter), if you haven't saved enough of your profits to carry you through, your required capital falls short, and you'll likely make cuts and other short-term decisions that will hurt the business in the long term.
Customer service and profitability are closely linked. Most businesses that provide fantastic customer service also have fantastic levels of profitability. It's a huge mistake to believe the customer only cares about price, and the only way to deliver the lower price is to cut profitability.
Ultimately, many contracts are awarded on the basis of price. You must make investments in cost-saving technologies and systems.
Profit dynamics & construction contracts
Multiple variables are inherent to the profit dynamics of different project types, some of which are referenced above. Let's drill down a little deeper and review some basic contract types as well as what specific profit dynamics affect each.
Lump sum/fixed price/stipulated sum — In this type of contract, the contractor agrees to perform a specific scope of work for a set price, which can only be modified via a change order. Key profit dynamics include:
Solid estimate: Without a thorough and accurate estimate, making a solid profit is unlikely. Feedback loops between operations and estimating are crucial to continue tightening the estimating process.
Clear scope: With a fixed price, it's critical to be clear on exactly what is and isn't included. Everyone on the project team must thoroughly understand the scope. It's not uncommon to see a field crew perform a scope of work just because they did so on the last project, even when it has been excluded from the current project.
Early buyout: Purchasing the materials and subcontracts required to build the project for the budget dollars that were in the estimate, or even saving money at this stage, is a big driver of profitability.
Monitoring production: Monitoring field productivity to make sure it meets or beats the estimate is essential. If there are variations, these should be noted frequently, and every effort should be made to experiment with changing methods or people to meet the productivity goals. All productivity issues should be discussed regularly with management so that better estimates can be produced in the future.
Unit price — In this case, the contract value is described as a series of specific items with a price and cost per unit, along with estimated quantities. The contractor is paid for the quantity completed multiplied by the unit price.
Key profit dynamics include all of the items above plus a quantity management factor. Having a good idea of what the final contract value will be is vital. You can only do this by regular surveying the job site to determine what the final quantities installed will be. The quantities listed in the contract are often estimates; therefore, they can vary significantly from the final numbers. When preparing the bid and setting individual pricing for each unit, knowing which quantities are likely to run over or under will allow you to place different values on them that enhance profitability.
Time & material (T&M)/cost-plus — This type of contract method is common for certain change orders within other contract types, as well as for whole projects. Typically, it is used when: (1) the scope isn't able to be clearly defined prior to beginning construction, (2) unforeseen conditions are encountered, or (3) the project owner believes it can be managed so that the total cost will be lower than a lump sum.
Usually, contractors are reimbursed for labor, materials, and other expenses. They are also allowed a markup in order to cover overhead and profit. Sometimes, these contracts are done as a “fixed fee,” where the contractor is allowed a fixed amount of money to manage the project, including overhead and profit, regardless of the ending direct job costs, which are reimbursed.
These contracts and change orders are challenging to manage because most people hear the term “T&M” and assume there is no real risk involved. Therefore, management often becomes sloppy, costing precious profit dollars. The key points to remember when managing these contracts are: (1) they are very labor intensive internally and (2) while the downside risk is limited, so is the upside.
On a lump sum contract, if you do phenomenally well and bring the job in at $20,000 under budget, you'll not only get the overhead and profit you had in the bid, but you'll also recoup additional cost savings. For the T&M contract, the cost savings will be passed through to your customer. If your markups are set as a percentage, you will actually make less profit and cover less overhead. For this reason, it's important to pay attention to every detail, including:
Labor rates: Negotiate your labor rates so they cover all costs. The rates you negotiate up-front determine your profitability. Unless there is an ability to cover indirect costs, such as material deliveries, safety equipment, vehicles, small tools, etc., elsewhere in the contract, these need to be covered in the labor or material commodity rates.
Billable/non-billable labor: Making sure that as many costs as possible are billable to the project will enhance profitability. For instance, will material delivery time from your warehouse to the job site be billed? What about your project manager's time? How about the contract administrator or assistant who helps prepare the detailed T&M billings?
Material commodity rates: Negotiating how material pricing for commodities, such as pipe and wire, will be charged to the customer is crucial for streamlining the billing process, and also for ascertaining that things like procurement time, deliveries, and material-handling costs are covered.
Contractor-owned equipment: If the project requires use of equipment the contractor owns, how will these be paid for and at what rates? If they will not be paid for separately, then these costs should be built into the labor rates or recovered in some other way.
Small tools: Figure out how equipment like pipe threaders and benders will be recovered on the job. Many of these tools are very expensive, so it's unfair for you to purchase them and then pass the labor savings on directly to the project owner without getting reimbursed in some way for their investment.
Markups: Depending on what is and isn't allowed for the above items, you'll have to negotiate the markups (percentage of costs) at a level that will cover the indirect and overhead costs of building the project, as well as providing a reasonable level of profitability.
Fixed fee: If the project is fixed fee, then it is critical to manage the project to come in close to the original budget and duration that the fee was based on. If their project size changes substantially, or will be an extended duration, it's important to try to negotiate an increase in the fee to compensate for the additional overhead costs.
Tracking/billing: All of the above points are part of the project startup. The crucial steps occur daily with tracking every detail of the project costs and making sure they get to the billing correctly. Every time a foreman doesn't write down material or tools used, it eats into the profitability of the project, which is rarely recovered. Have training for each element on what costs are going to be billed for a particular project, and make sure your people are trained to track things at that level.
The last thing to keep in mind is no project execution will ever be perfect. Although you'll almost certainly never reach 100% on any of the items discussed in this article, by trying to apply these lessons on a daily basis, your project teams will become as profitable as possible.
Brown is the founder/president of D. Brown Management, a consulting firm located in Lodi, Calif. He can be reached at firstname.lastname@example.org.
Sidebar: Operational Profit Killers
- Not controlling cost and production effectively
- Not tracking billable items
- Overrun on schedule — extended general conditions
- Too much job-site overhead (general conditions)
- Office overhead costs too high
- Missed change order opportunities
- Not closing scope gaps with subs and vendors
- Damage to vehicles and equipment
- Damage to installed work on the project