Prevent Profit Fade

This article is the first in a two-part series. The second part can be found here.

Avoiding profit fade, trending reductions in gross profit on a project, involves adopting these three management practices: (1) identify the causes of profit fade early, (2) quantify its worst-case outcomes and (3) mitigate its causes and seek reversal of negative trends.

Profit fade is best identified and averted when the project information system is integrated into the bidding, billing, costing and project management functions of the company. Within these functions, it is best illuminated by processes that require project managers to provide periodic forecasts of cost at completion. Once the sources of profit fade are identified, they can be addressed.

Recognizing Why Profit Fades
When labor costs get ahead of project completion, the only way to get the project back on track is to know what is happening from a quantifiable standpoint. Typically, profit fade can be traced to six causes:

• Incomplete or overly optimistic estimated production or unit costs
• Underestimated labor or equipment rates
• Unbillable change orders or extra work
• Poor supplier or subcontractor performance
• Inadequate field supervision, resources or training
• Adverse weather conditions

When the cause of profit fade has been identified and quantified, the project team’s efforts to reverse or mitigate the fade must be monitored through the job costing system to determine whether those efforts are successful.

Budgeting for Profit
The ability to identify and manage profit fade begins with a project budget based on the bid and includes a workflow that allows for consistent reporting. Reporting should include current costs and job progress that can be compared to the original cost estimate.

Unfortunately, many companies fail to integrate the processes of estimating, bidding, budgeting and job costing. It is important that bids and costs can be compared easily so that the cause and effect of variances can be identified.

The first step to integrating these processes is to require the estimator to develop a budget for the project before work begins. The budget should be based on the final bid amount and require the inclusion of quantities to measure progress and trends. Phase and task codes for items such as labor time cards and material invoices should be established and universally understood by the field and the accounting office.

Starting with a documented budget allows the company to quantify completion percentages, attribute dollar values to phases and tasks, capture unassigned costs, validate rates and allow for cost analysis in the event of change request, dispute or future bid. Without a budget that is comparable to production costs, it is difficult to identify and control the causes of profit fade.

Meaningful Job Costing
Many problems that lead to profit fade can be addressed through a better understanding of the job’s actual cost. Accurately quantifying work performed allows the project manager to analyze costs more effectively and make adjustments in the field during the course of the project to eliminate or reduce profit fade. Job-cost phase codes should also be used to achieve a unified understanding of cost data between the field and the accounting department. Without a common understanding of this data among all parties, there is no accountability for its accuracy.

Profit fade is most likely to arise from areas where cost and revenue components are not well understood, so phase codes that are established for the budget should be realistic and meaningful. Consistency is more important than granularity. If there are too many phase codes, employees may err when assigning tasks to codes and, in doing so, render reports inaccurate. Periodic review of unused or overused phase codes will allow managers to identify tasks that are ill defined. Finally, productivity and unit cost trend analysis relies on consistent reporting of the quantities of work completed during the accounting period.

Adopting Best Practices
Use the following methods to mitigate profit fade:

• Use phase and task codes in your budget and job cost system.
• Report labor and equipment usage on a daily basis.
• Report and enter completed quantities of work on a daily basis.
• Allocate payroll tax, insurance, benefits, equipment costs and overhead by code consistently.
• Implement a purchase order system to track committed job cost.
• Track equipment utilization, ownership and operating costs by each piece of equipment.
• Produce labor cost reports by job and phase and distribute weekly.
• Produce monthly job profitability reports.
• Require that project managers forecast construction costs at completion on a regular basis as determined by the size and complexity of the project and the company’s reporting needs.
• Require bids and forecasts to be approved by management.
• Establish a plan for remedial actions to be taken when necessary, including adjustments to crew size, equipment assignments and schedules.
• Include completed jobs in individual project managers’ profit fade analyses.
• Discuss reliability of profit fade estimates with project managers.

Adopting these practices is the first step in a continuous improvement process that will boost profitability and help you communicate with surety underwriters and bank loan officers.

The Impact of Proactive Measures
In construction, it is rare for projects to be completed exactly as planned. The true measure of control is the ability to manage the changes that occur. Along with assisting with efficiency and internal transparency, such awareness shows the surety underwriters, loan officers and other users of financial statements that the company is able to identify profit fade early, analyze its causes and lessen profit fade as projects move toward completion.