Contractor Profitability: Tracking Real Profit

How much money are you making on that job that’s wrapping up?  Not sure?  You’re not alone.

Unfortunately, many contractors-some who are quite successful-are not able to effectively measure their real profit on many jobs. In a business that is labor and material intensive, with razor-thin margins and innumerable variables, tracking real profit without a high degree of accuracy can be a fatal mistake.

Beyond just knowing where you stand so you can plan for the future-two important factors-the ability to stay in business and maintain good cash flow can be threatened if you are unable to show a lender or a surety that they are making money on their jobs.

We have worked with hundreds of contractors with a variety of systems for tracking real profit and have found that the most successful among them follow a number of key steps and measure certain vital components. Among the most important are those that affect job costs, so that’s the segment we’ll examine first.

Job Estimating

In order to make a profit on any job, a number of variables must be accounted for and carefully considered; one of the first to think about is job estimating.  You could do excellent work, manage the project well and complete the job on schedule only to lose money on it because you made inaccurate assumptions when you were estimating the job.

An important part of job estimating is factoring in a certain amount of gross profit, usually measured by percentage. However, to figure in a proper percentage, you must have a good handle on other aspects of your estimate. Otherwise, the figure that was initially a solid percentage will wind up being a much smaller percentage of what you actually spent on the job when the final costs are calculated.

Many contractors fail this important area, and when their profits are smaller than anticipated, they simply attempt to make up the difference on future jobs by increasing their fees and expecting their workers to get the work done in less time. This rarely, if ever, works and does not address the fundamental problem-a lack of knowledge about what the job will cost. This issue leads to numerous other problems and can prevent the contractor from effectively managing his business and productivity.

Successful contractors break an estimate of the job into phases and plan the way it will be billed.  This helps them analyze when costs and billings will occur during the life of the job.  The contractor can then project cash flow for the job and plan accordingly.  A contractor should do his or her best to break down the schedule of values to his or her benefit, resulting in positive cash flow from the beginning of the job.

Job Costing

A key component of tracking real profit is accurate and thorough job costing. Job costing is the system you use to account for costs associated with each job. If these figures are not accurate, you may wind up forecasting false or inaccurate profits on a job. When the final accounting is done, you may have actually lost money on the job. In some instances, depending on your financial systems, it may be difficult to actually track your job costs; you could wind up losing money and not understand where those losses stemmed.

There are a number of key job costing components, all of which must be carefully analyzed and accounted for:  (Not every component will be applicable to every contractor.)

Labor

Obviously, if you are not a general contractor, labor is one of the largest single cost factors of any job. It’s unlikely to be overlooked, but can easily be underestimated.  These costs can be tracked against the budget based on hours or dollars..

Materials

Following close behind labor is the cost of materials. Also a seemingly simple concept, this cost would appear to be the actual dollars paid for the materials you use to complete a job. However, this figure should also reflect carrying costs such as storage, interest payments (if you had to borrow the funds to purchase the supplies) and even the opportunity cost of any money tied up in materials that may not be recouped for many months.

Subcontractors

Careful attention must also be paid to subcontractors’ costs and how they are estimated and tracked.  It is customary for a contract to be signed, fixing the cost of a specific part of the contract.  You must ensure both parties are on the same page regarding the scope of services, or you could find yourself spending unanticipated dollars to finish a job.

A handful of other overlooked or underestimated job costs include:

Payroll taxes

When calculating labor costs, a separate line item should be established for payroll taxes. This is a significant number and includes FICA and state unemployment taxes, among others. These are large numbers and should be broken out separately for tracking and benchmarking purposes.

Insurance

Insurance is a huge cost these days. There is a range of different insurance types that must be considered including: general liability insurance, worker’s compensation insurance and pollution insurance (among others). Depending on your specialty, there may be other insurance you pay as well. All costs should be allocated across your various jobs, based on actual exposure.

Equipment

While you probably do not directly charge your clients for equipment, you should factor it into your estimates and job costs. If you have invested in a backhoe, for example, and have cash tied into the piece of equipment or a financing line you have tapped to pay for it, you should allocate some of those costs into each job. Equipment costs also include costs for wear and tear, maintenance and possibly training.

A simple way of calculating equipment for job costs is to determine the rental cost for that piece of equipment, plus a reasonable markup, and then use that number in your job cost calculations.

All costs should be monitored against the budget or estimate.  The monitoring process is different depending on the job.  Some jobs are very complex or have small margins and may require daily or weekly monitoring, while other jobs may only require bi-weekly monitoring.  Every job should be analyzed on a regular basis to make sure costs have not been incorrectly charged.

When there are frequent comparisons of job costs to budgeted costs, change orders and potential claims can be identified early and addressed before they become a problem.  Many contractors forfeit considerable profits by not monitoring the situation.

Scheduling/Project Management

Lost time can be a major source of lost profit to a contractor, which is often not fully considered when planning and managing a job.  Effective project management with proper scheduling and sequencing provides the project manager with a road map of the project. This road map, or schedule, will help ensure that critical activities will be completed on time. It positions the contractor to deal with the unexpected as quickly and as cost-effectively as possible, all of which will increase the chances that the project is completed on time and on budget.

There are, of course, some projects that will not finish on time. Although it may be a logistical issue for the owner if the job is not completed on time, it could be a huge financial issue for the contractor-as the planned completion time passes, more and more expenses are incurred, which can eat into your profit significantly.

There are consulting firms that can assist a contractor with project scheduling. The key to an effective project scheduling effort is the ability to identify critical activities in the project that must be completed before other work can continue and then to set up a system, which could include the tracking of associated labor and materials. This will allow those critical dates to be hit on time, so that work can continue per the schedule and as efficiently as possible.

Ian Street, president of Nautilus Consulting, whose firm works closely with many successful contractors, has explained construction scheduling this way in his seminars:

“Construction scheduling, at its most basic level, can be compared to preparing a Thanksgiving dinner. If you want to have the turkey ready by 3 PM and it takes six hours to cook in the oven, the turkey had better be in the oven by 9 AM. In order to make sure that happens, it needs to be thawed and prepped prior to 9 AM. Each of those steps has critical points that must be met to stay on schedule. Proper job scheduling puts together a visual map to help ensure those critical points are met, the job stays on schedule and is ultimately profitable.  Contractors we have worked with view scheduling as a cost of doing business that ultimately pays for itself with increased efficiency throughout the construction process.  For those contractors we’ve worked with who have lived through the nightmare of projects gone bad, it was the intelligent use of the project schedules that minimized their loss, and in some cases, led to full recovery of profits that would otherwise have been lost.”

Accounting Systems

Having a strong accounting system is vital to the process of tracking real profits. Beyond simply keeping track of accounts payable and receivable and serving as a general ledger, accounting systems can be used in more sophisticated ways as well. Job costs, such as materials and labor, can be clearly tracked if they are captured in your accounting system.

Yet, many companies are unaware that these programs also have the ability to track job costs and employee time. In addition, industry specific software allows owners to run a profit/loss statement per job to track every expense and bill including how overhead was allocated. 

“Contractors are often surprised by the amount of information that can be tracked with these systems and the power that information can have on their bottom lines when they analyze it and make business decisions based upon it,” said Robert J. Murray, CFE, president of GCM Systems, an information technology consulting firm that works with contractors on their accounting systems.

Benchmarking

If you are not already familiar with it, benchmarking is a key management concept that is making its way into the construction industry. It can be a powerful tool in helping you run your business more profitably.  Benchmarking is simply keeping track of how you do various things and comparing that with accepted industry standards to see how you stack up. Things that can be readily benchmarked include wages paid to workers, technology expenses, capital ratios, profit margins and more.

For example, a Fischer, Miertschin and Pollack research paper on benchmarking in the construction industry indicated:  “There is a tendency to overestimate total costs by 8 percent (on average) and underestimate schedule by 8 percent (on average), while change orders average +11 percent.”

Depending upon your specialty, more or less benchmarking data may be available with a little research. Your accountant, if well-versed in your industry, could also be an excellent source of benchmarking data, as he or she likely has key performance indicators (KPIs) for a number of other construction companies, some of which may be similar to yours.

For contractors who currently do not track real profit, or do a poor job of it, the good news is that there are tools and concepts in the market that can help them to begin to do so.

In addition, technology tools-some of which you may already have at your disposal-can be a powerful force in successfully tracking job costs and, ultimately, real profit.  The use of benchmarking data and scheduling software or consultants can also help ensure you’re on the right track.  In any case, if you begin to take steps in the right direction, you will find that you are better able to get a handle on your business, better manage its profitability and ultimately enjoy the fruits of your labor.

David S. Warshauer, CPA, CCIFP, is a manager at Grassi & Co., CPAs. Grassi & Co., CPAs is headquartered in Lake Success, NY, and has additional offices in Manhattan and worldwide through Moore Stephens International Limited. Warshauer can be reached at 516.336.2407.

Construction Business Owner, April 2008