This article is the second in a two-part series. The first part can be found here.
All contractors experience profit fade, a trending reduction in gross profit on a project, at some point. However, the magnitude of such a loss of profit can be mitigated if the correct controls are in place.
Since construction companies often have projects underway when interim and year-end financial statements are required, they also often have to estimate projects’ profit on their reports. If these estimates are not required periodically or do not accurately consider productivity, committed costs, timing of posted transactions and probability of supplemental revenue to compensate for extra work, these statements will be misleading.
When companies properly apply generally accepted accounting principles to their financial reporting, the impact of profit-affecting events is mitigated. The profitability graphs below illustrate this concept:
Each graph illustrates the effects of the same event causing profit fade. The difference is the manner of reporting.
Graph A illustrates the reporting of profit on a project in which the manager refuses to believe that overall profitability was at risk following a profit-impacting event. Once the final revenue and costs are known, the loss of profit can no longer be mitigated, and the result is a surprise ending.
Graph B illustrates a trend of increasing profit fade as a project moves toward completion. In this example, the project manager believes profit in such an event is reduced only by the amount lost on the work completed by the date of the discovery, and no steps are taken to stem profit fade. In fact, as reporting continues in this case, it becomes clear that profit fade has taken place over the life of the project, and profit is affected drastically.
Graph C illustrates the proper application of generally accepted accounting principles. In this situation, the magnitude of the negative impact on the project is estimated, and a conservative reduction in the estimated profit is applied as soon as possible after the event occurs. As time lapses, the full impact of the event is mitigated through adjusted project management practices or negotiation of increased revenue. As this illustration shows, it’s best to communicate bad news as soon as it is discovered and good news when it is certain.
Monthly or quarterly forecasts of profit at completion also ensure that the field supervisor, project manager and accountant use the same set of data to understand the profitability of a project, collaboratively develop solutions and accurately report the projected outcome on the work-in-process summary. Unfortunately, many companies do not give this practice the attention it deserves. These companies are unable to reverse or stabilize profit fade.
The Project Manager’s Role
It is an essential function of project management to understand the causes of incurred and anticipated costs in the final project revenue. The project manager is the best person in the company to provide top-of-mind knowledge of the budget, estimated productivity, scope of work, status of change orders and costs on an ongoing basis. Equally important is the project manager’s understanding of the potential for pending change-order pricing to be resolved in favor of the company. The project manager may also be the first to discover reductions in scope that will adversely impact revenue to a greater extent than the associated cost, leading to a reduced profit forecast for that item of work.
An accurate and current job cost report with estimated productivity compared to actual productivity is essential for the project managers, accountants and executives who are responsible for profitability estimates. Project managers do not always fully comprehend the concept of accounting periods and often rely on the cash position of the project (revenue minus cost) to develop estimates of profitability. Unfortunately, this does not take into account factors such as a large invoice the project manager may have approved, thinking that it was included in the booked job cost. Such misunderstandings can lead to underestimated costs, overestimated profits and adverse discoveries that come too late to address.
Projects that experience less-than-estimated productivity often show a negative cash position or under-billed status when evaluated on a cash basis. To improve the reliability of forecasting, an explanation of any under-billing should be required by management. Advance material purchases that cannot be billed until installed, differences in billing and accounting period cutoff or delays in billing change-order work might constitute acceptable reasons for under-billing. Similarly, under-billings resulting from poor productivity early in the project must be analyzed to understand the increased productivity required from the time of the projection through the end of the project to achieve the average productivity estimated at bid time. To carry inexplicable under-billings or to insist that change orders will be approved despite continuing denial by the customer will result in the kind of surprise illustrated in graph A.
Along with being inherently useful, forecasts that accurately estimate cost impacts due to varying project circumstances are also valued by surety underwriters and loan officers. These professionals appreciate forecasts that attempt to identify the full magnitude of the profit fade at the point of discovery rather than exhibiting increased fade over time as the earnings increase at a slower pace than cost. Similarly, contractors strain their relationships with all users of financial statements when forecasts proclaim “all is well” until a negative cash position is discovered at the end of the project. Such lax reporting misleads the users of the financial statements and highlights the absences of effective forecasting processes, proactive project management and ongoing financial oversight.
Inaccurate forecasting undermines the credibility of a company’s reporting and management practices. Demonstrating the company’s interest in early detection, accurate forecasting, proactive mitigation and predictable results authenticates the management staff as professionals. It is essential that business owners require managers to know each job’s profit position on an ongoing basis and to be working to improve it.