Steve Coughran, CPA, is chief financial officer of the international construction company EMJ Corporation and is a management consultant. Coughran has launched and managed three cross-industry companies and has developed and led programs, such as the Strategic Financial Leadership Academy and the “Growth-Driven Leadership and a Strategic Financial Leadership” course at the University of Denver. Coughran holds a master’s degree in business administration from the Fuqua School of Business at Duke University. His book, “Outsizing: Strategies to Grow Your Business, Profits and Potential” is available at Amazon.com and major bookstores. Visit stevecoughran.com.
In recent decades, headlines about “the rich getting richer” have cluttered top media outlets. While the nation has heartily consumed stories of income inequality, few are informed about the primary engine of this disparity—the stark earnings gap amid corporations. An economic partition separates top earners from lagging organizations, creating a distinct fissure between the haves and have-nots.
According to Nicholas Bloom’s Harvard Business Review article, “Corporations in the Age of Inequality,” a slim percentage of top-earning companies actually earn significantly more profit than their rivals in what’s been deemed the “winner-takes-most” economy. This enables these winners to pay more for sought-after skill sets and top-tier workers (fueling an income gap) and, therefore, leverage high-caliber talent to continuously outperform and outearn within the market.
In Fortune’s annual list of the United States’ 10 most profitable companies, seven of the 10 remained on the list from 2016 to 2017. (Apple has been the country’s most profitable company since 2015.) It’s a virtuous cycle, wherein profit leads to profit, and industry leaders pile on to their successes. The companies at the top are not only staying at the top; through continued improvements, they are elevating the boundaries of the top tier. As leading companies earn more, there is less profit remaining for lagging companies, only widening the gap.
To demonstrate the divide in the construction industry, I partnered with the Construction Financial Management Association (CFMA) and Coltivar Group to analyze a representative sample of 363 industrial and nonresidential U.S. construction companies ranging from $1 million to over $1 billion in revenue. I measured economic profit, net income and less-weighted average cost of capital x invested capital (i.e., net property, plant, equipment plus working capital), as an objective lens to compare the companies.
While accounting profit is referred to as earnings before interest, depreciation, taxes and amortization (EBIDTA), net operating profit after taxes (NOPAT), or net income, is often companies’ default metric due to its familiarity and simplicity. However, this metric does not represent the flow of money. Accounting methodologies surrounding depreciation, amortization, impairment, provisions, valuation and accruals can mask the true economic performance of a company.
Economic profit, on the other hand, acknowledges the opportunity costs of making tradeoffs by measuring net operating profit (less taxes) after subtracting the cost of capital. Therefore, it provides a more impartial view of financial performance.
After computing the economic profit earned by each firm, I segmented the results into deciles (e.g., bottom 10%, illustrated in Figure 1). While 50% of companies had a competitive advantage, defined as the ability to earn above-industry-average economic profits, the calculation revealed that companies in the 10th decile, or top 10%, earn 64% of all economic profit.
And the top 20% earn nearly 83% of all economic profit, fulfilling the Pareto principle, or the 80/20 rule: The remaining 80% of companies (even those that technically earn a competitive advantage) are confined to the dog-eat-dog environment of the lower deciles, where they contend for leftover scraps of industry profit.
What determines this inequitable distribution of economic profit? How did these successful contractors achieve the initial success to advance up the curve? Though many assume that greater capital and resources automatically funnel into economic profit, a company’s size is a negligible determinant of decile.
In fact, 51.4% of contractors in deciles nine and 10 earn less than $100 million per year, and only 23.6% earn $500 million or more in revenue. As such, smaller contractors are earning a coveted position on the economic profit curve next to larger rivals. Growing the top line in the short term does not necessarily result in margin improvement over the long term; the differentiator must be strategy.
The book “Outsizing: Strategies to Grow Your Business, Profits, and Potential” defines how great companies design and implement strategies that propel them along the economic profit curve. While the top 20% of companies are capturing most of the profit, interviews and surveys of thousands of executives and employees revealed merely 10% of respondents reported being highly satisfied with their strategies.
Once companies leverage robust strategy design and execution to truly tap into their potential, they can make incremental improvements and bold moves, advancing along the profit curve.
1. Build From Advantages
To create a powerful strategy, companies must first understand customers’ unique values and capitalize on inherent positional, asset and capability advantages to better serve them. Take for example, the patent, one of the most common and powerful asset advantages. Research has shown that “the industries that have sustained the highest average returns are those that ‘rely on sustainable competitive advantages, such as patents’,” according to “Even for Companies, the U.S. Is Split Between Haves and Have-Nots,” by Sam Wilkin, Harvard Business Review.
In “Drug Companies Have Big R&D Expenses and Still Make Large Profits,” featured in Fortune magazine, Erik Sherman says that though they bring in only 23% of the revenue, pharmaceutical companies earn 63% of the U.S. health care industry’s profits. “Big pharma” has devised solutions to customers’ health needs and protected these investments by investing in lucrative drug patents.
In other industries, companies may drive profit through positional advantages. For instance, Walmart touted a 2018 gross profit margin of nearly 25%, according to Statista. The megabrand has defined itself as the low-cost leader. By predominantly establishing a presence in rural and suburban areas, the retailer operates with “2.5 times as much selling space per inhabitant in the poorest one-third of states as in the richest one-third,” said Kyle Emory, in “Walmart’s Rural Dominance: A Brick & Mortar Advantage in an eCommerce Battle.” The company has minimized its property prices through the establishment of low-frills stores in inexpensive areas, allowing it to squeeze out an additional cost advantage over competitors.
Other companies capitalize on unique capabilities, bundling individual skill sets, managerial techniques, company culture, team ability and expertise to execute. Some companies drive cost reduction through the corporate capability of efficiency.
Through building information modeling (BIM), project management software and automation, construction companies digitize their processes to cut costs. Once a company determines its advantages, whether it be assets, industry position or capability, they are better equipped to pursue investments, allocate resources and make strategic decisions that result in value capture.
2. Understand Key Financial Levers
When magnified, each of the economic profit deciles slope slightly up and to the right. Therefore, companies must design strategies to drive incremental improvements that enable them to overcome the gravity of their deciles. Over the past 2 decades of working at companies in a variety of industries, I have witnessed financial misunderstanding and misinterpretation as a slipping point for organizations that tilt to the left side of the decile.
Financials are often obscured by leaders’ struggles to discern the story behind the numbers. They mistake profit for cash and run out of fuel for the business. They ignore throughput, leverage inaccurate forecasting to navigate decisions, and/or fail to tie their metrics to strategy.
Driving economic profit requires companies to understand what profit truly is. Companies must know the levers that they can pull to achieve results. Financials reveal insight into strategic operations, indicating areas of strength and weakness and guiding company focus and procession. Business is a machine impacted by every individual. A strong base of organization-wide financial knowledge is the start to growing the bottom line.
3. Build Mechanisms to Execute
Finally, high-performing organizations instill discipline into their cultures. Creating and acting on an outsized strategy requires significant effort. However, design and implementation are facilitated by making strategy habitual. While mission, vision and values may point companies in the right strategic direction, efficacy is achieved through consistency and cumulative improvement.
Contractors in the top deciles create initiatives, actions and results by defining their overarching objectives, distinct activities to achieve them and the metrics to track their progress toward key goals. They forge accountability. These contractors don’t grow profit by making it the focus of their strategy. Rather, their spot on the curve is a testament to their unique, customer-centric advantages; their financial prowess; and a firm commitment to their strategies.
By intelligently leveraging advantages and financial information, firms can make great strides to advance along construction’s economic profit curve within a given decile. Whether a company is operating on the left or right end of the curve, the focus should be on winning within their decile, earning their fair share of economic profit and steadily advancing up the profit ladder.