Interpreting construction’s most meaningful metric
by Steve Coughran
June 19, 2018

Today’s volatile construction industry, dominated by demanding owners, labor shortages, increasing competition and shrinking profitability, leaves many contractors wondering “How can we survive amidst growing risk and uncertainty?” To combat the instability, contractors must apply an analytical lens to manage their businesses and ensure long-term viability. Successful contractors possess the tools and analytical capabilities necessary to monitor and continuously refine performance, often relying on income statement metrics, such as revenue growth, gross margin or net profit. More advanced companies combine asset, liability or equity metrics from the balance sheet, such as current ratio, accounts receivable turnover, days of cash, return on assets, debt to equity, return on invested capital and debt service coverage ratios.

To extend your company’s analytical capabilities beyond these two financial statements, you should also analyze cash flow metrics, such as cash profitability or free cash flow trending. However, this extensive combination of metrics alone cannot guarantee company success.

Observing One Metric Beyond Cash Flow

Research indicates that nearly 70 percent of companies that go bankrupt are profitable when they close their doors. This startling statistic provokes the question: How can a company fail when it is profitable? While profit and cash flow are critical metrics, viewing them in isolation, exposes companies to risk. In addition to financial analysis, companies must reimagine the way they measure work by paying close attention to the productivity metric throughput. Without adequate attention, throughput is the lethal operational oversight. Refer to the amount of work your company exerts over a specified period as a key indicator of efficiency and performance. The numerator typically consists of some derivative of field-producing revenue like earned revenue per superintendent, project manager or field laborer. The denominator is derived from some variant of time. For example: monthly, weekly or hourly.

Understanding the Throughput Metric

After adjusting accounting by netting out subcontractor revenue and deferring unearned revenue, the calculation for throughput can reveal significant insight. For the data to provide value, employees must understand the implications of such numbers and how to impact the outcome. To demonstrate, consider the scenario represented below.

When asked to decide which job the company prefers—assuming equivalent selling, general and administrative (SG&A) expenses—93 percent of survey respondents stated they would elect Project A. Based on the given information, Project A is the logical choice, as it generates the highest gross profit margin. However, this situation omits one piece of information crucial to the decision-making process—time.

Shifting Away From the ‘Pick-Two’ Triangle

There is a common contractor exercise that involves a facilitator drawing a triangle and labeling the sides “quality,” “price” and “speed.” The facilitator then instructs the contractor to pick the two sides most integral to business success. The model is intended to illustrate how contractors are constrained by these resources, forcing them to make a critical trade-off and focus on only two of the three sides. While trade-offs are critical to strategy, what if there is a way to maximize all sides of the triangle? What if competing in today’s economy not only enables, but requires you to emphasize quality, speed and price, not just two of them?

In the competitive construction market, quality is now considered an essential element in all products and services. Companies that sacrifice quality, even temporarily, struggle to compete. The importance of quality is evident in Chipotle’s recent scandal following the outbreak of foodborne illness resulting from undercooked chicken. Chipotle’s brand equity slumped after the release of food poisoning reports. Recouping its image and mitigating future incidents cost the company millions of dollars and valuable time. Crisis management distracted the company’s strategic direction. Meanwhile, Qdoba was innovating its products and pricing model, progressing beyond its fast-casual competitor. Chipotle’s brief lapse in food quality detained its success. Thus, quality is a tactical element companies must get right.

Speed occupies the other side of the triangle. Our increasing demand for haste has accelerated the economy where on-demand, next-day shipping and instant gratification are becoming the norm.
The sluggish construction industry, however, has struggled to keep up. Coltivar has found that over 20 percent of projects take longer to complete than originally scheduled, and productivity in the construction sector has decreased by 0.4 percent over the last thirty years in comparison to a positive 2.2 percent compounded growth in all other industries. Innovative companies recognize the need for speed and are devising methods to achieve momentum despite talent shortages and subcontractor constraints. Prefabrication, 3D printing, equipment innovations and other delivery methods are improving the speed of projects. Still, the industry is not yet approaching full implementation.

The final side of the “pick two” triangle is price. This is where misunderstanding most commonly occurs. The confusion stems from viewing price in nominal terms, rather than as a function of time. When the speed side of the triangle is dissected into a component of time and becomes the denominator of price (e.g., weeks, days, hours), the company can maximize the three sides of the triangle, presenting upside for both the client and the contractor.

Evaluating Projects Based on Throughput

To explore this concept deeper, return to Figure 1. Remember, most people responded that Project A was the favorable choice. However, when additional information on the project is provided, true project value is revealed:

Now which job is more attractive? When applying Figure 2’s throughput information, Project B becomes the better choice. This is true because Project A has a throughput of $71.68 (Contract value/Man-hours) in comparison to Project B at $156.25. To emphasize the implications of this scenario, assume the company’s overhead costs are $125 per man-hour. The company would lose money on Project A while earning a 50 percent gross profit margin.

Contractors frequently stumble when focusing on contract value and gross margin percentages. In fact, the chief executive officer (CEO) of a general contractor (GC) approached Coltivar for guidance as his company struggled with liquidity issues. The company had successfully completed jobs for customers and supported its employees for over twenty years. The GC explained that the management team