Construction Today

Taken by Surprise

Staying profitable in a competitive bidding environment requires contractors to understand their key financial data, or risk making bad decisions.

by Mike Rudd

An increasingly competitive bidding environment in the construction industry is catching some owners by surprise. If owners don't wake up and pay attention to the tightening of profit margins, their companies will take a big hit, and some of them won't survive. To avoid this recipe for disaster, it is essential for construction company owners to really understand key financial data and use this information to prepare accurate, competitive bids that don't jeopardize the company's future or put its financial and personnel resources at risk.

Key Industry Indicators

The growing number of competitors or bidders is a key indicator that a competitive environment exists. Contractors who once shunned smaller or less-complex projects are actively seeking these contracts. This greatly impacts smaller businesses because bids from larger contractors usually reflect the experience and efficiencies not available in smaller firms.

A second indicator is when a higher percentage of bids appear to be under the market value. Sometimes builders will submit low bids to win multiple contracts within a subdivision. Then, if the contract is awarded, the company might charge a higher price in the future to make up for the low price on the first job. This can be a dangerous strategy to follow.

Yet another indicator of changing economic conditions relates to terms of payment in the marketplace. When vendors and suppliers tighten credit, require payments to be made per terms and insist co-pay checks to satisfy lien releases, it signals a tightening of the economy. As a result, more pressure is put on a company's cash flow, potentially requiring increased borrowing, which in turn reduces profitability.

During this kind of environment, industry players focus on short-term survival. The most common reaction – and a flawed one – is to drop prices to ensure there is some work in the pipeline. Ultimately, this leads to a decreasing cash flow and a downward spiral of the organization.

When the bid-to-award ratio decreases, revenues tend to drop. For example, a contractor could usually count on a 32 percent award ratio but, in a competitive bidding environment, this ratio may drop to less than 10 percent. The work reduction increases the pressure on the business, causing a domino effect.

First, owners who fear not having enough work to keep employees busy often "make work" to keep employees engaged in non- or minimally profitable work. Then, because employees are spending time in the shop, the variability of labor becomes fixed. This triggers a jump in the overhead rate, which, in turn, increases costs while profitability plummets.

The consequences continue. Labor productivity decreases as employees stretch out the work. Project costs increase, resulting in less profit and forcing the business owner to bid less on future jobs. This results in lower margins, causing a cash-flow shortage that does not enable a company to maintain its vendor relationships. The downward spiral continues until the business owner can no longer meet the business obligations, and the result is bankruptcy.

Understanding the Financials

The biggest weakness most construction companies face, especially in this marketplace, is the lack of understanding of key financial data. This includes knowledge of what information is required to manage and control their business environments through both prosperous and lean economic times. As a result, many business owners make bad decisions.

One way to remedy this situation is to create a chart of accounts that realistically represents the actual activities of the company. For example, break down the revenue categories into the actual types of businesses, such as commercial, residential new construction, residential remodel, tenant improvement or government work. This differentiation is important because they each have significantly different margin contributions. As such, being weighted to one as opposed to the other requires a different approach to the work. Include only the truly variable costs – sometimes referred to as cost of goods sold – such as labor and related burden, including union burden if applicable; equipment rental; materials; and sales commissions.

Also include indirect costs. Tracking indirect costs allows business owners to account for costs related to working on projects even if they can't be allocated to one specific project. Some of these categories include supervisor wages; estimating wages; small tools and supplies; consumables; training; fuel and oil; and auto and equipment repair.

In addition, the chart of accounts should include comprehensive general and administrative expenses such as accounting fees, amortization, interest, rent, owner's wages, administrative wages and utilities. By charting all the accounts and revenues, business owners can keep track of their key critical variables, allowing them to make smarter business decisions when preparing bids. When construction company owners know the business overhead rate and can apply it correctly to establish breakeven points for each bid, they will see that bidding under this number is a losing proposition.

Employee Productivity

Once a bid is won, it's essential to hold employees accountable for productivity. One way to accomplish this is to require the production superintendent to buy off on the bid prior to submission to reduce the "not-my-fault" syndrome. Additionally, develop performance-based job descriptions with and for key employees. For example, if the company has a 20 percent bid-toaward ratio and one of the company's objectives is to generate $5 million in revenues, then the estimator must bid at least $25 million to achieve the company's objective. Translate this into daily, weekly and monthly standards. These performance standards must be developed with the employee.

Another strategy to remain profitable is to develop excess-profit-based incentive plans that reward employees for areas under their control. Employees have no control over rent, owners' wages and truck payments. Therefore, if the incentive is tied to the company's overall profitability, it can be de-motivating for employees. On the other hand, employees typically have control over variable costs, labor, materials, overtime and consumable supplies.

Excess-profit incentives are based on the premise that the business owner requires a minimum return on the risk of being in business, and a profit amount is set aside for the owner's future and value of the company. For example, an owner has determined that a margin contribution of 34.5 percent is required to achieve the return on risk and provide adequate profit. Any amount over this minimum percentage is eligible for incentive rewards. The objective is to stimulate employees to take active roles in managing the job profitability. This plan contains both positive and negative components to motivate employees to work as a team.

By knowing their strengths and weaknesses and initiating strategies to mitigate weaknesses, companies can remain afloat during difficult periods. Understanding the costs of doing business, establishing the break-even point for bidding and rewarding and motivating employees will help companies survive, no matter how desperate the situation.

Mike Rudd is director of client services with International Profit Associates and Integrated Business Analysis (IPA-IBA). IPA and its related companies provide comprehensive business consulting and valuation services to companies in the United States and Canada. For more information call 847-495-6786 or visit www.ipa-iba.com.