Navigating Risks: Insights into the Construction Industry - Part 1

Navigating Risks: Insights into the Construction Industry – Part 1

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In the bustling world of construction, success isn’t just about building structures—it’s about navigating a complex landscape of risks. From financial missteps to supply chain disruptions, construction companies face numerous challenges that can impact their bottom line and reputation. In this blog, we’ll explore some of the key risk factors that affect the profit-making ability of construction companies and discuss strategies to mitigate the risk effectively.

Inaccurate Accounting

Precise cost accounting is essential for construction companies to maintain financial health. Strong internal controls, including regular audits of ledger accounts, are crucial for producing accurate accounting reports. Mistakes in accounting can lead to misstated financial reports, which can have serious consequences for a company’s credibility and projected profitability. Implementing robust internal controls ensures the accuracy of financial information and helps prevent costly errors.

Inconsistent Tracking of Job Costs

Accurate tracking of job costs is vital for measuring project performance and optimizing profitability. Without proper tracking, construction companies may struggle to assess the true costs of their projects, leading to budget overruns and reduced profitability. Implementing effective systems for tracking job costs allows companies to make informed decisions and improve their overall financial performance.

Lack of Inventory Control

Inventory management is another area where construction companies face significant risks. Poor accounting of inventory can result in job cost errors and impact project profitability. Companies must establish detailed systems and procedures for tracking inventory transactions to ensure accurate cost information. Failure to maintain proper inventory control can lead to inflated costs, strained relationships with suppliers, and even impact banking and bonding relationships.

Late Payment to Subs and Suppliers

Delinquent payments to subcontractors and suppliers can disrupt project timelines and strain relationships. Prompt payment laws require contractors to pay subcontractors within a specified timeframe, but late payments can lead to subcontractors refusing to work or even legal action. Late payments to suppliers can also cause disruptions to field work and reduce profitability on projects. Ensuring timely payments is essential for maintaining strong relationships with subcontractors and suppliers and avoiding potential business failures.

Summary

The construction industry is fraught with risks, but with careful planning and proactive measures, companies can mitigate these risks and thrive in a competitive market. Failing to address risks associated with inaccurate accounting, inconsistent job cost tracking, inventory control challenges, and late payments, can make it difficult for construction companies to secure the surety bonds they need to guarantee the completion of their projects.

Construction companies can safeguard their financial health and position themselves for long-term success by partnering with Direct Surety, a truly unique Surety Bond expert. Using our deep experience as contractors, we are uniquely qualified to help an underwriter understand how a client of ours is equipped to manage specific project risks, thus enabling us to obtain bonds for our clients when others can not.

Stay tuned for the next installment in our series, where we’ll explore additional risk factors and strategies for success in the construction industry. Remember, understanding and managing risks is key to building a solid foundation for your construction business. And when it comes to securing surety bonds, trust Direct Surety for reliable solutions tailored to your needs.

Track Finances to Identify Underperformance and Reduce Costs

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Equipment

Routinely comparing what is budgeted for versus what is spent for each item of work in progress is the only way to effectively control project costs. This comparison is the only way for project managers to identify and correct underperforming areas before they snowball and become costly, project-delaying issues.

Once problem areas are identified, project managers can focus on bringing performance back on track. Without a level of cost control, underperformance will only be discovered after the project is complete, when it is too late to make adjustments to prevent overruns.

HOW TO MEASURE PERFORMANCE

Every project manager should regularly measure the cost of labor, equipment and materials. Labor is the most likely factor to fall out of control due to varying construction techniques or site conditions. Inefficient building methods or unexpected obstacles can single-handedly cause poor output and destroy a project’s profitability.

Labor

Now consider how labor is measured. To their detriment, some contractors prefer to compare the cost of labor to budgeted labor costs. With this method, the cost of labor and burden varies over geographical locations and leads to potentially inaccurate numbers.

Instead, consider analyzing the labor hours actually expended (using weekly labor reports) compared to labor hours budgeted. This creates an accurate means of comparison that is more widely applicable. Potential overruns are more readily identified, providing the most efficient means of controlling labor.

Equipment

Equipment costs are typically tracked on an hourly basis. Comparing actual equipment hours consumed to the hours budgeted provides the best real-time control. But pay close attention to internal equipment costs versus the cost of operating rental equipment. It may be less expensive to rent versus own. If that is the case, it’s likely time to get rid of that old, worn-out equipment.

Materials

Finally, materials costs can be measured in the field on a consumption basis. In this case, comparison of units consumed versus units budgeted is the best method. Using more materials than planned can be an indication of waste and a warning that poor planning or execution of work has occurred. For this reason, materials must be tracked based on usage and continually compared to the budget.

INDIRECT COSTS

Don’t forget about indirect costs, which include job-related items that cannot be charged directly to a specific job because the expense applies to multiple jobs. Think of things such as materials bought in bulk, equipment such as generators or compressors that move from project to project, and overhead costs such as insurance costs.

Indirect costs need to be routinely allocated every month to figure out the complete cost of a job. If indirect costs are omitted, profit margins will be overstated on completed projects, which means the next project likely will be underbid.

ACCURACY EQUALS PROFITS

Project managers play an integral role in delivering a successful and profitable project. Accurate and regular tracking of project labor, equipment and materials costs allows a project manager to identify areas of underperformance and make adjustments.

Make sure the appropriate mechanisms are in place to facilitate quick and accurate comparison of the actual usage of labor, materials and equipment to what is budgeted. Attaining maximum control over costs is the only way to maximize a company’s profit-making ability.

 

Written by David Druml

David Druml is founder and president of Direct Surety, a new type of surety that provides contract surety bonds directly from an underwriter to the contractor rather than through a broker network. A former contractor and founder of multiple construction and risk management companies, Druml has developed a proprietary risk analysis system for the construction industry. He is also an instructor at the University of California Berkeley Extension, teaching enterprise risk management to contractors.

Project Managers — Get Control of Your Costs

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There is only one way to effectively control your project costs and that’s to routinely compare what you’re spending versus what you’ve budgeted for each item of work in progress.

This comparison is the only way for a project manager to identify and correct underperforming areas before they can snowball and become project-delaying, costly issues. Once problem areas are identified, project managers can focus on bringing performance back on track. Without a level of cost control, underperformance will only be discovered after the project is complete and when it is too late to make adjustments to prevent overruns.

What to Measure?

Every project manager should regularly measure the cost of labor, equipment and material. Labor is the most likely to fall out of control due to varying construction techniques or site conditions. Inefficient building methods or unexpected obstacles can single-handedly cause poor output and destroy your project’s profitability.

Now consider how you’re measuring labor. To their detriment, some contractors prefer to compare the cost of labor to budgeted labor costs. With this method, the cost of labor and burden varies over geographical locations leading to potentially inaccurate numbers. Instead, consider analyzing the labor hours actually expended (using weekly labor reports) next to labor hours budgeted. Now you have an accurate means of comparison that is more widely applicable. Potential overruns are more readily identified, providing the most efficient means of controlling labor.

Next, how is your equipment performing? Equipment costs are typically tracked on an hourly basis. Comparing actual equipment hours consumed to the hours budgeted provides the best real-time control. A word of caution! Pay close attention to internal equipment costs versus the cost of operating rental equipment. You just might find it is less expensive to rent versus own. If that is the case, it’s likely time to get rid of that old, worn out equipment.

Finally, material costs can be measured in the field on a consumption basis. In this case, comparison of units consumed versus units budgeted is the most favorable method. Using more materials than planned can often be an indication of waste and a warning that there has been poor planning or execution of the work. For this reason, materials must be tracked based on usage, and continually compared to the budget.

Accuracy Equals Profits

Project managers play an integral role in delivering a successful and profitable project by accurately and regularly tracking project labor, equipment and material costs. Make sure the appropriate mechanisms are in place to facilitate quick and accurate comparison of the actual usage of labor, material and equipment to that which is budgeted. Attaining maximum control over costs is the only way to maximize your profit-making ability!

Too Much Backlog & Overextended Resources – What Should You Do?

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Every contractor’s goal is to have enough backlog to fully utilize all resources without overextending manpower, cash or time. There’s no question that this can be a tricky balancing act.

Taking a Closer Look

When you look closer to why construction businesses fail, an excessive backlog is one of the most common reasons. The lack of qualified manpower can significantly impact production, as well as profitability. When schedules are not met profits will generally decline. Adding to this snowball effect, a profit decline can create financial concern to banks and bonding companies when they evaluate your business. Contractors sometimes assume they will be able to borrow the necessary funds once they obtain additional backlog, but that’s often not the case. Lending institutions generally base lending decisions on past performance not future needs. And winning more work than a contractor can presently fund is really an indicator of a poor management performance rather than wise business strategy.

Knowing Your Backlog

So how do you make sure to keep your finger on the pulse? Tracking workflow is the key and the principal tool for managing your workflow is a backlog report. It’s an important and often overlooked means for monitoring a company’s ability to maintain volume, balance resources and project working capital needs. Of course, garbage in equals garbage out. A backlog report must be complete, identifying all jobs awarded and in progress including anticipated start dates and projected durations. The backlog report should communicate the actual scheduled start dates of ALL work including jobs with intended start dates in the distant future that have no impact on their near term cash flow because they eventually will.

Bidding Smart

A complete backlog report is the foundation for your bidding strategy as it is used to determine if you have sufficient resources in manpower and money to take on more work. And to make sure the necessary resources are available to self-perform work, the rate for runoff of self-performed work must be determined. Only with this information can a prudent decision be made as to whether to bid work as self-performed or to subcontract it out. With a backlog report in hand you have the necessary tool to determine what jobs to bid and how competitive to bid them. Yes, maintaining volume is a balancing act and it is always better to error on having more jobs rather than less. But more should never be too much and only by maintaining a backlog report will you clearly see the way.

Big is Not Always Better

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An improving economy is often a precursor to a rise in contractor default. Why is this the case? For starters, in the excitement of building a bigger backlog contractors are often unprepared to support an increased workload with the existing resources. Uncontrolled growth often jeopardizes the efficiency of existing systems and can disrupt once successful workflow, and thereby cause overspending throughout the organization. A common statement from contractors is: “I did much more work but made way less money.” What’s the reason?

Growing Pains

Growing your company without a regard for the necessary time to effectively train personnel and obtain the necessary resources often result in no apparent gain in profitability, even though additional volume is performed. In effect, work volume outruns the company’s ability to manage and supervise the construction projects. When this occurs, project management and supervision become over-taxed and the sole focus becomes just getting the project built. Management of the project from a cost perspective gets lost, and change orders and paperwork tend to fall through the cracks. Also, subcontractor change orders are often ignored only to disrupt the relationships, triggering emergency measures to satisfy their payment requests. So, how do you grow efficiently?

The Risk of Taking on Larger Projects

Contractors often think the answer is to minimize the need for additional management resources by simply going after larger projects to increase volume. There is no doubt that controlling project size is difficult in an industry where big jobs lead to growth. Since project management resources may not be readily available to undertake many small projects, it may seem far easier to grow by simply taking on bigger jobs that can be handled by the existing management structure. However, bigger projects most often require more experienced management. When management is not experienced enough to handle a large project (often with a larger degree of difficulty) back charges occur, claims typically arise and profits are blown. Many companies have failed by taking on projects that are dangerously large in comparison to their ability to withstand a loss. But there’s an answer!

Controlled Growth

Under a controlled growth strategy both project size and degree of difficulty are considered, and the potential for failure is mitigated. And controlled growth allows time for the expansion of systems in addition to providing time for the related training programs to develop. By systematically building the management infrastructure, your company can take on an increasing number of jobs and build the experience and resources necessary to eventually manage larger projects.

In summary, carefully evaluate the mix of project sizes your company undertakes because if something goes wrong on one of these projects that are too big to handle, the consequences can be catastrophic. Both future bonding needs and capital needs can be put in jeopardy, in turn, resulting in business failure. What then is the key? Don’t let your excitement over emerging opportunities cloud the sound business practices that you have used to succeed thus far. Big is not always better!

Bid to Win!

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The Ingredients for Success —

Every contractor knows that intelligent and accurate bidding is a critical ingredient to success, however, many contractors focus more on running jobs to make a profit rather than bidding smart to avoid a loss. The only way to consistently produce accurate bids that meet your company objectives is to put in place a well-designed and disciplined bidding procedure. Such a procedure should include three essential steps to meet profitability goals and reduce overall company risks.

#1 – Decision to Bid

A decision to bid a project should be made by senior management with a clear understanding of the types and sizes of projects your company wants to bid, plus your desired results. All too often an estimator is the de-facto authority deciding which projects to bid, yet the estimator lacks knowledge of past project performance or long-term company goals. While an estimator may be encouraged to bid a job because the company is a pre-approved bidder or the project seems exciting, a decision to bid may not be in your best interest. Every decision to bid should be consistent with the company’s overall goals, and give due consideration to the type and size of project that will produce the best results.

#2 – Bid Review

Every project your company chooses to bid should be reviewed by key members of your staff well in advance of the actual bid date and time. Preparation of bids in advance avoids late night and last minute “fire drills,” and helps ensure that errors, omissions or misaligned logic is less likely. A final review should take place at least 24 hours in advance of the actual bid so that on bid day the process can focus on material and subcontractor quotes.

Also, the bid review should be conducted with a senior staff member and the estimator in charge of the bid. For projects of significant size, inclusion of project management and top-field personnel in the bid review process can be highly beneficial since it brings in actual day-to-day field experience. And remember, the perspective of others can be critical to identify potential lapses in bidding logic, subs or suppliers that may be questionable, or planned building techniques that may be impractical. In most cases, a detailed bid review process will either identify an over-estimate of costs and/or costs that the estimator simply did not consider.

#3 – Bid Day Procedures

Finally, adopt a consistent bid day procedure. These procedures are particularly important if the process is comprised of last minute material and subcontractor quotes. At a minimum, try to get vendors and subcontractors to submit their proposals in advance of bid day to ensure the scope of work, and the inclusions and exclusions, can be assessed.

Pricing can wait until bid day, however, knowing in advance what is included in the price saves you from potentially overlooking costs that need to be included in your bid. Even with an attempt to get proposals in advance, you will still need knowledgeable people to study last-minute quotations on bid day. These individuals must be able to quickly:

  •  Determine the scope of work
  •  Recognize inclusions and exclusions
  •  Spot materials not conforming to the specifications
  •  Identify dramatic price differences and questionable subcontractors
  •  Verify the scope when the pricing appears too low

Altogether, a well-designed and disciplined bidding procedures is made up of these three essential ingredients, and following the procedure is the best way to avoid errors and increase the likelihood of success while conforming with overall company goals.

Lessons Learned from the Nigerian Bank

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A few days ago, I received another email from a “close and personal friend” who is a high-ranking manager at a bank in Nigeria. My “close” friend must really trust me more than anyone else because he asked that I hold, in trust, $10 million US dollars for his cousin, a now deposed village leader. Now, all I needed to do was to email him my bank account numbers and a few personal details to make sure the money got deposited. Sound familiar? If you have owned a computer with online access in the last fifteen years, you have likely received an email from a friend in Nigeria. The scam is a global classic and the reason it has continued for so long is because there is an endless supply of people who fall for it even though this fraud is so obvious.

Not All Frauds are Equal

Not all frauds are quite as obvious, especially in the construction world because of the large sums of money involved in projects. Even in the smallest firms, frauds can go undetected indefinitely and the schemes to defraud are countless.

There are ways to prevent, detect and/or deter fraud. As clarification, we are not addressing property theft or inventory shrinkage. Instead, my focus is more the “white collar” crimes, or frauds that occur mainly in the office such as forgery, phony invoicing, padded time sheets, “feather bedding,” banking schemes, check kitting, supplier bid tampering and workers’ compensation fraud, to name a few of the most common. We have seen all kinds and it boggles the mind.

Pay Attention

The first line of fraud defense is vigilance. Fraud is out there so pay attention to the way the business operates. If your instincts tell you something is wrong, it may be that it is wrong. Change banking and computer pass codes often. Bring in a “surprise” auditor to review your books, and check out your cash management and credit card procedures. Spread rumors about the fact that you are checking for irregularities. Cross train office personnel and every so often rotate positions. Fear that a person’s dishonest activities might be discovered by a fellow employee is a powerful deterrent. Hey, fear works! Sometimes the best deterrent to a would-be internal crook is the fear of getting caught. So, pay attention, put in place some simple precautions and incorporate fear into your controls. It just might prevent hard earned money from disappearing out the door!

Know Thy Equipment

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Too often, contractors with significant equipment inventory use industry standard rental rates for anticipated equipment usage instead of actual costs when preparing a bid—a practice that could cause you to lose a job in today’s tight bidding environment. Using industry standard rental rates simply does not take advantage of the potentially lower cost of owned equipment.  After all, owning your own equipment is supposed to be an advantage, right?

Looking at the Whole Picture

There is more than one reason to know your actual equipment costs. For example, you should know actual equipment costs in order to make key decisions about equipment replacement. Operating older equipment that is prone to breakdown can actually cost you more than industry standard rental rates. In addition, if your equipment needs frequent repairs, you could incur jobsite interruptions and associated inefficiencies driving down profits and making it difficult to afford replacements. And if funds are not pooled in reserve for equipment replacement, it can become very difficult to afford new equipment due to the additional debt burden required.

Clearly, owning equipment is a double-edged sword. The added productivity that might result from owning equipment can be countered by an excessively high cost of operation. That is why tracking equipment costs is imperative. Lacking equipment costs information, you could dispose of a piece of equipment with a low operational cost instead of another similar piece with a high operational cost. Companies relying heavily on owned equipment can be severely impacted by poor decision-making such as this, likely making it difficult to remain competitive and leading to potential business failure.

There is a saying, “if you want to play you have to pay.” With respect to this topic, “if you want to buy you have to track.” It is that simple. If your company relies on construction equipment to get the work done, implement a comprehensive equipment costing system that monitors all elements of repair and maintenance. With detailed equipment cost tracking, a contractor knows all cost components including fuel, tires and tracks, amortization of major repairs, and hard and soft shop costs, and, therefore, can make intelligent decisions in fleet maintenance and replacement. In short, “know thy equipment.” With this knowledge you can bid more competitively and avoid false expectations.

A Fist Full of IOUs

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More construction businesses fail from the lack of cash due to poor cash management than from “bad” jobs—it’s a fact. One of the main causes of poor cash management is the ineffective collection of receivables.

Your ability to survive—and even grow—in this industry demands that you get paid in a timely manner. Timely means getting paid as agreed to in contract documents.

Historically, the construction industry ranks among the worst in terms of completing the work-invoice-payment cycle. The further you are down the payment chain, the more likely you are to be the subject of payment float (i.e., the last one to be paid).

Are there laws against this? Sure. There are federal and state “Prompt Payment Act” laws, and their legal equivalents. Is slow pay or floating money a breach of contract or possibly illegal? You bet. Call Perry Mason.

While you are waiting for Perry or his legal aids to show up, consider implementing some proactive routine practices to ensure your business avoids the obvious implications of running out of cash.

  1. Collect receivables: The collection of receivables is a critical business management function. A weekly review of receivables, their due dates and their aging is an absolutely necessary function of a management team. That’s you! If a customer owes you money and is past due, contact them daily until it is collected. Do not be shy about going directly to the front desk of the customer’s office and asking to be paid or making a fuss with the project owner. The squeaky wheel most often is the one that gets the grease.
  2. Avoid Paid-if-Paid clauses: NEVER sign a contract containing a “paid if paid” or “paid when paid” clause. These types of clauses are usually illegal, and even if they are not, don’t sign them even if pressured to do so. Also, unless it absolutely cannot be avoided, do not stop work to leverage payment. Get legal help before you try this tactic because it can backfire for all sorts of reasons.
  3. Implement a disciplined management regimen: Schedule a regular time to review the status of accounts and particularly overdue receivables.

At Direct Surety, we work with construction contractors of all sizes, specialties, geographic locations and market segments. Along with providing more surety credit at a better price, we also provide tools that reveal best practices used by all of the top construction companies. Proper collection of receivables is only one of over 75 practices that you can put in place to maximize your profit-making ability and minimize your risk of failure. Partner with us to learn more about how Direct Surety can empower you to grow and prosper!

Congratulations! You’re Broke.

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Mismanagement of Cash Flow —

At Direct Surety, we have had the opportunity to work with many successful construction organizations. We’ve also worked with a few not so successful companies that should have been. The main cause of these business flops has almost always been their rocket-like success and then the sudden discovery they’ve run out of operating cash. And we’re not just talking about fragile start-ups either. The big guys fall just as hard and for the same reason: mismanagement of cash flow.

A rapid run up in booking new work (even at top dollar) and then also having to perform this work seemingly all at once (job stacking) will, on one hand, read nicely in the “work in back log” column of any financial report. On the other hand, it has the potential to drain operating cash. Timing is everything.

Let’s revisit the term “job stacking” again. It’s really not difficult to picture. The estimating department is hitting one home run after the next (and throws a few parties along the way), and is also booking one obligation after the next. In doing so they may (rightfully) assume unlimited resources (e.g., labor, equipment and material) to perform the work. The estimators (even if it’s you) rarely have a clue about cash flows, banking or credit lines. Even if they are aware of the timing of these new projects, plans can and do change. As we all know, schedules and work flows shift and, therefore, so does cash. Remember, most construction companies go broke while having their best year.

It’s critically important that an almost constant analysis of cash flows be performed. This means scheduling and forecasting durations of individual projects (on a time-based minimum 90-day rolling calendar) tied out to individual job specific cash demands (weekly at a minimum) and corresponding progress billings and actual cash income cycles. Yes, it’s like trying to hit a moving target, but in reality this is representative of the financial condition of your company. Sound tedious and totally boring? Perhaps so, but your ability to manage cash is the heart of the reason why you’re able to stay in business.

Of course you can’t forget to subtract all those projected costs it takes to run a business called overhead (yuk … unless it includes your own salary!). Hint: The net total of the projected cash-in (you hope) generated from jobs and cash-out coming from overhead, when added to your actual cash on hand, should always be positive. If not, then make certain you have in place a significant operating credit line, or adequate cash somehow in reserve, for short-term (very short) negative cash flow.

And finally, remember, if you aren’t managing your cash, the famous Tao Chou proverb applies: “Success is a fleeting illusion.” The American version of this same proverb is: “Never believe your own press.”