Construction companies should know how to identify and manage any issues that can lead to a reduction in a project’s gross profit.
Profit fade is a gradual reduction in the gross profit on a project. Profit fade analysis is a bit like looking in the mirror — it’s a self-evaluation at a time when we can understand the impact on a project and affect the outcome. It also demonstrates to others (such as surety underwriters and loan officers) that we are monitoring job profitability.
Many problems that lead to profit fade can be addressed through a better understanding of the job's actual cost.
How to detect profit fade
Effective profit fade analysis involves adopting three management practices:
- Identify the causes of profit fade early.
- Quantify the worst-case outcomes.
- Mitigate causes of profit fade and attempt to reverse negative trends.
Profit fade can be identified and averted when the project information system is integrated into the company’s bidding, billing, costing, and project management functions. These processes should require project managers to provide periodic forecasts of cost at completion. When forecasts identify profit fade, it can be addressed early.
Why profit fades
When labor costs get ahead of project completion, the only way to get the project back on track is to quantify what is happening and why. Typically, profit fade can be traced to six causes:
- Incomplete or overly optimistic estimated production or unit costs
- Underestimated labor or equipment rates
- Unbillable change orders or extra work
- Poor supplier or subcontractor performance
- Inadequate field supervision, resources, or training
- Adverse weather conditions
When the cause of profit fade has been identified and quantified, the project team's efforts to mitigate the fade must be monitored through the job costing system to determine whether those efforts are successful.
Budgeting for profit
The ability to identify and manage profit fade begins with a project budget based on the bid and includes a workflow that allows for consistent reporting. Reporting should include current costs and job progress that can be compared to the original cost estimate.
Unfortunately, many companies fail to integrate the processes of estimating, bidding, budgeting, and job costing. It is important that bids and costs can be compared easily so that the cause and effect of variances can be identified.
The first step to integrating these processes is to require the estimator to develop a budget for the project before work begins. The budget should be based on the final bid amount and include quantities to measure progress and trends. Phase and task codes for items such as labor time cards and material invoices should be established and universally understood by the field and the accounting office.
Companies that start with a documented budget can quantify completion percentages, attribute dollar values to phases and tasks, capture unassigned costs, and validate rates. It can also allow for cost analysis in the event of a change request, dispute, or future bids. Without a budget that is comparable to production costs, it is difficult to identify and control the causes of profit fade.
Meaningful job costing and phase codes
Many problems that lead to profit fade can be addressed through a better understanding of the job's actual cost. Accurately quantifying work performed allows the project manager to analyze costs effectively and make adjustments in the field throughout the project to eliminate or reduce profit fade. Job-cost phase codes should also be used to achieve a unified understanding of cost data between the field and the accounting department. Without a common understanding of this data among all parties, there is no accountability for its accuracy.
Profit fade is most likely to arise from areas where cost and revenue components are not well understood, so phase codes that are established for the budget should be realistic and meaningful. Consistency is more important than granularity. If there are too many phase codes, employees may err when assigning tasks to codes and, in doing so, render reports inaccurate. Periodic review of unused or overused phase codes will allow managers to identify tasks that are ill-defined. Finally, productivity and unit cost trend analysis relies on consistently reporting the quantities of work completed during the accounting period.
Adopting best practices can mitigate profit fade
Adopting the following practices is the first step toward boosting profitability and demonstrating your credibility with surety underwriters and bank loan officers:
- Use phase codes and task codes in your budget and job cost system.
- Report labor and equipment usage daily.
- Report and enter completed quantities of work daily.
- Consistently allocate payroll tax, insurance, benefits, equipment costs, and overhead by code.
- Implement a purchase order system to track committed job cost.
- Track equipment utilization, ownership, and operating costs by each piece of equipment.
- Produce and distribute weekly labor cost reports by job and phase.
- Produce monthly job profitability reports.
- Require that project managers forecast construction costs at completion on a regular basis as determined by the size and complexity of the project and the company’s reporting needs.
- Require bids and forecasts to be approved by management.
- Establish a plan for remedial actions to be taken when necessary, including adjustments to crew size, equipment assignments, and schedules.
- Include completed jobs in individual project managers’ profit fade analyses.
- Discuss reliability of profit fade estimates with project managers.
These practices help contractors clearly communicate the financial situation of their projects. In addition to turning around profit fade situations, these tools demonstrate the kind of business acumen that will inspire confidence with your important funding sources.
Proactive project management demonstrates credibility
In construction, it is rare for projects to be completed exactly as planned. The true measure of a contractor’s credibility is the ability to manage the changes that occur. Along with assisting with efficiency and internal transparency, a contractor’s awareness of profitability shows surety underwriters, loan officers, and other users of financial statements that the company is able to identify profit fade early, analyze its causes, and lessen its impact as projects move toward completion.