Impacts of financial decisions
Addressing Profit Fade Builds Credibility for Construction Companies
Credibility is everything in construction. Your reputation rides on the projects you’ve successfully completed. But project managers must consider an incredible number of variables when they bid a project, and at some point, all contractors experience profit fade, a trending reduction in gross profit on a project. To those with a financial stake in the project, it doesn’t matter so much that a project doesn’t hit its projected profit, but rather how far off the mark it is in the end. If the correct controls are in place, when a project’s profitability begins to fade, proactive management and troubleshooting can mitigate the loss.
It’s better to recognize a project is headed downhill, because you can still turn it around.
Surety underwriters and loan officers value reliable forecasting
Project managers, accountants, and executives who are responsible for profitability estimates all need accurate and current job cost reports that compare estimated productivity to actual productivity. Project managers often rely on the project’s cash position (revenue minus cost) to develop profitability estimates instead of using accounting periods. Unfortunately, cash position does not take into account factors like a large invoice the project manager approved, thinking that it was included in the booked job cost. Such misunderstandings can lead to underestimated costs, overestimated profits, and losses that come too late to address.
Projects with low productivity often show a negative cash position or under-billed status when evaluated on a cash basis. To improve the reliability of forecasting, management should require an explanation of any under-billings. Advance material purchases that cannot be billed until installed, differences in billing and accounting period cutoff, or delays in billing change-order work might constitute acceptable reasons for under-billing. Similarly, under-billings resulting from poor productivity early in the project must be analyzed to understand the increase in productivity that will be required through the end of the project to achieve the average productivity estimated at bid time. To carry inexplicable under-billings or to insist that change orders will be approved despite continuing denial by the customer will often result in abrupt profit fade at the end of the project.
Along with being inherently useful to management, accurate forecasts are also valued by surety underwriters and loan officers. These professionals appreciate forecasts that attempt to identify the full magnitude of profit fade at the point of discovery rather than later in the project timeline. Also, contractors test their relationships with all users of financial statements when forecasts proclaim "all is well" until a negative cash position is discovered at the end of the project. Such lax reporting misleads the users and highlights the absences of effective forecasting processes, proactive project management, and ongoing financial oversight.
The project manager is critical in detecting profit fade
The project manager is in the best position to provide first-hand knowledge of the budget, estimated productivity, scope of work, status of change orders, and costs on an ongoing basis. Equally important is the project manager's understanding of the potential for pending changeorder pricing to be resolved in the company’s favor. The project manager may also be the first to discover reductions in scope that will reduce revenue and profit.
Best practices in responding to profit fade
Companies can mitigate the impact of profit fade by properly applying generally accepted accounting principles to their financial reporting. Monthly or quarterly profit forecasts also ensure that the field supervisor, project manager, and accountant use the same set of data to understand the project’s profitability, collaboratively develop solutions, and accurately report the projected outcome on the work-in-process summary. Unfortunately, many companies do not use this practice and consequently are unable to reverse or stabilize profit fade.
Profitability fade will fade away
The profitability graphs below illustrate how a project manager can address the same event causing profit fade three different ways. In this example, the asterisk represents the moment when profit fade is detected in a million dollar project with 10 percent projected profit ($100,000). Let’s just say that some work had to be redone to correct a mistake that would cost $50,000. In Graph A, the manager refuses to believe that overall profitability will suffer — that somehow profitability will inexplicably recover. Once the final revenue and costs are known, the loss of profit can no longer be mitigated, and the result is a large, abrupt, and an unfortunate loss.
Profitability fade is a one-time incident
Graph B represents a situation in which the project manager believes profit has been reduced only by the amount lost on the work completed by the date of the discovery ($50,000), so no steps are taken to stem profit fade. In fact, as reporting continues throughout the project, it becomes clear that profit fade has continued throughout the life of the project, as other elements are impacted by the initial setback. Profit is eventually affected drastically. In this case, cumulative costs are $50,000, but profit fade is only recognized month by month, as the costs of remediating the problem are incurred.
Profitability fade is recognized and addressed
Graph C illustrates the proper application of generally accepted accounting principles. In this situation, the magnitude of the impact on the project is accurately estimated, and a conservative reduction in the estimated profit is applied as soon as possible after the event occurs. As the project continues, the full impact of the event is mitigated through adjusted project management practices or negotiation of increased revenue in other areas of the project. The project manager communicates the bad news as soon as it is discovered, keeps stakeholders informed of the project’s progress, and communicates good news when it is supported by fact.
Credibility inside and outside the business
Early detection and recognition, accurate forecasting, and proactive mitigation provide predictable results and demonstrate the credibility and professionalism of management staff. Similarly, inaccurate forecasting undermines the credibility of a company's reporting, management practices, and leadership. It is essential that business owners require managers to know each job's profit position throughout the project, so that they can work to improve it. By showing your reporting systems are efficient enough to forecast often and accurately, and that project managers understand project fade and act on the information they have access to, contractors can build and preserve a strong reputation among bonding agents and the others that support the financial side of construction projects.