Smith Office Solutions, Inc. Articles

WHY CONSTRUCTION CONTRACTORS FAIL

 

WHY CONSTRUCTION CONTRACTORS FAIL

JOSEPH NATARELLI, CPA AND ROBERT S. MERCADO, CPA, CCIP

JOSEPH NATARELLI is the Managing Partner of the New Haven practice, and a partner with UHY LLP. He is also the UHY National Construction Group Director and a licensed Certified Public Accountant in the states of Connecticut, Rhode Island, Massachusetts, New Jersey, and New York with more than 20 years experience with international accounting and consulting firms. He maybe reached at ; mailto: jnatarelli@uhy-us.comjnatarelli@uhy-us.com. ROBERT S. MERCADO is a Managing Director of UHY Advisors NE., LLC and a Partner with UHY LLP. He is a licensed Certified Public Accountant in the state of Connecticut and a Certified Construction Industry Financial Professional. He may be reached at ; rmercado@uhy-us.com.

Every contractor wants to make his business stronger and here two seasoned accounting professionals provide tips tailored to the construction industry.

Most of us agree-the construction industry is in a period of unprecedented growth. One construction CEO, quoted in the October 2006-"Top 400"-edition of Engineering News Record, noted that "there's at least enough work out there for everyone." ¹ But, even in the best of times, construction contractors can and do fail. Why? This article explores a number of pitfalls that face every contractor in any economy. Familiarizing yourself with these pitfalls can help you avoid both big and little headaches.

When boom can become bust

At least in the Northeast, a boom often leaves homeowners and companies looking under every rock to find a contractor to do their jobs. This makes for a situation where a contractor is sorely tempted to step into new lines of work. The reverse is also true. In bad times, contractors looking for work may try to pick up any contract work they can get their hands on. Whatever the reason, be sure to understand the risks associated with new areas before you move in. In both boom and bad times, first continue to do what you do best.

Boom times often bring with them shortages of qualified workers, sureties, and supplies. It is especially important to confirm the availability of supplies and personnel when preparing bids. Often, penalty provisions for not completing a contract on time can be quite high.

The big one. Remember when Fred Sanford would clutch his chest and cry out, "Oh, this is the big one! You hear that, Elizabeth?! I'm coming to join you, honey!"  In the construction industry, the "big one" maybe a request to bid on a contract the size of which your company might never have considered before. Before you answer the call, it is important to think about the effects of bidding on a contract that is much larger than the ones your company normally tackles. It's not just hiring more people (which in itself may be difficult). You will also need to find new suppliers who can provide you with larger quantities of materials (or new kinds of materials). Your cost estimates will need to give consideration to the problems inherent in larger scale projects. Managing labor resources can be difficult on long-duration contracts. Rising prices of supplies can also be critical over the long term. Overhead burdens (insurance and so forth) can change quickly with the size of a contract. The larger and longer the job, the more chances there are that things can go wrong.

Even if your company isn't taking on "big" jobs, the number of jobs you are considering compared to the past may pose risks. When your company grows, your project management internal control needs will also grow. You may even need to reconsider the internal structure of your business.

Finally, growing your business also means growing your lines of credit and surety bonding capacity. You may need to line up new investors or new lines of credit to provide adequate capitalization. A good, construction-oriented CPA can help you assess the quality and quantity of your company's working capital.

New areas-new risks

Another situation created by a boom in any business is the temptation to literally step outside of the familiar. If construction work is plentiful, a few towns, counties, or states away, it maybe a good time to consider expanding your business geographically. Or, it may be that one of your best customers moves into a new territory and expects you to follow. As with anything, if the playground is different, the rules are bound to be different. Be aware of how costs, contracts, state regulation, and even customs may be different. If you are planning to expand your business into a new geographic area, consider partnering with a company already familiar with the area.

Supply costs. Sometimes, differences in costs to complete a contract between geographic areas can be quite dramatic. For example, for a contractor working at Tweed New Haven Regional Airport in New Haven, Connecticut, the cost of a cubic yard of concrete may be $97.

But a contractor working at New York City's LaGuardia Airport-just 73 miles away-could face a much higher cost per cubic yard. Without being aware of differences in the cost of supplies, a New Haven contractor bidding on a similar job at LaGuardia may well be the lowest bidder on the project. But that low bid will surely be at the expense of the contractor. Of course, this example may seem absurd, but even a slight increase in prices can cause a profit fade that could make your surety reassess his relationship with your company.

Types of contracts. Moving into a new region may also mean encountering new types of contracts. For example, housing contractors usually use cost plus contracts. These may not appear to pose a risk at first glance, but many include stiff penalties for completion delays and limits on reimbursable costs. Contracts with governmental entities often carry different risks and these risks can be different for every government.

Differences in regulation. Crossing state lines may mean different state-imposed requirements for environmental sensitivities, work guarantees, warranty periods, and workman's compensation and other insurance requirements-just to name a few. Making a bid on a contract without understanding these differences can be more than a nuisance. It can be expensive and it may dramatically change or eliminate the profit margin on new contracts.

Differences in work ethic. Expanding into a new geographic area requires companies to add new employees. These new business locations may introduce your company to employees with an entirely different work ethic. It may be something as simple as expecting a higher basic wage or as different as working with a labor union or union subcontractors for the first time. But, consider this example. An acquaintance of ours worked for a company that decided to move one of its manufacturing processes from Ohio to Tennessee. The company hired all new employees for its facility and things were going along well until it came time to plant tobacco. When that day arrived, none of the employees showed up for work. It was time to plant tobacco! The company's operations screeched to a halt until planting was done. The employees returned to work and operations began again ℓ until it was time to harvest tobacco! This is an extreme example, but it highlights the risks involved with changes in work ethic.

Employee turnover

No matter whether contractors are facing a boom or a bust, qualified workers are difficult to find. Unless you create a worker-friendly, safe environment for your employees, employee turnover rate is likely to be high. The higher the turnover, the higher the risk is that things can go wrong. Boom times often create a greater than normal shortage of qualified employees. Your company can avoid some of this risk by making sure its pay rates are competitive. Many of the same things can be said for subcontractors. Subcontractor turnover also creates risk. And, most customers won't be happy if they begin to feel that job staffing is a revolving door.

Even when your company's working environment is perfect, it may be hard to protect against competitors' pay rates intended to lure good employees away. Your company can minimize this risk by training employees in a multitude of skills so that should one leave, you won't be left without someone to perform key elements of your contracts. Documenting the processes required for each job also helps alleviate risk because someone stepping in to fill the void will have a starting point.

Job costing systems

Estimates and quality job costing are more important in the construction industry than in any other industry. I can't think of any industry that is based more on estimates. And, all of these estimates entail risks. Unlike others, contractors must set their prices in the bidding process-before work can begin, before supplies can be ordered, and before all costs can be known with certainty. Instead, estimates are used for making bids. Estimates are used to predict what remains to be done. Estimates are used to report revenues and determine interim profits on contracts. Estimating gross profit and percentage complete is essential to operating and accounting for construction contracts. Working capital, revenue and equity-all of which are bases for your bonding agents-are all derived from these estimates.

To reduce the risks of estimating, it is essential that your company has a job costing system that reliably captures all contract costs, including labor, material, equipment, and other direct and indirect costs for individual contracts. All of a contractor's risks are in individual contracts, not in contracts as a whole.

Profit fades. "Profit fades" is a term used to describe the decline in estimated gross margins from the beginning to the completion of contracts. One of the principal reasons why contractors show profit fades is poor estimating. When a company consistently shows gross profit fades, its bankers and sureties discount its financial capacity even more than the percentage of fade. For example, if a job is open and shows a 15% profit, but when it closes it shows only a 10% profit, a surety won't discount a contractor's capacity by just five percent. He'll make a larger discount. What profit fade is telling a company's financial backers is that it doesn't know how to estimate jobs. The past is a predictor of the future.

Working with subcontractors. If your company works with subcontractors, good job costing and estimating also entails making sure subcontractors aren't billing for costs before they should be paid. Subcontractor bills should be consistent with the percentage of completion shown in their work. When a company pays subcontractor costs before they are incurred, it has the effect of overstating revenues because costs are charged prematurely to contracts. When a contract is completed, the true revenue amount often looks like a profit fade.

Internal controls systems

A good system of internal controls allows a contractor to thrive. A deficiency in internal controls creates financial and credibility risks. Good internal controls systems should encompass all systems and all personnel that participate in production management, cost administration, and contract management. Among other things, internal controls ensure that all costs are measured and allocated to contracts, that equipment and other assets are safeguarded, that billings are made on time, that contract work meets quality standards, and that your company is in compliance with all laws and contracts.

Good internal controls systems go hand-in-hand with quality job costing and estimates. Contractors rely on accounting systems to provide information about overhead, payroll, supplies, and equipment costs. These are crucial to preparing bids and to an understanding of where your company stands on each contract once work begins.

When production quality controls aren't in place or aren't functioning properly, contractors run the risk of incurring unnecessary materials and supply costs and labor costs to correct defects in workmanship or product quality. Even if your supplier guarantees the quality of materials and supplies, contractors still incur labor and other costs if defects aren't discovered before materials are used.

Watch cash flows!

It is virtually impossible to overstate the importance of cash flows when evaluating the viability of any company-including construction companies. Poor cash flows expose a company to the type of risks that can quickly become its downfall. CPAs, sureties, bankers, and investors all agree.

Fast-growing companies are especially vulnerable to cash flow problems. A good contractor is always over billed and uses the owners' funds to finance the project as opposed to using his own working capital and equity. However, be sure your company isn't relying on cash flows from other jobs to make up shortages. If your job costing system isn't excellent, your company may be using the cash from some jobs to fund loss jobs and not even know it.

There are several simple things a company can do to improve its cash flows. First, when entering into new contracts, contractors should negotiate the best interim or progress payments possible. Making a $2 million dollar profit on a $5 million contract is great unless your company has to pay for supplies in June and won't be paid on the contract until December. Begin to keep a record of when regular customers actually pay their bills and of how long it takes for their checks to clear. This will help you make better cash flow projections. And don't be afraid to call customers and remind them that their payments are due. Second, stretch out your company's own payments as long as legally possible. Or, be sure to take advantage of your suppliers' early payment discounts if the discounts are greater than the money your company can make on short-term investments.

Third, contractors should monitor contract progress to take advantage of early completion incentives and to avoid delay penalties or damages. Most penalties are not only tough on cash flows but on the overall health of a company. Fourth, consider leasing equipment. Companies with established credit can lease equipment and make periodic payments rather than paying out lots of cash up front. Fifth, set up a cash reserve for your company. Do this before adding bells and whistles-like newer pickup trucks-to your operations. Sixth, organize back-up financing. Work with your company's banker to establish a credit line and use cash flows projections to show him when and how much of a line you expect your company will need.

Seventh, start working right away on unapproved/unpriced change orders and claims. Companies that don't pursue these while construction is still in process are already 50 percent less likely to get a favorable settlement (and favorable cash flows). Finally, monitor subcontractor cash flows. Unless you have a payment bond, a late payment to a supplier by a subcontractor can create a lien on a finished project, affecting cash flows from customers, including retainages.

Contractors and restaurants

The construction industry is the second largest industrial sector in this country-second only to government. It also is the industry with the second largest failure rate in the country. Only the restaurant industry has a higher failure rate (and most of my construction clients want to own restaurants!). We can't speak to what causes restaurants to fail, but we can tell that one sure thing increases the risk of contractor failure-making ill-conceived purchases. Buying things they don't need or can't yet afford leads contractors to several problems, especially smaller contractors. The things purchased don't need to be something as obvious as a speedboat or a Porsche. It can be as simple as buying specialized equipment for one job when your company has no need for that equipment in the foreseeable future. Consider short-term leasing.

Buying things your company doesn't need or can't afford often has unintended consequences. For example, suppose a small contractor buys a big ticket speedboat on credit. If his margin starts to fade on current contracts, he'll start worrying about how to pay off that unnecessary debt. He may be tempted to underbid on new contracts just to improve his cash flow. In a worst case scenario, he may be tempted to shift costs from one contract to another to fraudulently claim that completed contracts were profitable when they weren't. Once this process begins, he'll not only lose his company, he'll also be liable to his surety and others for the eventual effects of the fraud. For larger contractors, the purchase may be a new office building that says "We're Here," but the rest of the scenario will be the same.

A good CPA

A good CPA can help you avoid most of these pitfalls. Most CPAs don't want to be an expensive book on your company's shelf-we want to add value to the services we provide. For example, once we understand your company, we can give you ideas for better cash management and for improving your estimates of job costs and percentages of completion. Remember, the construction industry is unique and relies heavily on estimates. Before year-end, your CPA will help you with bank planning, income tax planning, and capital and financial needs planning.

A good CPA can also help you work with your surety and your banker. He can make sure your company has the financial statements, appropriate interim and annual schedules, and other information that the surety will require-such as schedules of contracts in progress, contracts completed, and backlog and disclosures about the extent to which contract billings are already being used as bonding collateral. He can meet with your surety to give him a better understanding of the components of your balance sheet, for example, by explaining that there are specific, legitimate reasons for costs in excess of billings. Part of a good CPA's job is to make sure everyone is educated. The last thing we want is for a client to have a line of credit pulled because, for example, a banker didn't realize that receivables were already bonded.

Finally, remember that higher risks should equal higher rewards. Own up to the fact that your company is in an industry that is at a very high risk of failure. Don't go for the CPA firm with the lowest fees. Go for the firm with plenty of experience in construction accounting. Your company won't regret it.

 

Updated January 16, 2008