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Exploring the Many Facets of an ESOP
It’s often said that construction is a risky business, and that’s not in reference to just job safety. Construction is also highly risky from a financial perspective – thin profit margins, unpredictable site conditions, volatile costs, change orders, and the use of multiple subcontractors. In addition, many construction projects are performed over long periods of time, which only magnifies the risks. As part of your construction accounting strategy, the construction CPAs at Doeren Mayhew offer six ways contractors can minimize financial risks and maximize profits:
Do a postmortem on recently completed jobs, both profitable and unprofitable. Compare each job’s estimate to the actual figures and investigate any significant discrepancies. Were job costs accurate? Were assumptions about productivity, labor and materials requirements, and other factors reasonable? Document your findings and refer to them when creating future estimates.
Review all project documents carefully before you begin a job and be sure that everyone involved understands them. Set a realistic schedule that accounts for the possibility of unforeseen circumstances, such as unanticipated site conditions, bad weather, changes or additions. Make sure you have procedures in place for identifying changes in the scope of work, documenting those changes, and processing change orders quickly. Missing or mishandled change orders can be damaging to profitability and cash flow.
The only way to know whether jobs are profitable – and to develop accurate estimates – is to understand their true costs. That means having a system that accurately captures, classifies, and allocates direct and indirect costs. Most contractors do a good job of identifying a job’s direct costs, such as labor, payroll taxes, materials and subcontractor expenses. But it’s equally important to allocate indirect costs – such as equipment, rent, supplies, clerical staff salaries, insurance, marketing and legal fees – to specific jobs.
Construction is fraught with uncertainty. No matter how well you plan, developments during a project can significantly affect your costs, profits and cash flow. Rather than wait until a project is complete to assess the damage, it’s critical to prepare and monitor work-in-progress (WIP) reports to track financial performance during the project. This allows you to identify problems while there’s still time to do something about them. For example, WIP reports that indicate declining gross profits or underbillings may reveal poor estimating, inefficient project management, lax billing practices or other weaknesses.
The need to control costs, especially during tough economic times, is obvious. But if you focus only on big-ticket items, such as labor and materials, it’s easy to lose sight of gradually increasing overhead expenses, which, over time, can do serious damage to your profitability. To avoid “overhead creep,” continually monitor and evaluate expenses for things such as insurance, company cars, advertising, supplies, subscriptions, and travel and entertainment.
Including a profit cushion in your bids helps protect your company against the risks and uncertainties inherent in the construction process. The amount of the markup depends on the nature and size of your business, the size of your projects, and other factors, such as project-related risks. It’s important to select the amount of markup carefully: If it’s too high, you may lose jobs; if it’s too low, you may take on too much risk. An effective strategy for adding profits to your bids is to use different markup percentages for different line items. For example, you might mark up labor, which is more uncertain, by one percentage, but use lower percentages for materials and subcontractor expenses, which generally are more predictable.
The lesson here is that you should be thinking about profitability – and what you can do to improve it – starting with the bidding process and throughout the course of each project. If you wait until projects are complete or until the end of the year, you may be in for some unpleasant surprises.
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