As anyone in the building and construction world knows, a Contractor’s success is directly related to his/her ability to predict and control cost. Builders don’t struggle or fail because they suddenly forget how to do high-quality work. Typically, when good performers run into problems, it is because they get in “over their heads” on time and cost, and the problems spiral out of control from there. Skilled, refined job costing is essential for a contractor’s staying power, consistent profitability, banking relationships, and, ultimately, personal wealth accumulation from the business. In Part 1 of our blog, we will look at five key concepts in Job Costing that should provoke some important conversations between you, your management team, and your trusted advisors.
1. Consider Taking a Bottom-Up Approach to Budgeting
You must understand and control your overhead (“below the line”) costs before you can have confidence that your estimating is correct. Mistakes here will continually cause frustration and under-performance. With a tight handle on fixed overhead, you can go after business as aggressively or as conservatively as you see fit, without worrying that your back office expense is going to eat up all the profit. At any assumed Gross Revenue number, start with what you know your net profit needs to be (after you’ve paid yourself fairly as an Executive) in order to meet your obligations and goals (let’s say 10% of revenue). Work upward by adding in your fixed overhead costs (let’s say 15%). Now work above the line to calculate your Cost of Contracts. In this example, it needs to be 75% (for a 25% Gross Profit Margin). That number will vary among specific contractor types and sizes, but establishing the right Gross Profit target for your business is critical to the cost and pricing process, and requires careful professional analysis.
2. The Materiality of Materials Cost
In particular, if you are in an industry that relies heavily on commodities and materials, establish a system that allows you to quickly anticipate significant price movements. We are often at the mercy of global economic changes, changing trade policies, politics, and weather. Do you have procedures in place to anticipate those effects a month from now? Six months from now? A year or more? Remaining in a reactionary mode can cause major problems, supply interruptions, and financial losses. If you reasonably expect volatility, how do you protect yourself financially on job bids?
3. Don’t Forget About Mobilization
Just because you know exactly what you’re doing doesn’t mean that you have identified all of the costs associated with where you’re doing it. Fuel cost is an obvious component of this – the farther you go for a job, the more gas you need to buy (and, as noted above, keep an eye on those fluctuating gas prices). Have you truly factored in all of the costs of doing that remote job that looked so enticing on paper? How many are on the crew, and how many extra hours’ labor and burden cost are you incurring? Is it cheaper to put them up in a hotel, or have them drive back and forth? What about materials sourcing? Do you have some room in your numbers to account for increased delivery cost, versus buying from an unfamiliar, but closer, source? Contractors often under-price their work when they travel, due to competitive pressure and inadequate methods of capturing and analyzing costs.
4. Overtime Pay Can Be Your Friend (If it’s Efficient)
Paying time-and-a-half consistently is no way to run a profitable business, but consider doing some calculations to determine how to strategically use overtime to increase your profits. Simply put, the decision about how many employees you need on a work crew is dependent on the total estimated man-hours needed to complete the job, in relation to your target gross profit on the job. In pure economic terms, the cost of adding one more employee to a job must be measured against the alternative cost of using overtime labor with a smaller crew. Such a decision, however, is not always purely economic; in the construction field, keeping a steady crew together with consistent work may be of greater long-term value than a slight increase in profit on a particular job.
5. Price Your Risk
Job Costing is directly related to your pricing decision, and it must take into account all of your business risks on the job. Risk-based pricing is a hallmark of sound economics, and it applies to construction as well. Your costing system should provide protections, in the form of increased gross profit, for jobs with particular risk factors. Earlier in this post, we mentioned pricing for out-of-market travel. If you are bidding on a larger-than-usual job, or one that includes work that you don’t normally do (or will require you to find a subcontractor for certain work), you are increasing your risk and should be paid accordingly. Not only will this prevent losses, it will keep you disciplined by ensuring that you are at your best bidding on work that is in-market, familiar, and manageable.
These principles are just a few of the most important in your job-costing process. Enlisting qualified financial advice and analysis to help you develop the right process will put you at a competitive advantage. At CLM Advisors, we have consulted contractor businesses on these issues and more. In Part II of this series, we will explore sound management and reporting of your job-costing system.