CLEAN UP YOUR BOOKS
Thomas C Schleifer, Ph.D.
While operating the nation’s largest workout firm for sureties, I had occasion to audit the financial statements of hundreds of construction companies that had failed mid-project. While the causes of those failures varied widely, the inability to produce dependably accurate financial statements was a consistent theme.
Cost to Complete
On every job my firm was called in to investigate on behalf of a surety, we would review the prior five years of the failed contractor’s financial statements and accounting processes to see if there were any consistent clues to the impending collapse in the financial reporting. We learned from these interventions that:
- These otherwise successful contractors would suddenly run out of money and must abandon ongoing projects in progress to their sureties. Because of flaws in their accounting procedures, contractors would unknowingly be heading for insolvency long before they realized they were in trouble.
- In almost every case, we discovered that because the “cost to complete” numbers were arrived at by an estimate (that seemed to consistently error on the optimistic side) the reported project profit percent would start out fine and then decline as the jobs wore on. For example, when the job was one quarter complete, the profit margin might be 8%. By half-time that number would look more like 6% and at the three-quarter pole it might be 4%. It was easy to see where that optimism was heading.
- The assignment of overhead costs was also fairly erratic, so reliable on-going corporate profit numbers were almost always foggy and fluid.
- In addition, most of the failed companies we assessed did not insist on prompt payment. Extras were not well-documented. Progress payments were negotiated timidly. Payment was slow and often contentious.
- Over time as construction services came to be seen as a commodity by owners, low bid competition became reckless, and estimators rarely seemed to take proper cost inflation into account. In other words, the emerging commodity pricing mentality of owners resulted in many of these failed contractors bidding way too aggressively for work. In the heat of battle, however, contractors were rarely conscious that they were sometimes bidding below costs eventually incurred.
Clean Up Your Books
The flaws in the accounting practices and financial statements that we uncovered during many years of investigating failed construction concerns are still evident today in too many construction companys’ accounting procedures. Contractors are not accountants. In fact, too many contractors see their accountants as “bean counters” and rarely assign them much management authority. If you feel uncomfortable with the accounting reports you are receiving, the first steps necessary to “clean up your books” are:
- To hire an accounting professional with real construction experience and promote him or her to the senior management position of CFO.
- Task your new CFO with analyzing and adjusting any “fudge factors” to state more accurately your “costs to complete” ongoing projects. You can discover what I refer to as the “fudge factor” by taking 5 years of historical work-in-progress reports and analyzing how far off (on average) actual performance the cost to complete calculations have been over the life of the projects. (If most of the same field and office people are managing the work it’s a safe bet that their “optimism” bias will be consistent year after year.) A professional CFO will recognize this optimism bias and adjust the reported numbers to convert them to a more accurate management tool.
- Overhead costs must also be calculated accurately and updated on a real-time basis. These costs should be accounted for and charged to projects on a continuing basis and never “manipulated” to make things look better in the interim. (Which we have observed to often be the case in poorly run operations.)
- There are any number of failed construction enterprises that may have survived if they had all the money that was owed to them. Poor management of accounts receivable, including managing the payment process, is one of the major risks in the construction business. Managing prompt payment should be one of the main duties of your new CFO.
- I recommend giving your CFO oversight responsibility for estimating and the bid submission procedure. Everyone else involved is invested in getting the new work. The professional CFO is invested in a profitable business. There’s a big difference in these two perspectives and the appropriate balance is critical. A skilled CFO can diplomatically improve that balance.
Conservative Management in Turbulent Markets
In a shrinking recessionary market, as long as cost inflation and labor and supply shortages joust with commodity pricing and intensified competition; profit margins are at risk and undercapitalized contractors are in jeopardy. Conservative management is the only road to success in these post-Covid turbulent times. In the current market, however, conservative management means thinking outside the box by making bold choices to take your company in a new direction. Start with reimagining your CFO.
Next Week: More on Conservative management and thinking outside the box.
Find additional information on topics discussed here in the book The Secretes To Construction Business Success, published by Routledge https://bit.ly/3G9ornf.
For a deeper look into the role of a CFO and their position in your company, read more here: CFO
For a broader view into financial management, read more here: FINANCIAL MANAGEMENT & RISK
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