My overview of the construction industry breaks down the management function into three broad categories: 1. Getting the work 2. Doing the work 3. Accounting for the work. The Chief Financial Officer’s (CFO’s) role in “Accounting for the work” is self-evident, but his or her contribution to “Getting the work” and “Doing the work” is somewhat less obvious but no less essential.
A Unique Business Model
The financial foundation of all construction activity rests on a company’s ability to accurately estimate jobs and submit competitive, profitable pricing.
Of course, the company is then tasked with executing the contract it has entered into. The unique nature of construction, however, is that contractors set their own price target and then, with a large team of independent actors, hopefully working together over an extended period of time, under highly volatile market conditions, try to hit their own target and take home a fair reward for doing so.
Well, what could go wrong in that game (I ask sarcastically)?
Anything and everything, (I answer).
When contractors don’t hit the target they set for themselves the contract relationship devolves into disputes and sometimes litigation where nobody wins in that game but the lawyers.
Can you imagine GM or Ford setting the price of their vehicles before they knew what it cost to build them? With highly scientific and professional estimating contractors attempt to calculate the cost of complex construction projects in advance of attempting to build them for that cost. Traditionally, experienced estimators and project managers handle estimating. However, the construction company CFO is seldom involved. Many Chief Executive Officers, thinking their CFOs know little about construction, don’t seem to recognize the value of the mathematical applied science of the accounting disciplines and their potential use in many areas of the construction business, beyond “accounting for the work”. This has been a critical error in judgment in the industry since the beginning.
Estimating and Accounting
Estimating is a highly sophisticated combination of the applied sciences of engineering, project management, mathematics, and accounting.
These sciences involve formulas and calculations to establish the lengths, areas, volumes, or weights.
The team then completes the estimate by pricing the quantities they developed.
At this point, you have the fundamental elements of an estimate (quantities and costs).
This seems to work fine, except for my experience with thousands of financially distressed construction businesses resulting from estimating errors. I have never understood, with an accounting department in the firm, why all construction enterprises don’t use them in assuring the accuracy of their estimating mathematics and as qualified experts in discussions of the variables that constitute risk.
Transformation of Data
Pricing quantities to arrive at cost is a transformation of data (from quantity to cost). Completing this transformation of data for an entire construction project requires an intimate knowledge of accounting principles, supply chains, and the factoring of labor cost variables over an extended period of time. It also requires imagination, assumptions and judgment to account for the risk inherent in a complex activity that takes place over an extended period of time. This is where a professional CFO, schooled in the science of accounting, should be joined with the estimators and project managers in arriving at the total project estimate. This is where estimating becomes an art.
The Proper Role of the CFO
Because of the unique risk factors inherent in the very nature of construction estimating, it is beyond prudent to include the profound data skills of a knowledgeable CFO in arriving at the total projected cost of a project. To arrive at a total project estimate, the team needs to:
- make judgments based on market conditions, bid requirements, and other project-specific conditions.
- take into account the scale of the project, volume discounts, and assume productivity and labor premiums depending upon the hours of work that may include regular, night shift or weekend work.
- determine; when there is limited access to a historical database or the item is very new, pricing that requires an educated guess.
- adjust pricing depending upon whether the material is sole-sourced, the work is self-performed or subcontracted.
- establish markups that may require judgment, depending upon factors like schedule, time of year, risk tolerance, etc.
Only after the estimators and project managers have delivered final quantities, and the accounting team has verified the mathematics can the team, including the CFO, factor in the variable risks and produce an accurate total project estimate that can be safely used to create a competitive, profitable price.
Need to Include the CFO Because:
The financial foundation of all construction activity rests on a company’s ability to accurately estimate jobs and submit competitive, profitable pricing. And do this repeatedly.
Next week we will cover the CFOs critical role in “Doing the work”.
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For more information on the science of estimating, read more at: https://simplarfoundation.org/?s=estimating
For a broader view on role and duties of a CFP, read more here: https://simplarfoundation.org/?s=cfo
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