In my experience, construction firms do not operate under firm budget disciplines like most other industrial concerns. Contractors usually craft project budgets in advance but rarely use them as a management tool. Because of the complexity and variability of each project a construction company undertakes (each new project is like going into a new business), contractors often find themselves using budgets like optimistic suggestions and constantly adjust them as projects progress over time. This approach reduces budgeting to a semi-useless exercise, and most contractors see it that way. As one contractor put it:
“This business isn’t like setting up a production facility, standardizing costs, marketing the product, and then delivering it to the consumer at a price that allows for a reasonable profit. We are forced to predict what it will cost to build a project no one has ever seen before. A novel design, in a new location, built in partnerships with new subcontractors, over an extended period, does not lend itself to accurate cost predictions. Add to that unknown material cost inflation and the potential for errors in complex execution and it is not supervising that budgets in construction are often best guesses or wishful thinking. Even the estimators can’t get it right every time.”
Business Planning
As construction companies grow into substantial firms their banking and bonding relationships require them to submit budgets in advance of funding approval. They spend quite a bit of time preparing what appear to be operating budgets but are actually financial reporting to lenders and sureties. Contractors are savvy enough to know that even when these budgets are prepared with great care, it is highly unlikely that they will play out in the real world. Weather, labor unrest, materials cost inflation, specification changes, extended schedules, and an untold number of other unforeseen variables constantly buffet construction project budgets and often render them immaterial. That’s why, in my experience, most contractors rarely try to operate within firm budget guidelines.
Forecasting vs. Budgeting
However immaterial formal budget disciplines may be to contractors, the wide variety of financial risks that typically characterize a complex construction project requires contractors to predict with some degree of accuracy the impact a project will have on their working capital capacity. This carefully crafted prediction is commonly called a forecast as opposed to a budget.
- A budget is a guideline for achieving a desired outcome.
- A forecast is a prediction of what will probably occur if a certain array of variables come together in a predicted order.
Because contractors must finance as well as build projects, every future contract represents a substantial financial commitment on the contractor’s part. Before they sign for any project, contractors should forecast the impact on the firm’s financial capacity to be sure they can finance the project through to the end. Cash flow forecasting is perhaps the most important function the construction CFO is responsible for.
Updating
What’s more, cash flow forecasting is not a prediction of a construction firm’s working capital capacity at some future point in time. It is an active management tool that should be updated regularly because cash flow variables have impact.
- A project owner who had been paying on time may be suddenly delaying payment for their own financial reasons.
- Material shortages might be unexpectedly increasing unit costs.
- Productivity may have been overestimated and gradually puting downward pressure on available working capital.
- Quality, specification, or completion disputes might delay expected payments.
Dynamic Banking Relationships
Active cash flow forecasting is a critical component of dynamic banking relationships. Contractors should foster “partnerships” with their bankers that allow both parties to understand the day-to-day financial management of a highly complex and variable construction company. Arm’s length “banker/lender” relationships seldom go well for either party because of the dynamic financial nature of the business. Closer relationships work better.
- Bankers should be willing to make accommodating adjustments throughout the extended duration of a construction contract.
- Contractors must make every effort to provide bankers with necessary intelligence and cooperation to ensure a profitable, risk-adverse transaction from the banker’s point-of-view.
The Indispensable CFO
Managing a construction firm’s capital capacity is a highly complex management task that goes far beyond the simple static act of pre-project cash flow forecasting. Because contractors have been put in the position of financing as well as building projects, they must take an active interest in their capital capacity just as if they were bankers managing their credit limit. This is the job of an experienced and professional CFO. The CFO is an indispensable member of the team.
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