How is it possible that construction concerns being run by professional managers in the 21st century often run out of cash and suddenly cease operations? Most modern industrial companies have heads-up enough to file a bankruptcy and ask the court to help them work out their problems. Suddenly ceasing operations to the surprise of subs, vendors, clients, and even company top management seems to be confined to the construction industry (and small floating crap games). Why?
The Unique Nature of Construction
The unique nature of the construction business is, as they say, “the fly in the ointment”.
“Construction is a multi-layered endless symphony of independent sub-contractors playing out a complex composition over many months in a highly competitive market marked by a volatile cost environment and a variety of competing stakeholders.” You may want to read that again.
Wow! Under those circumstances, trying to keep track of how profitable, multiple partially completed jobs are at any one time, and trying to determine the cost to complete each job is almost impossible. That is why construction companies sometimes suddenly run out of cash.
An Approximation Based on Two Guesses
Trying to determine the exact percentage of completion of a construction project in progress is like pinpointing the exact location of a moving train.
WIP reporting by its very nature is an estimate based on two other estimates: first, the original estimate for the project and second, the estimate of the percentage of work completed at a given point in time. In addition, the process relies on accurate field reporting, which is problematic because accurate means precise and an estimate is an opinion. This inherent lack of precision in WIP financial accounting becomes even more dangerous when you realize that WIP can represent 50% or more of annual reported profits on year-end financial statements, so mistakes can mislead contractors into believing they are profitable even if they are not.
The Science of Statistics
As a consultant to construction companies and a professor of construction management, I studied thousands of construction financial statements and determined that industry-wide profits were on average overstated by more than one percent, a significant amount when you consider that profits were already slim. The research on five years of financial statements compared the profit on every project in progress when first reported in a year-end financial statement, to the profit reported on the year-end statement when the same project was a completed project. For the thousands of statements studied, the combined final profits were over a precent less than reported on interim statements, which I refer to as “net profit bleed”.
A deeper dive into these five years of data revealed an interesting bias in these WIP estimates:
- Some project managers were continually optimistic and the profits they foresaw had, by the completion of their projects, fallen off. I call this “profit bleed.”
- Other project managers did the opposite, under-reporting profits early in the work that regularly resulted in profit improvement at project’s end. I refer to this as “sandbagging.”
Extensive study determined that these biases could be measured and used to “adjust” out the bias effect. I calculated the average bleed or sandbagging for each project manager over the prior five years and determined if the averages were changing over time. Then I established what average best represented the present rate of bleed or sandbagging. With specific percentages based on historic data I could calculate, with a reasonable degree of confidence, how much any project managers’ WIP reporting likely varied, and in what direction. This, as it turned out, was a form of statistical analysis.
Statistical Bias Adjustment
I developed a system to automatically adjust for the average profit bleed or sandbagging. When the contractor’s chief financial officer or his cohort accessed the WIP information, the number was displayed in the original amounts reported but also automatically discounted for profit bleed or increased for sandbagging by the historic factor associated with each project manager. The corrected amounts could then be used in compiling improved and more accurate interim and year-end financial statements.
We Need a New Industry Practice
This “statistical bias adjustment” is easy to implement because the field reporting processes and the procedure for inputting the reported data by accounting staff does not have to change. The automatically corrected amounts are simply used in compiling more accurate financial statements. The adjusted data need not be kept secret and can be shared with the project managers. We found that they understood and appreciated accounting’s final input and were relieved when they were not asked to change the way they estimated work in progress.
When Bias Adjustments become standard accounting procedure, it will reduce the failure rate in the construction industry.
For more information on the science of accounting and WIP, read more at: https://simplarfoundation.org/category/business-of-construction/business-strategic-project-planning/
For a broader view on role and duties of a CFO, read more here: https://simplarfoundation.org/?s=cfo
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Please circulate this widely. It will benefit your constituents. This research is continuous and includes new information weekly as it becomes available. Thank you.