Last week we settled on this definition of business which bears repeating:
Business is the purposeful pursuit of profit through the commercial activity of satisfying customer needs at a cost that is less than the selling price. To be classified as a business, an enterprise typically exhibits several key traits:
- Profit Motive: Most businesses operate to generate a profit—financial gain after all costs are paid.
- Economic Activity: They involve regular, continuous transactions rather than isolated exchanges. (With the glaring exception of construction).
- Risk & Uncertainty: Operating a business inherently involves the risk of financial loss or market shifts.
- Value Creation: They must provide a good or service that satisfies a societal need or want.
Findings from CMA
For many years I operated CMA, my consulting company that completed failed construction projects for Sureties who had issued payment and performance bonds. I worked with and interviewed thousands of contractors who had defaulted on the bonds and learned about their profit beliefs. Here are the findings about construction profits and the beliefs held by contractors that led to these failures:
- Decades of research into the causes of contractor failure demonstrated that a large percentage of contractors fail to make a profit.
- I found that, in fact, some contractors don’t seem to be in business for the profit. They’re in business to stay in business and make their living from it.
- Construction profit margins have been steadily declining for more than 40 years.
- Too many contractors take jobs they know may lose money because they need the work to cover ongoing overhead.
- Construction accounting is unable to determine the precise profitability of work-in-progress. Construction accounting rules allow the use of “estimated” amounts to determine the percentage of job completion and the resulting amount of revenue earned against which costs will be charged. This accounting methodology has caused contractors to lose faith in interim profitability metrics and rely more on cash flow to determine the ongoing success or failure of work-in-progress.
- Contractor financial statements are made up of multiple partially completed jobs so they cannot accurately determine whether the company is operating at a profit in any given accounting period.
- Most contractors know that jobs acquired in highly competitive “low-bid” government auctions may lose money. They disregard profit in favor of cash flow and take these jobs to maintain their sales and growth goals.
- Unlike manufacturing and retail who can accurately determine the profitability of all financial transactions because their model transaction repeats itself many times in a single accounting period. Construction profitability can only be estimated (sometimes guessed at). The construction financial transaction is not a repeat of a model transaction (Total cost of production minus the selling price = unit profit). Each construction contract represents an entirely new financial transaction (new selling price – new costs booked against estimated revenues) paid over an extended period (not continuously repeated within an accounting clycle).
One Man’s Profit is Another Man’s Cash Flow
After a decade of completing failed projects for Sureties I began to realize that the word “profit” did not have the same meaning for contractors as it had for other business executives in other industries.
Most contractors start out as small concerns that are trying to “make a living” providing construction expertise to various owners. These small businessowners learn to book every expense to their company to avoid having to pay taxes at the end of the year (This is the first accounting principle most contractors learn). In other words, they are trying to avoid declaring much profit. At that level, profit is a dirty word forcing the payment of taxes. This early experience impacts their beliefs about profit, even though they often grow into quite extensive concerns, some contractors remain uncomfortable with the concept of taxes.
Of course, they understand that their company’s business activity needs to generate profit to stay in business and continue to grow, but some never seem to get clear at what stage in their evolution they should be paying taxes. As long as the cash keeps flowing from one job to the next, some contractors tend to leave the bits and pieces of precise profit and loss calculations to their accounting departments. In effect, they lose “touch” with “profit” and focus primarily on “cash flow”.
Back to Profit
This blog site is devoted to reinstating “profit” as the primary purpose of the contracting business. The steady erosion of profit margins we have been discussing is multiplying the risk of complete collapse for many contractors. There is little room for error in a complex business fraught with error. It is time to step back and take a critical look at the beliefs we hold about profit and recognize the errors our industry is making managing what is now one of the largest and most economically impactful industries in America.
Stay with us as we expand on these issues.
For more information on profits, read more at: PROFITS
For a broader view of construction billing read more at: BILLING
To receive the free weekly Construction Messages, ask questions, or make comments contact me at research@simplarfoundation.org.
Please circulate this widely. It will benefit your constituents. This research is continuous and includes new information weekly as it becomes available. Thank you.
