In the current economic climate, contractors are slashing margins to break even (or less), chasing projects that are not aligned with capabilities and making decisions with an eye toward merely surviving. Smart contractors have sought projects that are a good fit, hired wisely and managed their overhead strategically; however, even the best-managed firms need to regularly review the competitive environment in which the firm operates by examining the climate, customer, competitor and company factors driving performance. If a contractor’s strategic plan was developed in a different market than the current one, the context most assuredly has changed and could affect the company’s short- and long-term performance.
In order to survive and thrive in any situation, construction firm managers need a dashboard containing a few key metrics to effectively analyze their company performance factors and predict their ability to weather rises and falls in the market.
The following five key performance indicators are valuable aids to executive decision-making.
- Backlog and pipeline quality indicator to evaluate the strength of the business development/sales operation.
- Backlog margin spread to evaluate the future, near-term financial performance of the company.
- Liquidity indicator to evaluate the cash usage and needs of the company.
- Overhead as a percentage of revenues to evaluate the efficiency and field-orientation of the company.
- Gross profit per employee (by category) to evaluate the efficiency of the company’s field operations.
Backlog/Pipeline Quality Indicator
A backlog/pipeline quality indicator forces contractors to strategically evaluate the quality of work under contract and the work-acquisition pipeline. A signed contract used to be nearly as good as money in the bank, but in the current market each job in backlog must be graded for the likelihood of execution, security of financing and firmness of customer commitment. Likewise, project opportunities must be evaluated to determine any distinctive advantage the contractor may bring. Contractors must design a work acquisition and retention strategy that ensures a sufficient amount of profitable backlog to fund operations through a depressed economic cycle.
The work in backlog and in the pipeline is broken down among various categories to provide a quick visual representation of the contractor’s business. Then, each category of work is discounted based on the probability of performing the work and collecting payment. While quality ratings are subjective, the intent is to conduct the evaluation as a way to design a backlog management strategy. Higher quality pipeline and backlog items should be watched for indications of slippage, while lower quality work should be aggressively managed and losses minimized. Ultimately, having a means of identifying the best opportunities and developing a strategy for capturing them is how a careful contractor will survive the current down cycle.
Backlog Margin Spread
This next indicator is a potent predictive tool that can allow a contractor to assess the financial health of its backlog and ensure the firm is entering a downturn with the right mix of jobs and the right amount of overhead. By looking at the anticipated monthly gross profit of a firm’s backlog and comparing that profit to the firm’s anticipated monthly overhead expense, contractors can identify the point at which gross profit falls below the point of breaking even. This is especially helpful in a down market, as it provides management with important deadlines to either acquire new, profitable work or begin to resize the company’s overhead structure to prevent loss.
For example, contractor XYZ seems to be doing fairly well, with a $360 million backlog at a 3.4 percent average gross margin. Yet, a look behind the numbers reveals future problems. Examining the backlog report with the percentage completion data indicates this contractor will be significantly overbilled. While this practice can help reduce liquidity pressure, overbillings are listed on the balance sheet as a liability for a reason; the contractor has received payment and now must perform the work to justify that billing without additional revenue on that portion of the work. While a good economic climate and continuing growth in backlog makes this a non-issue, high-margin replacement volume may be difficult to find in a downturn.
Contractor XYZ’s backlog shows some disturbing issues. For several jobs, the high levels of overbillings accrued to date mean the contractor will be losing money in each month that work continues on those jobs. The billings are already so far ahead that if additional high-margin replacement work doesn’t occur, the contractor’s expenses will exceed monthly billings.
While these ramifications are important in their own right, plotting the profit per month remaining against the contractor’s overhead highlights a bigger problem. This contractor has annual overhead costs of about $3 million. Plotting average monthly gross income versus average monthly overhead expense shows the results of high overbillings and low-margin replacement work. In contractor XYZ’s case, the highly profitable backlog begins to dry up after April. In July, the firm will begin paying to complete its contracts. As a result, contractor XYZ needs to proactively tighten overhead and seek out additional profitable opportunities in the first quarter, rather than waiting until the latter half of the year to react.
Liquidity Indicator
Successful contractors know that cash is king. However, cash management practices vary widely from firm to firm, and few contractors use a liquidity indicator to evaluate whether their cash management practices are working for them or against them.
A liquidity indicator is a graphical representation of the firm’s cash management practice. When negative, the liquidity indicator demonstrates a practice of using other people’s money to finance construction operations; that is, the firm’s subcontractors and vendors are financing the work in process through accumulation of accounts payable. Conversely, a positive liquidity indicator is a sign that the contractor is burning its own cash to finance the work in process.
Consider a construction management firm in the south that performs nearly $200 million annually with after-tax profits of about 1.6 percent. It is strongly overbilled, with overbillings net of underbillings at $4 million. Leadership’s lack of focus on cash management means the firm needs to have a week’s cash on hand ($3.6 million) to finance its work.
Conversely, a Midwestern general contractor performs $165 million in revenues with an after-tax margin of only 1 percent. Yet, the contractor is able to gain in cash position year to year because customers’, suppliers’ and subcontractors’ money finances its backlog. Management of its payables and receivables is providing the firm with three extra days of working cash per month. This provides a cushion to keep money flowing smoothly if a late payment occurs.
Although the southern contractor surpasses the Midwestern contractor on both revenue and profitability, it takes a very casual approach toward billing and collection and must burn cash to sustain operations. One large missed or late payment by its customers might send the firm scrambling to pay subcontractors or, at the very least, cause heartburn for senior management.
Overhead as a Percentage of Revenues
This is perhaps the most simple and intuitive metric used to forecast trouble for a construction business. While overhead expansion during periods of strong revenue growth is expected—and even necessary to a certain extent as revenues fall—cutting overhead in response to periods of decline is often difficult.
Companies grow attached to the new perks available to employees, to the extra help around the office and to larger expense accounts. Often, the initial reaction is to slash areas that are easiest to cut. For example, it is much less difficult to reduce training expense this year than to put a recent hire out of work. However, overhead costs need to be evaluated with as dispassionate an eye as possible to ensure the firm gets the most it can out of every dollar of revenue spent on overhead.
A mid-sized road contractor in the Northeast is a good example of how this “overhead creep” can be especially painful in a tight market. First, because of high sensitivity to fuel and other commodity price swings, as well as a general loss of focus as the business grew, gross margin fell substantially during the past few years. Second, overhead expenses have grown, as the business has nearly tripled in size. In fact, this period of revenue growth ultimately has proved negative because operating margins have fallen year after year. Had the contractor been paying closer attention to overhead expenses as a percentage of revenue, the firm could have been making hiring and purchasing decisions that supported a more profitable growth strategy. Instead, the company is facing the prospect of making deep cuts as the costs of performing work rises and the supply of profitable work falls.
While overhead as a percentage of revenue is a lagging indicator (meaning it has more of a reporting effect than a predictive one), it is easy for any contractor to measure and should be an important part of proactive management.
Gross Profit Per Employee
While most contractors can reference their gross revenues and profits with a high degree of accuracy, many do not evaluate these important measures by the number of employees it takes to achieve them.
Contractors often benchmark peer companies by gross revenues and gross profit per project manager, superintendent, business development employee, accounting employee, etc. As a financial management best practice, contractors should conduct this type of analysis by position against prior periods. The value of this kind of analysis is twofold.
- The contractor is able to see if the per-person revenue and gross profit trends justify a change in human resources practices either by adding or releasing personnel to accommodate revenue changes or evaluating the current workforce against historical performance.
- A contractor can use this measurement as another lagging indicator to see if revenue trends (on an annual percentage of revenue basis) are positive or negative, and take action as needed to react to these trends.
When this analysis is performed on an internal basis, a contractor can evaluate whether the firm’s project managers are becoming more or less efficient at executing projects, whether the business development team is bringing in as much work as in past years and whether the accounting department is too lean or too large.
For some contractors, gross and net margin have fallen off only slightly, but revenues and profits per project management employee have tailed off considerably. This can be attributed to the relatively fixed nature of project management hires over the short term. Beyond the obvious value of this trend analysis, management can narrow the scope even further to find the relationship of estimating cost to dollars of work bid. This type of information serves as a valuable behavior modifier to discourage time wasted on chasing out-of-niche work.
With these predictive financial management tools, contractors can assess the relative strength of their market and their readiness for turbulent times.