by Kenneth J. Hedlund, CPA
Economic indicators have led to the conclusion the recession is behind us. However, this doesn’t provide much comfort since the operating environment is still extremely challenging with little relief in site. Further residential mortgage failures, potential impact of upcoming balloon payments, refinance challenges, likely defaults in the commercial mortgage market and other factors are causing concern that a double dip recession is not out of the question. Bank lending/financing is still difficult, resulting in limited private commercial work. There has been a fair amount of federal, state and local projects and since less than 20 percent of stimulus money has been spent to date, this does appear to be an area of opportunity. At this point most of the stimulus money spent has and will continue to be on road work and other horizontal construction. At some point we anticipate stimulus money with some additional allocation to the vertical construction market. However these opportunities in federal work is one many contractors are diversifying and looking to participate which reduces the overall value proposition.
Most contractors have had a challenging year in 2009. We work with several hundred contractors and generally with few exceptions what we are hearing is gross revenue reductions for 2009 from 2008 anywhere from 5 percent to as much as 50 percent. Those that are having pretty good net profit years seem to be accomplishing that with a combination of decent backlogs and related margins carried into the year plus proactive overhead and staff reductions. The good news is that they now have theoretically survived the recession. However, ongoing patterns of less work, increased competition, lower margins and slower pay continue to create a challenging environment. And since the construction industry will lag in realizing the impact of the recovery, even the most optimistic say it may be late 2010 and into 2011 and potentially even 2012 before work picks up and backlogs improve. All indicators are that for most, 2010 will still be as or more difficult than 2009. Following are some discussion points and contractor best practices to further “Retool for the Economic Recovery.”
We will continue to see margin compression, which will further intensify competitive bid, fixed price bid risk. With less of a margin for error, sound practices will be critical as ever in estimating, subcontractor and vendor approval, project management, scope and change order management, billing and collections. Maintaining profitability and minimizing project fade will be essential.
It is important to understand the impact of working in such a competitive environment and accepting lower margins. What is the real impact of a contractor that normally averages 10 percent margin accepting an average of an 8 percent margin in order to continue to get work? That will require an increase in gross revenues of 25% to get to the same overall margin dollars (need $1,250,000 in volume at 8% to result in the same gross profit from $1,000,000 at 10% or $100,000 gross profit). Accepting work at even further declining margins from 10 percent to 5 percent will require an increase of gross revenues of 100% to get to the same overall margin dollars (need $2,000,000 in volume at 5% to result in the same gross profit from $1,000,000 at 10% or $100,000 gross profit). The likelihood in the current market of making up the margin shortfall with volume is very unlikely let alone extremely risky. Be realistic in setting budgets for 2010. Cost, volume, profit analysis is a critical analysis to perform. Budgeting for growth in volume and margins might be too optimistic, like looking through rose-colored shades. It would be advised to consider realistic conservative revenue and margin projections and right size your organization from an infrastructure, overhead and staffing standpoint. For many contractors and entrepreneurs, this is a difficult concept and contrary to their instinct and tendency for growth.
Following are several areas that successful contractors focus on in any economic environment to maintain a level of profitability and cash flow.
Profit is important and cash flow is key. Increased diligence in protecting profits from owner, second tier contractor, supplier and vendor failure is essential. Do your homework up front with significant increase in acceptance and approval of those with whom you choose to work. And then routinely monitor and use proactive risk management to protect your organization. We have seen routine use of joint checks, filing and protecting lien rights, etc., come into play more and more in recent months. When billing, if outstanding receivables age beyond normal terms, know your tolerance level. Don’t let anyone get so extended that their failure could also be your demise.
If at all possible, you should minimize additional bank borrowings and plan to cash flow from operations. To accomplish this, a cash flow projection must be used to provide the contractor with the necessary information to proactively manage the organization. A 30-60-90-120 day cash flow projection should be a component of a contractor’s routine financial data. To provide for effective management and decision making, the cash flow must be conservative and you should meet or beat your projections. If there is an indication that there will be a cash flow deficit, it will be necessary to refine management plans and potentially implement cost reductions in overhead and, if necessary, staff. Most contractors have already done this to some degree. But it may become necessary to cut beyond just the fat and into the muscle and bone. Have a plan and know in advance what your plans are for future cuts. Identify tier 1 (easiest) to tier 5 cuts (most difficult). As projections indicate future cash flow deficits 30, 60, 90 or 120 days out, the cash shortfalls can be avoided through effective and proactive management and implementing tiers of already identified cuts.
Focus on increase operational efficiency. It’s the simple concept of doing more with less. That is where you can create success in this difficult market. If you have effectively right sized your organization and are left with high performing employees, you can capitalize on production and efficiency. Regardless, we strongly recommend putting in place a system of performance measurement to provide a model of accountability. In the design of such a plan, contractors should focus on five critical areas that typically include operations, financial, business development, employee satisfaction and customer satisfaction. Routinely monitoring employees’ progress towards meeting the objectives set in the performance plan in these critical areas will maximize overall return on investment (ROI) in any economic environment. Further, it’s the concept of what you measure you can manage.
In summary, retooling for the recovery will require proactive and sound business principals and best practices. These concepts apply to any economic environment. But prior years have allowed companies to let their guard down and still be successful. Many have survived in spite of limited or less than thorough application of these concepts. At least in the near term, the margin of error has significantly diminished and not applying sound business practices can quickly result in failure.
Contractors that effectively apply these principals will be positioned for continued success in the current challenging economic environment and poised to thrive in the ultimate recovery.
In future ACP publications, Somerset CPAs Construction Team will contribute articles in the areas of contractor management best practices as well as financial and tax updates. In addition, ACP and Somerset will host a series of webinars—The Contractor Success Series: Financial Power Tools and Best Practices for the Construction Industry. This exclusive industry-specific series provides participants with priceless information with practical application of the subject matter focused on: financial success, operational efficiency and risk management, optimizing employee performance, developing a culture of business development and maximizing customer satisfaction. Success in these key areas will maximize return on investment (ROI).
This article ran in the January 2010 issues of the ACP magazines.
Associated Construction Publications and Somerset CPAs Construction & A/E Team invite you to participate in our Contractor Success Webinar Series: Financial Power Tools and Best Practices for the Construction Industry. The webinars will be presented by Ken Hedlund and the construction experts of Somerset CPAs plus occasional guest industry experts and will be moderated by ACP’s National Editor, Greg Sitek. These presentations will be beneficial for construction-industry business owners, COOs, CFOs and other key managers.
Webinar #1: Retooling for the Recovery Tuesday, February 23, 2010 11:30 a.m. to 1:00 p.m. (Eastern) – Presentation / 1:00 p.m. to 1:30 p.m. – Open Q&A Is the construction industry on the road to recovery? Is your company positioned to make the most of it? We will discuss what can be done today to make your company stronger now and better positioned for the industry recovery. We will provide operational and financial strategies for navigating an economic downturn, working with banks and sureties, improving your balance sheet, right sizing, maintaining profitability, maximizing cash flow and more. We will present a contractor-specific toolbox of ideas for consideration to maximize the potential for your organization to maintain financial stability now and be poised to thrive with the recovery.
How to Participate
Utilizing GoToWebinar and your telephone, you can participate at your desk or in a conference room with a group. There is no limit to the number participants at one location. For detailed information on the webinar or to register, go to www.Somerset-Team.com.