Strategic CFO, Bradford Pack, discusses the 7 most common financial challenges faced by construction companies.
With long project times, sizable material orders, and upfront labor costs, the construction industry often faces a variety of financial challenges. Below are some of the top financial challenges and mistakes we see construction companies facing.
1 – Doing Work Without Documentation
One common financial mistake construction companies make is doing additional or changed work without documentation.
The construction industry is very hands-on, meaning a lot of decisions and changes are made on the field based on a quick conversation and a handshake. All too often, that additional work doesn’t get documented through a formal change order before the work is done.
If the change does make it to the office for documentation and invoicing, it’s common for the pricing to have already been negotiated on-site and invoiced without formally crunching numbers. This often results in little to no profit for the extra work. The result of these undocumented changes is an added cost to the contractor that may or may not be billed in the end.
Why it’s an issue: Undocumented changes or changes that have invoiced at a loss can mean reduced profit margins or even a loss on a project.
How to fix it: Construction companies can fix this financial issue with a better set of processes to facilitate mid-project changes. It starts before the project begins with a detailed scope of work and is supported by a detailed change-order process. This process should be designed to allow time for the contractor to put together pricing—instead of shooting from the hip—as well as documenting project changes and sending them to the finance team for invoicing. This document should be signed by both the contractor and customer before the additional work is started.
2 – Invoicing Late & Missing Bank Draws
Many projects have invoice submission deadlines for a monthly draw from the bank. If you miss the deadline, then it may not be until the next month before the invoice can be submitted to the bank and paid.
Why it’s an issue: Just because your invoice hasn’t been paid on time doesn’t mean your workers and vendors are going to wait for their money. If late invoicing has become common practice in your company, you’re likely having to front or float costs until the invoice is paid. This not only increases your financial risk, but also means you have less cash on hand to put back into the company.
How to fix it: Late invoicing is often the result of lax reporting systems, a lack of communication from the field, or an overworked financial department. Consider consulting with an outsourced CFO to determine where systems can be improved for more timely invoicing and optimized cash flow. Many financial issues related to cash flow in construction companies can be resolved by restructuring a few key financial processes. However, if your processes are optimal and you believe the issue lies in an overworked financial staff, you may consider hiring a part-time bookkeeper or financial controller to help balance the workload.
3 – Misunderstanding Costs
One of the most common financial mistakes in the construction industry is not having a clear understanding of costs. A construction company should have comprehensive knowledge of down-to-the-detail costs. This includes not only materials and labor, but equipment and administrative costs as well. Without this understanding, projects may be incorrectly priced, leading to jobs that are ultimately destined to be money losers.
Why it’s an issue: Without in-depth knowledge and processes surrounding costs, you can’t have an educated view of your profit structure. You’re likely bidding some jobs too low, losing out on some projects you’ve bid too high, and may have undiscovered adjustments that, if made, could maximize profits across the board.
How to fix it: The best place to start is to look at your income statement. Are expenses being properly allocated to the associated jobs? Are there any costs that aren’t accounted for? Do you have a method for factoring in expenses such as equipment depreciation, administrative expenses, or property rentals? If you’re not sure where to start, consider consulting with a CFO advisor.
4 – Misallocating Costs
Hand-in-hand with the mistake of misunderstanding costs is the misallocation of costs. Each project’s costs should be meticulously accounted for to achieve a more reliable analysis of profitably. Without this information, a construction company may not know whether a job is truly profitable or not.
A common issue construction companies may find is that they have some jobs that are extremely profitable, and others are not. While for many construction companies these projects balance out to be “overall profitable,” but without a deeper look, construction companies may be leaving money on the table and missing out on a higher level of profitability.
Why it’s an issue: Making the best financial moves for your construction company means having detailed financial data to make more informed and strategic business decisions. This starts with an accurate allocation of costs. Better understanding costs can lead to more optimized profits on all projects, ultimately leading to a more profitable company.
How to fix it: If you have a talented financial staff, then some analysis and a more detailed refinement of financial processes can usually do the trick. However, if your financial department is staffed only with bookkeepers and/or accountants, you may want to consider bringing in an outsourced CFO on a fractional basis to help with some optimization.
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5 – Fixed Material Cost in Bid Contracts
Some contractors have built into their contracts the ability to adjust material prices due to market fluctuations…and some don’t. For example, when steel prices jumped a few summers ago, some companies saw an increase in material costs almost overnight and many had to eat the cost since they couldn’t contractually pass the cost on to the customer.
Why it’s an issue: Market changes, especially in the current manufacturing environment, fluctuate quickly. This can mean taking an unexpected loss if you don’t have language in place to protect yourself from unexpected changes.
How to fix it: Implement language in your service contracts to allow for adjustments based on market price. Some construction companies, to avoid ambiguity and distrust with their customers, will set standard language where if the market price for materials changes by a certain percentage then the extra cost will be invoiced to the customer.
6 – Insufficient Cash Reserves
Construction companies generally have to front all of their labor and material expenses, sometimes by as much as 90 days or more. Depending on where they are in the construction cycle and how big the job is, they may not see some cash come in for up to a year. If a construction company doesn’t have the cash reserves to handle this, they may end up having to take out unnecessary loans or delay important payments such as payroll. This can accrue interest costs or cause distrust with vendors or employees.
Why it’s an issue: The construction industry is already laden with plenty of financial risks. It’s important to minimize the amount of time between the time you pay your employees and vendors and the time you receive payment from the client. This will help to minimize your financial risk and keep more cash on hand for seasonal fluctuations, unforeseen circumstances, and for preserving working capital to more strategically grow your business.
How to fix it: One change contractors can make is by requiring a 25-50% deposit on a project. This can help reduce the amount of labor and material costs being fronted by the company. You can also consider renegotiating vendor contracts to extend billing cycles or to pay some or all of the costs after the project is complete. This works best when you have a good, trusting relationship with your vendors. If you don’t yet have this type of relationship with your vendors, start cultivating one now.
7 – Front-Loading Costs
A final critical issue construction companies often face is front-loading costs. This is the tendency to use money received from one client project to pay for the costs of a second construction project. This often occurs because of a problem project, such as one that is improperly bid or that runs into delays or labor overages. The construction company will scramble and “rob from Peter to pay Paul.” This can often turn into a cyclical problem, causing issues further and further down the line and creating significant risk.
Why it’s an issue: Taking from a second project’s funds to pay for the first project can put the company at risk of not being able to finish the second project, ultimately putting both projects at risk. It can also damage relationships with the other customer since this misallocation of their project funds may mean a lack of funds for their project and can often result in delays or temptations to cut corners on quality.
How to fix it: Front-loading is often the result of poor project planning, improper bidding, and/or lack of a timely and robust forecast. Bids should ensure that the fees charged in the early phases of a project correlate to the value of the work performed. Implementing a rolling forecast for each project and ensuring that all bids have a sufficient contingency built into the later phases of a project estimate can both manage or eliminate risk of front-loading.
How can we help?
Does your construction company suffer from any of the above financial issues, or from a problem not listed in this article? We can help! We have several CFOs on our outsourced CFO team who are experts in the construction industry. Call today to discuss your challenges with a CFO or to schedule a free consultation.
About the Author
Bradford Pack, Consulting CFO
Bradford is a senior executive with over 25 years of experience in finance, accounting, administration, and operations management roles around the world. He has managed global teams and advised executives, board members, and other key stakeholders. He has also mentored hundreds of individuals at all levels, backgrounds, and areas of expertise.
Bradford has worked in multiple public and private companies of all sizes and stages, from pre-revenue startup and VC/PE to large publicly-traded Fortune 100 companies. His industry specialties are commercial construction, manufacturing, IT, SaaS, and Enterprise Software,
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