Are Your Projects at Risk of Low Profitability?
This is part 1 of 2.
If projects are the primary revenue stream for a business, then careful financial management of each project is critical for the success of that business. Managing a project’s finances means much more than just focusing on its revenue, it clearly also means vigilant control of costs, along with ensuring contract terms laid-out by the client are successfully delivered on time.
Additionally, clients and other stakeholders can be very demanding in their requests to be regularly updated on the budget status of a project. Management, for example, will want to keep a close eye on ensuring the budgeted project margin is realized once the project is complete as it is the foundation of their business model. Project managers will therefore need to be able to produce detailed reports on project finances on-demand that include analysis on actual margin and profit. And compare that against the planned, or budgeted, profit to determine any variances. A project manager will therefore need to apply key techniques for ensuring target profitability is achieved. In this article, we explore several methods for protecting and maximizing profit from project estimate all the way to close out.
This article is part one of two parts. We’ll release part 2 in the coming weeks. For now, enjoy the first four of eight methods for eliminating threats to project profitability in construction projects. Please feel free to leave a comment below to share your thoughts and experiences.
1. Planning and Budgeting for Success
The work breakdown structure (WBS) and cost breakdown structure (CBS) are the primary structural elements of the project plan. The WBS should layout all the activities, cost areas, schedule and milestones that are required to complete the client deliverables. This is a hierarchical representation of work, timing and objectives to be achieved. The CBS is also a hierarchical structure, but represents the budgetary cost areas of the project broken down into more granular cost codes to be budgeted, tracked and progressed over the duration of the project.
Once the WBS and CBS are established, the project can then be estimated.
1.1 Project Estimating
Clearly the initial project estimate sets the baseline for all the cost, revenue and margin expected to complete the project. As any good estimator will tell you, the art of the estimate is being able to strike that tricky balance between targeting maximum profitability while submitting a competitive bid that will win the business. If the project is under-estimated, profits are compromised, if it’s over-estimated, the bid is less likely to win.
1.1.1 Utilize Benchmarks and Norms
Estimators need to lean heavily on historical pricing benchmarks for similar work or projects. Using a software system can help with this as it can track and aggregate all historical data and report on pricing on everything from materials to labor services to rental equipment and more.
Estimators should also rely on standardized costing databases as norms for what price to bid for the various resources that go into an estimate.
1.1.2 Account for Indirect Costs in the Profit Margin
Another piece that often gets overlooked in project planning and estimating is how to allocate project indirects in the bid price. Indirect costs can include project costs that are not directly related to the completion of deliverable activities. For example, project management, mobilization, legal, administration, etc. These are costs that often have no specific home on the work breakdown structure; but need to be prorated across the project direct costs as part of the reimbursable margin.
1.1.3 Identify and Manage Risk
Project risk can pose a real and potentially damaging threat to a project if it’s not planned for and managed carefully. Not all projects are inherently risky as they can be in an area of core competency for the contractor. Larger projects that span years and dip into areas of potential uncertainty, however, can carry significant risk which should be identified and accounted for. This can be done through agreed-upon contingency planning or by isolating these areas into a different pricing model or special contract terms; or simply estimated with sufficient padding to absorb the potential for risk.
1.1.4 Negotiate Hard
The negotiating phase is an integral part of contract management and getting good at it is vital for starting a project with a favorable deal and reasonable terms. When work is scarce and competition is fierce, contractors don’t necessarily have the upper hand in negotiations, but this doesn’t mean you have to walk away with a losing proposition and slim margins if you can negotiate terms that don’t compromise profits but nevertheless give the client what they want. This leads to the next section on contract terms and making very sure you’ve read the fine print.
2. Know Your Contract Terms
In order to eliminate friction, penalties and delays in getting paid by the client, the contractor has to be very familiar with what is required to complete the project deliverables according to the contract terms agreed-to with the client. These terms define the method and frequency for how the contractor recognizes revenue and gets paid for their work – regardless of the contract type, lump sum, T&M, cost plus, unit price, etc. Getting paid, however, can be subject to any number of conditions that need to be met; and it’s the responsibility of the contractor to evidence the substantial completion of a deliverable, milestone or progress prior to the client approving the associated invoice. Understanding these terms is thus vital for smooth billings, revenue collections and therefore, profits.
3. Use a System to Track Everything
Once the planning phase of the project is complete and the project moves into execution phase, it’s vitally important to track the project’s daily activities, costs, hours, etc. And it’s equally important to use a system – rather than spreadsheets or paper – to capture this project information. Information such as:
- Hours of labor & equipment
- Materials & consumables
- Physical progess such as installed quantities or completed deliverables
- Subcontractor costs and hours
- RFIs & scope changes
- Photos, documents
It’s key to capture this data on a daily basis so that you can monitor your project’s health in real-time. Using key metrics and performance indicators provided by the system enables the project team to identify issues early on, so that they can take corrective action swiftly before small issues become bigger issues. You also are rewarded with a wealth of data to substantiate and defend your position should anything go wrong, or anyone question your assumptions.
4. Keep Your Eyes on the Prize
It’s tragically uncommon for contractors to monitor profitability and profit trends in real-time. It’s easy to lose sight of the ultimate purpose of why you’re doing this in the first place – which is profit – and get caught-up in just getting the work done. People are hardwired to want to do the job and do it well; and this is clearly a desirable trait. Coinciding with that, however, it’s critical to also take care of business and finances to make certain you’re achieving the margins that were planned. Crunching numbers and scrutinizing the project financials is clearly the boring stuff that people frequently avoid or neglect.
5. Monitor Planned Profit versus Actual Profit
All projects are planned with a target margin baked into the price, but how do you know if you’re achieving that margin as the project plays out? How do you know if certain areas of the project are not performing well and are risking the overall profit of the project? This is again an area where a system can truly help. It’s effortless for a system to continuously calculate actual margin on a real-time basis and compare that with the original target margin.
To be clear, I’m not suggesting any company compromise quality for the sake of profit. What I’m advocating is to recognize that they’re both equally important. It’s just business.
More to Come...
Stay tuned for the second half of this article where I’ll discuss the importance of monitoring cash-flow, change orders and more.