By Ron Coleman
Often, we get so caught up in our day to day operations we forget that the reason we are in business is to make money. Some keys to making money are managing cash flow effectively and knowing exactly how profitable each project is as it progresses.
With service work and time and materials work, we know how many hours we have paid out and how many we have been paid for. This makes it relatively straightforward to calculate our profits.
It is more difficult with small retrofit jobs, but as they usually get completed within a month or so we can also monitor its profitability with little difficulty. Service work and time and materials jobs have good cash flow and often we can get deposits on retrofit jobs. In fact, we should always endeavour to do so.
Larger job challenges
The real difficulty occurs when we are running larger jobs. Large retrofit jobs and new construction often run for many months and it is very rare that the accounting records show the real profit of a job in progress. The month-end reports are generally way off.
Contractors like to bill as aggressively as possible in order to maximize their cash flow. While this is great for cash flow it tends to overstate the monthly profitability quite significantly. This means we are never sure how much profit we are making on the project until it is completed. We are likely showing too much profit at year-end and paying income tax on profits we haven’t yet earned and worse still we may be paying out bonuses on profits based on “fake news”.
Many commercial mechanical contractors work on a 12 percent gross profit. I recently reviewed the statements of a mechanical contractor who has done over $30 million in sales over the past four years and averaged a gross profit of 10 percent. Believe me when I say that is not unusual. Consider that this contractor has a holdback of 10 percent, which means he can’t even cover his direct job costs without over-billing and has no recovery of overhead either. He does not get into a positive cash flow on the job until he collects his holdback.
His only solution to managing cash flow is to attempt to over-bill. This gets tougher as the job progresses. Once you get to about 75 percent complete it is easy for the client to evaluate the progress and suddenly your cash flow gets cut off.
Managing cash flow
In order to ensure that you understand when you are likely to have cash flow problems, you need to get a real handle on your work-in-progress.
Companies that have bonded jobs are obliged to make these calculations monthly. How accurately they do them is hard to know.
The objective is to determine whether the job is overbilled in relation to the progress and to the costs incurred.
There are four ways of calculating the under/overbilling:
- Use actual cost in your ledger compared to the amount billed;
- Use amount billed;
- Use percent complete; or
- Use a work-in-progress adjustment based on cost incurred.
Use the actual cost in your ledger compared to the amount billed:
As this is the amount of expenditure you have actually incurred and what you have invoiced, it reflects what your ledger is showing which is unlikely to be realistic.
Use amount billed:
Using the amount billed and adjusting your cost to reflect your expected gross profit on each job tends to overstate the percent complete and is thus likely to hide potential errors in profitability.
Use percent complete:
Using the percent complete and adjusting our ledger can provide accurate data. This relies on the site people providing realistic input. If a job is not going well, they may be overly optimistic and hide the truth. Also, getting this information on all jobs in a timely manner can be time-consuming.
Progress versus cost
Use a work-in-progress adjustment based on cost incurred:
This is my preferred method of tracking work-in-progress.
In the charts on this page, figures in red are inputted and figures in black are calculations
|Job Title||Current Contract value||Estimated costs||Estimated gross profit||Estimated markup||Billed to date||Costs to date||Expected billing to date||(Under)/ overbilling||% Complete||% Complete|
|2||Contract value, including approved changes||Estimator/PM|
|3||Contract costs, including approved changes||Estimator/PM|
|4||Estimated gross profit||Column 2-3|
|5||Estimated mark-up||Column 4/3|
|6||Billed to date||General Ledger|
|7||Cost to date||General Ledger|
|8||Expected billing based on cost to date||Cost + (cost x Col 5)|
|10||% complete||Column 8 as % of column 2*|
|11||% complete||Project Manager’s estimate|
*100 divided by estimated cost multiplied by cost to date (100/Col 2*Col 7)
Leave nothing to chance
Twenty-five percent of trade contractors make exceptional profits. They don’t get those results by leaving things to chance. Measure, monitor, manage. These are three very important keys to success. If you would like to be one of those top 25 percent, then start by implementing a good work-in-progress system and measure, monitor and manage these results every month.
In the chart, in Job 1 we have highlighted two items to be investigated. Column 9 tells us we are overbilled and columns 10 and 11 show a discrepancy in job progress between where our accounting and our project manager believe our results are. We have now measured our results and monitored them, and this gives us the tools to manage them. Go on, make your business profitable.
PS: While this content will help you manage your profitability, do review new legislation on prompt payment to ensure you manage your cash flow. A lack of cash flow will bankrupt you a lot faster than a lack of profits.