Profit fade can be a serious problem for construction companies. It’s not only a red flag for sureties and lenders, but also a negative indicator regarding the overall financial performance of the business.
As the name suggests, profit fade simply means a decline in expected gross profits over the course of a project. There are many potential causes, including overly optimistic estimates, inaccurate job costs, unbillable change orders, unexpected job-site conditions and unreliable supply chains.
If profit fade affects only a couple of projects a year, you might be able to make up the lost dollars on other jobs. But if it becomes a systemic problem, the impact on your bottom line can be devastating. Here are five tips for avoiding profit fade:
1. Create a budget. It’s difficult if not impossible to identify and manage profit fade without a realistic budget for each job, based on the original bid.
2. Monitor work in progress. A budget is ineffective if you simply put it on a shelf, or file it away on a hard drive, and forget about it. Monitor each job’s progress closely and follow up on any discrepancies between budgeted and actual performance. Prepare regular work-in-progress reports to track:
- Contract prices,
- Amounts billed and costs incurred to date,
- Projected final costs, and
- Estimated gross profits.
Tracking this information in real time alerts you to problems early and allows you to address them before it’s too late.
3. Get a handle on job costs. Evaluate your estimating and job costing systems and processes to be sure they’re accurate and complete. If profit fade is an issue, use more conservative assumptions in your estimates. Include contingent costs to provide a cushion against potential delays and other unanticipated expenses.
4. Build protections into your contracts. It’s hard to avoid profit fade if your contracts are vaguely worded or make it easy for the owner to change the project’s scope. To minimize unanticipated costs, double-check that your contracts clearly define the nature and scope of work and set forth straightforward change-order procedures that ensure you’re compensated for extra work.
5. Learn from your completed jobs. Analyze completed jobs to look for patterns and trends. Determine whether profit fade is associated with certain types of jobs, locations, customers or personnel. If you identify a clear cause, address it immediately.
Unfortunately, in today’s uncertain economy, there’s no way to eliminate the risk of profit fade altogether. However, by identifying factors associated with this common problem, you can take steps to prevent it from adversely affecting your financial performance on future jobs. Our firm can help identify, track and analyze the right metrics for catching and mitigating profit fade.