This is Part One of a series in which Rob, Stephen, and Wade discuss the reasons many contractors fail, and what you can do to avoid those all-too-common pitfalls. The first reason contractors fail? Accounting.
Topics we cover on this episode include: inadequate capitalization, inadequate cost tracking systems, low profit margins on a job, estimating problems, procurement problems and slow collections.
Welcome to the Contractor Success Forum. Today, we’re discussing why contractors fail as part of a multi-part series. And today’s part of the series is accounting.
At the Contractor Success Forum, we provide financial strategies from three long time industry professionals, promoting healthy thought provoking discussions and tips for running a better, more profitable and successful construction business.
Today we have with us as we always do, Wade Carpenter with Carpenter & Company CPAs, helping contractors nationally to become permanently profitable. And also, we have with us Stephen Brown with McDaniel-Whitley Bonding & Insurance, providing innovative solutions in surety bonding. And me, Rob Williams with IronGate Entrepreneurial Support Systems, driving profits in contractors’ businesses. Each of us has over 30 years in the construction finance world, and we’re happy to be with you guys today. The first subject we’re going to talk about today is inadequate capitalization.
So, does inadequate capitalization cause contractors to fail?
I’ll start on that one. The answer is yes. Yes. And yes, Rob. It causes contractors to fail. You ask how much working capital does a contractor need? It’s everything you can get your hands on. But from a practical standpoint, you’d look at 10% of your current work program as a minimum working capital that you probably should keep on hand.
I know this is a big subject right here. We could probably do a whole show on just this, but tell me, as, as the CPA in this, you haven’t seen anybody not have proper capitalization before, have you?
Oh, it happens all the time. We see people all the time try to bootstrap their construction business. They get mad at the man they’ve been working for and they jump out and say, I can do this myself and they don’t have any plan. They, Oh, then I can do this better than the man.
And it’s typical that a lot of them do not have the capital to get going and definitely not to bond a job off the bat. And so it’s a continual problem.
Well, let’s talk about what is the proper amount of capitalization in terms of ratios or capital. What do you require, Stephen, when you’re talking about the property capitalization?
10% of your backlog, work on hand, and working capital. If you have a million dollars worth of backlog, you need a hundred thousand dollars worth of working capital. That’s just a tried and true amount from the surety industry. But the right answer, Rob, is as much as you can get.
Is that a firm rule? Because I think when I was in the contracting business, we thought that was just a hard, fast rule. And then I remember with the books and everything, there were some other things that would change on that and certain things count and other things don’t count. Can y’all talk about that a little bit?
Well sure. A lot of construction projects need a lot of equipment. You own that equipment you’ve paid for that equipment. So that’s less capital that you need. You don’t have to buy equipment, you don’t have to lease equipment. That’s the number one factor of how to spread that working capital over a larger work program.
We look at it as, what is a healthy company, and generally speaking, yes, there are rules about bonding. But we tend to tell people that 1.4 times working capital. If you got 1.4 times more current assets than you do current liabilities, that’s the general rule of thumb. And I try to help people at least attain that as a healthy target for themselves.
Yeah, that’s really great to know. The second topic that we have today is inadequate cost tracking systems and Wade, you are the job costing guru CPA that we’ve got. Tell us about your cost tracking and how you can do that. He is a remote job costing person. I didn’t know that even existed. That’s a great service to be able to take advantage of.
Well, I know a lot of contractors will inevitably tell you, I know how I’m doing on my job by my gut. And believe it or not, if you don’t have good books and records, you have no idea what your overhead really is. And a lot of people use the same overhead rate they’ve always used at their last company or something. Your structure may be very different from what you had. Your company, one year to the next, that overhead rate can change dramatically. You go adding people, you go adding, you know, office space or things like that. That overhead can really drive that amount up and if you do not have a good job cost tracking internally, you don’t have a handle on your job in my opinion.
Stephen, tell us about job cost tracking in your experience and why contractors fail when they don’t have good job costing and what you look for.
As your company grows. If you’re not tracking your job costs, then you’re not managing your company. I see a lot of contractors whose companies manage them. Tracking your job cost is the most fundamental part of managing your construction company. Especially if you bid a job on a tight profit margin, you’re going to want to squeeze that job and control the cost, aren’t you? So how are you going to do that if you don’t know what your job costs are?
Have you ever had anybody that didn’t have good job costing or any experiences in that?
Yes. And, uh, you know, it’s, it’s ugly. Every one of us and our business has a customer at some time, a contractor, when you asked how their year’s going, they base it on how much money they’ve got in their pocket or in their bank account. You say, you know, but do you really know? Just use the systems, guys, that Wade and other construction-oriented accountants have put together. They work. There’s a reason why they’re so successful.
We used to have a saying that we’d say, would you rather have the lowest cost or would you rather know the lowest cost? I had a business partner in the trust manufacturing business. We used to argue about that sometimes. Do you want to have the lowest cost, but then you may not know exactly how to price it? Or would you rather know your costs, even if it’s not quite the lowest, and then you know where to price it to bid it?
And so I was of the opinion to know your cost and he was of the opinion to have the lowest cost. So we always had a little battle, there, you know, and Wade, can you kind of give me any kind of sense of what you think on that? I saw you nodding.
Yeah, well, I mean, absolutely. And it’s not just having a good cost system. It’s having a timely cost system. If you find out how you’re doing on your job next month, when you’re already, something goes wrong on a job and it’s tougher to recover from that loss and I think about it, like, the old saying about standing in a cow pasture, if you know where you stand, you tend to stand in a better place.
I like that one. I’ll have to remember that one.
That’s a great one, Wade. And another thing that I always thought was fascinating about the construction industry is it’s the one industry where there is a limit on how much profits you can make, but there’s no limit on how much you can lose on a job. And that’s why having capital and tracking your cost are so important.
Well, speaking of knowing your cost so you can have good margins through pricing it, our next topic is low profit margins. Who wants to start talking about that? And I guess I’ve never had low profit margins. That’s not true.
I can jump in if you want. A lot of contractors after the recession, you know, they were bidding jobs at a low profit margin to keep the doors open- you know, we take it a lower profit margin to get the job. And that’s where going back to the cost tracking, if you don’t really know your overhead, if you really don’t know how you’re doing all those jobs, it can go South in a hurry.
I can definitely remember the ’09 crisis and we were trying to get the revenue. And so the stories about, are you trying to increase your revenue for your job? Or do you need to increase your profits? So we were trying to bid and win bids down there at the builder’s exchange, and we were just wanting to win. We wanted to keep the factory full and keep our employees in there. And it got to be kind of a crazy situation. Stephen I, I remember our steel framing, interlude that we had a partner in there. We were not producing the steel on that one, but we had a 30% margin on those jobs. And the problem is it was a negative 30% margin on that when we finished, so that was a kind of a tough time and a tough job. He was keeping his guys busy, but if you’re in a negative 30% margin, that also was a material pricing problem because steel skyrocketed. And that was part of another subject that we had.
That’s kind of the key, Rob, of what the three of us talk about. Managing risk, you know, so that doesn’t happen. How do you manage risk? How do you keep that from happening? And how would you have kept that from happening again, Rob, when you think back about that particular job?
Well, I really think about that in terms of the Profit First that we talk about a lot on here, because you know, Wade and I are both Mastery Certified Profit First Professionals, and we really work on looking at the profit first, not the revenue. So if I had done that and controlled my costs and focused on that profit, we probably would have been better off doing some smaller jobs with a profit, but we were trying to get those great big apartments and jobs to keep things busy, where we would have been a lot better off. looking to maximize our profit through those months. It sounds so obvious looking in hindsight, but that’s not the way our thought is – our thought is revenue. And when we’re bidding and we’re doing things, we kind of make this assumption of the percent of our margins, and the assumption of the percent of our overhead, things like that when that’s not really the reality.
So, you know, focusing on that profit first, rather than the revenue first is how I would say I’d correct it. Wade, I saw you kind of nodding over there. What were you thinking?
Well, I know this is not a subject for today, but I know chasing that top level. I think we did a podcast on that. It’s natural to assume that if you grow that top line, you’re going to grow the bottom line. And in construction, if you’re doing the wrong types of jobs you’re getting the lower margins. A lot of times you can be doing a lot more, running a lot harder and making a lot less money.
And the thought process that we had was, go out there and just get it and then we’re going to make it happen. And we’d say that out loud: just go get it. And then we’ll figure it out. Well, sometimes that’s not the best strategy. And also some of those jobs, we didn’t collect very fast on those same jobs that I’m talking about. The collection’s got slow, which that is our last topic for today is slow collections.
I saw a survey the other day that said the average collection date on the invoice for a construction company is 83 days. That’s a long time.
Yeah, Wade has got this great spreadsheet that we look at that counts the days from not only when you complete the job, and get the collections, but how long do you have to have those materials in the beginning, and you add all those together. But this topic is about the slow collections, and in my mind as a contractor, I was really just counting the profit. And I knew it might be a little slower. But I thought, well, we got the profit. We have these things or some kind of finance mechanism. We’ll just, again, worry about that later. And we didn’t read all the details of what might happen.
They were wanting us to hurry and get that job because they were wanting it done so fast and we just thought everything was going to happen so fast. And one of those jobs, it took me a year to collect on it and it was a big job and that was not happy, and it wasn’t like I wanted to just go sell that receivable to somebody. That starts a whole mess of problems.
Whoa, don’t go there.
Yeah. That’s another show, but, talk about a little bit, Wade, about the ratios, the slow collections. And then what does that do to these ratios that you need for your bonding? Because I think that’s sort of the bottom line.
Well, it all goes back to cashflow and, you know that 83 days it can easily run that and more if you’re doing retainage, you know, if you’re holding retainers receivable and people need to remember that you’re financing the job or you’re owner, or you’re general contractor, depending on who you are.
Everybody in your organization needs to be a part of, let’s make sure this bill gets out on time. Let’s make sure we follow up on collections. And you know, sometimes if you’re doing something like a federal job , some of that’s out of your hands, but there are also owners and general contractors that are slow to pay and it can take a Contractor out.
That subject right there, I am definitely not afraid for us to repeat that over and over and over again. So I hope that comes up on a whole lot of our episodes. I’m not afraid to be redundant.
Me either, rob. Because you’re building the job, you’re not financing it. Maybe you need to explain that to the owner in your initial sit- down meeting before the project starts. What does the contract say and how can I bill it as fast as possible? And I expect you, Mr. Owner, to, get me my payments so I can do the job the way you want it done. Because again, construction is the one business where there is a cap on how much profit you can make, but no cap on how much money you can lose. It’s terrifying when you think about it from that perspective. So let’s just control those risks by running your business properly.
Right. Well, that is a great stopping point. Great statement. This is a great topic and we have more episodes of why contractors fail coming up. So, this is the Contractor Success Forum. We have financial strategies for you and your construction companies.
I am Rob Williams. We have Wade Carpenter, Carpenter & Company CPAs, and Stephen Brown, with McDaniel-Whitley Bonding and Insurance. Don’t forget to scroll down, you can look in the show notes down there if you’re doing this on a podcast and see all our information. Click on those links to our show page for many more resources and maybe some more videos that you can watch and links to other episodes that we have. So thanks for coming to the Contractor Success Forum today. See you later.