Early in my career, I spent many man-days developing a detailed report with graphs, charts, tables, lots of text, and circles within circles, depicting such things as the need for “congruency of strategic culture development,” trying to answer that question. The lead plumbing foreman, listening to my field recommendations, wasn’t buying any congruency that day. The president and owner of the mechanical firm pulled me aside afterward and said, “Glenn, this big, pretty report is all very nice, but what am I going to do about my brother-in-law?”
That’s when I began to better understand what most seasoned consultants understand — that less is often more. Simple, effective ideas that can be implemented are arguably one of the greatest values a consultant can bring to the table. Understandably, contractors have different objectives when it comes to determining how much money they should be making, but the bottom line is the bottom line.
Almost everyone has heard the old adage, “It’s not how much money you make; it’s how much you keep.” Presently, too many contractors are overly focused on the top line. In today’s construction recession, however, that statement carries significantly more weight. The top line is extremely hard to grow. In fact, more than 95% of all commercial contractors have had to shrink the top line in order to survive — all the more reason why you should have a “bottom-up” thought process.
Before determining how much money you should be making, it’s important to start with the understanding that construction is a risky business. Historically, it has one of the highest failure rates in the United States — both in good times as well as in bad times. Next, you must understand the concept of risk vs. reward. The reward — or return in the construction industry — should be relatively high compared to other industries. I used to throw out banking as a good example of a lower-risk/lower-return industry, but many banks got greedy and upped their risk profile considerably. Many banks (and former banks) have re-learned the risk/reward principle the hard way.
Given the risk a contractor faces, a return of 25% to 40% on his or her investment is not unreasonable. It should, in fact, be your target — and the first metric that goes into your algorithm. A simplified way to do this takes your annual net profit (before taxes and any shareholder distributions) and divide it into your current book equity number from your balance sheet. Best-of-class contractors often hit this percentage range year after year, irrespective of market conditions. Impossible, you say? Joel Barker, the famous futurist and management guru, says, “If you believe it can’t be done, get out of the way of those that are already doing it.”
As a one-time partner in the world’s largest management consulting firm to the construction industry, I saw thousands of contractors’ financial statements and worked closely with just as many inside their operations. I have seen firsthand the “best-of-class” contractors consistently achieve these returns. How can you emulate these results? Obviously, at this point, the answer becomes more complex. However, there is a simple and powerful road map to ensure your success — the bottom-up budget planner or, what I like to call, the “brother-in-law” solution.
Here is where you will want to create your own spreadsheet, ask your financial people for assistance, or enlist the help of a third-party consultant. A sample Excel template is also available at www.contractorscore.net/ROIBudget.html.
- Start with your ROI calculation mentioned previously. Go back several years and generate a range of percentages from your statements. Use the confidential management version of your statements — not the formal statement that you show to the IRS (because it may have adjustments). If your results are not in that 25%-plus range, be realistic and select a target return on equity that is reasonable.
- Next, get out your chart of accounts for expenses and go through them line by line. Determine if that cost is fixed or if it is variable. Does it stay pretty much the same as your revenue volume changes? If so, then label it as a “fixed” cost. If it moves up and down with revenue, like all direct jobs costs, then call it “variable.” Many contractors already have these costs broken into direct costs and fixed overhead.
- Start with the fixed overhead. Go through each line item and determine if that number is acceptable for the upcoming year. If it’s not, then adjust it up or down. Over the past few years, most contractors have slashed these costs.
- Review your direct job costs, and determine if the percentage of revenue each line represents is accurate or if it can be tweaked (hopefully downward). Trade contractors should pour over the labor number, because that is where the greatest risk and reward traditionally lie. Improving your labor productivity by putting in more work with the same or less labor cost can have a tenfold effect on your bottom line, compared to reducing fixed overhead.
- Add the dollars you calculated in Step 1 (desired ROI) to the dollars of adjusted fixed overhead that you determined in Step 3, and you have “the nut” that needs to be covered.
- Divide the percentage of revenue you developed on all your variable costs from Step 4 into “the nut,” and you back into the sales volume needed to make all of this work.
- Now perform a reality check, and determine if that required sales volume is doable. If it is twice the size of any annual revenue you have ever done, then you need to make some adjustments. You can either make improvements to the variable cost percentages (the biggest bang for your buck), reduce your fixed costs further, or lower your target ROI. Try these adjustments in that order.
Matteson is president of Contractor Score LLC in Raleigh, N.C. He has more than 30 years of experience working with contractors and their organizations. He can be reached at [email protected].