In today's competitive construction environment, the cost-based-pricing approach does not ensure solid profitability. No longer can electrical contractors apply traditional lump-sum techniques for estimating the cost of construction, account for a little extra to cover unknown risks, and then add a reasonable profit to arrive at a selling price. That's because today's selling price is set by the customer and the market.
For many contractors, the existing methods of cost, such as earned value analysis (EVA) or quantity installed measurement (QIM), are cumbersome and inaccurate ways of calculating the correct cost and pricing model — both on the job site and in the back office. In fact, many companies have abandoned these methods because they do not capture the complexity of their work. As outlined in the October 2006 issue of EC&M in the article “Agile Electrical Construction” on page C42, job productivity assurance and control was introduced for better measurement of the labor productivity related to the construction put in place (CPIP). To measure the impact of jobs' and customers' overall behavior on the contractor's back room operation, a new method of cost impact — customer positioning and control (CPAC) — is introduced.
The CPAC model
This method provides a practical and reliable approach to examining the quality of production by identifying the demands placed on an organization's resources relative to the value produced. You can easily measure and compare the profitability impact of various customers, subcontractors, projects, divisions, or branches — each of which has unique operating philosophies and practices. As a result, areas of strength and weakness become clearly visible. CPAC also provides a method of monitoring the effects of changes over time, as plans are implemented to address areas of insufficient profits or significant costs.
Identifying the impact of your cost drivers (Identifying Customer Cost on page C14) on a customer-by-customer and project-by-project basis, CPAC measures the cost and effort required to meet the demands of each customer or project by dividing the project back room operations into categories or activity codes. You separate these categories by type of work, and position the cost codes according to their impact on the resources needed (hours and dollars) to address each project's or customer's demands.
CPAC uses a 4-quadrant positioning method to evaluate a customer or project based on recognized profits or revenues. As shown in Fig. 1 (click here to see Fig. 1), a customer or project that falls into the first quadrant generates high profits both with respect to the investment and to the allocated fixed costs. Those falling into the second and third quadrants generate lower profits per resource investment due to high requirements (time or cost) to serve the customer. If a customer or project is positioned in the fourth quadrant, both time and cost factors are low. That means it would typically generate insufficient profits for the investment of resources. Any customer falling into the fourth quadrant may need to be fired. However, before going that far, let CPAC help you identify the cost drivers causing that customer to be positioned so poorly.
You can establish baselines or reference points for positioning your customers in a number of ways. Some possible reference points include:
Historical performance (company level, type of work, divisions).
Case in point
Each customer, project, or subcontractor is visibly and objectively positioned according to its impact on time and cost. For example, Fig. 2 (click here to see Fig. 2) shows three projects positioned against a target goal and a break-even point. While Project 1 is doing quite well, Projects 2 and 3 are bringing in only enough revenue to cover the investment — not necessarily the most effective application of resource time.
With CPAC, you can also easily identify projects or customers providing sufficient revenue but insufficient profits. In the earlier example, all three projects were above break-even levels; however, only Project 3 was well positioned above the target goals. If the three projects are re-evaluated using profits instead of revenues, we find that although Project 3 was well positioned from a revenue perspective, it doesn't fare so well when it comes to profits. In fact, Project 3 is in the fourth quadrant, suffering in terms of its financial draw as well as its use of time (click here to see Fig. 3).
CPAC's flexibility also allows several other applications that easily follow the guidelines of positioning and trend monitoring, including:
Making relative comparisons
What factors make one project or customer better than another?
How are resources used on one project compared to another?
How do customers compare with respect to realized profits or revenues as a return for effort and cost?
Compare a job or customer to a template or a “signature”
What configuration makes a good job?
Where might additional resources need to be deployed?
Grouping of work
Which customers, types of work, and size of projects realize insufficient profits or revenues as a return for effort and cost?
You can further analyze each project or customer to position its components and determine which elements are cost drivers and which contribute the most to profits and revenues. Fixed costs can be divided into codes, according to natural distinctions on how the work is performed. For example, you may use internal activity codes, such as executive, estimations, project management, field, safety, and administration. You can also identify your actual cost drivers by positioning each of these cost codes according to their impact on the project based on that project's or customer's demand on your resources.
Many management fads have tried to improve the knowing-doing gap that haunts many top executives, but to no avail. Fads focus on the symptoms and not the causes of cost drivers. They typically identify the correlation, not causal relations of events. To correctly position customers or projects, we have shown that companies are first required to identify their main cost drivers and categorize them either as fixed or variable costs. Only then can they apply CPAC and other managerial tools such as statistical process control.
We have proved by logical deduction that only after determining the underlying financial operational model can the appropriate positioning model be selected and applied to track and analyze customers, projects, and resources. Correct selection of the tracking and positioning model will help you identify the hidden root causes of your overall operational shortcomings.
Subordination of all the activities in your company, based on CPAC predictions, will enable you to focus on the right problems, at the right time, with the right resources. By simplifying the analysis of cost drivers to the resources that matter the most, you can also monitor and manage the most uncertain element in every business more effectively: people. The effectiveness of this resource can then be the measure of customer, project, and subcontractor's contribution to your profitability.
Sidebar: Identifying Customer Cost
Cost of collection — A job could be very profitable; however, one that takes six months or longer to collect for will have a very low financial productivity. For example, using Wall Street's evaluation of the cost of money, based on 30-yr stock market return of an average of 12% per year or 1% per month, a project that recognizes 15% gross profits for a subcontractor only earns 9% if it takes six months to collect the funds. This loss is not traditionally recognized as part of accounts receivable.
In addition to accounts receivable, research data from MCA shows that subcontractors carry, on average, 10% of their annual sales in underbillings (UB). To recognize this cost, take a $20-million electrical contractor as an example. Assuming it tracks its UB and follows the national average, $2 million will be tied up in UB. The Table (click here to see Table) shows how to calculate the cost of this negligence.
Eliminating this cost for a typical $20-million electrical contractor can amount to an increase of between 50% and 100% in net profit. All savings will be added directly to the net profit, because overhead will stay constant. Except for annual income taxes, nothing else is in the way of these monies and the bottom line.
Cost of estimation. If your customer's drawings and specs require you to spend a higher-than-average time to estimate the job, your cost of estimation will increase while your chances of winning the job decrease. One of the measures for successful estimation is hit ratio (HR), the ratio of how many dollars you have to bid in order to get $1 of work. According to MCA's national survey, most contractors' HR is around 10%. This means that to be a $10-million contractor, your estimators have to estimate $100 million of work annually. The average expense of the estimating department is about 1% of the dollars bid. In this case, the cost of carrying the estimation department will be around $1 million annually.
Cost of safety — Another back room factor driving different projects' cost deals with safety requirements, dictated by the owner and/or the general contractor. If you don't take this factor into account, your bids will be lower than your competitor's. You may win the job, but only to lose money on it.
Cost of accounting — Tracking vendor and customer invoices is another cost driver. Locations of the job, taxability of the project and material, and prefab taxation will add to the cost of dealing with certain customers and projects.
Whether or not you have a measure of your direct project costs (labor, material, tools, equipment), lack of measurement and visibility of the back room operations can hide the full impact projects or customers have on your business. The various cost drivers listed above are typically “allocated” to the project as overhead or indirect costs, without consideration of their demands on your resources from project to project or customer to customer.