Estimating in Construction – Part II (Financial Outcomes Evaluation)

Estimating in construction is a tool to guide the construction management team towards improved profitability (an internal control system). Estimates by themselves do not generate profits; actual performance creates profitability for the contractor. Estimates act as the technical manual for the project. Once the project is completed, the contractor must compare the actual results against the estimate’s values. In effect, the financial outcomes are evaluated against the originally estimated hard costs. The information gleamed from this evaluation educates the construction management team with what works and any failures. Then end goal, identify poor performance. It is then up to the management team as to how to properly address this issue eliminating this type of mistake in future work. The long-term results are improved profits, higher quality performance, improved customer satisfaction and most importantly, the esprit de corps that comes with team success.

Financial outcomes against the estimated outcomes are the end result the contractor uses to identify jobs or projects with less than expected performance. Understanding this end result is essential with appreciating the purpose of generating good estimates. This particular lesson teaches and illustrates how the actual financial performance is compared against the anticipated performance as drafted with the estimate(s). The final outcome evaluation starts out with a modified version of the construction company’s income statement (profit and loss statement, a.k.a the P&L). This modified version is then converted to a columned project P&L. This customized income statement is known a a project profitability report from the financial set of reports in construction. With this information, each project’s profitability is then compared against the estimated profitability to determine job performance.

Part III in this series takes this holistic information and breaks it down further to either functional or group costs to identify actual issues. For the purpose of this lesson, the goal is identify overall performance per job; discovery of the core issue is taught in Part III and IV of this series.

To start, the construction management team must first convert a standard financial report to a customized layout.

[do_widget id=black-studio-tinymce-6]

Estimating – Standard Financial Report Conversion to Profitability by Project Report

With financial accounting there are customarily five top level financial statements. They are:

Balance Sheet
Income Statement (P&L)
Retained Earnings/Capital Accounts Report
Cash Flows Statement
Notes to the Financials

For the purpose of this respective lesson, the focus is on the income statement (P&L). A typical contractor’s income statement will look like this:

Nailed It Construction
Income Statement (Traditional Format Presentation)
For the 12 Months Ending December 31, 2019
Construction:
Contracted $ZZ,ZZZ,ZZZ
Upgrades/Change Orders Z,ZZZ,ZZZ
Services ZZZ,ZZZ
Other Z,ZZZ
Closing/Contractual Allowances (ZZZ,ZZZ)
Adjusted Construction Sales $ZZ,ZZZ,ZZZ
Direct Costs of Construction (Hard Costs):
Materials Z,ZZZ,ZZZ
Labor ZZZ,ZZZ
Subcontractors Z,ZZZ,ZZZ
Other ZZZ,ZZZ
Sub-Total Direct Costs of Construction Z,ZZZ,ZZZ
Direct Field Production Profit Z,ZZZ,ZZZ
Indirect Costs of Construction (Soft Costs):
Project Management ZZZ,ZZZ
Insurance ZZ,ZZZ
Transportation ZZ,ZZZ
Other    ZZ,ZZZ
Sub-Total Indirect Costs of Construction    ZZZ,ZZZ
Gross Profit (Field Production Profit) Z,ZZZ,ZZZ
Overhead:
Management Team ZZZ,ZZZ
Facilities ZZ,ZZZ
Office Operations ZZ,ZZZ
Compliance/Other ZZ,ZZZ
Sub-Total Overhead    ZZZ,ZZZ
Net Profit $ZZZ,ZZZ

This is the same report as illustrated in Part I of this series. As taught in Part I, the direct costs of construction align with the estimates’ hard costs of construction. The indirect costs and overhead are irrelevant when evaluating financial project performance. Thus, the customized report, customarily referred to as a ‘Limited Scope Report’ looks like this:

Nailed It Construction
Projects Income Statement (Limited Scope Presentation)
For the 12 Months Ending December 31, 2019
Construction:
Contracted $14,804,601
Upgrades/Change Orders 2,007,114
Closing/Contractual Allowances (806,209)
Adjusted Construction Sales $16,005,506
Direct Costs of Construction (Hard Costs):
Materials 4,595,437
Labor 697,455
Subcontractors 5,465,032
Other 908,775
Sub-Total Direct Costs of Construction 11,666,699
Direct Field Production Profit $4,338,807

Please take note of the following differences with the traditional income statement.

A) The title of the report is different; it is designed to be clear to the reader that the information is restricted to field projects only.
B) Construction revenue is restricted to just what the projects earned during the time period. In this case, service and other income are not project driven with this company; thus only the revenue generated by the projects are included.
C) Only revenues and direct costs of construction are included. All other costs (soft and overhead) cannot be assigned to a project; therefore they are not included in this limited focus presentation.
D) Values have been inserted in the respective rows in order to help with clarity and better illustrate the purpose of this lesson.
E) Direct project profits average 27.1% of adjusted contractual values; commonly referred to as adjusted sales price.

The above illustration is about the normal values as seen with a customized home builder. Based on performance, this particular contractor is in the 7o percentile bracket of performance; i.e. not the best; but well above average for customized home construction.

This particular contractor completed and sold 16 houses during 2019. The key is to convert the aggregated dollar amounts into a columned report by project. Almost every accounting software including QuickBooks can prepare this type of report for the contractor. Once the report’s conditions are programmed, the outcome will look like this:

Nailed It Construction
Project Profitability by Project
For the 12 Months Ending December 31, 2019
Construction: Job #1       Job #2       Job #3      Job #4      All Other Jobs       Totals
Contracted $792,000 $1,031,100 $699,000 $1,506,399 $10,776,102 $14,804,601
Upgrades/Change Orders 21,707 96,400 59,608 213,451 1,615,948 2,007,114
Closing/Contractual Allowances (24,916) (37,996) (34,809 (102,114) (606,374)    (806,209)
Adjusted Construction Sales $788,791 $1,089,504 $723,799 $1,617,736 $11,785,676 $16,005,506
Direct Costs of Construction (Hard Costs):
Materials 194,813 264,611 187,400 361,777 3,586,836 4,595,437
Labor 21,185 38,602 12,844 61,703 563,121 697,455
Subcontractors 307,818 361,006 202,096 410,951 4,183,161 5,465,032
Other 66,072 51,555 51,883 72,061 667,204 908,775
Sub-Total Direct Costs of Construction 589,888 715,774 454,223 906,492 9,000,322 11,666,699
Direct Field Production Profit $198,903 $373,730 $269,576 $711,244 $2,785,354 $4,338,807

Notes to the above report:
1) To keep the report concise, all other jobs are the remaining 12 homes aggregated together in one value per row of information. In a full report, there would be 17 columns for the 16 projects plus the total column.
2) The totals column matches the limited scope presentation report above.
3) The goal of the report is to identify profitability per job completed during 2019 and the amounts that tie to each respective group of costs at the job level.

With this information presented in this format, the construction management team can now determine operational and financial performance.

[do_widget id=text-59]

Estimating in Construction – Operational and Financial Performance

In Part I of this series, estimates are defined as a control tool for performance. Estimates are created using ‘Hard Costs’ for the respective functions/stages of construction and the corresponding grouping of costs by type (materials, labor, subcontractors, etc.). Take note that with the financial report, the job’s profitability is set forth as an outcome associated with types of costs and not via functions or stages of construction. This is done on purpose. There are two reasons hard costs are grouped by type in the financial report, i.e. the income statement (P&L statement).

First is the traditional presentation format customarily seen by third party reviewers of financial information, more specifically, the banks. Bankers historically don’t want the information in the form of stages of construction or functions of construction as they are not builders. However, they do understand the concepts of materials, labor, subs and other forms of hard costs to build a structure. They use this grouping of information to compare one builder against the industry standard or another builder. Thus, when an estimate is prepared, all hard costs should also have the ability to be grouped and aggregated by the core types of construction costs as identified here:

Land
Materials
In-House Labor
Out-Sourced Labor
Trades (Subcontractors)
Equipment
Other
Allocation of Indirect/Overhead (customarily found with governmental contracts and compliance; this is an advanced lesson with estimating)

Secondly, costs are accumulated by type with the financial report to keep the report simple in its presentation. If, the report is formatted by function or stage (phase) of construction, the direct costs section of the financial report could go on for several pages depending on the nature of the contractor’s business. Imagine the presentation format for a bridge builder. Bridge builder’s have more than 30 phases or stages of construction; each stage would have materials, labor and equipment utility to report. This type of functional report is customarily an in-house (internal) management report designed to provide operational results and financial comparison. This is explained and illustrated in Part III of this series for estimating in construction. However, some operational results can be gleamed from the summation presentation, grouping of costs. But the real value is the financial comparison.

To illustrate, let’s first review the profitability by project but with some additional information. The report will include the profitability as a percentage of adjusted net contract values (the dollar amount after reducing the gross contract earnings by closing costs and allowances granted to the home buyer in the schedule). Review the following report:

Nailed It Construction
Project Profitability by Project
For the 12 Months Ending December 31, 2019
Construction: Job #1       Job #2       Job #3      Job #4      All Other Jobs       Totals
Contracted $792,000 $1,031,100 $699,000 $1,506,399 $10,776,102 $14,804,601
Upgrades/Change Orders 21,707 96,400 59,608 213,451 1,615,948 2,007,114
Closing/Contractual Allowances (24,916) (37,996) (34,809 (102,114) (606,374)    (806,209)
Adjusted Construction Sales $788,791 $1,089,504 $723,799 $1,617,736 $11,785,676 $16,005,506
Direct Costs of Construction (Hard Costs):
Materials 194,813 264,611 187,400 361,777 3,586,836 4,595,437
Labor 21,185 38,602 12,844 61,703 563,121 697,455
Subcontractors 307,818 361,006 202,096 410,951 4,183,161 5,465,032
Other 66,072 51,555 51,883 72,061 667,204 908,775
Sub-Total Direct Costs of Construction 589,888 715,774 454,223 906,492 9,000,322 11,666,699
Direct Field Production Profit $198,903 $373,730 $269,576 $711,244 $2,785,354 $4,338,807
Project Profit as a % of Adjusted Sales 25.22% 34.30% 37.24% 43.97% 23.63% 27.11%

This one additional line of information provides the construction management team with a wealth of information. First, notice that the overall average for profitability from jobs is 27%. Thus any job that performs significantly different in either direction (>3%) warrants a management team discussion as to the source(s) of the contributing factor(s). In this case, all four jobs have significantly different outcomes than the average.

Job #1, is 93% of the expected outcome in accordance with this report. This doesn’t mean it performed poorly, the contractor may have agreed to do this job for that margin due to subjective issues. Without comparing the actual results from the estimated results; guessing or speculating is inappropriate. The same goes for the higher than normal financial results related to Job #4. Again, without the comparison to the estimate; it is not prudent to speculate. For now, the results are merely indicating financial outcomes against the average for the year.

With a full presentation report, i.e. all 16 projects are columned, there will be one or more jobs from the ‘All Other Jobs’ pool that will weigh down that aggregated pool. It could be that all remaining 12 jobs performed below the average and that only Jobs 2 through 4 did well. Without a full columned report, the management team can’t delineate the source of the less than average performance. Thus, this report is critical with identifying job profitability on a per job basis. It still can’t identify the actual underlying operational performance without a comparison to the estimated hard costs results. Therefore, the accountant prepares individual reports by job illustrating performance by types of costs. See below for Job #1:

Nailed It Construction
Job #1 Actual to Estimated Costs by Cost Types
Actual    Ratio   Estimated Hard Costs Ratio Over/(Under Estimated Amounts)
Adjusted Construction Sales $788,791 100.00% $788,791 100.00% Not Applicable
Direct Costs of Construction (Hard Costs):
Materials 194,813 24.70% 172,400 21.86% $22,413
Labor 21,185 2.69% 39,700 5.03% (18,515)
Subcontractors 307,818 39.02% 292,500 37.08% 15,318
Other 66,072 8.38%    53,800 6.82% 12,272
Sub-Total Direct Costs of Construction 589,888 74.78%       558,400 70.79% $31,488
Direct Field Production Profit $198,903 25.22% $230,391 29.21%

This report provides a wealth of information to the construction management team. First, take note of the presentation format. Both actual and estimated costs are presented along with the actual and estimated ratios of performance. Secondly, there is a column identifying in dollars the amounts that either exceeded (OVER) the estimated value or were an improvement (UNDER) against the estimated value. The project had a budgeted profit of $230,391 or just over 29% of the estimated revenue (contracted value).

Three of the types of costs exceeded the estimated hard costs to build this home. The most significant change is located with materials. The management team would want to find out why materials significantly exceeded the estimated value. $22,413 is 2.84% of the revenue. If the expected profit is 29.21%, then the material overruns were 9.7% of the expected profit. This is a major blow to the overall project’s performance. This negative outcome with materials is mostly offset by the better than expected in-house labor projected cost. However, it would appear that the use of additional subcontracting labor costs allowed for lower in-house labor to complete the project. Without more information, it is mere speculation at this point; but it is a good educated assumption.

Without more information, the management team can only tell where the cost overruns and benefits exist based on the group of costs types. More information is needed. An internal management report that breaks out the respective functions or stages of construction along with each stage’s values with the respective cost types will identify the likely source of the respective cost overruns. The next lesson in this series will illustrate, explain and educated the reader how to evaluate this more detailed report.

This actual to estimated cost report is generated for all 16 jobs. The management team should sit down together and review each one and along with the detail costs by function report (Part III of this series) can then identify the underlying discrepancies. With this knowledge, the team can implement new procedures or educate the estimator(s) as to the underlying issues and make changes to the respective decision models.

As for the above report, please note the following:

A) The report is laid out around around costs. Revenue in summation is the point of reference only to generate ratios for comparative purposes only.
B) The over/under column can be confusing for novice readers. Take note how cost overruns are a positive outcome in this column. Your average reader gets confused because they think it should be a negative result, i.e. a negative value is a result of poor performance; the costs came in ‘MORE THAN’ expected. The key is the reference point, the ESTIMATED COSTS are the starting points for each group of costs. Thus, the change reflects an amount that is either greater than or less than (symbolized by an negative value) the estimated amount. The cumulative total is matches the absolute total difference between the actual and estimated outcomes.
C) Estimated costs are rounded to the nearest $100 increments. This particular company’s policy is to round up all final estimated costs to the nearest increment of 100. There are distinct advantages to this and is explained in more detail in a future lesson.

Estimating in Construction Financial Outcomes Evaluation

Estimating in construction serves as the best overall internal control for contractors. The outcomes serve as the starting point to evaluate overall performance of the construction project(s). It all starts with comparing the actual costs grouped by type sourced from the direct costs of construction part of the income statement (profit and loss statement). These costs are then columned by job and each cost group is summed. This summed value should match the direct costs as reported in the income statement. This Project Profitability by Project report is the overall summation report in a series of internal reports that are used for evaluation of the company’s overall operational and financial performance.

With each job’s breakout in summation, a more detailed comparison report is necessary to understand the key source of financial discrepancies. The next level report is at the job level. An actual to estimated cost report by cost groups is prepared along with ratios against the revenue earned is included. This report informs management of the overall summary outcome and provides the necessary guidance to focus on the more job detail level reports.

Without the estimated amounts grouped by cost types, the initial set of reports can’t assist in identifying key issues. As stated earlier, all estimates should provide both functional or stages of construction values and total costs grouped by cost types as necessary information.

KEY LESSONS LEARNED TO DATE IN THIS SERIES

Estimates are the number one tool in construction to control outcomes, i.e. profitability.
There is a difference between hard and soft costs. Hard costs are directly assignable to a project/job.
Only hard costs are used with estimates.
The contractor’s income statement is designed to report direct costs (hard costs) in its own section of the financial report.
The direct costs of construction (hard costs) can be further formatted by job with a columned report layout identifying the cost groups by type for each job.
From this point, each job can then be compared against the estimated group costs as a whole for evaluation of financial performance.

Act on Knowledge.

[do_widget id=text-59]