Branching Out in Construction
Minimum Bottom Line Profit Should Average 9.4%!
For Trades & Subcontractors, at Least 11%
After Income Taxes Are Paid!
When you own a small construction company many people depend on you. There are your family, employees and subcontractors. A typical $2,000,000 per year operation will have upwards of 20 people dependent on the contractor for their livelihood. This can get stressful and overwhelming for the contractor especially if they are only involved in one or two lines of construction.
To reduce risk and provide greater security to all parties the small construction company should consider branching out. What I mean is adding an additional class or line of construction work to the company’s portfolio so that in hard times there are more opportunities for work. It makes sense, because if you think about it, it is easy to get involved in other forms of similar types of work. For example a new home contractor can explore additions or remodeling as additional sources of income. Often it is the other way around as most new home contractors got their start in additions or remodeling.
Well there is a proper way of addressing this and going about analyzing the experiment to see if you can and should explore other forms of work. I’ll use my real life example and explain the basic concept of horizontal integration in construction. Then I want to explain how to document the entire process and finally review the results and analyze the outcome. I’ll use my story to explain each one of these areas of branching out.
Branching Out – Horizontal Integration
I got my start in the construction industry by getting involved in the restoration business. I was in public accounting and these two guys that own a 10 man restoration company wanted to get a financial guy onboard to help them expand the company. I agreed to join them and after a few months of doing some accounting work I learned a few things. First off, the margins were not as good as they should be and secondly the project managers who also estimated the jobs were terrible at estimating and controlling the costs.
I met with the two owners and explained that we need to explore other similar areas of construction in order to ascertain what is profitable and those forms of construction work that were marginal. Only one of the owners held a contractor’s license and he too was concerned about focusing on just one line of business. I explained to him that when a company gets involved in other lines of business in the same industry it is referred to as horizontal integration. It is a common tool in the large publicly traded companies. For example Proctor and Gamble not only provide laundry detergents, they also provide household cleaning products and personal hygiene products. Basically that company is in the business of providing cleaning agents for health purposes.
In residential construction this means lines of business such as additions, remodeling, restoration, renovation, and mitigation (emergency responses to household emergencies). So here goes my story:
I was able to convince Fred the one with the contractor’s license to try a nonresidential construction industry to ascertain if there is any value in these other areas of construction. We were both greatly concerned that if one of our insurance providers of work were dissatisfied with our quality that we would be placed on the proverbial back burner for a while causing a significant decrease in revenues and jeopardizing the livelihood of several of the key employees. So I offered to run a test project at the commercial level to evaluate profitability and viability.
He granted permission and so I began by exploring the area of commercial build outs. I wrote up three estimates from a list at the local builder’s union and waited for a response. About two weeks later I got a phone call from a project manager coming into the area to build out a retail outlet for a fashion retail store. We have an outlet mall in the area and they needed someone to provide the license and the workforce to build out the retail space.
Simple job, basically gut the existing facility, bring in the sewage and plumbing for two offset bathrooms, build a floor to ceiling wall structure for an office and fitting rooms. Build the manufactured display cases and shelving systems and trim it out. It was a relatively small job in the overall scheme of things and my estimate was in the low 60’s.
In summation, our little company was exploring a new line of work in construction but it is no longer residential based, but light commercial. To analyze the results, I needed to document the job appropriately.
Branching Out – Document the Attempt
In negotiations with the outside project manager he had several stipulations and conditions. I had to provide my worker’s compensation insurance with an additional insure and a $100,000 bond. It took me one hour of work to get this done and I included the company’s contractor license, business license, general liability policy, auto policy and property insurance. In addition he stipulated the names and work backgrounds for the respective onsite workers. I chose seven guys altogether and two subcontractors and completed my negotiations with them. All toll, about two days of work to do the mobilization function. Now for the first meeting at the job site:
I showed up at the job site about twenty minutes early and of course he was about 20 minutes late. Some excuse about not being familiar with the area, it is one main road and that is it. Right away I could tell there was going to be a problem. He handed me the paperwork and said he had to have this completed in 17 days starting in three days (a Saturday). I laughed out loud. I looked at him and said, I’m not your guy. I explained that in this county it will take me at least 3 days to pull a construction permit and then given the nature of the local codes department and the need for 10 separate inspections; the absolute best I could do was about 3 weeks.
He cited a clause in the bid documents that expressly required not more than 21 days. Yep I responded. I saw that and also there was a little caveat in the inspections clause that provided allowances for any unreasonable delays beyond our control. I did my homework and easily understood contracts. I told him that the local inspectors think they are Gods and therefore they sometimes make life more difficult by not showing up until the next day. I don’t have control over them and therefore I can’t be held accountable to their actions. Again I said the best he was going to get was 21 days and since the starting day was on a Saturday, most likely the permit would not get issued until the following Monday. So in reality, I said 23 days. “Just being honest”, I stated.
Of course this went over like a brick wall and throughout the project he kept retorting how long this was taking over his expectations. He claims that other subcontractors he hired could do the work in the period of time he allotted. After about 7 days of work I started giving him the look of, ‘You are Kidding Me’.
Well, Fred pulled some strings and got the permit on Friday. He was lucky in that the head guy went to his church and Fred asked him politely to do this as he rarely asked for favors.
Throughout the job there were problems, not one or two, more like 40 or 50. I ran two shifts of guys, 4 in the morning and 3 in the late afternoons into the late night. We were doing close to 85 man hours per day of work. On the weekends, the guys would work about 50 man hours per day so I was paying some hefty overtime for this project.
At night I would go back to the office and load the data into the accounting software because I really wanted this to be successful, but I wanted to know the truth about all the associated costs. This was important to us and our future livelihoods depended on the final decision for this project.
Believe me I documented every cost and every hour of work by the guys. Using my job costing system I was able to fully identify all direct costs of construction. Since I had been involved in the books for quite a time, I knew the formulas to allocate the indirect costs of construction (transportation, management, insurance, fringe benefits, tooling and supplies). I tracked the exact number of miles for the work vans, the number of hours of work, even the darn 4 pack of toilet paper for the port-a-john was expended to the job. I spent several hours out there everyday and yes, I got a lot of flak from the project manager about not getting this done fast enough. I can’t tell you how many times I wanted to tell him to ‘Kiss My A..’! But this time was well spent because I knew what tickets for expenses belonged to this job and I tracked this like a hawk.
All in all, I thought this was a nightmare. I’m an accountant and to manage a project in a new branch of business was different for me but we needed the test run just to have some results.
Branching Out – Analyze the Results
Well as promised, our company got the job done 21 days to date after the permit was issued. On that Friday morning, the county issued the retail occupancy permit and the fire department did their inspection too. To make this happen, it was an entire company wide project on that Wednesday and Thursday as we set up the shelving systems, display cases, racks for clothing and the cash register stations. It felt good to have this done and Fred was pleased with the outcome.
He looked at me and said “I hope we made a profit here because if this turns out well, we could do a lot of these here at this outlet mall (76 stores total)”. I got our check on Friday afternoon for $62,700. I asked Fred to hand the employees a $20 bill each and he told them the drinks were on the company.
I spent the weekend tallying the bills and collating the data. We were set to meet on Tuesday morning to review the project and see if indeed commercial build outs could be a new line of work for us.
At the meeting I showed the spreadsheets in detail related to the project: but for summation purposes, here it goes:
Contract Revenue $62,700
Labor $29,842 *includes overtime
Labor Overhead 6,219
Other 2,109 *Includes the cash bonus to the guys
Sub-Total Direct Costs 50,695
Fringe Benefits 1,344
Sub-Total Indirect 8,287
Project Margin $3,718
Fred first asks if this is good or bad. I shook my head and said it is bad. We still have overhead for the company and these projects have to generate more than this to cover these overhead costs (accounting, facilities, office administration, compliance reporting, communications and Fred’s salary). This isn’t going to cut it.
He wanted to know everyone’s opinion and the subjective issues involved. This is what came out of this test:
- The emergency aspect of this service lends itself to a disproportionately greater risk with miscalculation of costs.
- The stress with fulfilling the time schedule creates undue hardship on all parties especially the staff.
- Fred had to pull some strings as a contractor to get the participation needed from subs and from the county’s inspectors.
- Many of the employees found the work environment uncomfortable as time constraints forced them to take shortcuts which doesn’t happen in restoration work.
- One positive aspect was the comradery of the employees working together for two days as a team to complete the project.
- Lost opportunity in getting work in our regular line of business as we turned down two different requests to get jobs in lieu of this project.
Overall the job was successful but a financial failure. All of us agreed that we could do this in really hard economic times, but that we should shy away from this work and look at other ways to bring security to the business. I decided to shift my focus and figure out ways to increase profitability with the existing type of work and give attention to reducing the overall risk for all involved. This is featured in future articles.
If you are thinking of branching out with your construction company, consider running tests to gain an understanding first. You might be surprised with the results.
By the way, that project manager called me about four months later with another job at that outlet mall. He wanted us. I told him to ‘Kiss my A..’. Act on Knowledge.
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