Minimum Bottom Line Profit Should Average 9.4%!
For Trades & Subcontractors, at Least 11%
After Income Taxes Are Paid!
The best internal control tool to maximize profit in construction is an estimate. Estimates act similar to a dashboard of critical information necessary to evaluate overall performance. In insolation, they serve the purpose of determining the minimum core price to charge the customer in order to deliver enough contribution margin to offset that project’s share of indirect and overhead costs. Any value in excess of this core price adds to the company’s bottom line. If properly set up, administered, monitored and evaluated upon completion; estimates are a critical element of the accounting feedback loop. This one internal control tool delivers more value to owners and management in construction than any other control device.
This article introduces estimating in construction. It is the first in a series of lessons about estimating in construction.
In order to appreciate the value estimates provide to the contractor, this introductory lesson focuses on the important role estimates play with reporting financial results; specifically how estimates relate to the final outcome in the income statement (profit and loss statement, a.k.a P&L). This lesson first introduces hard and soft costs and their respective relationship with the four major sections of the income statement (P&L). Each section of the income statement (P&L) has a unique role with providing information to management. With this understanding of hard and soft costs and their relationship with the income statement (P&L), it is easier to understand the underlying concept of creating estimates. With this knowledge, a contractor or the management team can then easily gain an understanding of the financial performance of the company as a whole.
It all starts with understanding hard and soft costs.
Hard and Soft Costs
These two terms are synonymous with the construction industry. They refer to the field operational costs to complete a project. Hard costs are the actual materials, field labor, subcontractors, equipment utility and consumables to actually do the physical work. Soft costs tie more to intangible costs necessary to get the work done. The most common or expensive soft cost is project management. Rarely can project management payroll be directly assigned to a project. Often, project managers work several projects at a time as the projects are in different stages of construction. In those cases when project management can be directly assignable to a project, project management is then considered a hard cost.
Other examples of soft costs include:
- Field Personnel Benefits
- Safety Equipment/Gear
- Governmental Compliance
- Field Communications
A key attribute to separate hard and soft costs is the ability to directly assign a cost to a job. It doesn’t matter whether this cost is tangible or intangible in nature; hard costs are directly assignable, i.e. without a doubt that cost is necessary to construct the project. Here are some examples:
Engineering – almost every project requires some engineering work or some kind of report indicating proper deliver of a particular part of a job. For example, with home construction, local governments require an engineer to certify that the footer was properly built or that the framing will hold the load over an extended period of time. In effect, the engineering report shifts the risk of loss for that aspect of construction to the engineering firm.
Permit – a permit is merely a permission slip from the local government to proceed with construction. Although only a piece of paper (intangible in nature) and it is not a physical cost that will stay with the project; it is still a hard cost of construction.
Environmental Barrier – here is a physical item but doesn’t stay with the project; you don’t find environmental fences still in place once the project is completed. However, the cost is directly associated with that project; thus, it is considered a hard cost.
Other examples of hard costs that are intangible in nature include:
- Debris removal
- Facilities (port-a-potty, wash stations, temporary utilities, etc.)
- Temporary access/egress
- Capitalization of interest (explained in an advanced lesson with estimating)
- Inspection fees
- Plans (copying, amendments, reprints)
- Builder’s Risk Insurance
Whereas soft costs are defined as those costs that cannot be directly assignable to a particular project. In effect, they are ‘SHARED’ among many projects. The best example of this is transportation. When a field worker puts gasoline in a company truck and drives it to a project; it would appear that the fuel is directly assignable to the project. But in almost all cases, that fuel is shared with other projects because that worker goes to several projects in that vehicle over the course of consuming the fuel. The same is true of the truck’s repairs and maintenance, insurance premium, lease payment and of course the Hawaiian Hula Dancer Bobble Head doll on the dashboard. It is nearly impossible to assign these costs to a particular project because they are shared over many projects over many years. There does exist a tool to assign these costs and that is explain in the advanced lessons of estimating; for the purpose of understanding hard and soft costs, transportation costs are considered soft in nature.
Just as hard costs have some intangible items that are classified as hard costs; soft costs have tangible (physical in nature) expenditures that are not directly assignable to a project. These include:
- Tooling (ladders, hand tools, power tools and specialty equipment)
- Radios/Cell Phone Communications
- Safety Gear
- Personnel Gear (Hard Hats/Vests/Gloves/Knee Pads)
The key to understanding hard and soft costs isn’t whether the particular expenditure is tangible or intangible, it is whether the cost can be directly assigned to the job. If yes, then it is referred to as a ‘HARD’ cost. If not, it is called a soft cost.
With this knowledge of hard and soft costs, it is easier to now understand the sections of the construction income statement (P&L statement). Understanding hard and soft costs is essential to grasping the overall value estimates provide with construction. These two terms are used multiple times throughout this series with estimating. If you are having a difficult time comprehending hard and soft costs (it typically takes the average person several interactions with the the terms before they accept and become comfortable using them), please read: Hard and Soft Costs With Construction.
Contractor’s Income Statement (Profit and Loss Statement)
The contractor’s income statement (P&L statement) has four groupings of value. The first and easiest to understand are sales, i.e. contractual income. Accountants refer to this as the revenue section. It is the contracted earnings along with any upgrades, change order amounts and other forms of field income. It is adjusted for allowances and this is explained in a latter lesson. For now, the reader only needs to accept that revenues are contracted amounts earned from project work.
The second section is the most important for the purposes of understanding estimates. This section of the income statement (P&L) includes the direct costs of construction; it is strictly the ‘Hard’ costs of construction. The third section of the income statement with construction is called ‘Indirect Costs of Construction’ and is exclusively the ‘Soft’ costs of construction. The fourth section is commonly referred to as overhead. It is in effect, front and back office operational costs. Here is a simple format for the reader to absorb:
Nailed It Construction
Income Statement (Summary Format Presentation)
For the 12 Months Ending December 31, 2019
Contracted Income $ZZ,ZZZ,ZZZ (Section One – Revenue/Sales)
Direct Costs of Construction Z,ZZZ,ZZZ (Hard Costs)
Indirect Costs of Construction ZZZ,ZZZ (Soft Costs)
Gross Profit (Field Production Profit) Z,ZZZ,ZZZ
Overhead ZZZ,ZZZ (Office Operations)
Net Profit $ZZZ,ZZZ
Notice an important breakout of this financial report; the upper three sections are exclusively field production/operations. The fourth section or bottom section is entirely office expenditures.
The above format is high level summary, it is only four grouped sections of the income statement (P&L statement). A traditional summary format looks like this:
Nailed It Construction
Income Statement (Traditional Format Presentation)
For the 12 Months Ending December 31, 2019
Upgrades/Change Orders Z,ZZZ,ZZZ
Closing/Contractual Allowances (ZZZ,ZZZ)
Adjusted Construction Sales $ZZ,ZZZ,ZZZ
Indirect Costs of Construction (Soft Costs):
Project Management ZZZ,ZZZ
Sub-Total Indirect Costs of Construction ZZZ,ZZZ
Gross Profit (Field Production Profit) Z,ZZZ,ZZZ
Management Team ZZZ,ZZZ
Office Operations ZZ,ZZZ
Sub-Total Overhead ZZZ,ZZZ
Net Profit $ZZZ,ZZZ
It is important for the reader to identify the four respective financial values with this traditional presentation. Please locate revenues, hard and then soft costs in the report. Hard costs are highlighted to reinforce the importance of this section of the financial report. This section is the most important section because it ties directly to estimates.
Underlying Concept of Estimates and the Financial Results
The direct costs of construction, i.e. hard costs, are the core values generated in estimates. The estimator is determining the actual hard costs to complete the project. An estimate is about ‘Hard Costs’ and not soft nor overhead costs. Is it with this hard cost value and knowledge about soft, overhead and desired profit that the estimate is turned into a proposal to a customer. Estimates are an in-house tool used to develop a proposal. Estimates are never presented to the end customer. The customer’s proposal has a breakout for the respective functional costs (explained in a future lesson); but a customer NEVER EVER sees the actual estimated hard cost to do the respective work. Future lessons go into more detail about this.
The key to estimates is that an estimated hard cost to do a job is compared to the actual hard costs for the same job. The actual hard costs for the respective job is located in the direct costs of construction section of the above financial report. The estimate is a side report and its corresponding values are compared to the actual results to determine how well or poorly the contractor did with the initial concept of how much it is going to cost to get the work done.
This is the Ah-Hah moment for the reader. The core purpose of an estimate is to compare the conceptualized hard cost to complete a project against the actual direct cost to complete the project.
Naturally, there is a lot more to this; but for now, this is the foundation of estimates – HARD COSTS TO ACTUAL COSTS. With this information, the company can determine where (within the estimate) and why performance (actual value against estimated value) exceeded expectations or cost overruns driving the project’s projected profit down.
An illustration is appropriate at this point:
Fred is a general contractor and only builds middle class homes on private lots. After completing a particular project, Fred’s projected profit was substantially less than anticipated. His final job costing report identified several problems. This is the outcome related to the foundation of the home. Here is Fred’s estimate and actual report for the foundation of the project:
All Costs Are Hard Costs
Estimate Actual Over/(Under)Budget
Materials (CMU’s/Sand/Mortar/Other) $1,902 $2,285 $383
Labor (3 Hrs Clean-Up) 90 75 (15)
Subcontractor (Mason) 3,100 3,685 585
Equipment Rental 211 211 0
Sub-Total Foundation $5,303 $6,256 $953
Fred reviews the report and can’t understand why actual costs went over budget by $953. He calls his project manager up and asks why materials were more than anticipated and why the sub charged more than the sub’s original estimated submission. The project manager reports back that additional CMU’s had to be purchased to compensate for the additional two courses of block laid towards the garage end of the house. It turns out that the lay of the land required additional courses of block to level the house. The additional block requires additional time by the mason, thus the overall subcontractor charge was higher. These additional courses of block drove the overall actual cost of this section of the estimate higher.
Lesson Learned: In the future, take better measurements for the lay of the land with respect to the footprint of the home. Any slight deviation significantly increases the cost of the foundation due to additional materials and time to lay the block.
Go back to the introductory paragraph about this lesson. Estimates are an internal control tool to maximize profits. It is a dashboard of information for the management team. It is designed as an information feedback tool to identify success and failure. The goal is to learn from the results and make adjustments for the future. It is a learning tool to help improve profits over time. Estimates DO NOT generate profits; estimates act as a guide towards evaluating performance, both physical and financial performance.
The next lesson in this series takes this financial outcome from the income statement statement (P&L statement) and compares it against the pool of estimates used to generated the predicted direct field production profit. This is the first in a series of lessons about estimating in construction. The first few lessons explain ‘WHY’ estimates are used. Act on Knowledge.