Minimum Bottom Line Profit Should Average 9.4%!
For Trades & Subcontractors, at Least 11%
After Income Taxes Are Paid!
Most construction projects are divided into phases of construction. Phases have many different names, but the most common are:
All terms are interchangeable and really refer to the steps of construction. A typical home goes through multiple steps: 1) site work, 2) footer/foundation, 3) framing/structure, 4) trades and so forth towards final completion and punch out. Estimating is prepared in stages with some costs that will exist throughout the entire project (debris removal, facilities, environmental fence, etc.). But in general, almost every project has a phase or a set of work milestones to complete before the project is finally finished.
Estimates in construction are prepared in a similar timeline fashion as project milestones with an overall section to cover those costs that are ongoing throughout the project’s entire time frame. For the purposes of this lesson, the term ‘Phase’ is used to indicate these respective steps of physical construction. In Parts I and II of this series, estimates are created using hard costs of construction; those costs that are directly assignable to the respective project. Throughout this project’s timeline, all assignable costs are keyed to the project and ultimately aggregated by cost type (materials, labor, subcontractor, equipment, other) in the direct costs of construction section of the income statement (P&L statement). To break these costs down into phases, the estimator needs to understand how data in entered into the accounting software. Once entered, the costs can then be accumulated by phase using a customized report from the accounting software. Most accounting software allow an estimate to be entered thus the customized report can compare actual hard costs by phase against the estimated costs by phase. With this report, the construction management team can now hone in on any cost overruns by phase or cost savings.
With this data, the team can dig further into the details to find the driving cost that creates the difference between the estimated amount and the final actual amount. The following sections explain this job costs by phase evaluation process.
Without a good data management system (accounting software) hard costs cannot be accumulated to a job or to the phases of construction. Therefore, estimating becomes less valuable because the management team can’t discover the underlying reasons for discrepancies between actual outcomes and expectations. Both the accounting system and the estimating system are required to make the entire process informative and beneficial to the company. Thus, data entry is important to the outcomes.
Most accounting software allow job costing to exist. The accountant merely sets up the phases of construction as a cost code for data entry. Thus, all costs entered are assigned to a cost code (phase of construction and/or type of cost) along with the project’s unique identifier. One of the most popular accounting software used in the small business world is QuickBooks. QuickBooks allows the data to be entered by cost code and assigned to the respective job (QuickBooks uses the term ‘Customer’ for the job name).
When a bill or time sheet is received, the dollar value is assigned to the project under a specific cost code. Cost codes can be designed as phases of construction. This is an example of a simple home contractor’s phase codes for construction:
01 – Project Management – ongoing costs that exists throughout the project such as debris removal, port-a-john, interest, engineering, permit, inspections etc.
02 – Site Work – initial land clearing, arbor work, site access, final landscaping, shrubbery and sprinkler systems. Includes driveway, walkways, swells and exterior issues.
03 – Foundation/Footer – includes crawl space items, basement construction and steps.
04 – Structure – framing, windows, exterior doors (including garage door), roofing, siding, brickwork, gutters, soffitt, trim, deck and exterior buildings
05 – Trades
06 – Walls – from the moisture barrier and insulation through sheetrock/plaster. Includes interior doors, painting, trim and closet/door hardware.
07 – Cabinets/Vanities/Countertops – includes any stair work/trim; this cost code includes all custom trimwork.
08 – Flooring/Tile – any form of flooring (hardwood, laminates, carpet etc.) are included; all tile work whether bath or floor is also included.
09 – CO’s/Specialties – change orders, upgrades, custom items such as pools, retaining walls, exterior light systems, theater systems etc. are included in this section.
Every hard cost is assigned to the respective project and to one of the above phase codes. With only nine phases of construction, it makes it easy to identify discrepancies. To do this though, the company must first prepare a customized report that allocates out all hard costs by the respective phases of construction.
Actual Costs of Construction by Phase
In Part II of this series it was taught how to compare aggregated actual costs by type to the estimates values, illustrated here:
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
The management team now wants to break this down by phases of construction. If data is entered as stated in the prior section, the management team can indeed get data out based on the phases. Look at this report for the above Job #1.
Nailed It Construction
Job #1 Actual to Estimated Costs by Phase of Construction
Phase of Construction Actual Ratio Estimated Hard Costs Ratio Over/(Under Estimated Amounts)
01 – Project Management $53,019 8.99% $49,700 8.90% $3,319 10.54%
02 – Site Work 51,291 8.70% 50,900 9.12% 391 1.24%
03 – Footer/Foundation 47,208 8.00% 45,200 8.09% 2,008 6.38%
04 – Structure 121,617 20.62% 111,800 20.02% 9,817 31.18%
05 – Trades 97,904 16.60% 97,100 17.39% 804 2.55%
06 – Walls 71,559 12.13% 69,800 12.50% 1,759 5.59%
07 – Cabs/Vanities/Tops/Appl’s 55,613 9.43% 55,300 9.90% 313 .99%
08 – Floors 47,896 8.12% 41,400 7.41% 6,496 20.63%
09 – CO’s/Specialties 43,781 7.42% 37,200 6.66% 6,581 20.90%
Totals $589,888 100.00% $558,400 100.00% $31,488 100.00%
This report identifies three distinct phases causing almost 73% of the cost overruns. Please review:
04- Structure $9,817 31.18%
08 – Floors 6,496 20.63%
09 – CO’s/Specialites 6,581 20.90%
When companies initially implement estimating and financial evaluation processes, they customarily discover large discrepancies within one or two phases during the early years. As these are corrected via policy and procedure changes, the volitility begins to decrease and the over/under values begin to move towards zero. The end result is significant improvements in overall job profitability and company wide profits. Typical driving forces for cost overruns in the early periods of using estimates include:
- Failure to adhere to subcontracting quotes; i.e. allowing subs to charge more for unnecessary work.
- Failure to properly document change orders with the customers; this causes costs to increase but not the corresponding revenue.
- Sub call-backs tied to poor planning.
- Poor documentation of communications with vendors/suppliers thus increased charges from vendors/suppliers.
In the above, notice that in Phase Four, cost overruns totaled $9,817. Review of the details discovers that the roofer charged a $1,250 return fee because the roof penetrations from the plumber were not done prior to the roofer’s initial trip. Under California law, the roofer had to pay his entire team for a 1/2 day of work each and no physical work was done on that day. Additional review identifies exterior door upgrades requested by the homeowner without a corresponding change order. Other issues discovered included some custom brickwork performed at the direction of the project manager authorized by one of the corporate partners.
Phase Construction Details
The management team must focus on the top three phases/stages/milestones of construction with the greatest contribution percentage of the difference between the actual and estimated hard costs of construction. Over time, the entire process will incrementally improve as the company learns from its mistakes and successes with construction. With a focus on the top three phases, the accounting team can provide the details of both the actual costs and the corresponding estimated amounts.
For example, here is a report on the floors section of the above report. Look for the significant discrepancy value in dollars at this level of review.
Nailed It Construction
Job #1 Actual to Estimated Costs by Detail
Phase 08 – Flooring
Item Actual Estimated Difference
Foyer Tile $391 $400 (9)
Kitchen Tile 3,418 2,800 618
Bath Tile 8,686 8,100 586
Porch/Exterior Tile 2,847 2,100 747
Hardwood Floors (Mts) 11,327 11,300 27
Sanding/Sealing 7,788 5,300 2,488
Stairs 3,796 1,800 1,996
Carpet (Bedrooms) 9,643 9,600 43
Totals $47,896 $41,400 $6,496
The team looked at the bills from the professional sander and the estimator’s notes. The estimator used a schedule of values from another professional sanding company and only used the core base price to estimate the cost of the sanding and sealing of hardwood floors. Upon review of the respective schedule of prices, the sanding subcontractor noted that the prices are based on an open area of hardwood; hallways, stairs and flooring with railings require an additional $2.35 per square foot. The additional charge is due to the extensive labor to use auxiliary equipment beyond the traditional 8″ belt driven sander. The configuration of the winding stairs and the connection to the upstairs open air with railing hallway added all the additional costs.
The team contacted the tile subcontractor to ask why his fees were higher for the tile throughout the house. The tile sub responded that in accordance with his arrangement, the respective floors would be level, i.e. already floated with a masonry mixture. This was the agreement between the project manager and the tile subcontractor. The project manage failed to properly prep the floor for the tile subcontractor. Since floor prep is customarily done with in-house staff, this would also explain a part of why the in-house labor was significantly less than the projected estimated amount for labor (sourced from the Actual to Estimated Costs by Cost Types report, see Part II or section one of this lesson).
Thus, all the costs in excess of the estimated amounts were driven by the failure of either the estimator to use the proper schedule of fees or the project’s manager’s error with proper preparation of the floors.
With the lessons learned, the company’s estimators are now required to include additional amounts per square foot for subcontracting for hardwood floors when the scope of work includes hallways, stairs, railings or other barriers that impede the traditional 8″ belt sander.
Summary – Estimating in Construction, The Financial and Operational Evaluation Process
Estimates are the absolute best tool to control construction profitability. When individual projects have expected results driven by good estimates, the contractor can expect financial profits to follow. By comparing actual costs and estimated hard costs, the construction management team can then use a step-down process via reports to discover the underlying drivers of discrepancies from the estimates. As explained in Parts I through III of this series:
- Only hard costs are used with estimating in construction; soft costs are excluded.
- Aggregated costs by type are reported in the income statement (P&L) for all jobs over the accounting cycle.
- Actual costs can then be columned by job and a summary of job profitability is rendered.
- Those jobs with significant job profitability discrepancies can be further evaluated by using a Job Costing by Phases of Construction Against Estimated Costs.
- With each phase’s actual and estimated amounts, the respective phases with issues can then be further broken out in detail to determine the actual source of the discrepancy.
- The construction management team creates a ‘Lessons Learned’ report and implements changes either in processes or updates the estimating procedures to ensure more accuracy with estimating.
The end result is a continuous improvement with overall operational and financial results from projects. Over time, this improvement will result in corporate profits. The next set of lessons in this series will cover concepts, tenets and principles of estimating. Act on Knowledge.