In a traditional business, there is conventional wisdom that generally holds true no matter what. Construction is an industry with several of its own differences that defy a traditional solution. Today we are exploring some of those things and why you shouldn’t always listen to the common answer, because it might not all be true.
Topics we cover in this episode include:
- Myth: If I get to X dollars in revenue, life will be easier
- Myth: Accounting is the same for construction as it is for other industries
- Misconceptions around subcontractors being bonded back
- Myth: I always have to be the lowest bidder
- Myth: all projects are similar
- Myth: Profitability is solely about cutting costs
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Wade Carpenter, CPA, CGMA | CarpenterCPAs.com
Stephen Brown, Bonding Expert | SuretyAnswers.com
[00:00:06] Wade Carpenter: In a traditional business, there is conventional wisdom that generally holds true no matter what. Construction is one of those industries that has several of its own differences that defy a traditional solution. Today we are exploring some of those things and why you shouldn’t always listen to the common answer, because it might not all be true.
Come on in, let’s talk about it. This is the Contractor Success Forum. If you’re new here, I’m Wade Carpenter with Carpenter Company CPAs. With me, my co host, Stephen Brown with McDaniel Whitley Bonding and Insurance. Stephen, I’m looking forward to this discussion.
[00:00:38] Stephen Brown: I am too. It’s, it’s interesting. It’s a mystical topic. It’s it’s exotic. And I know all our listeners want to hear what we have to say about it, hopefully.
[00:00:49] Wade Carpenter: Yeah, I think there are several things that as I started down this road, I was like, well, there’s a lot of things that I feel like are not the conventional wisdom, and I think we’re just going to throw a few of these out, and we may, if it works out well, I think we may get some specific things on job costing or cash flow.
Myth: If I get to X dollars in reenue, life will be easier
[00:01:05] Wade Carpenter: But the first one I wanted to throw out there is there’s a common misconception in construction that if I can just get to X dollars in revenue, let’s just say it’s a million dollars or five million dollars or to that next level, however you define it, life gets so much easier. Now, I know I have my realities on that. How do you see that?
[00:01:26] Stephen Brown: Well, we talk about it all the time on the Contractor Success Forum, so that, that was an easy one, Wade. But it’s the most important one I think we can talk about. If I just get to X amount in revenue, all my problems are going to be solved. And that’s just not, that’s not true.
Because along with that increased revenue comes increased costs. Increased headaches, more time to do the project. All these elements add to risk and the risk affects whether you make a profit or not.
[00:01:55] Wade Carpenter: I absolutely agree. I see it all the time where they think that, I’m just going to get to this next level of revenue and essentially costs are going to be the same.
Well, as they grow, the overhead tends to grow with it at a higher rate, unless you’ve got some kind of checks on it. And you end up having to hire more people. You may have to get a bigger office. You may have to invest in more overhead. And a lot of times that doesn’t translate to more profit, as you said. So.
[00:02:25] Stephen Brown: But the right increase of revenue where you’re controlling the costs, that’s not an issue. It’s just a misconception that it’s all about sales and that will solve all my problems.
[00:02:38] Wade Carpenter: Absolutely. But as you grow in construction, we talk about cash flow all the time. And growth takes cash in construction. You can’t just overnight jump from 1 million to 5 million dollars.
You can, but you’ve got to have a plan to be able to collect that money or get some financing to do it. So, it’s just something that we’ve talked about, and I’ve said it before, I’ve seen people grow themselves right out of business.
[00:03:05] Stephen Brown: Me too. Me too. And as you’re growing, you’re pushing a bond program out of its comfort level and you have to be able to prove to the bond underwriters how you’re going to manage this growth. So I guess the two kind of go hand in hand there, don’t they?
[00:03:20] Wade Carpenter: They do. And as people grow, they don’t realize that, again, the headaches grow. As the overhead grows and the people grow, you’ve got more things to accomplish. And a lot of times I’ve seen where the contractor actually takes home less after they grow this company. And it’s sad to see.
And what I say is controlling the growth and knowing where you’re going to be and how you’re going to get there from a cash flow standpoint, as well as growing profitably.
[00:03:50] Stephen Brown: Mm hmm. Strategery. That’s what’s needed. Strategic. Okay. All right. What’s another common myth that we need to debunk that’s unconventional about the construction industry?
Myth: Accounting is the same for construction as it is for other industries
[00:04:02] Wade Carpenter: Well, a lot of people think that accounting is always the same. And a lot of people don’t understand balance sheets, but balance sheets are going to look very different for a contractor versus a traditional business.
And some of the things that we may see that are different are things like the receivables may be longer, and they may have things like retainage that sit there for a long time, depending on how you do your accounting, whether your percentage completion basis or completed contract, you may see things where we’re accounting for WIP, and a lot of these things you’re not used to on a traditional company.
[00:04:40] Stephen Brown: Yes, absolutely.
[00:04:42] Wade Carpenter: And you say,
[00:04:44] Stephen Brown: well, my bonding agent’s bothering me about this.
[00:04:47] Wade Carpenter: I just have to get this in place to make the bonding company happy. Why are they mandating that we do this?
[00:04:53] Stephen Brown: And from my perspective, if
[00:04:56] Wade Carpenter: you’ve got a good construction oriented CPA, then a lot of your problems disappear because they
[00:05:01] Stephen Brown: understand and
[00:05:02] Wade Carpenter: can explain to you why you need to have these systems in place, why you need to report it the way you do. And how to read a financial statement for a construction company.
Right. But there are some differences. And whether you pick up a balance sheet or a P& L, you probably can tell if that balance sheet is properly stated. A lot of times there are a lot of signs that maybe not everything is there. Do you see that?
[00:05:30] Stephen Brown: Mm hmm. Absolutely. And from a bond underwriter’s standpoint, the financial statement either makes sense or it doesn’t. But there’s a lot of terms, and you were talking about completed jobs versus percentage of completion accounting for construction contractors. Then you can add in billings in excess of cost and cost in excess of billings, over and under billings. There are so many elements to a construction oriented accounting financial statement that differ from any other industry that it’s like comparing, apples to jumbo jets, they’re just that far apart.
[00:06:08] Wade Carpenter: Yeah. Well, another thing that we’ve talked about before, retainage. If you’ve got a contractor that they’re definitely holding retainage on that contractor and you don’t see it on their balance sheet, well, number one, their billings are not right. It’s not properly stated. If you’re trying to do over and under billings, it’s going to look like you’re way under billed all the time. If you don’t have these inputs on a balance sheet properly done, your working capital, your debt to equity, a lot of these things are going to look out of whack.
[00:06:36] Stephen Brown: A bond underwriter’s going to look at that and assume you’re losing money on the job.
[00:06:40] Wade Carpenter: Right. So that’s balance sheets in a nutshell. I know we’re not going over that, but why don’t we talk about the differences in Profit and Loss? Because I see there’s differences in a traditional profit and loss for a, say, a retail company or a service business or whatever it is.
[00:06:57] Stephen Brown: Sure. If I’m a baker and I bake a bunch of pies and cakes and folks don’t come in and buy those, then I have the loss of that product. But I’m limiting how much my loss is going to be that day based on how much I bake. But in the construction industry, there seems to be a limit on how much you can make on a project, but there never seems to be a limit on how much you can lose on it.
[00:07:21] Wade Carpenter: Absolutely. Yeah, one of the things I see is different, and I see it all the time, is that the structure of a Profit and Loss Statement should be very somewhat different than say a service business, where the cost of sales at the top, it should include those things that go into the job. And I think we recently did a podcast on some of these indirect things that should go in there.
But if we’re not seeing like the materials and the cost of goods sold, or we’ve got contract labor or subcontracts that are in the general and administrative section, you’re not going to have a consistent gross profit, right? So I know you, the banks, they’re going to look at these ratios and they look way out of whack. So that’s in a nutshell, does that make sense to you? Or do you see that? Or–
[00:08:15] Stephen Brown: It makes perfect sense.
[00:08:17] Wade Carpenter: For you, does that not also make it very hard to compare apples to apples when one contractor doing the exact same thing has things properly classified in the Cost of Goods Sold section versus the General and Administrative section?
[00:08:32] Stephen Brown: Yeah, it throws everything out of whack. It’s just more and more explanations that you have to make to the bond underwriter that can slow down the process of getting your bond approved. For sure.
[00:08:44] Wade Carpenter: You also see some of these things where they’re sometimes inconsistent about what goes in job cost versus goes in SG&A. So if they change the system from one year to another, and you’d be surprised how much I see that. That, again, somebody’s looking at hey, did your overhead go way up or did your margin go way down?
And unless you’re consistent on the P& L and properly classify them, that is not going to look right in a construction company.
[00:09:13] Stephen Brown: Mm hmm.
[00:09:14] Wade Carpenter: Okay. Well, there’s a couple other misconceptions, I know we talked about from a bonding standpoint, is there one you want to throw out there that you see all the time that people think that they’re doing right, but–
[00:09:26] Stephen Brown: Well, again, good information and good communication gets the job done. So good accurate information about how your projects are performing, how you’re doing, and why a certain job makes sense to you, that’s how you get off the ground running on getting bigger bonds approved.
Misconceptions around subcontractors being bonded back
[00:09:44] Stephen Brown: And I’d say a major misconception with my clients is they’re like, I’m bonded the subcontractor back, so I’m not going to get that much bond credit back. And the answer is yes and no. So you’re like, well, what kind of answer is that?
Well, the answer is that yes, you do get a little bit of break in the way they compute the bond credit they want to give you, and that the sub is bonded back. But at the same time, they say, well, this sub, whether you’re bonded back or not, you could have problems with them. They may not default on the job, but it may cost you more money. You still have the risk on the job. You still have the exposure on getting the project completed. And you’re asking us to bond the construction of that project, and 12 months warranty on the workmanship of it. So you’ve got a lot more moving parts in there.
So that’s what I get a lot. I don’t understand. I know we got X amount on the book, but we got 80 percent of it sub bonded back.
[00:10:41] Wade Carpenter: Right.
[00:10:42] Stephen Brown: That’s just one of them I was thinking about.
[00:10:44] Wade Carpenter: Can I ask you some questions about that? Because, I can’t say I completely understand. I’ve seen it myself, but I don’t completely understand. Is there I guess they’re looking at track record with the subs maybe, or do they give you a half credit or is there any rule of thumb or how does that work?
[00:11:02] Stephen Brown: They look at it differently, but basically, they want you to know we are not bonding your subs. You’ve asked them to bond back, that makes good sense. That protects you in case they default on the job or they don’t pay their materials or suppliers for their part of the project.
But all in all, they’re looking for you doing the job. So as a general rule, when you have projects that require more subcontractors and you bond them back, they’re a little bit more lenient in the amount of bond credit they will give you. But it doesn’t automatically wipe the slate clean and reinstate that credit once you sub bond someone back.
They’re bonding you, not your subs. So they can make their decisions however they see fit, and if you don’t like their decisions, then as a bond agent, we can move you to another carrier. But I can just tell you with good communication, that’s really not necessary.
[00:11:55] Wade Carpenter: My standard answer when somebody gives me a tax question that there’s a lot of variables in place, my standard answer is, it depends. It depends on the situation, and so, that’s a good enough answer for me.
[00:12:09] Stephen Brown: Okay, well, we’ll run with that. What other type of unconventional wisdom in the construction business that’s out there that we need to talk about.
Myth: I always have to be the lowest bidder
[00:12:19] Wade Carpenter: Well, there’s a common misconception, I’ve always got to be the low bidder. I’ve got to secure these contracts. Having all these contracts is my key to success. So, they perpetually feel like they’ve got to undercut everybody else. The Reality to me is a lot of people are slowly putting themselves in the ground.
They’re working themselves harder than ever. They may have more revenue and backlog than ever, probably more than they can do, but they’re not making any money. They’re not taking any more home. Do you see that?
[00:12:50] Stephen Brown: Absolutely. When you said working yourself into the ground, that’s a good way to describe it. You’re not getting the rewards of working yourself into the ground and you think, well, this is what I have to do to stay in business. I’ve got payroll to meet, I’ve got to get X amount of work on the books. I’m going to run out of work in X number of months. I’ve got to fill that in quickly.
It’s all a knee jerk reaction that can really sink your ship because, so many times that project that you’re bidding at a low margin has some costs associated with it that you didn’t anticipate. And getting the job finished and paying those costs just absolutely don’t come from outer space like magic. You’re you still got the problem, the problem doesn’t go away. I think that’s a great topic, Wade, because contractors chasing jobs with low bids usually have to over manage that project just to get them to break even. I see it all the time.
[00:13:48] Wade Carpenter: And again, I think we could spend a lot of time talking about that because they feel like, hey, we’re going to be the low bidder, but maybe it’s a bigger project. So we need the cash flow.
And I was actually having this conversation with that plumbing contractor I talked to yesterday. He’s like, you know, I’ve got a salesman out there that he’s bringing in some great numbers and we’re going to give him a percentage on how much he collects every month. Well, I’ve seen it before. They’ll go out there and sell the job at a loss. They don’t care because they’re getting their higher commission. So they’re just bringing in the dollars.
But the bigger problem there is knowing. How much we can afford to bid it for. And if you’re not going to make a certain level of profit, or at least covering your overhead, and again, saw this 2008 when things were going down, it was like, let’s just get some cash flow in the door. That can spell disaster.
So that’s one of the biggest misconceptions I see is we got to get more work. We got to get the top line up and then everything will be solved.
[00:14:48] Stephen Brown: That’s right. And what I’ve seen so many of my successful contractors do when they’re in that kind of a situation is they’re always working on a niche that they can do, that they’re not going to have to bid against a lot of other folks. Find a niche, find specific customers that will let you do cost plus work for them and make sure that you’ve got your cost right, and develop that relationship and it really helps you get through the hard times.
Myth: all projects are similar
[00:15:17] Wade Carpenter: Okay. Well, another myth I see, essentially seeing all projects as similar. And essentially bidding them the exact same way. And I’m going to use that same plumbing contractor that I talked to yesterday, I used this exact same example. They were perpetually running themselves into the ground, and they were doing things by linear foot.
So I use the example of they do some residential stuff. And I was like, well, if you’re re-piping a house and you’ve got one that you’ve got to get in a crawl space in the mud, and re pipe that house where you’ve got very little room to move around versus re piping a house that’s in a standup basement that’s got easy access, it’s going to take you a lot less time to do that job.
And I hope that makes sense, what I’m saying, but.
[00:16:03] Stephen Brown: Yeah, time is money.
[00:16:04] Wade Carpenter: You have to sometimes take into account the factors that go into a job, not just, let’s have a standard cost for that. Does that make any sense whatsoever?
[00:16:13] Stephen Brown: Well, it makes perfect sense. I understand where you’re going with that. Even though jobs may seem to be, on the surface, just another job, you’ve got the location involved that differs, and then you’ve got dealing with the local community in that location, I see that on commercial jobs all the time.
You’ve got a lot of other variables. The weather may be a variable. Also the cost for moving your equipment and housing your folks at a new location. You have to figure that out accurately. So.
[00:16:47] Wade Carpenter: There’s so many different versions of how this might look, but, you may do some for, say, a government job versus a commercial job versus a residential job. You can’t bid them the exact same way because it may be some things like, as you said, the seasonality, it may be, that weather plays a factor.
Some of them are going to pay differently, maybe some of them require bonds, and they’re just, you can’t just assume that a linear foot price across all jobs, just using that example is going to–
[00:17:22] Stephen Brown: Right. And also, let me throw in another one. The time constraints may involve you having to put the right amount of overtime in the project. Rush shipping cost, added materials cost because you need a rush.
[00:17:35] Wade Carpenter: Right.
[00:17:36] Stephen Brown: So, that’s a good point, Wade. Give me one more before we end this.
Myth: Profitability is solely about cutting costs
[00:17:41] Wade Carpenter: Another thing that I see that some contractors do, and how we express this can be different ways, but profitability is solely about cutting costs. It’s having the cheapest solution, and having good control of your job cost is key, but there is a point where you can cut too far. And I can give you some examples, but you got any thoughts on that?
[00:18:07] Stephen Brown: You’re cutting into quality. You’re cutting into generally the happiness of your employees as they’re doing the job. They consider themselves professionals, and they want to do things the right way for you. And you cut their legs out from under them. What else were you thinking along those lines?
Is that kind of what you were thinking?
[00:18:28] Wade Carpenter: Well, there’s definitely where you can cut the meat out of a job using cheap materials, and sometimes that can backfire. One of the most vivid examples I remember, I used to work with a very large, well known company that I will not use the name, very large general contractor. And they were adamant about, they would, if you didn’t clean up on the job, we’re going to back charge you $10,000.
They would beat up their subs. They would stretch the cash flow to no end. And they got to a point where they could not get subs on jobs. They could get the jobs all day long, but they were cutting costs and they went so far extreme on this that it hurt their reputation, it hurt their profitability because they ended up having to bring in people from different states because they didn’t know their reputation. And I hope that makes some sense, but–
[00:19:20] Stephen Brown: No, it makes perfect sense. That old expression, throwing out the baby with the bathwater.
[00:19:25] Wade Carpenter: But that was a very vivid example that I see, but you also see that when 2008 hit, it got very tight and people started cutting the wrong things.
[00:19:35] Stephen Brown: Mm hmm.
[00:19:36] Wade Carpenter: A lot of 2008 was, hey, we waited too long to cut some things, but cutting the wrong things, it’s hey, I got to get rid of this project manager, but they were the key to getting this stuff done profitably.
[00:19:48] Stephen Brown: Mm hmm.
[00:19:49] Wade Carpenter: Sometimes you’ve got to make some hard choices, and there’s no absolutes on this particular category, but it’s just something I wanted to throw out.
[00:19:56] Stephen Brown: Okay. Well, good point.
[00:19:59] Wade Carpenter: Well, I thought it was some really good, hopefully thought provoking topics. So maybe we’ll give us a shot again if–
[00:20:05] Stephen Brown: And let us know of some other ones that we’ve missed that we can share with our listeners.
[00:20:11] Wade Carpenter: Well, Stephen, thanks for doing that. Thank you all for listening to the Contractor Success Forum. Check out those show notes at ContractorSuccessForum. com or on the Carpenter CPA’s YouTube channel for more information. Consider subscribing and follow us every week as we post a new episode and we will look forward to seeing you next week.