WHAT IS THE appropriate compensation for an owner of a contracting firm? How much is the right number? Isn't just a salary with expenses enough?
These are good questions for all construction contractors. People have different answers. Consequently, it is reflected in the bid results on any given day.
Some contractors want to make a living while others are trying to build wealth for themselves. To be sure, if you compete with those who just want to make a living, you will have to be satisfied with just that. There is no profit margin in their bids; therefore, there can't be any margin in yours.
If you want to build wealth, compete against those contractors who want to do the same. Their prices are higher so your bids can be higher. Great news for anybody in business.
To establish an ROI, we must first agree that there is risk in construction contracting. For those who don't believe that there is some, we would point to bankruptcy statistics. Construction contracting is still No. 2 in terms of percentage of business failures. It is a business that is famous for what poker players call a "bad beat." Just when the signs are clear that you will win, the last card is drawn and it defeats you.
That last card can be any number of situations such as: extraordinary weather; payment delay or non-payment;tenured (trusted) supervision gone bad; uncompensated change orders; disorganized client; site conditions; and litigation.
These are a small sampling of bankruptcy reasons. You only have to suffer one to end the life of your firm, and there are dozens more.
So, if you now agree that we have risk, we can discuss what the charge for that risk should be.
The Federal Reserve is one place to start. The interest rate that the Fed charges banks for borrowing money is the "risk-free rate." It is assumed that the money in all situations will be paid back, hence no risk. That rate, at present, is in single digits. It is not important what it actually is. What is important is that our business has risk and the amount charged for the risk of construction work should be more than that. Stating that it should be a double-digit interest rate is a rational conclusion.
What that double-digit rate should be, however, is inexact. So, we should now discuss what a reasonable amount should be in between 10% and 99%.
Look to the credit card companies. They charge anywhere from 9.9% to 20+% depending on their customer. This is their risk and gross profit calculation rolled into one number. Don't forget our bankruptcy law was changed to make it harder to discharge credit card debt. This translates into less risk for the issuers.
Contractors don't have the luxury of low bad debt exposure as these companies do. Additionally, contractors have a relatively small number of clients, any one of which represents a greater chance of financial problems if that receivable is uncollectible.
I submit that the risk rate charged on a contractor's work should approach 30% if not more. To clarify, this is a rate that is not a profit margin, but a premium on the contractor's working capital lent to the project.
Getting 30% on your cost of doing a project is a great idea, but it may be impractical if you want to win work. (Or is it?). Remember that profit margin is not the same as return on investment.
Return on investment on a project is an odd concept. Let me try to explain.
First, let's agree that the cost of the money to build the work is the correct basis for the calculation.
Also, we work in the second riskiest industry, so our returns should be higher than all other industries except for the restaurant business. Therefore, if we place our capital at risk, we should expect high returns.
Third, contracting's business model is unique in that we have:
- No large up-front investment in plant or equipment. (If equipment is needed, we can rent it.);
- Our billing amounts are unique for most projects and can be increased or decreased depending on our agreement with our client;
- Retention is kept on each billing;
- Our accounts payable for material can be matched with our accounts receivable for that same material.
There are many other factors, but these are the primary ones. To calculate a proper return on investment on a project, we should use the following factors: amount and timing of cash out; amount and timing of cash in; and gross profit dollars.
Note that the return on investment for a construction firm starts at the project level. Without profitable projects, a contractor's business cannot be.
The above three factors are used in a mildly complex equation to arrive at a return on investment percentage. I've outlined this formula in my book, "Managing a Construction Firm on Just 24 Hours a Day," and I have it in a CD of templates that we offer on the Web.
At Stevens Construction Institute, we have confirmed that using a return on investment calculation at the bidding stage is a best practice. Contractors use this along with other factors to set price. It keeps them away from bad pricing decisions.
Certainly, you might use this same formula to ascertain the return on a completed project. This exercise is equally valuable.
The top quartile of contractors earn about a 40% return on their invested working capital. That is, they are highly successful in a financial sense. One reason for their success is that they use thoughtful financial practices to keep them profitable.
Obviously and more importantly, doing great craft work once the project is won is crucial to success in construction.