A gradual decline in expected gross profits over the course of a project is known as “profit fade.” It not only undermines financial performance, but also may raise red flags with sureties and lenders. For these reasons, contractors face an operational imperative to recognize why profit fade happens and know what steps they can take to stop it.
So, what can cause profit fade? Many things, often in combination. Poor or overly optimistic estimating, inaccurate job costing, and unbillable extra work or change orders are all common culprits. Unsatisfactory performance by subcontractors or suppliers can be a cause, as can lax project management or field supervision on the part of the general contractor. Adverse weather conditions or other unexpected jobsite challenges may also contribute to the problem.
It’s normal to experience any one of these issues over the years in the due course of business. However, if your jobs regularly suffer from profit fade, you should formally and directly address it.
Direct and indirect costs
Another major contributor to profit fade is overlooking the nuances of direct and indirect costs. Direct costs, of course, pertain directly to the project at hand. Indirect costs relate to contract performance but on a wider scale. They can be trickier to deal with because they’re often hidden from view.
Take, for instance, insurance expenses. They often lead to profit fade because premiums tend to change from year to year. But, with a little effort, you can parse workers’ compensation and liability costs into an hourly rate for different trades and incorporate this data into labor cost calculations.
You can take similar measures with vehicle insurance. Price the cost of drivers at an hourly rate different from that of nondrivers. Apply a mileage rate for gasoline and depreciation by estimating how many miles a driver will have to travel on a typical day. From there, you should be able to integrate vehicle insurance costs into hourly calculations so you can cover all true costs — and have enough to cover overhead and the profit margin.
There are a variety of other ways to prevent fade. For starters, evaluate your estimating and job costing systems and procedures to be sure they’re accurate and complete. Consider using more conservative assumptions in your estimates. Build in contingent costs to provide a cushion against unanticipated delays and expenses.
Also, analyze past jobs to look for patterns and trends. Is there a correlation between profit fade and certain factors, such as job type, location, contract size or customer? Is profit fade more likely to occur on jobs involving certain estimators, project managers or other personnel? Talk to employees involved with those jobs to identify any factors that caused actual costs to exceed estimated costs. Use this information to improve your estimates and management practices on future jobs.
Your contracts may be part of the trouble, too. Ambiguous or poorly drafted language can quickly lead to unanticipated costs — particularly if you and your client have different expectations regarding the work involved. Be sure your contracts clearly define the nature and scope of the work you’re expected to perform and provide straightforward change-order procedures to ensure that you’re compensated for extra work.
Before you execute any contract, develop a thorough, realistic budget. Tie it to the original cost estimate and establish procedures for reporting actual and expected completion costs as the job progresses.
Finally, carefully monitor a job’s progress and investigate discrepancies between budgeted and actual performance. Regular work-in-progress reports can help you track:
- Contract prices,
- Amounts billed,
- Costs incurred to date,
- Projected final costs, and
- Estimated gross profits.
Continually monitoring this information allows you to spot problems early and resolve them before they do irreparable harm.
A key priority
There are few worse feelings in the construction business than giving your all to a project only to see the profit margin gradually shrink to a minimal amount or, worst of all, disappear completely. Prioritize the prevention of profit fade.
The content featured in this article originates from our bi-monthly Contractor Newsletter. Subscribe below and stay in the know.