Understanding Construction Financial Management – Ensure Long-Term Financial Health and Sustainability of Your Business
The construction industry, like any industry, requires a well-defined product or service, enthusiastic and talented personnel, and a strong customer base to succeed. However, success in this industry is considerably more challenging than in most sectors. According to Census Bureau data, over the last 10 years, construction businesses failed at nearly 1.5 times the rate of companies in other sectors.
Watch our video below or read the article underneath to understand more!
General research concludes that construction businesses are an inherently risky endeavor compared to other businesses due to growing project costs, rising material and labor expenses, labor difficulties, more competition, and declining profit margins. According to data from the Bureau of Labor Statistics, of the 69,296 private construction firms that started operation in 2001, 56% were still around three years later, 26.6% made it to year 10, and only 17.2% were still in operation 20 years later. That’s a failure rate of nearly 82.8% (https://www.constructconnect.com/blog).
There are various contributing factors to why construction companies fail. This failure is not caused by a single issue but through several missteps. However, the most prevalent is the absence of sound financial management.
Based on recent studies, the most lucrative construction companies invested heavily in recognizing the importance of their financial health; and therefore, took the necessary actions to ensure their financial stability. In this article, we will review construction financial management and how it affects the long-term financial health and sustainability of construction companies.
What is Construction Financial Management?
Construction financial management is the proper allocation and accounting of financial resources, such as the use of cash and management of other assets (ex. machinery and equipment), to reduce project costs, maximize profits, and assure long-term business financial health.
Every decision in the construction business impacts not only the construction project but its overall financial position as well. Consider a major bidding decision, which necessitates considerable executive planning and analysis of many factors involved. This may require analyzing the company’s financial resources to determine whether to finance the project externally or use internal resources. Other considerations include whether the company should lease or purchase the additional equipment needed for the project, and if the company purchases equipment, how should it be financed, and, finally, what profit and overhead markup should be added to the bid. The answers to these questions give us an understanding that construction financial management is essential to make the proper decisions and actions for the company. It also monitors a company’s overall cash flow, solvency, and profitability, while ensuring that each construction project has a realistic budget and that each project is completed within budget, which would lead to profitable projects, financial stability, and overall company success.
The difference between financial management in other industries and construction financial management
Financial management, in general, is the process of accounting for the resources, primarily monetary, and managing them to ensure their proper utilization. However, financial management in the construction industry is a bit different from financial management in other industries, as the dynamic and complex nature of the sector makes it difficult for the concepts to work without some modification (https://indieseducation.com/construction-financial-management/).
To comprehend why construction financial management is different from the financial management of companies outside the construction industry, let us compare the financial management between the process of fiberglass insulation management and construction company management. (https://www.pearsonhighered.com/assets/samplechapter/0/1/3/5/0135232872.pdf).
The insulation manufacturer is process-oriented, whereas the construction company is project-oriented. Although the insulation manufacturer produces different types of insulation, the range of products that they produce is limited. However, almost everything a construction company does is a project. Because of this, a construction company must keep accurate construction costs for each and every project. Not only must the cost be tracked for each project, but also the cost must be tracked for each group of components on a project. This data is necessary to control the costs of the current project and to bid on future projects. With each project requiring a different mix of labor, materials, and equipment, knowing the cost of the components for a project is necessary to bid on future projects. As a result, the need for particular construction financial management is necessary in order to avoid underestimating costs and risks of overspending on construction projects.
2. Decentralized Production
The insulation manufacturers perform all their work at a centralized location, whereas the construction company performs its work at a number of decentralized locations. Insulation manufacturing plants are set up at a fixed location with the equipment being dedicated to a specific manufacturing process for years. Employees come to the same plant year after year.
In the construction industry, the equipment and employees are seldom dedicated to a single project year after year. Equipment and employees may move from job to job on a regular basis. As a result, the location of each employee and piece of equipment must be tracked to ensure that their costs are charged to the correct job. Additionally, each crew and piece of equipment must be managed as a profit center.
3. Payment Terms
The insulation manufacturer bills the buyer at the time the insulation is shipped or ordered, with the expectation that the buyer will pay the full bill within a specified number of days. For many construction companies, their work consists of long-term contracts for individual projects, with monthly progress payments being made by the owner as the project is being built. Additionally, the owners often withhold retention—funds used to ensure the contractor completes the construction project—thus deferring payment of a portion of the progress payment.
In addition, the insulation manufacturer is constantly shipping materials and billing for them, which creates a relatively uniform cash flow cycle throughout the month. For many construction companies, all of their projects are on a similar billing cycle, which creates huge spikes in the cash needed for the projects. As a result, construction companies have unusual cash flows and require modification to accounting and other financial procedures to handle retention and the timing of cash flows.
4. Heavy Use of Subcontractors
The insulation manufacturer would never subcontract out a step in its manufacturing process, yet many construction companies rely heavily on subcontractors’ work. The use of subcontractors allows a construction company to tap into a subcontractor’s financial assets during the construction process. The use of subcontractors has a great impact on the finances of a construction company. Because of these unique characteristics, it is important for the manager of a construction company to have a sound understanding not only of financial management but also of how financial management principles are applied to the construction industry. The tools that financial managers are taught in business schools must be modified to take into account the unique characteristics of the construction industry if they are to be useful to construction managers.
Four concepts for better financial strength (https://procfopartners.com/profit-improvement/)
Construction is a fascinating and confounding process. When managed properly the business process runs smoothly, but since there are so many places for processes, budgets, scope, and relationships to go off track, having a strong financial leader to centralize management is vital. There are four essential concepts for developing better financial strength inside a construction company:
1. Training operations team members to understand finance– It’s crucial that everybody, from leadership down to field employees, understands your company’s finances and their importance to revenue and profitability. Teaching the basics of finance, like revenue, committed costs, variable costs, and profit helps everybody make smarter decisions. Understanding and practicing against the percentage of completion and its impact on earned revenue and profit is essential.
2. Measuring what’s meaningful – Having key performance indicators (KPIs) and important metrics available at a glance helps leaders and others make informed decisions and better understand the real-time financial health of the company. They also empower you to make proactive decisions rather than reactive choices.
3. Work smarter, not harder– Construction is sometimes thought of as an archaic business. The adage work smarter and not harder is applicable to the construction industry in general. Let’s explore some financial techniques and tools that can be used to make a firm more modern and productive:
- Use software or applications that help create estimates on the front end to provide faster and more accurate estimates of costs to develop bids, down to the hour or square foot.
- Utilize cloud-based project management to streamline the interaction of field-to-office operations including field connectivity for sharing daily field reports, project drawings, and time management. Establish and stay disciplined to a predictable, repeatable change order management process.
- This will help avoid margin fade. Using prefabrication to reduce completion risk and time.
- Automate processes to help draw processes sticking to deadlines, submission formats, and field approval for completed work.
4. Risk Management for Construction Companies – Lastly is risk management, factors include:
- Subcontractor risk management, such as applying for lien waivers, COIs, and understanding completed contract risk
- Contract management which make use of a change in material pricing provision
- Pre-start due diligence confirming project financing is in place by either talking with the title company or lender providing the financing for larger project
- Employ a backup lender, bonding, and insurance companies to mitigate the risk of change in underwriting from the primary service provider
- Prequalify subcontractors – determine they have the right experience, financial strength, team, equipment, etc.
HWAA can help strengthen your Financial Management!
HWA Alliance of CPA Firms specializes in a few selective niche industries of which the construction industry is one. We have served the construction and real estate development industries since our inception. We have provided a variety of services to community development corporations, real estate developers, contractors, and syndicators. Our financial management solutions are divided into four components: Planning, Evaluation, Reporting, and Finance. HWA Alliance of CPA Firms will assist you with developing clear and concise objectives and strategies to achieve your financial goals. Our professional financial managers will provide ways to effectively identify issues, strengths, and weaknesses to ensure financial success and reporting mechanisms that allow you to track and monitor your financial position. We will help you develop cash flow management, investing, and debt elimination strategies and identify possible funds and capital sources.
Let us help you achieve the financial strength and success your construction company deserves. Contact us today!