How do we proactively plan our business if we are changing our cost structure dramatically? How do we judge whether an additional cost or investment has been a financial success?
There are various methods in the general business environment however, in construction contracting, we must use breakeven analysis.
Our goal is to know how much volume we must earn over the year to keep from losing money.
Construction is a world of not enough work or too much work, it is never “just right”.Knowing how much revenue is a critical success factor. It is legend that too much volume will kill a contractor faster than too little. Knowing when to stop (or at least slow down) can mitigate this danger.
How to determine the minimum volume to breakeven on your costs.The basic formula is to determine the gross profit percentage expected from the work. Take that and divide into the fixed costs.
You will need to determine your overhead cost (assume $1 million) and a planned Gross Profit Percentage (say 20%) is all you need.
Therefore – 1,000,000 / .20 equals 5,000,000.
It is harder than it seems. This equation may sound simple, it is. However, there are several traps that might trip you up on the way to executing the plan and realizing the financial results.
Will you need extra overhead to pay for the additional volume? Is there a savings opportunity due to this investment? This is where business judgment and plain old “gut feel” are valuable.
This is analogous to determining the total cost of building a project. We have costs that are direct and indirect plus overhead. Once we arrive at that number confidently, then dollars added to it are profit.
A further step is to separate fixed overhead from variable overhead. That is to determine what will increase (or decrease) greatly due to volume and what is relatively fixed. As an example, telephone cost will directly rise with volume. More work, more minutes on the phone, more faxes and cell phone usage increases. Rent and the President’s salary would be fixed. So to further define the equation is to the gross profit % plus the % of variable overhead less 100% gives you the variable contribution.
Here is the calculation:
Total Revenue 100%
Direct costs 80%
Variable Overhead 5%
Results in 15% variable contribution
Fixed overhead costs $1,000,000
To reach breakeven is to generate $1,000,000 of gross profit, which is divided by .15. We need of revenue $6,666,667. This is our breakeven revenue.
The planned gross profit percentage has to be what is collected. This, again, can be a tricky formula. In contracting, discounting of change orders by clients is common. Additionally, non-payment occurs from time to time. Hence, being conservative (meaning worst case) is the best strategy. Change orders are often held to the close-out phase where the client’s leverage is the greatest. Non-payment will happen to a contractor in his career. We hope only once, but the odds are more often than that.
There is no easy way to perform this budgeting and planning process. It is iterative. A contractor must look at it periodically and after some sleep. The good news is that a contractor’s profitability is highly correlated to financial planning. This is the reward. However complicated, this is the good news of going through financial hard work.
Matt Stevens is President of Stevens Construction Institute, Inc. A management consulting firm which works only with construction contractors. Learn more at www.stevensci.com
For more information on this critical subject, purchase a copy of my McGraw-Hill book, Managing a Construction Firm on Just 24 Hours a Day. We offer a bundle with Excel templates that are featured in the book to help assist in making financial, estimating and project management decisions.