Gross profit increases as costs decreases. Gross profit analysis provides clues about management’s ability.
Declining Gross Profits are indicators of
1) Unplanned overtime
2) Uncompensated changes to the work
3) Excessive materials waste
4) Rework / Shoddy workmanship
5) Defective materials
6) Inefficient labor
Gross profit can not be recognize without physical progress toward completion
Quite common for contract amounts to change and for projected gross profit to change along with it.
Changes themselves are reinforcement of a contractor’s timely completion of updates.
Operating leverage is a mathematical technique to measure the effect of sales on profits. In other words, what percentage of each revenue dollar is profit and then how much does it change with a decrease or increase in sales.
AS we know, part of a contractor cost structure includes fixed costs. These costs by definition stay the same despite changing volume. Variable cost change greatly with a change in volume.
Operating leverage in the amount of gross profit to net profit before tax.
So a contractor who has the following financial statement:
Direct Costs 3,200,000
Gross Profit 800,000
Net profit before tax 100,000
Operating leverage 8.0
Operating leverage is dangerous in construction. It implies that there is correlation of revenue to profit. There is no question that higher volume does not bring an equal or higher gross profit.
The implication is that the if you raise or lower revenue, the net profit should closely follow the operating leverage ratio.
Certainly on the side of decreasing volume it holds. Smaller contractors make a greater percentage of profit than larger contractors.
The dangerous implication is that higher profits should follow higher revenue. This is simply a brutal assumption to make. Expanding volume has been the death of most ex-contractors. The majority of the time it has been the search for volume or a larger job that has been a difficult end to a construction business.