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What Is Profit Fade?
No contractor wants to discover that they aren’t going to make as much profit on a project as initially estimated. Unfortunately, it’s not uncommon to find that the profit margin for a given construction project shrinks or even disappears by the time work is completed. It’s even more unfortunate that sometimes, that “profit fade” doesn’t become apparent until it’s too late to do much about it.
Project owners and surety bond providers typically require periodic financial reports showing the percentage of project completion and the profit recognized as of each reporting date. In a perfect world, those percentages match—when 50% of a project has been completed, 50% of the total estimated profit has been recognized, and so on. At the end of the project, when 100% of the work has been completed, and 100% of the estimated profit has been recognized. It’s when 100% of the profit has been recognized before 100% of the work has been completed that cash flow problems arise, and the contractor may even experience a loss on the project rather than a profit.
Why Does Profit Fade Occur?
Profit fade becomes a strong possibility when conditions such as the following exist:
- The original cost and profit estimates were overly optimistic
- The bid was too low
- There were unbillable change orders or rework
- Subcontractors or workers did not perform as expected
- Supply chain issues or severe weather caused unanticipated delays
- Project expenses and tasks are not monitored and tracked in real-time
The causes of project delays and higher-than-expected costs are many and not always easy to anticipate. But most cases of project fade can be attributed to poor execution, coordination, and integration of estimating, bidding, budgeting, scheduling, job costing, and expense tracking. Consequently, preventing profit fade is largely a matter of internal transparency and collaboration, with some contingency planning thrown into the mix.
Best Practices for Preventing Profit Fade
Here are some tried-and-true ways to minimize profit fade.
- Improve cost analysis through the use of job-cost phase codes and task codes and allocate all costs by job phase code. This helps remove human error from real-time cost tracking, permits early course correction when costs are getting out of line, and provides a basis for more accurately estimating costs for future bids.
- Report work completed and labor, equipment, and materials used daily, if not in real-time. It’s particularly important on longer, more complex projects to know where things stand at any given point in time. In many cases, monthly reporting is not sufficient to detect potential profit fade and take corrective action quickly enough to preserve profitability.
- Do not act on unauthorized change orders. Billing unapproved or disputed change orders with the expectation of an increase in the total contract price can result in profit fade as the job progresses and change order revenue is not received.
- Avoid overbilling. Overbilling becomes problematic when project costs are underestimated to begin with. It’s common for contractors to overbill early in a project to ensure sufficient revenue to purchase materials without taking out a loan. But if costs are underestimated, overbilling often leads to profit fade, as the remaining project revenues are insufficient to offset the excess costs, which reduces profit.
- Periodically re-estimate costs and recalculate profitability. Frequent reality checks enable contractors to detect any profit fade early enough to do something about it.
- Take immediate, proactive measures to preserve profitability when profit fade appears likely. For example, crew size, equipment assignments, and work schedules could be adjusted to reduce costs or accelerate task completion.
- Take profit fade into account when evaluating construction project managers. Shared accountability for project outcomes goes a long way toward ensuring profitability.
- Train project managers on profit fade prevention. They are ideally positioned to identify work practices and site conditions that contribute to waste, cause delays, and increase costs.
None of these best practices require large investments in technology or human capital.
The Impact of Profit Fade on Bonding Capacity
Sureties understand that profit fade sometimes happens for reasons beyond a contractor’s control, particularly in the event of natural disasters such as earthquakes, wildfires, tornados, and the like. Occasionally realizing a profit that is less than originally estimated isn’t the kiss of death as far as sureties are concerned. However, a pattern of projects that yield little or no profit is likely to raise questions about a contractor’s credibility and competence, which could affect a surety’s willingness to guarantee the construction bonds needed to support new business. Minimizing profit fade must be a priority for contractors of any size.
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