Trying to determine the exact percentage of completion of a construction project in progress is like pinpointing the exact location of a moving train. The errors in calculating profit from work-in-progress (WIP) can be a nightmare for both contractors and their accountants.
What if a contracting company knew the historic profit level associated with a particular manager or customer? And what if a contractor was able to anticipate or periodically correct the anticipated results based on its knowledge of this history?
I decided that was the best way to operate several years ago, when I was a consultant to companies and a professor of construction management. After studying thousands of construction financial statements, I became convinced that industry profits have been, and continue to be, overstated by more than one percent—a significant amount when you consider that profits are already slim.
And this profit bleed—sometimes also called profit fade—is hard to detect. It goes unnoticed during growth periods because a greater amount of profitable WIP obscures the evaporation of profits on other projects. During a declining market this goes unnoticed because underperformance is blamed on the business slowdown.
One of the issues with WIP reporting is that it is an estimate based on two other estimates: first, the original estimate of project cost and, second, the estimate of the percentage complete of the work at a given point in time. The process relies on accurate field reporting, which is problematic because accurate means precise and an estimate is an opinion. (I hesitate to refer to it as “an approximation based on two guesses,” but that’s how some people have described it.)
WIP can represent 50% or more of annual reported profit, so mistakes can mislead contractors into believing they are profitable even if they are heading toward bankruptcy. Whether they are accidental or intentional, errors obscure performance so that measuring profit or loss becomes an approximation at best. Contractors who see 40% of the originally estimated project costs often believe 40% of the work is done.
Case in point: I was engaged by a frustrated large construction firm to do something about the constant swings in its projected profits. My solution was to adjust the reported WIP field information closer to reality based on the historic performance of the staff members who were doing the reporting.
In this firm, two dozen project managers were responsible for reporting the project percent complete on their respective projects. A study of the data from the prior five years demonstrated that some project managers were continually optimistic and the profits they foresaw had by the completion of their projects fallen off. I call this “profit bleed.” Other project managers did the opposite, under-reporting profits early in the work that regularly resulted in profit improvement at project’s end. I refer to this as “sandbagging.”
I began by calculating the average bleed or sandbagging for each project manager over the prior five years and determining if the averages were changing over time. Then I established what average best represented the present rate of bleed or sandbagging. With specific percentages based on historic data we could speculate, with a reasonable degree of confidence, how much any project managers’ WIP reporting likely varied, and in what direction.
An Easy-To-Make Fix
What we needed was an immediate reliable fix that would be easy to make and would allow us to accomplish the original goal of improving WIP accounting accuracy. The solution implemented had to cause minimal disruption of existing processes. The contractor's talented project managers took pride in running profitable work and I hesitated to critique their reporting because it might do more harm than good.
The resolution was easy to implement because the field reporting processes and the procedure for inputting the reported data by accounting staff didn't have to change. Instead, we developed a system to automatically adjust for the average profit bleed or sandbagging. When the contractor’s chief financial officer or his cohort accessed the WIP information, the number was displayed in the original amounts reported but also automatically discounted for profit bleed or increased for sandbagging by the historic factor associated with each project manager. The corrected amounts could then be used in compiling improved and more accurate interim and year-end financial statements.
My advice to the contractors was that secrecy is seldom appropriate. So the contractor informed each project manager about the adjustment made to their reported WIP from time to time. The project managers showed little concern and they even seemed to appreciate what was being done and that the solution required no additional effort from them. And that is understandable when you consider that change is always difficult.
Thomas C. Schleifer, PhD, is a turnaround expert and former professor at Arizona State University. He serves as a consultant to sureties and contractors and can be contacted via his blog at letstalkbusiness.net.