It happens to all of us at some point: You think you’ve got a good handle on what a job will cost until–wait a second–where did all those overruns come from?
Where you thought you’d be bringing in a healthy 20% margin, now you’re barely scraping by with 8%. How’d that happen? And more importantly, how can you keep it from happening again?
Problems like this happen when there’s a disconnect between what contractors think their estimated cost to complete is, vs. what a project’s real costs end up being. Mismatches here can absolutely decimate your profitability, and they’re hard to see coming ahead of time. But just because spotting overruns is tough doesn’t mean it’s impossible.
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Key Takeaways
- You won’t be able to get ahead of every overrun, but better project management will make it possible to course-correct before it’s too late.
- Don’t rely on basic formulas to tell you your estimated cost to complete a project. Instead, make sure your project management team knows how to accurately estimate and report job cost data.
- If the gross margins on your WIPs seem off, always defer to your P&L as the source of truth for company profitability.
Why Project Overruns Keep Tanking Your Bottom Line
The more information you have on a project, the better. Unfortunately, construction is a notoriously data-poor industry, and surface-level estimated cost-to-complete formulas don’t help.
Let’s say you’re working on a $1 million job and you’ve estimated a $700k cost to complete. If everything goes to plan, you’ll have a nice 30% gross profit margin.
Halfway through the project, you’ve hit $350k in costs. A basic formula (Estimated cost - Cost incurred to date) will tell you you’ve got another $350k estimated cost to complete. The problem is, your actual cost to complete might be $400k–but you wouldn’t know that until it’s too late to change course.
Somewhere in there, a subcontractor ran over, or maybe your labor force was less productive than you anticipated. None of this can ever be captured in a basic cost-to-complete formula, leaving you out of luck once you realize you’re $50k over budget.
You don’t have to keep flying blind though. With a little extra mental work, you can catch overruns like these before they ruin your profitability.
Fix #1: Make Sure Your Project Managers Are Trained
The short answer to unexpected cost overruns is better project management. Every project manager should be trained on the correct processes to estimate job costs, including how to report those costs on at least a monthly basis.
When trained well, project managers can go beyond basic formulas and deliver more accurate cost data. And when PMs can properly estimate cost to completion, they’re able to flag potential overruns early and adjust the budget as needed.
You’ll also be able to see exactly why these overruns are happening in the first place. Maybe you need to replace an employee who keeps missing deadlines, or maybe one of your PMs took on a bunch of out-of-scope work without billing change orders. Either way, you can’t address these issues if you don’t know the root cause behind them.
Fix #2: Use the P&L As Your Source of Truth
A lot of contractors come to me confused. Their WIP reports at the job-level look great–they’re achieving margins of 30+%. But at the company level, they’re struggling to keep enough cash on hand. What’s going on here?
Your WIP report might look great, but it doesn’t show you the full picture if your job costing is broken. Once you zoom out and look at your company’s P&L, you might find that your profit margin is only 15%. If this is the case, it means your job costing system is leaving out key information. If your WIP report shows you achieving a different gross margin than your P&L, you know you have a problem. Here are the most typical issues I see that cause this:
1. Missing costs in the WIP report
Often, your P&L will show correct accounting and include things like payroll taxes, employee benefits, job-related mileage, etc. But if your WIP report doesn’t include these costs, your numbers will be off. Worse, you’ll be leaving money on the table. If you aim for 30% margin, your bidding process has to include all of these costs. Otherwise, you’ll never hit your target.
2. Leaving costs out of your Cost of Goods Sold (COGS)
If your accounting isn’t correct, you may be leaving important costs out of your COGS. For example, your WIP report and P&L may show a 30% margin, but you still struggle to be profitable. You’ll incorrectly conclude that you have an overhead problem, which isn’t the case. The truth is, you have an accounting problem. If the accounting was correct, you’d see that you only have a 15% gross margin in the P&L, a 30% gross margin in the WIP, and the problem is actually that you aren’t as profitable as you should be at the job level.
Having an accurate understanding of your cost structure is absolutely critical. If it’s wrong, you’ll flounder trying to figure out which lever to pull to fix the problem.
Even if you’re feeling pretty confident, always check to make sure the margins reflected in your WIP reports match what your P&L says. If they’re not telling the same story, you know there’s a problem.
Wrapping Up
Here’s a secret: Most construction companies aren’t actually doing the work to fix overrun issues. This means you’ve got a golden opportunity to get ahead of the pack and make sure your systems are working for you, not against you.
Instead of firefighting every time a job is more expensive than you expect, take the time now to invest in better project management. It always pays off.