4 Financial Traps Construction Businesses Must Avoid

Some financial pitfalls that you need to watch out for - and be mindful of - as you operate your construction business.

Four Financial Traps Construction Businesses Must Avoid
Adobe Stock Images | By Maxim_Kazmin

Construction business owners often start their businesses with good intentions, and they have the know-how, experience, and connections needed to gain clients and carry out the work. However, many contractors and material suppliers overlook how important it is to allocate effort and time to managing finances.

Here are four financial pitfalls that construction businesses could fall into.

Lowering Markup To Win Jobs

The profit model of most construction businesses heavily relies on the markup for each project. However, to win jobs, it's a reality that competing on price is part of the strategy. Reducing your usual markup to win big jobs is part of doing business. Yet, many contractors and construction companies fall into the trap of lowering markup without a clear picture of whether the reduced contract price results in project profits. Bigger projects do have more "cushion" for lower markups due to the size of the possible net profit. However, without clarity on if a project is still profitable after lowering prices to win bids, you might find yourself knee-deep in deliverables without the returns to show for it.

Being inflexible with your markup isn't the solution either. Typically, smaller jobs allow for healthier markups. So, businesses can mitigate the risk of falling into the trap of being booked but broke by having a healthy mix of smaller and bigger jobs. Doing this doesn't remove the need to ensure that you're not losing money on the job. After all, the bottom line for any project is to increase your bottom line.

There are projects where taking a loss might be a strategic decision to get on the good side of a client who has more work to give. Be careful of this–as it's not always a given. All participants in a construction project, including the client, want to come ahead. So it would be best if you protect your interests by going into projects with clarity and decision-making based on facts, not assumptions.

Same Markup For Every Job

Like the last pitfall, using the same markup for items or overall percentages on all your jobs might simplify the work involved in pre-construction and bidding. However, projects are often wildly different as complex as they are, and this templated approach can cost you big. The revenue and profit you gain from jobs are not as simple as subtracting the costs from the contract price. You have to account for time spent managing the work on the job site, the in-house personnel who get tied to jobs, and other variable expenses and resource consumption that change depending on the nature of the project. 

Using the same markup for jobs is irresponsible, primarily when catering to clients of different sizes and backgrounds. You might be leaving money on the table or even losing money if you don't do a thorough financial and operational analysis of what a job will entail before you write up your quote, bid, or offer.

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Four Financial Traps Construction Businesses Must AvoidAdobe Stock Images | By Andrey Popov

Poor Financial Tracking Within Projects

Many construction business owners defer to not meticulously and honestly tracking the costs associated with a project for simplicity's sake. They have created justifications like minimizing the assumed impact of change orders on the overall profitability of a project or that they think being detailed in change order documentation can cause friction with the client. 

However, precise tracking for change orders and all the details involved in the project is just good business practice. It is essential not only in managing the project but also in ensuring that you’re able to file the appropriate preliminary notices required to preserve your right to file a mechanics lien in case there are payment issues later in the project. It also helps clients understand the actual costs of what they're having done. As a result, they'll be able to make better decisions as clients for subsequent projects and requests for amendments in your current contract. It's easy for these things to go out of hand, so establishing a straightforward process whenever there are change order requests is smart and essential.

Make sure that you document their requests, write up a detailed cost breakdown, and get on the same page with them before starting any work that's not in the contract. Absorbing these costs has no real business advantage and is only shaving off from your profits. 

Poor documentation on your projects also denies you reliable references for future projects. You may not have clarity on what costs a project entails, resulting in a poor understanding of your actual profitability. This lack of clarity will eventually lead to bad financial decisions and always being unsure of which logical adjustments are needed when refining your process and troubleshooting issues.

Poor Annual Financial Tracking

Poor tracking for every project is often part of a bigger problem–poor annual financial tracking. You're dealing with finances on a per-project basis, the business version of living paycheck-to-paycheck. You won't have a clear idea of where your business is financially, what types of clients benefit you the most, and what needs to be done to improve your standing.

There are many reasons why many construction businesses fall into this trap; however common it also is in other business sectors. Construction businesses are often caught up on short-term cash flow, and ensuring that all payables are covered and plans are correctly implemented. Project continuity, of course, is a crucial focus. However, business continuity can be significantly compromised if a business is not aware of where they are in the medium-term, at least its annual financial performance. 

Setting goals helps immensely. Metrics or key performance indicators help businesses have an objective look at numbers to assist them in evaluating their financial health. While these numbers only tell part of the story, having them to rely on helps in facing issues head-on as they arise instead of sweeping things under the rug, whether to avoid reality or to "keep things simple," which is often detrimental in the long run.

Financial Metrics To Consider Tracking

  • DSO (Daily Sales Outstanding) - Number of days it takes on average to collect on receivables
  • DPO (Days in Payables Outstanding) - Number of days it takes on average to pay creditors and suppliers
  • Gross profit margin - Total revenue minus the total cost of goods sold (expenses incurred to create/deliver products or services, not including overhead expenses such as marketing and sales), expressed as a percentage of total revenue
  • Net profit margin - Total revenue minus the total cost of goods sold minus the overhead and operating expenses, expressed as a percentage of total revenue

These are just some financial pitfalls that you need to watch out for and be mindful of as you operate your construction business. It is quite challenging to stay on top of finances alongside your day-to-day operations in running a business, but it's best to understand why it's equally important as the work you do on the jobsite. 

Ultimately, the goal is to have a profitable business. With awareness, conscientiousness, and diligence, you'll be able to stay on the right track as you continue delivering value to your clients.

About the Author

Patrick Hogan is the CEO of Handle.com, where they build software that helps contractors and material suppliers with lien management and payment compliance.