Know The Score!
Industry jargon with a lot more importance today than the simple check-off box of the heady go-go days prior to 2009. Official department of labor statistics claim a twenty-five percent unemployment rate in the construction industry. Reuters cites nonresidential construction spending has dropped over twenty percent in 2011. Office construction is down twenty-nine percent, hotels, forty-three percent and the recovery is expected to be slow and meager. Construction, being a mature industry in the U.S., has always been competitive but there is a new fundamental shift in all contractors’ market perspectives. Experts agree, this is a “new normal” with smaller volumes, tighter margins and even more cautious owners.
Many contractors’ balance sheets have been decimated. Excepting a small minority of the clever or the lucky, commercial and institutional contractors have downsized and lowered expectations. Reputation and years in business count for little when a GC can’t pay his subs, the trades can’t afford to fully man a project or pay their vendors. There is a new real-time urgency in gauging the ability of a contractor to fund work. Traditionally, performance bonds and subcontractor default insurance mitigated the worst case scenario, default. They still do, but that comes with a cost and when the stats are done, the probability of a contractor default on any one particular job is still quite small.
The reality is that a financially weak contractor can probably limp through nine out of ten jobs and finally succumb on the “last one”. Its only then the bond or SDI come to the rescue and still with additional cost in delays and headaches. What about those other nine jobs…a ninety percent probability, one of which is your job? It’s a known fact that when a contractor gets into financial difficulty, they cut overhead, delay payments, re-structure debt (if possible), stir up change orders and stretch out jobs as long as possible. It’s a fiscal retreat, “run away today, hope to build another day.” The end result on your project is probably a shattered schedule and arduous change order, close-out negotiations. You may not have a default, but it can be almost as painful.
Here are some telltale signs your contractor could be heading down this slippery slope:
· You get a really, really low price. When the contractor is by far and away the lowest bidder on a job or a package and still insists the scope is complete, there’s probably some desperation in that number. The contractor needs this job to fund his previous jobs.
· Final negotiations are too easy. They accept all your terms immediately and can mobilize yesterday. That’s often another indication of panic and need to start some cash flowing.
· Base line schedules are late or never are produced. Not always a harbinger of financial problems as many contractors are not sophisticated at scheduling. It can, however, be a set-up for eventually extending the job within the contract terms.
· The initial payment submittal is obviously heavily front loaded. Some assertive billing is just good business on the contractor’s behalf, but when it looks way out of proportion to what’s been done, keep a closer eye on the job.
· The project superintendent is usually the first to notice a troubled trade contractor. The sub promises x number of men that week but never gets that many there and they are slipping behind.
· The owner starts hearing from the subs. First rumors followed by phone calls or “lunch” followed by letters. The GC is not paying his subs on time or completely, back charges seem beyond the norm. The same indicators can come from material vendors about a trade contractor to the General Contractor. Listen to the street.
· RFIs start to fly. Again, not always a symptom of financial stress, but if the design professionals have their work products adequately done, this could be a stall tactic or a “margin enhancement opportunity”.
· All RFIs lead to formal change requests. An extension of the point above.
· You see your contractor landing a disproportionate number of other jobs. You are not the only cash source in town. They employ the same tactics everywhere now. Additional work is arguably the last thing a financially stressed contractor needs.
· Delays, delays, delays. The contractor is stalling. They can’t pay their current obligations, so they will stretch everyone out.
These are some clues to help identify a problem in the making. What to do about them? First, a performance bond and/or SDI will mitigate the worst case scenario of default. You will have to weigh the cost versus your risk tolerance. Second, and the theme of this article, is employ good, solid pre-qualification.
Certainly not a guarantee to a trouble-free project, but a thorough qualification process cuts way down on these costly issues. As an owner, make sure your rep or GC/CM has a formal pre-qual process in place and uses it religiously. Examine their check list and criteria. Beyond the normal insurance requirements and project experience levels, ensure there is a sound financial vetting of all key subcontractors. Your general contractor should sort the trade contractors’ proposals applying the normal scope leveling and pricing criteria. Go one step further and lay down their Contractor Score next to all that. The second lowest price may be the better choice given the difference in the bidders’ current financial stability. This is especially pertinent with CM@risk delivery systems where you, the owner is sharing in some of the risk. The CM should counsel the owner on each package selection with this format. This approach has been a key reason why some GCs have been awarded the project.
Another critical aspect often overlooked after the job starts is to keep your contractors scored on a regular and recurring basis. This is especially important with smaller contractors as their financial position can radically change in a few months. Updating their Contractor Score on quarterly basis shows you a trend line and if it is becoming perilously negative, step-in and take pro-active measures. It never hurts to be first in line because it always hurts to be last.Summarizing, today’s market is challenging, but that always opens a door for the creative. There are more contractors in fiscal distress today than ever before. The beginning of a recovery is oddly the most dangerous period as financially starved contractors are jumping at every and all opportunities taking on work they cannot fund. You should know how that affects you and your projects. Bonding and subcontractor default insurance are valuable products, but only after death. A proactive approach is to understand the health of your contractors before starting.
This last section on reducing overhead focuses on warranty, callback issues and the warehouse or yard. Both offer opportunities often overlooked because they are almost always “in plain view”. Again, the effort to make many small changes or reductions add up to some real dollars especially in tight times like today.
1. Institute quality-control program.
2. Require employees who caused mistake to make repairs.
3. Reduce warranty period.
4. Process warranty claims promptly.
Warehouse and Yard
5. Consider reduction in personnel by letting job employees work in warehouse or yard when not on job.
6. Cut inventories or equipment to absolutely necessary items to reduce handling plus insurance, interest, etc.
7. Use graduate students in industrial engineering to evaluate space needs.
8. Investigate high-density stacking and storage systems.
9. Check with vendors about value and utilization of material.
10. Set up check-out system; positive control.
The next topics deal with small tools and taxes. Considering the current fluid state of our tax policies, you should check with your tax advisers if these ideas are still valid. They were at the time of writing.
Shop Supplies and Small Tools
1. Sell tools to employees for cost.
2. Charge for replacement.
3. Put identifying mark on major tools and keep records.
4. Pay higher wage to field employees who furnish their own tools.
5. Centralize tool storage, install check-out system and cut number of tools owned by the company.
6. Create a separate company owned by your employees and then sell or give tools and supplies to it.
7. Implement tool bonus program.
8. Minimum inventories reduce taxes in states with personal property taxes.
9. Challenge property valuations.
10. Eliminate unused operating licenses.
11. Close out dormant corporations to cut franchise taxes.
12. Reduce number of vehicles, therefore, tags. Request refund for unused tag life.
13. Deduct all meals and entertainment expenses for employees the full rate, not 50 percent.
14. Proposed 460 regulations include Home Construction Contract Exemptions where any contractor working on residential units or developments can apply the completed contract method of accounting versus percentage of completion. Defers tax obligations.
15. Take advantage of 10 percent solar-energy tax credits available through 2016. Use qualified energy-efficient products.
16. Take a 30 percent or up to $2,000 tax credit on solar panels.
17. Take a 30 percent or up to $2,000 tax credit on solar water heater (no pools or hot tubs). This is in addition to #16.
18. Defer hiring employees until after January 1 to reduce FICA.
19. Police unemployment claims to keep experience rate low.
20. File termination form with employment commission if employee quits or you fire with good cause.
21. Make sure you take what is called the Section 199, Domestic Production Activities Deduction: 6 percent of all W2s for production labor deduction in 2007 through 2009 and 9 percent in 2010.
Picking up where we left off, a focus on salaries is in order. Salaries typically account for half to two-thirds of a building contractor's fixed overhead. It is the number one area to reduce fixed costs as volume dwindles. Just cutting people, however, is not the only way to go about reducing salary cost. It's much more important to eliminate tasks and then the people that were doing them. Otherwise, the work load will simply be spread among the remaining staff and mistakes will happen, morale will erode and you may lose some good people you had hoped to keep.
Here are some tips on this subject that have worked well for many contractors.
Salaries for Management
1. Pay moderate salaries; pay bonus for extraordinary results.
2. Consider reducing total management team (number) before dollars.
3. Consider stock bonuses instead of cash; they are deductible and there is no cash outlay.
4. Cut earnings or fringe benefits (deferred compensation, auto provided and club memberships, etc.).
5. Cut managers first.
6. Pay bonuses to field first, executives last.
Salaries for the Office
7. Cross train to eliminate temporary employees.
8. Schedule time off, vacations during slow periods.
9. Consider personnel reduction and salary increase to remaining employees.
10. Encourage time off without pay; four-day week.
11. Do not use clerical staff as gofers.
12. Use temporary help, such as retirees, for peak loads.
13. Give compensation increases on merit, not cost of living.
14. If hiring, consider veterans or disconnected youths. Tax credit is now allowed in the American Recovery and Reinvestment Act.
Continuing with the next series of ideas about fixed overhead reduction, we'll focus on professional fees, rent and repairs & maintenance.
- Don't get audited statements unless the bank or bonding company absolutely require them. Keep it reviewed
- Ask your accountant what information is needed and have your clerk assist for reduction in cost.
- Use an accountant who understands contracting. A local accountant can be just as good as a national firm, and you might get more individual attention by a senior accountant at a lower cost.
- Use consultants that can outline what they are going to accomplish, how and at what price. Check references, help them gather information so you don't pay their rates for something someone else in your company can do.
- Lease unused space (sub-lease)
- Renegotiate rent with the alternative of moving.
- Get indefinite lease with six month option instead of fixed-period lease.
- For office maintenance, services are often less expensive than having a janitor. Consider having part-time, after-hours maintenance person.
- Consider capitalizing major repair items for P&L relief.
- Delay projects until people are available from jobs for good use of unapplied time.
- Do the minor repairs yourself, if possible.
- Eliminate the shop.