Most contractors I run across confess “I never have as much money at the end of the year as I expect to.” Do you suffer the same fate?
Do you arrive at year end wondering where your money went to? If so, I’d bet you’d like to learn how to avoid that ugly outcome.
Pay attention here, I’m going to let you in on a little secret that will help you end those unpleasant year-end surprises. Lean in close. Don’t tell anyone about this. It’s so secretive that few contractors do it. Are you ready?
Use a budget.
That’s it. That’s all it takes. Create a budget, track the variances, and take corrective action when necessary. Class dismissed.
Oh, you want to hear more? Okay. Keep reading to learn how to put a stop to those nasty year-end surprises.
Annual budgets allow you to stay on top of your financial progress as your year unfolds. They arm you with the ability to reel in expenses before they kill your bottom line. They force you to think through your business’ strategy and its resource allocations.
When you don’t have a budget to monitor, or don’t monitor the one you have, you are destined to arrive at year-end thinking “Rats. Where’d my money go?”
Contractors’ aversion to budgeting has always struck me as funny (not in the ha-ha sense). On the one hand, contractors tend to be obsessive about planning field work. They know that letting their field crews sort out what to do from day to day is a recipe for disaster. But on the other hand, they don’t apply that reasoning to their business. Lack of business planning leads to poor financial performance; it’s as simple as that.
You need a budget, it needs to reflect the reality of your market, you need to keep a close eye on its progress, and you need to take corrective action when it’s called for. Anything short of this will leave you with that “What happened?” feeling.
Look at the Market
Before diving into the how-to budget details, let’s make sure you understand the connections between your budget, your business plan, and your market.
Your budget is a financial representation of your business plan. Your business plan’s purpose is to take advantage of profitable opportunities in the market. Budgeting should not be attempted until your business plan has been developed.
Your business plan should be aligned to the size of your market, the prices your market will pay, and the cost of serving its needs. You can only make as much money as your market will support and your business plan will deliver. Budget accordingly.
Contractors often put the cart before the horse. They set sales, overhead, and net income goals, put them into a budget, and then try to craft a strategy to fulfill them. That sequence totally ignores the market.
It’s foolhardy to create the financial model and then try to craft a business plan that fits it when the business plan hasn’t been tuned to the market. First strategy; then budget; then meet the budget; then build a bulging bank account.
Your budget will be developed through five stages: preparation, rough draft, refinement, reality check, and rollout.
Stage 1 – Preparation
Unless you implement a new sales and marketing plan, you improve labor productivity, or you reduce overhead, your financial performance will be controlled by the market and the economy. If they grow, you will make more money. If they shrink, you will make less, or even lose, money.
In this industry, past performance is the best predictor of future performance - unless you force change. Build your budget on the foundation of your recent three year financial performance. To do that, gather together the balance sheets, income statements, and cash flow statements for those years.
Next, tap as many information sources as possible to gain an informed view of upcoming market changes. Visit with your banker. Visit with your insurance and bond agent. Buy construction forecast data from McGraw-Hill or a similar provider. Search the census bureaus’ website for reports on economic projections. Call the Federal Reserve and see what reports they have available. Call your local economic development councils.
Eventually, you will discover the experts’ consensus opinion. Even they can be completely blindsided by turns in the economy, but they are the most informed group to listen to.
Go over the information with your executive team. Reach consensus on your upcoming market opportunities.
Here are the Stage 1 steps.
- Grab the last three sets of annual statements.
- Gather up construction forecasts.
- Discuss market opportunities.
Stage 2 – Rough draft
The purpose of the rough draft is to give you a reasonable starting point. Your rough draft will not consider changes to your business plan nor changes in the economy. To create the rough draft, study the income statements from the last three years and determine:
- Your sales trends
- Your direct cost trends
- Your administrative overhead trends
- Your sales and marketing expense trends
- Your operations support trends
- Your labor burden trends
- Your average gross margin
Take your most recent income statement and adjust each line item for the trend (up or down) or jot down the three year average, whichever you feel is most appropriate.
Here are the Stage 2 steps.
- Determine trends and averages for each income statement line item.
- Decide whether the average or the trend is the most appropriate assumption.v
- Mark-up last year’s income statement accordingly.
Stage 3 – Refinement
Now, adjust the numbers for changes in the market and changes in your business plan.
If you expect the market to shrink, assume both your sales volume and your margins will shrink. If you expect your market to grow, assume either your sales volume or your margin will grow. Do not assume both will grow (we’re not going to go into this but it usually holds true).
Now estimate the cost impact of new business strategies. For example, you may decide to expand sales by pursuing the office building market. In order to land the work, you will authorize a $10,000.00 advertising campaign consisting of magazine advertisements, direct mail, and client entertainment. This spending would be on top of the advertising you do to generate your current work load. Your advertising budget needs to reflect the additional $10,000 investment.
When thinking through your business plan, look at closely the cost impacts of:
- Increased advertising to pursue new market
- Expansion of sales staff
- Purchase of new equipment
- Adding office staff
- Implementing or altering management information system
- Employee training and development
- Changing the bonus plan
- Entering a new geographic territory complete with local office
- Pay raises
- Rising health care premiums
Another budget impact you need to account for is improved selling performance. Assume your sales team persuaded another 20% of your clients to hand you negotiated contracts. You budget would need to reflect the higher mark-ups associated with negotiated contracts.
You are ready to finalize your first draft. Adjust the trended or average numbers for each line item by the impacts of your business plan. Re-type the document so that it is easy to ready.
Here are the Stage 3 steps.
- Verify your labor pool and operations support staff team can handle the projected work load.
- Verify the targets for sales volume and direct cost markup are reasonable
- Verify increases in marketing and sales expenses.
- Update equipment expense and depreciation to accommodate new equipment needs.
- Update sales volume goal.
- Update direct cost margin goal.
- Calculate expected work load (labor, material, equipment costs).
- Revise and re-type your budget.
Stage 4 – Reality Check
One of the primary reasons contractors fail to hit their profit goals is because they are overly optimistic about their gross margins. The time has arrived for everyone to join a no-holds-barred discussion on operations and sales.
You need to challenge all assumptions made that the crews will perform better than they have in the past. No baseless, pie-in-the-sky claims are allowed. Unless, there is a reason to believe turnover has been greatly reduced, more efficient equipment has been purchased, or the operations management team will be able reduce downtime and rework, do not assume your labor will be more productive than in the past.
The other claim that you must question strongly is the ability of the sales and marketing team to generate better quality leads and better paying jobs. Sales and marketing personnel are highly optimistic individuals by nature. Take their promises of greater glory with a grain of salt. Believe it when you see it, not before.
In other words, don’t take their word on gross margins at face value. You need to analyze it segment by segment. Discuss the real mark-ups each segments produces. Pull out your job costing reports to see what the real mark-ups ended up being.
Ask them why they believe the leads will be better and why the margins will improve. Segment by segment, forecast total sales and margins. Pull them together and compare to your budgeted direct cost and gross profit.
Adjust your budget accordingly. Now, you’ve finalized your budget. Time to roll it out.
Here are your Stage 4 steps.
- Call a meeting with your top operations and sales personnel.
- Review and discuss field performance and projections for improvement.
- Review and discuss advertising and selling segment by segment.
- Tweak the budget based on the outcomes of these conversations.
- Now, you’ve finalized your budget. Time to roll it out.
Stage 5 –Roll-out
Now that you’ve finalized the 12 month budget, you need to break it into manageable chunks (12 chunks that is). Create a spreadsheet with 14 columns. Label them by month. Each row is an income statement expense. The first column is the name of the expense. the second column is the total for the year. The third column is for January, the fourth for February, and so on.
Look at each income statement line item and determine whether it is an expense that stays consistent each month (e.g. office rent) or varies monthly. Many overhead expenses are billed twice a year or quarterly. Put the appropriate value under each month. The total for the months must equal the total for the year.
Pull up monthly sales for the last three years. Calculate the weighting of the sales per month. For example, if you typically sell $400,000 in July out of $3,200,000 annually, July accounts for 12.5% of your sales. Calculate 12.5% of your budgeted sales and direct expenses and put them in July’s column.
Continue filling out your spreadsheet until you have the entire budget accounted.
Make copies of the detailed monthly budget and distribute to all individuals who have spending authority. Pull them into a meeting, shut off the cell phones, and explain the detailed budget to them. They need to understand the expenditures planned by the budget, the logic behind the expenditures, the assumed gross margins, and the planned timing of the expenditures.
A word is in order here regarding cash accounting versus accrual accounting. If you are running your business on the cash accounting basis, you should set up your budget and track your progress on the accrual method. Cash accounting is great for taxes but terribly misleading for managing a business.
Here are the Stage 5 Steps
- Allocate the annual expenses to the appropriate months.
- Determine the historic pattern of your monthly sales.
- Create monthly budgets for sales, field costs, overhead, and profit.
- Present the detailed budget to your management team.
By completing the 22 step budgeting procedure, you now have in hand the tool that empowers you to manage your year end performance. Of course, the key word in there is “manage.”
The second reason contractors fail to hit their year end financial targets is because they fail to track their progress against budget and take corrective action as necessary. Have your accounting staff generate an income statement and cash flow statement at the end of each month.
A word is also in order regarding your accounting staff. Whether inside or outsourced, your accounting staff must get you these reports no later than the seventh of the month. Hold them accountable to that date. They will probably whine like mad but ignore it. Timely reporting must be a non-negotiable duty of their position or service.
The monthly income statement should show:
- Budget value for the month
- Actual value for the month
- Budget value year-to-date
- Actual value year-to-date
- Actual vs. budget variance for month
- Actual vs. budget variance year-to-date
- Projected year end based on current trend.
- Gather together your management team, review and discuss the income and cash statements.
Budgets do not produce the results. Managing to them is what produces the results.
As variances become apparent, investigate their cause and take all necessary action. That may mean visiting with someone or some group who is underperforming and discussing things can be done to meet the performance goals. Taking action may mean revising the budget in accordance with changes in the economy and market.
When spending exceeds plan, or sales fall short, discuss the situation with your management team and decide how to get back on plan, and whether the spending needs to be scaled back to offset poor sales or increased to take advantage of unexpected opportunities.
You should not ignore unforeseen opportunities just because money wasn’t set aside for them. Adjust the budget as better-than-expected opportunities arise. Reallocate your resources or increase your budget to accommodate the needed investment.
Translating your monthly income budget into a monthly cash budget is surprisingly easy and highly beneficial. Copy your income statement spreadsheet and translate the monthly sales figures into monthly cash receipts.
The way to do this is to look at your aged receivables. If you typically receive your money 45 days after the job, then your inbound cash trails your sales by one and a half months.
Your outbound cash is also pretty easy to figure. You field labor gets paid weekly. Your office staff twice monthly or so. Your materials are due in 30 days. The overhead expenses are already scheduled. Lease payments are due every 30 days.
Monitor your cash flow budget just like you do your income budget. Go over them at the same time. Usually, when cash flow is becoming a problem it is due to slow paying clients. You need to know that as quickly as possible so that you can chase the money owed to you.
To run a construction company successfully, you must pay attention to the rate at which your business generates gross profit and the rate at which it spends money on overhead. The only way you can know whether those rates are acceptable as your year unfolds is to create a budget and keep an eye on its progress. Otherwise, you might as well keep expecting those ugly year-end surprises.