| Spring
2003 |
Construction Advisor
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Profit Fade or Gain
Understanding What Bonding Companies Are Looking For
The dramatic slowing of the economy that began during
the third quarter of 2000 has had a number of ramifications on financial
institutions and insurers. When times get tight, so does credit. It's a
simple reality of the economy. Bonding companies are particularly
sensitive to the potential of increased defaults. It is no surprise, then,
that as the economic growth decelerates to a trickle, getting proper performance
bonds at attractive rates is more challenging. Therefore, it is imperative
that contractors not only understand what bonding companies are looking
for, but also avoid profit fade as much as possible.
The key to obtaining surety bonds is understanding how
the underwriter analyzes a construction company. Therefore, before going
through the process the construction firm should take the time to request
specific information from the surety regarding their underwriting
criteria, analysis and evaluation process. In general, bonding companies
are looking for the "Three Cs,": Capability, Character, and
Creditworthiness.
Obviously, the contractor's financial statements are the
critical component, but surety companies will also be interested in the
firm's work-in-process and completed contract schedules. The
work-in-process schedule will help the underwriter determine if the over
and under billings are reasonable and appropriate, and if the estimated
profits are reasonable based on industry standards. The underwriter wants
to know how you compare with your peers. Meeting or exceeding industry
benchmarks will give you an important advantage. Consistency is also key,
particularly over time. A surety will typically review the last three to
five years of completed contract schedules and compare them to
work-in-process schedules to determine if your firm suffers from profit
fade. Profit fade occurs when the original gross profit from the job is
reduced as time passes. This could be the result of poor estimating on the
front end of the job, or poor execution and unforeseen problems toward the
end of the project. Profit gain is the opposite.
Sureties want a high comfort level with the contractor's
estimating abilities, which helps reduce the wide swings in each project's
profitability. Bonding companies like to see that the contractor has shown
the ability to consistently avoid profit fade on jobs over time. This
provides the underwriter with a higher confidence level and gives the
contractor more credibility in dealing with the bonding company, which
ultimately manifests itself in better rates on performance bonds.
Here are a few rules of thumb, to follow, which may help
you achieve better rates:
- Be conservative. Better to show rising profits toward
the end of the job than profit fade, even if the net result is the
same. It's all a matter of perspective. Aggressive estimations up
front may come back to haunt you if you consistently ratchet down net
profits at the end of each job.
- Avoid making any adjustment to costs until at least
60% of the job is completed. This will help limit profit fade. For
example, if you purchase materials at a discount to your original
estimate, wait before you cut your estimate. The biggest variable is
almost always labor, so keeping some of this gain in your "back
pocket" is almost always a good idea. Adjust the initial contract
only when you have a very high confidence and excellent visibility
through the end of the job.
- Avoid job borrowing. The surety will look to see if
you are pre-billing some jobs to compensate for profit fade on others.
This generally raises a red flag.
It is also important to note that sureties analyze
profit trends based on type of work, type of contract, project manager and
estimate. Therefore, it would behoove you to look at the data in the same
manner. Is your firm better with residential or commercial work as opposed
to civil or municipal jobs? Have you had better success and margins with
cost- plus contracts versus fixed-price contracts? Or, do you have a
particular project manager or estimator that has a poor record? Sureties
will drill down for this type of detail and respond accordingly.
Understanding what surety companies are looking for is
an important step. Nobody likes surprises. And avoiding profit fade will
not only improve your overall business management, but it will also go a
long way in building trust with the underwriter and helping you achieve
the best rates for performance bonds.
The Construction Advisor is produced
quarterly by Bober, Markey, Fedorovich
& Company's Construction
Team. If you would like additional information about the services that
we can provide to construction companies and contractors, please call or
email our team leader, Dale A. Ruther, CPA, CIT at (330) 762-9785 or dale@bobermarkey.com.
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