Construction backlog expanded during the third quarter, according to Associated Builders and Contractors (ABC) Construction Backlog Indicator, which is great news following two quarters of declining backlog. While this increase in backlog indicates that new construction is on the rise due to economic optimism, there continues to be stiff pressure on bottom line profitability. This pressure poses a special challenge to companies when they seek to obtain surety credit.
In order for a surety agents to feel comfortable extending bonding to a contractor, they want to see a healthy gross profit on contracts and an ample net profit to carry the company into the future. This is how a company’s Work in Process (WIP) report plays a key role during both expanding and contracting markets.
In assessing the health of the contractor, surety underwriters want to see the original contract amount per job, the revised contract amount (as adjusted for any approved change orders), original cost estimate for each project, and the respective original estimated gross profit. In arriving at the estimated gross profit, the job cost projections should include (but not be limited to) any direct materials and equipment used, both direct and subcontract labor, and certain applicable indirect labor costs. These indirect charges would include vacation & holiday pay, payroll taxes, retirement contributions, shop supplies & small tools, equipment expenses, depreciation, pre-employment physicals, safety supplies & training, and maintenance & warranty costs. For the sake of consistency, estimated gross profit numbers must account for all of these costs.
The following two lines of your WIP report list the “cost incurred to date” and the “revised estimated cost to complete”. These two columns are an important indication to your surety underwriter as they directly indicate the profit fade or gain on a project – both absolutely crucial to daily project management and often critical to receiving surety credit. The contractor and the surety alike must know at all times what the ACTUAL project’s costs are on a contract – not just what was estimated. Only once these actual costs are established can you estimate the true cost to complete the contract. Sureties will be watching and measuring this progression.
If a company has an established trend of estimating gross profit of 18% on contracts, but actual is often 12% upon completion, this definitively points to a problem with estimating and can raise red flags on a contractor’s ability to predict job costs and efforts. This will indicate to a surety that management may not have good processes in place, and therefore may raise concerns on the company’s ability to generate and maintain profitable contracts, much less adequately cover their overhead. In addition, under this scenario a contractor’s working capital and net worth may be overstated, making a surety reluctant to extend surety credit within normal financial ratios.
In today’s highly competitive construction market, allocation of overhead, or “general and administrative expenses” as reported on a company’s income statement, can quickly deplete profits. It is for this reason that sureties require an inclusion of a schedule of completed contracts within a company’s year-end financial statements. A surety will compare the contracts in this schedule to their respective cost estimates within the WIP schedule to track the degree of accuracy in projecting cost estimates, as these estimates have a direct bearing on the final gross profits of the company.
If a surety agent cannot justify the extension of bonding to a company in light of their balance sheet ratios, an accurate WIP schedule that encapsulates the elements above could become the determining factor. For example, if a company has a healthy backlog that can at least conservatively cover expenses, it may still be possible to obtain surety credit on a particular job.
For more information on how surety underwriters look at WIP, please contact the Construction Professionals of McKonly and Asbury, LLP.