Introduction
The construction industry is especially susceptible to profit fade, which occurs when profit margins estimated at the start of a project decrease as the work is completed over time. This happens because construction projects estimate costs months (or years) before the work is completed, and those costs are based on labor, materials, and subcontractors that can all shift before the project is complete.
The challenging piece is that profit fade often isn’t readily apparent. A project can look profitable on paper for months, and by the time reporting shows otherwise, the opportunity to course-correct has passed. Note that profit fade doesn’t always point to inefficient operations or a poor job estimating, but instead occurs when the actual cost of a project reveals itself gradually and the shift isn’t caught early enough.
Consider an example: you’re building a $10 million project for which the land, concrete, electrical, labor, and other components add up to $10 million in cost, and your client is paying $12 million to build it. Your estimated profit is expected to be $2 million. Six months in, however, tariffs cause your material costs to rise by half a million. Nothing from the original estimate was incorrect, but changing circumstances caused margins to decrease. The companies that successfully manage profit fade are the ones that proactively follow a set of best practices to monitor job costs in real time and evaluate the project’s performance in a timely manner. That kind of visibility comes from having a strong accounting team in place.
Know What to Look For
A good rule of thumb is to start investigating once your margin has drifted by roughly two percentage points, since this is early enough for you to have options to adjust. To catch the change, you should be checking your work-in-progress (WIP) schedule on a regular basis. The WIP takes every active project and lines up what you originally budgeted against where you currently stand and includes:
- Costs incurred to date
- Revised estimate cost to complete
- Percentage of completion
- How much you’ve billed relative to that completion
When your estimated cost to complete the project increases, but the contract value doesn’t increase to match it, the gap points to profit fade.
For your WIP schedule to give you visibility, it needs to be updated on a monthly basis at minimum, as it’s one of the best early warning tools to identify profit fade. We’ve worked with companies that don’t catch profit fade because the WIP is only revised periodically, sometimes as infrequently as once a year when their CPA reviews it. This doesn’t allow time for adjustments to be made before damage is done. The WIP also needs to compare your current cost-to-complete estimate against both the prior month’s estimate and your original bid to capture any trends. It’s crucial that it reflects input from your field operations team and not just what your accounting system calculates. Your system can provide the percentage of completion based on dollars spent, but the field operations team needs to weigh in with the percentage of physical progress. A good WIP process ideally includes both.
Understand Common Profit Fade Causes
Profit fade typically stems from a combination of smaller issues that you should watch out for, which include:
Handoff from Estimating to Operations
The project’s cost is estimated based on assumptions about subcontractor pricing, labor, materials, and scope. Once the operations team takes over and starts buying out the work, the numbers start to vary from the original assumption. This is one of the most common places that profit fade starts.
Field Warning Signs
There are several common hurdles once the project actually begins that affect how profitable the job is once complete:
- Getting underbilled early in a project, meaning that your costs are running over what you’ve billed the client.
- Experiencing factors that cause a delayed start, such as labor shortages or bad weather.
- Burning through labor hours too quickly. For example, if a year-long project has a thousand-hour labor budget, and you’ve gone through 300 hours in the first month, you should stop and reforecast your estimated labor costs.
- Field crews performing extra work before change orders are processed and approved, which leads to unpaid work.
External Factors
Commodity and material costs (steel, aluminum, oil, etc.) can drastically impact your budget after the bid has been completed. Similarly, a tighter labor market in which there are fewer subcontractors to complete the work leads to a higher cost. While these factors generally fall outside of your control, they’re important to track so that you can respond and adjust accordingly.
Catch It Early with the Right Team
Avoiding profit fade ultimately boils down to having accurate, timely data and a WIP process that includes a review cadence. However, this is only effective if the financial information is reaching the people who can respond accordingly. Avoiding profit fade involves accurate job costing in addition to visibility and communication between the field and the accounting operations group.
Communication needs to move in both directions: field teams need to know how to flag issues, and the accounting side needs to translate their input into actionable items that the field can use each day. We worked with a $30 million alternative energy contractor that had a controller but no CFO and no structure for translating field activity back into financial visibility. We started meeting with their project teams directly in the field on a weekly basis, walking through cost-to-complete, projecting job costs, and coaching the team on warning signs to watch for and how to course-correct early. Implementing a weekly review process changed their ability to catch profit fade while there was still time to act on it.
The same principle applies beyond one-off reviews. Project managers benefit from ongoing training to improve financial literacy, including an understanding of how unexpected costs affect the P&L. This visibility for the project team goes a long way toward the buy-in that is needed for field personnel to avoid profit fade.
Many businesses don’t have the bandwidth to build strong accounting review processes while running daily operations. This is where bringing in outside accounting and finance support to implement review cadences and bridge the gap between field activity and financial decisions can make a tangible difference. Profit fade is often an inherent risk in the construction industry, but it doesn’t always have to be a surprise.
About the author
Jason Brown is a Senior Director at NOW CFO with 25 years of accounting and finance experience. He has served in the CFO seat for a range of successful construction companies across the southeast, from general contractors to sub-trade contractors.
