The Construction Contractor's Digest

Construction is under 20% in fixed cost to total cost ratio. In reality, a majority of contractors are under 10%. That places a huge premium on taking the right work, not cheap work. Furthermore, we must insist on a margin that is reasonable for the job.

In our business of contracting, we cannot use volume as a way to earn profits. We are not an airline or a restaurant. Our resources (good people, your expertise) are too scarce. We have to demand a value for these factors. Thus, we should have a profitable job.

If projects are profitable then, the firm will be also.

One of the lessons of our business is to not turn it into a fixed cost business. As an example, if you are a young utility contractor and buy (instead of lease / rent) a backhoe in your first year, you now has fixed costs or a "nut" to cover. This places more pressure on you to sell another job to cover this cost.

Crews can be a "de facto" fixed cost if we promise them a future. Just like buying a backhoe, this commitment puts pressure on the contractor to sell another job and keep it busy. With commitment to our people, there has to be some consistent stream of revenue. Otherwise, we have to lay them off from time to time. We well know that they will choose not to return at some point.

One of the keys to the variable cost model is that we can break even (earn profit to cover our fixed cost) with a minimal amount of volume. This is gives contractors some flexibility in finding the right kind of work. They don’t need to sell every customer, just a few who pay well. This is evidenced in that hit rates of financially successful contractors are less than 20%. Well - capitalized construction firms are not low bidders and low bidders are not consistently profitable.

Construction is a variable cost business that has a lower fixed cost percentage to cover. However, if volume is too great for labor man-hours to efficiently execute then, cost will exceed revenue (right end of graph) spelling financial trouble.

We should mention also that with all the risk involved, this extra margin gives a contractor a cushion to pay for unforeseen and uncompensated costs. If the client won’t pay, he has some funds to buy the extra labor, material, etc.

Think of it this way, if you keep your breakeven costs low, you have the ability to walk away from an unfair or overly demanding negotiation.

On the other end of the scale, if the contractors take on too much volume, he will certainly have cost rise and profit margins shrink. Said another way, costs and profit will cross over at the high revenue end of the curve.

This is due to two factors:

1. The last 50% of volume has to be sold cheaper than the first 50% of volume. Extra revenue has to be sold at discount.
2. Adding extra, unproven people makes us inefficient. Mistakes, rework, and general slowing of process occur. This drives cost up.

Again, the cost and revenue curves will cross. Financial losses will add up.
Under 50% fixed costs - we consider this a variable cost business and is typically a service business. This means that the most of the cost of the product or service is caused by a sale.

To repeat, construction contracting's fixed cost is under 20% and in reality, a majority of contractors are under 10%. That places a huge premium on taking the right work, not cheap work. Our net profits are less than 10%. We must insist on a margin that is reasonable for the job. There are too many risk factors for any other choice.

In our business of contracting, we cannot use volume as a way to earn profits. We are not an airline. Our resources (good people, your expertise) are too scarce. We have to demand a value for these factors. Thus, we should win a profitable job.

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Matt Stevens is a management consultant who works only with construction contractors. He has performed training and business consultation for the contracting community since 1994. Matt can be reached at mstevens@stevensci.com.

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