FINANCIAL ASPECTS OF PROJECT ENGINEERING AND CONTRACTING

1. FINANCIAL ASPECTS OF PROJECT ENGINEERING AND CONTRACTING Prof George Solt

2. How the business works Now that the necessary capital is in place, we can start to trade, for which we must first plan what we hope to achieve in the year. Business is like a jungle In the real jungle food (or flight) comes before fornication. Not going bust is more important than making a profit It is quite easy to go bust while trading profitably

3. How the business works TURNOVER is the year’s output, measured by the total amount of sales invoiced DIRECT COSTS are the costs which are attributable to executing the contracts that the company is working on, such as materials, engineering, site cabins, craneage, subcontracts, project management OVERHEADS are costs which can’t be attributed to any contract, such as the accounts department, the receptionist and the MD’s Jag

4. Overheads

5. How the business works CONTRIBUTION is what’s left of the contract price of a particular contract after the direct costs of that contract have been paid, and which goes into the company’s kitty to pay for the company’s overheads and profit PROFIT is what’s left at the end of the company’s year, when the company has paid all its direct costs and overheads.

6. How the business works

7. Planning for profit The elements of the Business Plan Turnover will be limited by working capital, the workforce and market share Overheads at the turnover can be estimated from historical information The anticipated percentage profit on turnover In contracting this is typically 2 – 5% These numbers fix the average contribution required on all contracts

8. Planning for profit

9. Planning for profit This plan needs a total of £2.5m in addition to the direct costs of the contracts to cover overheads and profit Accountants call this £2.5m the “Gross Profit” That’s 25% of the turnover, so each contract the company executes has to aim to make an average contribution which is 25% of its contract price The graph, which illustrates the point, is based on the assumption that all the contracts carry this same percentage contribution, so the contribution increases linearly with turnover.

10. Planning for profit

11. Planning for profit

12. Planning for profit

13. Planning for profit But of course that isn’t true - it would make two of our basic assumptions false First overheads do not remain constant with changing turnover – in practice, an increase in turnover would mean some increase in overheads Second the £10m turnover was the maximum which the company can achieve because of limited resources or working capital

14. Over-trading Increasing the turnover means overloading the workforce leading to mistakes and delays It also increases direct costs which requires more working capital If there isn’t enough working capital available the company becomes insolvent This pattern is called “over-trading” Engineers who have a good idea and set up their own company to exploit it often fall into this trap. Their idea is so good that the company is profitable and grows but they don’t increase the working capital to match the turnover and it fails

15. Over-trading A company failed because the Sales Director thought that overheads were “Fixed Costs” Once he had sold enough contracts to meet the turnover target he thought the overheads had been paid and went on selling more contracts but with a reduced contribution which undercut the competition‘s prices For several years running he exceeded the turnover target by 10% or more, and after five years the company went bust Moral: if it’s a good plan, then any serious departure from it can’t be good.

16. Marginal selling If turnover fails to reach target the graph shows that profit falls sharply The overheads will probably fall a bit but not enough to maintain the profit Under these conditions it is right to sell contracts with a reduced contribution, which makes it easier to get contracts That in turn should go nearer to filling the company’s capability to do work This is called “marginal Selling” If the company has under-used capacity, then any contribution which can be made from it is better than none Everything is different when there is spare capacity

17. How not to go bust Turnover is not the most important thing for the company There is only one way in which companies fail – by becoming insolvent due to lack of working capital Whether they are making a profit or not has little directly to do with that - many companies go bust with a full order book The Working Capital required as a percentage of the turnover varies between different types of industry and even between different companies in the same industry The figure for any individual company tends to remain fairly constant however much the turnover rises or falls

18. How not to go bust Here are some examples based on a £10m turnover company with £2m working capital Case 1 In one year, the company makes a loss of 2% on turnover - i.e. £k 200. This reduces its working capital to £m 1.8 - i.e. by 10%. That will not make a massive difference to next year’s trading when, with luck, business will be better, the loss recouped and the working capital restored. A modest and occasional loss doesn’t bring a healthy company down. Case 2 The Company has a major contract worth £3m, and there is a problem which delays a part payment of £1m. The company still has £1m of working capital with which to carry on and, if the delay is not too long, it ought to survive. The most obvious action is to go to the bank for extra finance, such as a temporary increase in its overdraft limit, especially if the cash crisis is expected to be short term.

19. How not to go bust Case 3 The company is working on two contracts each worth £3m. Both these suffer some setback: a payment of £1m is delayed on each, which reduces the working capital to zero. Unless cash can somehow be raised quickly the company cannot pay its bills and is insolvent. This can happen as easily to a company which is making a profit as one running at a loss, but in practice there is a big difference. If a company commands the bank’s confidence, the bank is more likely to help the company out of trouble. This shows that companies must not take on contracts so big that a serious setback on them can break the company. In the fatal case 3, the troublesome contracts are indeed only 30% of the turnover each, but with two of them in trouble that’s enough to bring the company down.

20. How not to go bust It’s not easy to turn down a contract that is too big for the company to handle Physical resources – manpower, machinery etc - can be hired A lack of working capital is less easy to solve unless the contractor has good relations with the bank There’s always risk of trouble and delay by things like weather, strikes and accidents. With a small contract, that’s a nuisance - with a very big contract, it can break the company That kind of disaster can happen as easily to a company which is making a profit as one running at a loss

21. Summary A company needs a plan for the year in order to achieve its maximum potential. The plan has to set targets for turnover, overheads and profit. If the actual turnover significantly exceeds that planned, the company may get into trouble. If it looks unlikely that the target turnover will be reached, marginal selling (by cutting the contribution on contracts) can be a useful partial remedy. Companies fail if they run out of working capital. Small, temporary losses are not usually fatal. A company must not take on contracts which are so large that they could cause it to fail