Nature of Construction Business

NatureofConstruction Business Aleš Tomek Faculty of Civil Engineering Department of ConstructionEngineering and Management CZECH TECHNICAL UNIVERSITY IN PRAGUE

126YMCC Construction Business Management IntroductoryLesson Aleš Tomek 2014

WHAT IS CONSTRUCTION • Construction involves the marshaling of materials, people, and equipment on a projectsite and assembling the materials in the proper sequence to construct a project thatmeets the customer's requirements. These projects may range from an individual hometo a sophisticated infrastructure project, such as a regional airport or a majortransportationsystem

The business management challenges in construction are toensurethat : • the revenue generated by the construction activity exceeds the cost of doing the work, • the company has adequate demand for its services, • the company has adequate financial resources to finance construction projects untilreimbursed by itscustomers, • the company has a skilled, motivated workforce of sufficient size to meet anticipatedrequirements, and • the cost of the company overhead is affordable based on the projected workload. CHALLENGES OF BUSINESS MANAGEMENT

Construction is an intensely competitive industry, with companies ranging in sizefrom less than ten employees to over tens of thousands of employees. • Because ofthe great diversity in the types and sizes of projects as well as the variety in the expertiseand size of companies, most firms tend to specialize in distinct segments of themarket,such as : highway, commercial, industrial, residential, electrical, mechanical, siteand utility, marine, and underground. Construction : competitive business

The following business responsibilities are similarforeverycontractor: • acquisitionofwork, • performance of the work, and • management of the financial, capital, and human resources of the firm. Business problemsofeverycontractor

The construction industry annually accounts for about from 5 to 12 percent of the grossdomestic product (e.g.10% inthe United States). It is a fragmented industry with a large numberof firms. Unlike manufacturing, construction does not require large capital investmentsto establish a business. Constructiondoes require sufficient cash resources tomeetfinancialobligations. Workingcapital - necessarycondition

Few construction firms fail from a single cause or from a sudden, catastrophic event. • One cause may predominate, but inadequate response to several interrelated factors isthe typical cause of business failure. The primary causes of failure can be grouped intotwo categories: external influences and internal problems. ExternalInfluences • prolongedeconomicrecession, • loss of a major customer, • newcompetition, and • shortageofskilledlabor. PRIMARY CAUSES OF BUSINESS FAILURE

StrategicPlanningIssues • Pursuit of volume To many people in the construction industry, business volume is ameasure of success. While it may indicate the significance of a firm in its relevantmarket, profitability is a more important measure of success. The pursuit of volumewithout a corresponding increase in profitability places the economic viability of the constructionfirmat risk. • Lack of comprehensive business plan Construction companies often do not havebusiness plans that guide their business decisions. They simply react to the market. Business planning requires an understanding of the market, procurement,the competitive advantages , services to be offered, the selection of marketarea, the selection of people and equipment required. Internalproblems as main cause offailure

Diversifying into unfamiliar types of projects • There is high risk, because appropriate suppliers and subcontractors maynot be known, and the technical requirements may exceed the expertise of thecompany's project management staff. Costs may be underestimated, resulting inunprofitable projects. • Unfamiliar contractingapproaches, such as design-build, results in significant financial risk Diversifying into unfamiliar geographic areas • New market poses great risk to a construction firm. Potential customers, suppliers, andsubcontractors are unknown. If the location of the new market is a significant distancefrom the company's normal area of operation, there will be little ability to augmentproject management staff with other company resources; placing greater stress on theprojectmanagement team. • Keywords: staffexpertise,design-build, risk

Lack of managerial maturity Construction firms often are founded by one or twopeople. As a firm grows, its management system must cope withincreased scope of work. Additional managers are needed, and the founders mustdelegate some authority for making business decisions to others. Continuing tocentralize all decision making in one or two people does not provide theresponsiveness needed to react to changing business conditions. Theonlysolutionis to delegatepower and responsibilities Keywords: delegation,centralized and decentralized model ofdecisionmaking End ofStrategicplanningissues

Increase in project size Unrealistic increase in project size may lead to financialdifficulties. The size of the project in relation to the capabilities of the firm may lead tosignificant financial problems. One large unprofitable project will have a greateradverse impact than will a small unprofitable project. Large projects may stressmanagerial expertise, subject the firm to greater risk, and require more capital to finance cash flowrequirements. • Unplanned loss of key personnel Itcan severelystress construction firms, particularly small ones. The loss can be due to death, toillness, or to resignation. Unplanned loss of management or technical expertise maytake considerable time to overcome and places small firms at great risk. Keywords: projectsize, cashflowrequirements StrategicImplementation/Control

Poor cost-estimating skills To ensure that a company remains a profitable businessenterprise, construction firmmanagers must understand the anticipated costs and risksof each project and price the work at a level to cover all costs and provide a profit. Constructioncompany managers should not pursue volume at the expense ofprofitability. This means that bids and cost proposals should not be reduced just toincrease the company workload, because with greater work volume the companyincursmore risk. Keywords: Overestimating, Underestimating ,Turnover versus Profitability

Lack of equipment control The cost of owning and operating equipment is asignificant part of the construction business. Controlling equipment costs is controllingthe amount of equipment owned, leased, or rented. Investingtoo much of a company'sfinancial resources (EQUITY)in equipment may degrade the firm's ability to finance its cash flowrequirements. Idle equipment represents an overhead cost that should be avoided.Equipment should either be used and be able to pay for itself, or returned to the rentalor leasing company or sold. Keywords: equity, overhead, lackofcontrol, building yard

Poor internal communications Poor internal communications between project sites and the home office plague many construction companies. Consequently, there may belittle warning of project execution problems or financial difficulties. In most instances,it only takes one or two disastrous projects to bring down a company. Early warning isessential if corrective action is to be taken on time. Keywords: homeoffice, projectoffice , reporting system, early warning End ofStrategicimplementation and Control

Poor use ofaccountingsystem • A number of contractor failures are caused by poor accounting practices or by a failure to review accounting records to determine thefinancial status of projects. A delayed customer payment often results in inadequate cash flow. By not using the current balance sheet, income statement, and job costreports, managers may be unable to identify financial difficulties until it is too late totakecorrectiveaction. Keywords: costcontrol, accrualaccounting, costaccounting Financial management issues

Excessive debt Cash flow requirements must be met either from internal resourcesor from debt. Some contractors rely on debt to compensate for the lack of businesscapitalization or equity. Excessive debt may cause such a drain on income that the capital resources of the firm do not grow or may even decline. The cost of borrowingshould be included in company overhead margins. Too high margins may make the construction company noncompetitive in tight markets. Keywords: debt, business capitalization, overheadmargin, mark-up, contigency, profit

HOW TO PLAN STRATEGIES? BS1.Develop comprehensive business plans and communicate company goals and objectives to allemployees. The business plan provides a toolfor assessing the company's current position and for establishing a vision of what thecompany aspires to become. In addition to containing goals to be accomplished, theplan should identify specific action plans that are to be undertaken by different segments of the company to assist in meeting the business goals.Seeseparatelecture. Keywords: business plan, goals BUSINESS STRATEGIES TO MINIMIZE THE RISKOF BUSINESS FAILURE

BS2.Test a new geographic area with a small project or a repeat customer. Develop awithdrawal plan if the project is not successful. Moving into a new geographic areapresents significant risk, in that the customers, the suppliers, and the subcontractors generally are unknown. To reduce the risk, either undertake a series of small projectsto learn the environment or enter the market with a customer with whom the companyisfamiliar. Keywords: pilot project, internationalprojects, withdrawalplan

BS3. Carefully monitor company management capabilities during periods of growth.Learn to recognize signs of inadequate management, and delegate. Adequatecompanymanagement systems and staff need to be available to manage the work of the company. Management capabilities need to be expanded prior to increasing the volume ofwork undertaken, so that the increased work can be planned and managed effectively. Sometimes companies increase their work volume without adequately increasing themanagement capabilities. In such instances, company managers become overworked.Also, the lack of adequate managementcapability may result in poor project performance and an unhappy customer Keywords: management system, standard procedures and checklists, management capabilities

HOW TO PLAN AND IMPLEMENT STRATEGIES PI1: Develop internal management systems that monitor the status of all projects and provideearly warning of problem areas. Good communications need to be established betweenall project offices and the company leadership. In addition, company leaders need tovisit project sites frequently to keep abreast of any issues. Frequent project cost andproject status reports are needed to closely monitor project execution. Keywords: project status, projectexecution monitoring

PI2: Form long-term relationships with industry professionals who can serve as soundingboards and listen to them. Among these specialists are bankers, bonding agents, insuranceagents, accountants, and construction attorneys. These individuals should be selected based ontheir industry experience and understanding of the type of projects undertaken by theconstruction company. Because they have industry experience, they can provide adviceregarding project risk mitigation and business processes. Keywords: risk mitigation, business development, constructionprofessionals

PI3: Increase project size gradually. Take on only one larger project at a time. Finish thefirst larger project and evaluate before taking on the next one. The amount of riskassociated with a project generally relates to its size and its complexity. Care must beexercised when pursuing projects that are larger than those historically constructed bythe firm. If the typical project size has been $5 million, it is better to pursue a projectvalued at $7 million than one at $15 million. This is to ensure that the company's managementexpertise and systems are enhanced to meet the demands of larger projects.Undertaking too large a project usually requires more cash flow than the companyshould risk on a single project. Keywords: projectcomplexity, workingcapital, expertise

PI4: Select project size based on the size of the construction company and its financialand human resources. Do not have more than 30 percent of a company's resourcesinvolved in a single project. Diversify among several projects to minimize risk 1.Success in the construction business depends onunderstandingthe risk faced on each project and mitigatingit. 2.Not all projects are successful.Sometimesthings do not work out as anticipated, and the construction firm incurs a loss. To minimize the potential for financial failure if a project is not profitable, theconstruction firm should undertake multiple projects, as long as it has sufficientmanagerial talent to supervise the projects effectively. Keywords: diversificationofprojects, lossprojects , failurepotential

WHAT FINANCIAL STRATEGIES ? FS1: Understand the cost of doing business, and price services appropriately. It is essentialthat company leaders understand their cost of doing business to include all companyoverhead costs. Services must be priced adequately to cover all anticipated costs andprovide a reasonable profit. If the company does not adequately price its services, itwill soon find that it is out of cash and in financial difficulty. Keywords: reasonable profit, overheadcostst, anticipatedcosts( i.ebudgetedorestimated), constructionservices , service provider

FS2: Prepare month-to-month cash flow budgets each year, and track results monthly. 1.Company leaders need to understand their financial needs to ensure that they have theability to meet financial obligations. 2.In most cases, construction work is initiallyfinanced by a construction company, and a bill or invoice is submitted to the projectowner for payment. This request for payment typically is submitted on each project ona monthly basis. 3.A cash flow analysis to develop a cash flow budget for the constructioncompany is needed for each project. If external financing is needed, the cost of thefinancing needs to be included as an overhead cost while calculating project budgets. 4.Actual income and expenditures need to be tracked to monitor the cash flow status ofthecompany. Keywords: liquidity, CF budget, income , expenditures

FS3 : Carefully manage company overhead, and reduce it during periods of decliningworkload. 1.Company overhead budgets need to be set at the beginning of each yearbased on what is perceived as affordable for a projected volume of work. 2.If the volumeof work does not materialize, the overhead budget needs to be reduced proportionatelyso that the company does not get into financial difficulty because company earningswere insufficient to cover overhead costs. Keywords: companyoverhead budget, earnings, volumeofwork, backlog

FS4 Finance equipment purchases with debt to preserve capital to finance cash flow requirements. 1.Capital equipment should be purchased using either a lease-to-own strategy or bythe use of equipment loans. 2.The concept is for each item of equipment to earn more eachyear than it would cost to make a loan payment or a lease payment. This will preserve theconstruction company's financial resources to fund its cash flow requirements. 3.If thecash is used to purchase equipment, the company could become cash-starved relative tomeeting its cash flow requirements and forced to go out of business. Keywords: capitalequipment, loan, lease-to-own , goingoutof business

FS5 : Purchase a line of credit as a contingency to cover unexpected negative cash flows. 1. Rather than waiting until there is a need to borrow funds, a company should purchasea line of credit from a financial institution. 2. Credit line is similar to a credit card, in thatexpenses can be charged to the line of credit when needed, and the amount of creditcan be repaid as soon as sufficient income is received. 3.There is a small fee for havingthe line of credit, but interest is only paid on the unpaid balance at the end of each month, similar to the situation with a personal credit card. Keywords: contingency, line ofcredit, fee, interest, balance

Nature of Construction Business