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What’s Inside Contractors Retool for Economic Recovery

page 4

Performance-Based Incentive Compensation Plans

page 6

Financial Power Tools

page 8

Access to Management Information Imperative for Contractors

page 10

The Human Resource Sins

page 13

What's Your Overhead Recovery Strategy

page 14

Effective Cash Management Strategies

page 16

Project Management Impact on Financial Reporting

page 18

Measure, Monitor and Manage Your Business (3M)

page 20

Strategic Bidding for Equipment-Intensive Contractors

page 22

Are You Performing Contracts in Multiple States?

page 25

Proposed Revenue Recognition Rules Affecting the Construction Industry

page 26

Succession Planning for Contractors

page 28

It Is All About Cash, Cuts and Margin

Higher Profits, Higher Pay, Everybody Wins Credibility = Credit

What You Don´t Know Will Hurt You

How Much Does A Bad Employee Cost?

Are You Really Making Money?

Shorten The Cycle

Are You Giving Away Too Much Work?

Analyze the Financial Health of Your Business Making Equipment Work For You State Tax Traps

Are You Ready?

Are Key Employees an Option?

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Contractors Retool for

Economic Recovery

E

by Kenneth J. Hedlund, CPA

conomic indicators have led to the conclusion the recession is behind Budgeting for growth in volume and margins might be too optimistic, like us. However, this doesn’t provide much comfort since the operating looking through rose-colored shades. It would be advised to consider realistic environment is still extremely challenging with little relief in site. Fur- conservative revenue and margin projections and right size your organization ther residential mortgage failures, potential impact of upcoming bal- from an infrastructure, overhead and staffing standpoint. For many contracloon payments, refinance challenges, likely defaults in the commercial mortgage tors and entrepreneurs, this is a difficult concept and contrary to their instinct market and other factors are causing concern that a double dip recession is not and tendency for growth. out of the question. Bank lending/financing is still difficult, resulting in limited Following are several areas that successful contractors focus on in any ecoprivate commercial work. There has been a fair amount of federal, state and local nomic environment to maintain a level of profitability and cash flow. projects and since less than 20 percent of stimulus money has been spent to date, Profit is important and cash flow is key. Increased diligence in protecting this does appear to be an area of opportunity. At this point most of the stimu- profits from owner, second tier contractor, supplier and vendor failure is essenlus money spent has and will continue to be on road work and other horizontal tial. Do your homework up front with significant increase in acceptance and construction. At some point we anticipate stimulus money with some additional approval of those with whom you choose to work. Then routinely monitor allocation to the vertical construction market. However these opportunities and use proactive risk management to protect your organization. We have seen in federal work have many contractors diversifying and looking to participate, routine use of joint checks, filing and protecting lien rights, etc., come into which reduces the overall value proposition. play more and more in recent months. When billing, if outstanding receivables Most contractors had challenging years in 2008 and 2009. We work with age beyond normal terms, know your tolerance level. Don’t let anyone get so several hundred contractors, and generally--with few exceptions--what we saw extended that their failure could also be your demise. were gross revenue reductions for 2008 and 2009 anywhere from 5 percent to as If at all possible, you should minimize additional bank borrowings and much as 50 percent year over year. For 2008 and 2009, plan to cash flow from operations. To accomplish those that had pretty good net profit years seem to this, a cash flow projection must be used to provide have accomplished that with a combination of dethe contractor with the necessary information to Retooling for the recovery cent backlogs and related margins carried into the proactively manage the organization. A 30-60-90year, plus proactive overhead and staff reductions.

120 day cash flow projection should be a compowill require proactive and The good news is that they theoretically survived nent of a contractor’s routine financial data. To sound business principles the recession. provide for effective management and decision The early returns on 2010 results indicate the making, the cash flow must be conservative and and best practices. majority of contractors have stabilized and range you should meet or beat your projections. If there from minimal losses to the majority at breakeven is an indication that there will be a cash flow defiwith small profit. In addition, we’ve even seen some cit, it will be necessary to refine management plans companies that had record years in 2010. Quite a mix of and potentially implement cost reductions in overhead results, but for the most part, stabilization. We have been getting a consistent and, if necessary, staff. Most contractors have already done this to some degree. message that there is more work to bid; however, most is feeding current back- But it may become necessary to cut beyond just the fat and into the muscle and logs that are short-term and don’t seem to cover a long duration. There is con- bone. Have a plan and know in advance what your plans are for future cuts. tinual pressure to bring in new work. However, ongoing patterns of less work, Identify Tier 1 (easiest) to Tier 5 cuts (most difficult). As projections indicate increased competition, lower margins and slower pay continue to create a chal- future cash flow deficits 30, 60, 90 or 120 days out, the cash shortfalls can be lenging environment. And since the construction industry will lag in realizing avoided through effective and proactive management and implementing tiers the impact of the recovery, even the most optimistic say it may be late 2011 and of already identified cuts. into 2012 before work picks up and backlogs improve. All indicators are that for Focus on increasing operational efficiency. It’s the simple concept of doing most, 2011 will still be as or more difficult than 2010. Following are some discus- more with less. That is where you can create success in this difficult market. If sion points and contractor best practices to further “Retool for the Economic you have effectively right sized your organization and are left with high perRecovery.” forming employees, you can capitalize on production and efficiency. RegardWe will continue to see margin compression, which will further intensify less, we strongly recommend putting in place a system of performance meacompetitive bid, fixed price bid risk. With less of a margin for error, sound prac- surement to provide a model of accountability. In the design of such a plan, tices will be critical as ever in estimating, subcontractor and vendor approval, contractors should focus on five critical areas that typically include operations, project management, scope and change order management, billing and collec- financial, business development, employee satisfaction and customer satisfactions. Maintaining profitability and minimizing project fade will be essential. tion. Routinely monitoring employees’ progress towards meeting the objecIt is important to understand the impact of working in such a competitive tives set in the performance plan in these critical areas will maximize overall environment and accepting lower margins. What is the real impact of a contrac- return on investment (ROI) in any economic environment. Further, it’s the tor that normally averages 10 percent margin accepting an average of an 8 percent concept of what you measure you can manage. margin in order to continue to get work? That will require an increase in gross In summary, retooling for the recovery will require proactive and sound revenues of 25 percent to get to the same overall margin dollars (need $1,250,000 business principles and best practices. These concepts apply to any economic in volume at 8 percent to result in the same gross profit from $1,000,000 at 10 environment. But prior years have allowed companies to let their guard down percent or $100,000 gross profit). Accepting work at even further declining mar- and still be successful. Many have survived in spite of limited or less than thorgins from 10 percent to 5 percent will require an increase of gross revenues of 100 ough application of these concepts. At least in the near term, the margin of percent to get to the same overall margin dollars (need $2,000,000 in volume error has significantly diminished and not applying sound business practices at 5 percent to result in the same gross profit from $1,000,000 at 10 percent or can quickly result in failure. $100,000 gross profit). The likelihood in the current market of making up the Contractors that effectively apply these principles will be positioned for margin shortfall with volume is very unlikely let alone extremely risky. Be realistic continued success in the current challenging economic environment and in setting budgets. Cost, volume, profit analysis is a critical analysis to perform. poised to thrive in the ultimate recovery.

4

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by Kenneth J. Hedlund, CPA

O

ne of the most effective financial power tools and certainly best practice concepts is the use of a performancebased incentive plan. Many owners are looking for that key ingredient to maximize their company’s success. We always hear owners say that their employees are the company’s most important asset. Attracting and retaining employees whose skills and commitment contribute significantly to the growth and profitability of the business should be a priority. While high-performing employees are typically driven by their own high standards, a performancebased incentive compensation package can often motivate them to continue performing at optimum levels. Often we see companies have profitable years and allocate bonus and other incentive payments on an arbitrary and subjective determination. However, wouldn’t it make sense to put an objective reward system in place to identify high performers and provide them with the highest level of incentives and truly reward them for their contributions?

There are two key components in the design of a performancebased compensation plan: 1. A corporate level funding formula 2. Determination of incentive allocations based predominately on employee performance

Corporate Level Funding Formula

For contractors, there is a minimum level of profitability that should be achieved before any incentives are considered. This minimum level of profitability considers many variables, including eq-

uity and working capital needs for bonding , banking , investment in capital assets, debt ser vice, owners’ return on equity, etc. Upon achieving this minimum level of profitability, employee incentive pools are then funded. For each incremental higher tier of profitability, incentives are funded at an increased percentage. This structure motivates employees to continue to reach for that next higher level of profitability. See graphic illustration below : Profit

Total Incentives

$1,000,000

$750,000

$500,000

$250,000

$0

Minimum Profit (Equity, Working Capital)

$50,000

$125,000

$250,000

Incentives

Corporate Funding Formula

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Determination of Incentive Allocations

An incentive compensation plan is designed to tie pay to performance and achieve gains in worker productivity. Such plans incorporate various incentives including but not limited to cash bonuses, commissions, profit sharing , deferred compensation, phantom stock and corporate stock ownership. The incentives can be paid current or deferred to some time in the future. An incentive compensation plan can be purely discretionary and may be targeted to individual employees, work crews, branches or profit centers, the organization as a whole or a combination of these groups. A performance-based incentive compensation plan takes it a step further—it is more predominately objective and designed to specifically identif y and incrementally reward the top performers.

We strongly recommend putting in place a system of performance measurement to provide a model of accountability and identif y high performers. Employees should understand what’s expected of them to qualif y for the incentive compensation. You should clearly spell out minimum performance standards that link corporate goals to managers’ and super visors’ performance objectives in order to earn incentive compensation. Incentive compensation plans are customized to a company’s specific needs and goals.

A performance-based plan employs objective criteria to determine incentive pay. These plans establish clearly identified objectives that the manager must accomplish in order to receive the compensation.

We work with contractors in the design of performance-based plans that employ the concept of Critical Success Factors (CSFs) and Key Performance Indicators (KPIs). CSFs are those integral processes that you must absolutely get right to achieve management objectives and ultimately success in your business.

KPIs are specific activities that are measurable and, when achieved, result in desired performance to achieve CSFs. CSFs and KPIs are well-documented, timetested and proven concepts that we have been able to successfully apply to the construction industry.

For example, KPIs for a project manager in the critical area of operations include routinely (i.e., monthly) updating costs to complete on contracts to identif y as early as possible project cost overruns, potential scope issues, implement timely change orders, minimize project profit fade, maintain project profitability, etc., all of which can significantly impact the bottom line. Such specific KPIs for project managers can be utilized to hold them accountable to timely and effectively manage this aspect of their responsibility.

Routinely monitoring employees’ progress towards meeting the objectives set in the performance plan in these critical areas will maximize company success measured as overall return on investment (ROI). It’s the concept of what you can measure you can manage.

As we indicated, these performancebased plans are predominately objective.

However, we will be the first to agree that there is no perfect, 100 percent objective plan. Plans we design always allow for some discretion and subjectivity. This allows for some flexibility. This is necessary because it’s not always possible to assess the contributions of top performers solely through a set of objective criteria. Since these individuals are often put in charge of the most complex projects, the need to have a component of subjective analysis of their performance may be warranted. A pure performance-based plan could end up undervaluing a key employee’s overall contributions, particularly on difficult or unusual projects where certain skills may be difficult to measure. A discretionary and subjective component of the plan will allow the ability to reward an employee based on your own assessment of the value of the employee’s various contributions.

Finally, the plan must not be an administrative burden. This is one of the critical issues that often results in plan failures. The plan must be easy to routinely (typically monthly) monitor and track. Over the years we have helped companies develop tools to streamline and efficiently and effectively administer such a plan.

If your company could benefit from introducing a performancebased incentive compensation plan or if you are dissatisfied with your current plan’s operation, we can help.

Routinely monitoring employees’ progress towards meeting the objectives set in the performance plan in these critical areas will maximize company success measured as overall return on investment (ROI).

In the design of such a plan, contractors should focus on five critical areas: 1. Operations 2. Financial 3. Business development 4. Employee satisfaction 5. Customer satisfaction

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By Steven J. George, CPA

T

oday’s challenging construction environment extends far from the brick and mortar work to your company’s conference room. In the “good old days” (which are certainly “gone by” for the foreseeable future), contractors worried more about field coordination and design/construction in an uncontrolled environment than they worried about obtaining and maintaining adequate credit facilities to enable their company to bid and execute a project. Today, surety and lending relationships are the first hurdles to conquer before you can bid or build anything. Increasingly slimmer margins and more competition require contractors to be on top of every aspect of their game, and those who are not--or even appear not to be--can be quickly frozen out of the proposal/bid process.

Surety losses in 2010 and 2011 are expected to soar, and as that happens, all credit will tighten, even more so than it has been in the past 18 months. What do you need to do now to ensure your company is not frozen out of the recovery cycle ?

Construction company leaders must shift their focus from the field operations to the administrative side of the business in order to maintain, build or establish relationships with lenders and sureties.

Procuring necessary credit in the form of banking and bonding requires careful planning. Sureties as well as banks want to understand a company’s leadership, operations and culture before extending credit. A culture of strong communications between field and office helps.

One of the single most important steps to ensure your company is creditworthy is keeping proper equity and working capital levels relative to the revenue volume you project. Aligning your company with a CPA with construction expertise can be very beneficial as there are many steps that can be taken to ensure both working capital and equity are maximized.

If your company is seeking credit, management’s ability to pro vide timely, accurate, monthly reporting to a potential creditor is critical. Reliable construction-specific accounting software that has strong job costing capabilities is a must. Monthly financial reporting packages provided to banks and sureties should include a bal-

ance sheet and income statement along with an accounts receivable aging report and a work-in-process schedule. The package should be provided 15-20 days after month end. The work in process schedule should be accurate and show margins by job with little fluctuation between months. Profit gain (as opposed to profit fade) in the latter part of execution is preferable.

Consistency, accuracy and timeliness help establish credibility in the internal reporting capability of your company, and this is a critical part of obtaining and maintaining surety and banking credit.

Two years ago, less than 10 percent of contractors prepared any type of cash flow projections or annual budget. The argument was, “I don’t know what jobs I will win, so how can I prepare a projection?” Today, extending credit is all about cash flow, and if you don’t have the people in place to prepare 120 day cash flow projections using anticipated backlog burnoff, you should be prepared to hire an outside firm to do so before you obtain further credit facilities. The projections should show realistic revenues and profit margins given your present marketplace. Again, establishing credibility is key here.

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Proactive communications are also important, as credit decisions by a bank or surety take much longer than in the past. Many credit decisions have been removed from the local level people you know and are now made by underwriters and loan committees you’ve never met. Information will need to be supplied so those parties understand the operational and financial history of your company. These decisions take time--yours, your staff ’s, time for the underwriter to process the information and time for the loan committee to hear the case and make a decision. Often, loan committees seek additional information, causing additional delay. One consideration is to work through the underwriting process and become prequalified before your company has a real need. If your company is not yet creditworthy, you will know the steps needed to get the company positioned for credit when it is required.

If your company has recently transitioned from one market segment to another (say from residential development to commercial or industrial), you will have to provide some narrative on your expertise in the new area. Did you hire someone with extensive experience in the area?

If your company is one of the many making a transition to public works, be prepared to show your track record of performance in this area. These are a few examples of the questions you should anticipate from your lender or surety.

If your company has had losses over the past year or two, do you have personal liquidity to put money into the business? Banks and especially sureties generally have no interest in being an equity partner in your business. So they will not be supportive if you have losses that owners are either unwilling or unable to cover personally.

Many smaller contractors who have traditionally worked as subcontractors for general contractors have seen a dramatic increase in requests to provide their own performance bonds to the general contractors, or at least prove their own ability to obtain a bond. This trend is expected to continue, so even smaller contractors need to take steps to be prequalified to obtain surety bonds.

Many historically profitable contractors, when going through the annual bank renewal process, have seen reduced availability proposed in their lines of credit due to lack of historical borrowing needs. Before you agree to a decrease in availability with your bank, discuss this matter with your bonding agent, because availability of a line of credit is often weighed heavily by a surety. Banks are becoming much savvier in charging customers for a line they don’t access, so you should expect to pay some type of availability fee if your company has traditionally not used its line of credit but still needs one to be available. This comes down to a cost/benefit analysis. If a surety demands it and your company bonds 40 percent of its work, the fee becomes a cost of doing business in your market sector.

A very important but often misunderstood or overlooked aspect of the administrative side of the construction business is understanding the loan documents from your bank/primary lender, including all terms, conditions and covenants. Many banks use multiple documents that have survivor clauses and are only signed at the commencement of your company’s relationship with them. Annual renewal documents are often far less detailed. Consider making a request in writing to your banker for a complete copy of all documents governing your banking and lending relationship with them. Once they are received, read them over and under-

stand all terms and how the documents tie together. If you don’t understand parts of them, and nobody does, set up a subsequent meeting with your relationship manager for them to walk you through and explain the documents. A few key points to look for during this process are a complete understanding of the borrowing base. For example, many banks exclude bonded accounts receivable from the borrowing base by definition, and if you are projecting to ramp up bonded work, this could cause a problem. Let me be clear on this, many banks have had those exclusions in their definitions but such matters have never been enforced. As banks go through difficult times, you can see why these terms, when enforced, can become difficult at best. Other clauses to watch for and understand include the “taint rule” where all accounts receivable from a customer are disallowed when one invoice becomes over 90 days past due. Understanding loan covenants and monitoring compliance are also critical factors to maintain a strong relationship with your lender. There are many issues like these to consider, and a competent CPA can help guide you through this review and help identify potential pitfalls.

If your company needs to seek alternative credit markets, institutional lenders may be a good source of credit, especially for those companies who have lots of equity in their equipment fleet. I have seen institutional lenders step in and make term loans based on a first priority security interest in all equipment, allowing heavy equipment companies to shed an uncooperative lender and move forward.

Factoring of accounts receivable is a costly alternative, but can help bridge the gap if your company’s cash flow and credit are really tight.

While times are tight and jobs are few, tightening up systems and processes may be easier than waiting until business is robust again.

By strengthening systems and procedures, credibility by outside creditors is enhanced, thereby making credit more readily available.

By getting back to basics and focusing on the administrative side of their companies and at the same time proactively strengthening relationships with creditors, contractors can greatly improve their creditworthiness with banks and sureties and help weather the economic storm.

CREDIBILITY

=

CREDIT

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By Jack Orth

N

ot so many years a g o, te chnolog y consiste d of adding machines, fa x machines, camcorders (Beta format no less) and Pac-Man arcade g ames. We’ve come a long way. Cell phones, Excel, e-ma il, internet, document ima g ing have replace d the 2-way radio, columnar paper, sna il ma il, yellow pa g es and file cabinets. In fact, in 1980 a limite d number of companies had the abilit y or resources to insta ll and ma inta in any t ype of computerization to assist with the da ily operations of the business. Fast for ward to 2010. According to a re cent CFM A IT sur ve y, over 90 percent of the respondents reporte d using some t ype of accounting/job cost/ payroll sof t ware in house. Additiona lly, 91 percent state d the y use an estimating sof t ware tool, while 83 percent reporte d using proje ct mana g ement applica tions.

S o as you can se e (and have a lready no doubt experience d ), there has be en quite a te chnolog ica l culture shif t since the early days of automation. Most, if not a ll in our industr y, are now utilizing various t ypes of sof t ware to assist with da ily routines and to more effe ctively use labor resources. In fact, many have utilize d the same sof t ware for some years and, except for the occasiona l sof t ware upg rade which is re quire d to stay in sync with e verchang ing operating systems, have not rea lly done much to enhance their “effe ctive” utilization. This beg s se vera l questions :

deploying all the features that come standard with their software purchase. When they first were introduced to the software, certain functionality and application “have to haves” are what attracted the contractor to purchase the software. Perhaps these “have to haves” were readily implemented and internal procedures modified to accommodate the newly installed software, but what about the other pieces of functionality that came standard with the software ? Were the additional features reviewed to determine if they mig ht be of value and applicability to the company in its quest to automate more processes ? Was a software professional consulted when the initial purchase was made to g uide the company throug h the implementation to take full advantag e of the software ? Has the company taken advantag e of software upgrades that may include new features ?

In many instances the answer to these questions is a resounding “NO.” Subsequently, an effective software utilization rate of 50 percent or less is not uncommon. Please realize that no company ever achieves 100 pecent utilization, but many hardly scratch the surface and fewer still do not even know what functionality they already own. For example, if your accounting firm asks for a trial balance in an Excel format, can your system easily produce it, does your ERP solution have the ability to export this report (and many others just like it) into an Excel spreadsheet format ? Do you take advantag e of “committed” cost/ purchase order/subcontract processes in your daily activities ?

Can reports be sent via email as a secure attachment directly from your ERP ? These questions and many more are becoming part of a growing outcr y of need for contractors that simply cannot afford to manually develop these items. In many cases they already have the tools at their disposal but do not know it.

What You Don't Know Will Hurt You

Are You Fully Utilizing Your Current Software?

Since 1997 I have professionally consulted on ERP (enterprise resource process) products and have noticed the vast majority of businesses do not fully utilize that which they have already purchased. In fact, many do not even come close to effectively

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Are You Receiving Required Reports/ Information From Your Software?

PJ Timberline Construction

Aging As of Date Aging Basis

06-30-2001 Accounting date

Tran Type GA

Gone With The Wind Insurance

06-30-2001

Aging of Unpaid Invoices

ID

Date

Amount

Current Column

Over 30 Column

Over 60 Column

Over 90 Column

Over 120 Column

Retainage

Paul Jones (555)111-2222

Invoice 1009 05-23-2001 2,937.87 2,937.87 326.43It seems that all too often during 2,937.87* .00* 2,937.87* .00* .00* .00* 326.43-* Non-Contract Totals a contractor’s quest to seek the “holy 0300100 NW Food Warehouse grail” of information they require to Invoice 010010000002 02-28-2001 13,000.00Invoice 010010000003 03-31-2001 23,860.00Invoice 010010000004 04-30-2001 233,160.00 233,160.00 35,380.00manage their jobs/company, they are Invoice 010010000005 05-31-2001 120,510.00 120,510.00 13,390.00Invoice 1013 05-31-2001 2,950.00 2,950.00 informed that it is not possible to re356,620.00* .00* 123,460.00* 233,160.00* .00* .00* 85,630.00-* 0300100 NW Food Warehouse Totals trieve the desired data from their ERP Gone With The Wind Insurance Totals 359,557.87* .00* 126,397.87* 233,160.00* .00* .00* 85,956.43-* solution. This leaves them with two opTC Tomorrow Construction Nick Mathas (555)111-3333 tions: 1) direct personnel resources to Invoice 1007 05-19-2001 118.35 118.35 13.15manually extract the information from 118.35* .00* 118.35* .00* .00* .00* 13.15-* Non-Contract Totals whatever sources are available or 2) sim0300200 Clackamas Office Park #4 ply do without the information. NeiInvoice 010020000001 02-28-2001 700.00Invoice 010020000002 03-31-2001 4,000.00Invoice 010020000003 04-30-2001 13,500.00 13,500.00 7,500.00ther of these options is good no matter 13,500.00* .00* .00* 13,500.00* .00* .00* 12,200.00-* 0300200 Clackamas Office Park #4 Totals how you look at it. Perhaps the manager Tomorrow Construction Totals 13,618.35* .00* 118.35* 13,500.00* .00* .00* 12,213.15-* is looking for a report as simple as an PGE Portland General Contracting Carl Hamrous (555)222-4444 accounts receivable aging report by cus0300600 PGE Line Contract 349204 WO345 Invoice 1010 05-04-2001 110.00tomer or job or both or perhaps he/she .00* .00* .00* .00* .00* .00* 110.00-* 0300600 PGE Line Contract 349204 WO345 Totals needs a report that tells them by project .00* .00* .00* .00* .00* .00* 110.00-* Portland General Contracting Totals manager or department just how profitUSA United Subcontracting Assoc.

John Dougherty (555)666-7777 0300300 Fort Wayne's Officers Club able their service work has been since Invoice 010030000001 03-31-2001 27.50Invoice 010030000002 04-30-2001 4,490.00 4,490.00 1,610.00the beginning of the fiscal year (see ilInvoice 010030000003 05-31-2001 22,545.00 22,545.00 2,505.00lustration). Either way, a good ERP so27,035.00* .00* 22,545.00* 4,490.00* .00* .00* 4,142.50-* 0300300 Fort Wayne's Officers Club Totals lution should easily be able to produce 27,035.00* .00* 22,545.00* 4,490.00* .00* .00* 4,142.50-* United Subcontracting Assoc. Totals such reports. If your ERP solution has a good report writing tool, perhaps a customized report or two would be in order to generate the required information. Additionally, there are other tools/solutions available that are able to extract data from most software systems (i.e., Crystal Reports, Access, etc.). If the information is in the ERP solution, then logic tells us that we should be • AP Active Vendors with No Payments in 180 days able to get it out in a usable format. In most cases, there are tools • AP Check Payee Name different from Vendor Name readily available to assist with data extraction.

• AP Incomplete Vendor Information (Missing address, phone, fax, etc.)

• AP Invalid Vendor Information (Area code for phone doesn’t match state) • AP Duplicate Payments Many contractors have spent countless hours and thousands (Same amount to same vendor within 90 days) of dollars to develop a comprehensive software solution only to • AP Vendor Invoices without attachments find out that it is an “island of information” unto itself. The data (no scanned documentation) stored in it is not sharable with any other software package in their • AR Customer Invoices without attachments possession. The painful process of massaging and re-entering the (no scanned documentation) data into their ERP or other solution is tedious and completely • PR Active Employees with No Checks in 30 days manual. Perhaps you have a very nice CRM solution in place and • GL Out-Of-Period postings (Any GL Transaction entered yet it does not share/update information that is already contained in your ERP solution. Maybe you are currently moving towards a on a date more than 30 days from the posting date) paperless environment and document scanning and control is on your radar but the scanned data is not linked to any area of your ERP system. With most of today’s software solutions, the ability running “lean” is the ultimate g oal, no company can afford exto share information back and forth is quite common, even if it cess personnel to handle the special projects and manual pro is in an import/export type of process. If the data cannot easily cesses we’ve discussed. And since running lean is the current be shared, there are other options that may be able to assist us in modus operandi for most contractors, it is imperative that esviewing the data in a “common” area. sential business manag ement information is current, accurate, sharable and available in the required format(s).

In conclusion, perhaps you need to re-evaluate your current software systems or simply re-evaluate how you use the systems you have in place. Either way, having solid, reliable and effiIf after reviewing these questions you answered “NO” to cient software solutions that g ive you mandator y information any or all of them, perhaps you need to ask yourself if your is critical to your business’ success today. Information contrib current systems are really performing for you the way you need them to. Let’s face it, in this competitive business world where utes to knowledg e and knowledg e is what we seek .

"MUST HAVE" REPORTS

Are You Able to Connect Your Current ERP Solution to Other Software?

Does Your Software Really Do What You Need It to Do?

11

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Page 1

Financial

power tool$:

Heavy Highway Contractors

Heavy Highway Contractors: Is Your Business Encountering Roadblocks?

Somerset’s skilled Construction Team can provide the insight you need to bypass the financial road blocks that have been holding your company back. We have an industry team dedicated to providing financial services specific to the heavy-highway industry and are uniquely equipped to focus on your specific needs.

Somerset is equipped to solve your heavy highway challenges: $

Review of Economic Lives for Equipment

$

Equipment Rate Review/Establishment

$

Measuring Equipment Utilization and Absorption

$

Equipment Cost Management Techniques

$

Surety and Banking Needs/Consultation

$

INDOT Pre-Qualifications

$

Creative Tax Strategies

$

Competitively Priced Accounting and Tax Compliance Services

The construction industry is unique.

Somerset understands it from the foundation up.

+

Š 2011 Somerset CPAs Somerset 2.indd 12

t Year s of Commitmen to Your Success

Ken Hedlund, CPA Steve George, CPA 866.920.0331 | e-mail: info@SomersetCPAs.com

www.IndianaConstructionCPAs.com

14/03/2011 10:54:01

The Human Resource

M

ost entrepreneurs and executives agree that the hardest thing to get right in business is the human equation. From my 27 years of experience in the business world as a business owner, a business executive, a board member and advisor, I have organized the most common HR mistakes into the following categories: 1. Hiring Sin 2. Firing Sin 3. Promoting Sin 4. Mentoring Sin 5. Burnout Sin

Hiring Sin

Generally, we are too quick to hire. Some of our favorite hiring criteria are the 98.6 degree test & the fog the mirror test. Why are we in such a hurry? We assume that SOMEBODY is better than NOBODY; most of the time this is simply not true.

We are really better off to work short handed with a committed team of proven performers for a period of time than to gamble on making a rush decision. Further, we have to live with our hiring mistakes for some period of time, and they almost always end badly.

They are also very expensive lessons, but more about that later when we discuss the firing sin in detail.

So how do we get this basic building block of business so wrong ?

We hire from the wrong pool of candidates. We don’t conduct the right pre-employment testing , and then we compound all of the above when we don’t ask the right interview questions.

So, what is the solution? The good news is that it is very simple.

For most of us, hiring is not a core organizational competency. Yes, we may have pockets of competency, but that hardly makes it a core competency.

Therefore, to avoid this sin we must get serious about engaging the right outside professionals to acquire the necessary systems, tools and expertise. I recommend hiring a recruitment process outsourcing professional or executive search firm. Yes, these advisors cost money, but they are much less expensive than the cost of a bad hire for which estimates range from one to three times the annual salary of the position.

Firing Sin

In this case, we have the exact opposite tendency from the Hiring Sin. We fire too slowly for a variety of reasons, including fear, because we do not know how to protect ourselves from liability in the firing process. However, I think the biggest reason we don’t pull the trigger quick enough is because we miscalculate the cost of underachievers in our organizations.

We estimate the cost of someone who gets half the output that we expect from the position as costing us 50 percent of their salary. The actual cost of tolerating underperformers is estimated at one-third of your total payroll cost, including fringe benefits and payroll taxes.

Somerset 2.indd 13

Sins

By Howard Cox, CPA, CMA, CIA

The reason for this is the dramatic effect that the workforce equity balancing act has on overall productivity. If you allow underperformers to exist, many of your other employees will dumb their performance down so they arrive at an equitable result in comparison to your underperformers’ output and compensation.

Promotion Sin

By Howard Cox, Somerset This HR sin may be the most damag ing of all because of what we call the Peter Principle double whammy. When you commit the Promotion Sin, you end up with an ineffective manag er in your org anization and you have lost one of your most, or in many cases, your sing le most productive front line teammate.

The g ood news is that the Promotion Sin is easily avoided if you understand the underlying root cause. The Peter Principle is caused by the fallac y that you should evaluate a person’s preparedness for a promotion based on their performance in their current job. The reality is that you need to evaluate their skill sets ag ainst those required for the new job instead.

Mentoring Sin

The Mentoring Sin is that many of us spend far too little time mentoring in our org anizations. Evaluations are performed on a periodic basis and many of us are not ver y g ood about that either.

Mentoring on the other hand is to be a constant in your org anization.

The best role models for mentoring are successful colleg e basketball coaches like Mike Krzy zewski and John Wooden. Coach K never misses an opportunity to coach and mentor his players on each and ever y possession in the real time of the g ame. Likewise, our internal meeting s should be used for more structured mentoring but are rarely utilized for same. Coach John Wooden believed that he should spend as much time preparing for his team’s practices as the time allotted for each practice itself. If you are g oing to have a one hour staff meeting , do you spend one hour preparing for it so that you ma ximize the opportunity to mentor your team?

Burnout Sin

The Burnout Sin is caused by the cumulative effect of all of the other HR sins. If you hire poorly, keep underperformers employed, promote people to positions where they do not have the skills to succeed and spend minimal time developing your human capital, you will end up with ver y few people in your org anization you can truly count on. You will then be ver y tempted to overrely on them until you run them out of your org anization.

My hope is that by coming to terms with these five basic HR mistakes you can create an org anization where you and ever yone else in it can prosper and reach their full potential.

13 14/03/2011 10:54:05

What’s Your Overhead Recovery Strategy?

Overhead Recovery Utilizing Dual Rates – A Case Study

By Chris Mayfield, CPA

A

significant factor in the profitability of any company is an understanding and appropriate allocation of its overhead.

This fact is especially true of construction companies. Just like direct costs, overhead is the real cost of doing business.

In addition, projects vary significantly in mix of costs – predominately comprised of direct labor, materials and subcontractors. Depending on the mix of costs, different projects inherently consume varying degrees of overhead resources. An appropriate estimate of overhead should be considered during the estimating and bidding process, and overhead should be applied to projects as they progress to ensure overall firm profitability.

The procedure for analyzing overhead includes identifying those expenses that should be included in overhead, determining an appropriate allocation method (labor hours, labor dollars, job costs, etc.) and developing an overall overhead rate to apply to jobs as they progress.

Most contractors allocate some overhead costs to projects. Using a single rate method based on labor hours or labor dollars appears to be the most commonly used method. However, this method has an inherent flaw. Under this method, projects that are predominately self-performed and therefore have significant labor costs will also have a heavy allocation of overhead. Alternatively, projects that are not self-performed and are predominately subcontracted may have minimal or no overhead allocation. Therefore, the single rate method utilizing labor hours or dollars does not consider the potential mix of costs projects can have and, in effect, will penalize projects that are labor intensive. We support the presumption that labor is the major driver and consumption of overhead resources. However, not all overhead costs are caused by direct labor costs.

Alternatively, not all overhead would be eliminated if there were no labor costs. Managing subcontracts, materials and other project costs also consume resources and therefore should have an allocation of overhead.

The most accurate method of overhead recovery is the dual overhead rate method. This method utilizes two different overhead rates – one for subcontractors and materials and one for direct labor. As we previously indicated, labor represents the largest component of risk and opportunity for profit on most construction projects. However, labor also consumes and generates the greatest amount of overhead. Therefore, under the dual method, labor will be allocated to the largest portion of the overhead; however, a second rate will also apply overhead to projects that have a component of subcontractors and material costs.

The dual overhead rate method, developed by FMI Corporation, is based on years of research on the behavior of overhead costs. It has been proven that overhead costs vary as the ratio of materials and subcontracts to labor varies. This supports the theory that overhead (as a percent of total direct cost) varies inversely with the materials and subcontracts to labor ratio.

The formulas for determining the dual overhead rates are provided below: Rate on Materials = and Subcontractors

Rate on Labor =

Allocated Overhead [(X ) * Labor] + Materials and Subcontractors

(X ) * Allocated Overhead [(X ) * Labor] + Materials and Subcontractors

Example Dual Rate Calculation Values for X are determined by the Materials and Subcontractors to Labor (M&S/L) ratio. These values are available in a pre-calculated published schedule call “Dual Rate Recovery, Table of Overhead Factors." For a copy of this table, please contact us via email at info@somersetcpas.com.

The calculation for ABC Construction Company, our example company, is based on the following financial information obtained from their budgeted financial statement.

Materials Labor

$7,500,000 $5,000,000

Subcontractors Overhead

$2,500,000 $2,000,000

1. First, calculate the M&S/L ratio. ($7,500,000 + $2,500,000) / $5,000,000 = 2 / 1, or 2 2. After the M&S/L ratio is calculated, use the Dual Rate Recovery, Table of Overhead Factors to obtain the X value of the M&S/L. In our example, an M&S/L ratio of 2 yields an X value of 3.13.

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3. Next, the dual overhead rates are calculated using the formulas provided above.

Rate on Materials = $2,000,000 and Subcontractors [(3.13) * $5,000,000] + ($7,500,000 + $2,500,000)

= 8 percent Rate on Labor =

(3.13) * $2,000,000 [(3.13) * $5,000,000] + ($7,500,000 + $2,500,000) = 24 percent

Thus, the dual overhead rates are 8 percent of Materials and Subcontractors cost and 24 percent of Labor cost.

Also for comparison purposes, if ABC Construction Company allocated overhead using a single rate calculation based on labor dollars only, the rate would be calculated as follows:

Total Overhead Labor Dollars

$2,000,000 $5,000,000

Overhead Rate Based on Labor Dollars Only

= 40.00 percent

Following is an example of a project that utilizes a single rate based on labor versus a dual rate from the calculations above.

Scenario A

ABC Construction Company Example, Overhead Allocated Using a Single Rate Based on Labor Dollars

Job 1 Job 2 Job 3 Materials $225,000

$175,000

$125,000 Labor

70,000 135,000 200,000 Subcontracts

115,000 95,000 75,000 Other Project Costs

20,000 10,000 15,000 Total Project Costs

$420,000 420,000 420,000

Overhead Applied Based on Single Rate, Labor Dollars @ 40 percent 28,000 54,000 80,000 Total Estimated Costs 448,000 $474,000 500,000 Materials and Subcontracts/Labor Ratio 4.86 2.00 1.00

As you can see, when comparing the two overhead allocation methods, the overhead applied to projects 1 and 3 var y widely.

But, Project 1 remains the same regardless of the method. This is because Project 1 has the same material and subcontract to labor ratio as the company has with its budget. If ever y project had the same ratio as the company budget, either overhead allocation method would be accurate. But in the real world, projects var y and the mix of costs can var y significantly. The dual rate method has been found to be more accurate than any other method.

It is also important to note that the development of dual overhead rates should be based on projected future costs. The best way to determine dual overhead rates is to use a comprehensive 12-month budget tied into the company’s fiscal year. If this computation is not possible, a 12-month current statement may be used. However, when this is done, the company is being g uided by last year's information. The company should recalculate the dual overhead rates at a minimum on an annual basis. Significant fluctuations in the company’s business operations may require up dating the dual overhead rates more frequently.

The biggest arg ument we have heard contractors use against utilizing the dual rate method is the perception that it is complicated.

But practically speaking , the calculations are simple and easy to apply, and no more effort is required than with any other method.

The benefits of utilizing the dual overhead rates method are great. Comparing overhead costs to industr y norms and benchmarks will identif y those costs that should be monitored to assist in improving profitability. This is a “ best practice” for the industr y that you should consider.

Scenario B

ABC Construction Company Example, Overhead Allocated Using Dual Rate

Job 1 Job 2 Job 3 $225,000 Materials

$175,000 $125,000 Labor 70,000

135,000 200,000 115,000 95,000 Subcontracts

75,000 10,000 15,000 Other Project Costs

20,000 $420,000 Total Project Costs $420,000 $420,000

Overhead Applied Based on Dual Rate Labor Dollars @ 24 percent 16,800 32,400

48,000 Subcontractor and 27,200 21,600 Materials at 8 percent

16,000 $464,000 $474,000 Total Estimated Costs

$484,000

Materials and 4.86 2.00 Subcontracts/Labor Ratio 1.00 Somerset 2.indd 15

15 14/03/2011 10:54:12

Effective Cash Management Strategies

A

by Kenneth J. Hedlund, CPA

primary focus for contractors continues to be obtaining work. Maintaining profitability is important; however, our focus in this month’s article is cash flow. Profit is important, but cash flow is key.

One of the primary reasons many businesses fail is their inability to meet financial obligations as they come due. No matter how sophisticated your business processes may be or how high the quality and delivery of your products and ser vices are, if your business runs out of cash, it will cease to exist. We have seen seemingly profitable businesses fail due to their lack of ability to maintain and manage cash flow.

It is surprising the number of contractors without a cash flow plan. Often the cash flow plan is just an annual projection done to accompany a bank loan renewal or application. Healthy businesses have good cash flow. Best practice businesses always have a profit and cash flow plan for at least the next 12 months of operations.

Our recommended approach and one of our key financial power tools for contractors is the use of a 12 month rolling cash flow projection.

The initial response from most is that you can’t project 12 months of cash flow accurately. We do not disagree that projecting 12 months can be difficult. However, the near-term component of the projection – 30, 60, 90 and even 120 days – should be very predictable. That is the real value of the projection.

The best practice rolling 12 month projection integrates the balance sheet forecasting cash, accounts and retention receivables, payables, operating line of credit and other debt ser vice. The balance sheet should be linked with a forecasted income statement including contract revenue, direct, indirect and overhead expenditures considering backlog burn off as well as reasonable pipeline assumptions. Finally, within the projection we recommend calculating key ratios each month including receivables and payable turn, current ratio, debt to equity and other ratios as well as testing for compliance with bank covenants. Updated monthly, the projection should accurately indicate if there will be a cash flow deficit anytime in the next 120 days.

Since the recession and now in economic recovery, banks and other creditors are less lenient, have tightened their lending and are more closely scrutinizing their accounts. Contractors are on the watch list and in the high risk category, so we suggest implementing proactive cash management procedures to effectively cash flow from operations. Contractors should plan to cash flow all costs, required long-term debt payments and either maintain or reduce the operating line of credit. For contractors fortunate enough to not be in debt or have not needed to borrow on their line of credit, their goal should be to maintain or improve cash reser ves.

If the 30-60-90-120 day cash flow indicates future cash shortfalls, management will have time to proactively and strategically address and resolve the shortfall. This can be done through speeding up cash inflows, slowing cash outflows and, if necessary, costcutting measures.

We suggest contractors review the following four metrics routinely to assess an overall cash management picture : • Days accounts receivable • Days accounts payable • Days work in process • Days inventor y, if applicable The industr y averages for these metrics are published in industr y sur veys. Compare your metrics with published industr y averages. Set expectations for your company to achieve best in class status in each categor y.

See case study Illustration 1 for an example of a specialty contractor. The "Base Position" column shows seven million dollars in revenues that is extremely profitable with a net profit of $1.2 million – about an 18 percent net! However, per review of the company’s balance sheet, they have zero cash and are maxed out on their line of credit – effectively in financial trouble.

Upon calculation of receivables, inventor y and payables turns, they were at 85, 90 and 30 days, respectively. Not even close to reported industr y averages. Under the " What-If Position" column, we recast their balance sheet considering their receivables, inventor y and payables balance as if achieving industr y average days of 60, 30 and 45 days, respectively. The impact was significant and resulted a net cash flow improvement of $1.6 million. This would have eliminated 100 percent of the borrowing on their line of credit, plus created a healthy cash balance. Sure, this case study and illustration is an extreme but shows the perspective of a seemingly profitable company that was on the verge of failure due to poor cash management practices.

Even a nominal 10 days cash flow improvement can profoundly change a company's liquidity.

Select Income Statement Information Total Revenue Gross Profit ( percent) Gross Profit Expenses Net Profit Net Profit ( percent) Select Balance Sheet Information Cash Receivables Inventor y Payables Line of Credit Receivables Days Inventor y Turnover Payable Days Net Profit Effect Total Cash Flow Effect (Improvement)

Base Position

What If Position

$7,194,601 27.46 percent $1,975,870 $695,902 $1,279,968 17.79 percent

$7,194,601 27.46 percent $1,975,870 $695,902 $1,279,968 17.79 percent

$0 $1,675,455 $1,286,810 $428,937 $1,040,977

$524,145 $1,182,674 $428,937 $643,405 $0

85 90 30

60 30 45

0

0 $1,565,123

Illustration 1

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14/03/2011 10:54:22

It is amazing the increase in cash flow that can be achieved when any combination of the four metrics that result in even a nominal 10-day improvement. Consider a 10-day cash flow improvement challenge. Determine the impact to your company’s cash flow that would result from a 10-day improvement, a modest and highly realistic goal. Then set the plan into action, hold those involved in any aspect of the cash flow process accountable and make it happen.

In regards to days receivables, it’s important to note it is measured from the actual date of billing to date of collection. But what about the administrative processing cycle that occurs prior to the actual billing ? For example, it’s not unusual for a ser vice contractor to perform a ser vice the beginning of a week, and all ser vice tickets for that week are turned in for processing the end of that same week. The next week all ser vice tickets are processed into bills. Bills are then returned for approval before final issuance. A processing cycle such as this could result in 15 or more days from the service date to the actual billing date—and this processing cycle is not considered in days receivable. This example is shown in Illustration 2, Processing Cycle Example. Some ser vice contractors have the technolog y to collect for ser vice calls on site immediately after the ser vice is performed. This is an immediate processing cycle and zero days receivable. Certainly best of class! Although this is ideal, it is not practical for all types of contractors or contract types. The objective should be to review your current processing cycle and put in place procedures to shorten the cycle as much a possible.

Illustration 2

Processing Cycle Example Monthly Calendar SU 1

M 2

T 3

W 4

TH 5

8

9

10

11

12

15

16

17

18

22

23

24

25

29

30

31

A

D

F 6

SA 7

13

14

19

20

21

26

27

28

B C

A = Ser vice Performed B = Ser vice tickets turned in for processing C = Prior weeks' ser vice tickets completed/processed into bills D = Bills approved and issued So, weekly billing added 15 days to aging. If monthly, the same proccess added about 45 days Contractors need to implement and maintain procedures with strong systems and controls to maximize cash flow. In addition to the concepts addressed here, you should at least monthly review costs to complete on projects to identif y early potential cost overruns and scope issues and potential need for change orders.

Bill to progress, do not underbill and, if possible, bill ahead. Set stringent policies for follow up on receivables at 30 and 45 days, and anything over 60 days should require contact by a primary contact/relationship manager.

Finally, a few comments regarding cash flow risk management – particularly in light of the current economy. Don’t let receivable balances get away from you and know your risk tolerance. You are extending credit to those with whom you do business. Increased diligence in approval of subcontractors, suppliers and vendors is essential. Do your homework up front with significant increase in acceptance and approval of those with whom you choose to work.

Understand their businesses and how they have been impacted by the downturn in the economy. Monitor and react to patterns of slow pay, which may be an early indication of financial trouble.

Within contract provisions, request payment before further work is done, consider joint checks and exercise lien rights.

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By Kenneth J. Hedlund, CPA

T

18 Somerset 2.indd 18

Contractor best practices would include a model that streamlines the process and minimizes the administrative burden asso ciated with routinely reviewing project status. The pain needs to be removed from the process to allow for project managers to do what they are good at, what they really like to do and what

Management

VP of Operations

Project Office

Contract Management

Contract Administration

Too often, construction companies give work away.

Financial Power Tool – Project Office Model

PM

PM

PM

PM

Management Information

he construction industr y is unique in many ways. One aspect that always comes to mind is that it is the only industr y that at any time a significant portion of the company’s assets (underbilling s), liabilities (overbilling s) and gross profit are based on “estimated costs” – that is, information or knowledge reported by “non-financial” personnel. Therefore, we have a situation where so much importance is based on proactive project management and reliable PROJECT OFFICE MODEL financial information coming from non-financial personnel. That can be a scar y thought. A company’s ability to acquire and update this information timely and accurately is critical to the success of any construction company.

Having streamlined, efficient and accurate systems and processes in place will provide for timely and accurate financials as well as early identification of project scope and other issues, minimize project fade and identif y the potential for change orders and other opportunities. Following are a few industr y best practices related to the integration of the financial aspect of project management.

PA

Accounting Department Controller

PM - Project Manager PA - Project Accountant

Illustration A 14/03/2011 10:54:46

management needs them to do – manage their projects. However, they must still participate in review and update of project status. Therefore, effective tools must be in place. Best practices over the years have been toward the Project Office Model (POM). The POM is designed to assist with project management. The POM consists of a team of Project Managers (PMs) working with a project accountant (PA) to efficiently complete the necessar y administrative functions of project management, thus allowing the project manager to focus on the job site. (Refer to Illustration A for a visualization of this concept.) The PA would be assigned to specific PMs. It is through relationship development that the PA and PMs form a team. The PA is in tune to the projects their team is working on, how costs should be coded, when progress billings can be prepared, what reports the project manager needs to review, etc. PMs should delegate any function that the PA can do and focus on what only he/she can do. This optimizes the cost/benefit of the PM position by minimizing the times a PM is performing clerical functions at his/her rate. PMs need to be more involved with the actual process of managing the progress of projects, relationship building with field employees and owners/customers and providing accurate, reliable information regarding the project’s status. We recognize this concept is one that may add additional overhead, however, conceptually the improvement in effective project management would offset the increased cost of employing such a model. Certainly, economies of scale come into play also. Regardless, all aspects of the processes that are comprised in the POM must exist for any contractor.

Effective Change Order Management

Too often, construction companies give work away. Contract managers and field super visors should review plans and specifications carefully and understand the importance of addressing any work not contemplated on these documents. Contract manag ers and field super visors should not perform any additional work without first obtaining formal approval. Making sure to identif y scope issues, and addressing them with the customer in a timely manner is key. This requires proactive and effective project management, and the proper tools (reports), reviewprocesses and oversight procedures must be followed and adhered to. Job status, cost variance and other reports should be reviewed at least monthly.

What is the impact of not passing through even a nominal change to a customer ? Let’s assume a project manager has identified a scope issue on a project that will require additional costs of $2,000. Due to the size of the project, customer relationship or other reasons, the project manager decides not to communicate the change with the customer and the company will absorb the cost. One way to look at the reality of the potential impact of such a situation is to consider a contractor that nets after all expenses a two percent net profit bottom line. For that same contractor to replace the forgone revenues on the potential change order, even if passed through to the customer at the contractor’s cost, it will take $100,000 of new work to recognize that same $2,000. Looking at the impact of change orders in this manner makes the evaluation of such decisions more critical.

Somerset 2.indd 19

Illustration B

Cash Flow and Margin

Complete work-in-process schedules should be reviewed by project manag ement and financial manag ement personnel at least monthly. These reports should be used to make sure that projects are billed to progress under percent complete with minimal underbilling s. Overbilling s and underbilling s are also often referred to as job borrow. Billing to progress or ahead (overbilling ) will indicate the contractor is billing at least to cover costs plus marg in, and theoretically the CONTR ACT OWNER is financing the project. Billing behind progress (underbilling ) is an indication that the contractor is billing less than incurred costs plus marg in ; therefore, the CONTR ACTOR is theoretically financing the project. (Refer to Illustration B for a typical example of what we should see in reg ards to billing s to revenues earned.)

Chang es in estimated project marg in should also be reviewed.

Any cumulative chang es in marg in of 10 percent or more should be deemed unusual and supported with a thoroug h explanation.

An increase in marg in or g ain mig ht indicate conser vative estimating . A decrease in marg in or fade mig ht indicate poor estimating or unforeseen job site conditions.

Tracking overbilling s and underbilling s and marg in fade and g ain by project manag er is a useful tool that should be used as a key performance metric for the project manag ement team (estimators, project manag ers, superintendents, etc.).

19 14/03/2011 10:54:49

by Kenneth J. Hedlund, CPA

T

he construction industry has been in a challenging operating environment, which has been impacting financial health and profitability since 2008 as a result of the severe economic slowdown and recession. Officially the recession is over and the economy is in recovery. However, the construction community continues to be challenged with less work, more competition and lower margins. As a result, “real time� assessment of the financial health of your construction company is as important as it has ever been.

Successful business owners are constantly evaluating the performance of their companies, comparing it with historical company figures and with industry peers. Business owners and managers must have the proper information to allow them to assess the profitability and cash flow of their businesses on a regular basis. After all, profit and cash flow are the true lifeblood of any business. To complete a thorough examination of your company's effectiveness, however, you need to look at more than just easily attainable num-

bers like sales, gross margin, net profit profits, assets, liabilities and equity. You must be able to read between the lines of your financial statements and make the seemingly inconsequential numbers accessible and comprehensible. This massive data overload can seem staggering. Fortunately, there are many time-tested, proven ratios that make the task less daunting.

Comparative ratio analysis helps you identif y and quantif y your company's strengths and weaknesses, evaluate its financial position and understand the risks you may be taking. The right combination and mix of ratios and other metrics with the proper assessment and analysis tell a story and provide essential information to manage toward success.

Information that should be considered includes performance benchmarks that measure business operations in terms of profitability, cash flow, overhead control, business development, project performance and staff performance and utilization. This information must be accumulated and reviewed on either a daily, weekly

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or monthly basis as appropriate. It must be provided timely, and a critical review should be performed in an effective and efficient manner. This information provided in a high level summary fashion is often referred to as a financial dashboard.

For a construction contractor, this type of information can take on many forms. It is important to note that both the bank and the bonding company will expect owners and managers of construction companies to utilize these tools for performance management and to have a good handle on the financial pulse of the organization. It is important to understand what the bank and surety are looking at and what their expectations will be.

Having the information is important. But making sure your team understands how to analyze the data is often the challenge.

Many construction company owners and managers are more wired to “ build projects” and may not have a strong understanding of financial statements, key financial ratios and other metrics that can help them better manage their businesses. Timeliness of the information is essential to allow for proactive assessment of the company’s position and to effectively implement a plan of action to improve profitability, liquidity, financial structure, leverage, etc. Although ratios report mostly on past performance, they can be predictive too, and provide lead indications of potential problem areas.

The initial step is to trend your company over a 4+ year period with key financial and operational ratios and other metrics.

Through trend analysis, you can identif y trends, good and bad, and adjust your business practices accordingly. Most if not all of these ratios and metrics can be calculated from year end financial statements and project work-in-process schedules. These should include key financial ratios that apply to any business type but also consider ratios that are unique and specific to the construction industry. In addition, if the company has an operating line or other credit, the specific ratios that are part of the required financial covenants should be included. Obtain industry data for each ratio, and benchmark your results to your peers. Industry data for contractors is readily available. But be wary of averages.

When was the last time you heard someone say they are happy to be average. Management should set goals and objectives to exceed averages and achieve upper-quartile, best-of-class results.

Following is an example of a Summary of Key Financial Ratios and other data that should be considered for a contractor: Balance Sheet • • • • • • • •

Current Ratio Working Capital Days Accounts Receivable Days Accounts Payable Net Over/Underbilling Debt to Equity Return on Equity Receivable/Payables

Contractor-Specific Ratios • • • • • • • •

Cash to Overbillings Underbillings to Equity Backlog Revenue Backlog Margin Months in Backlog Bonding Capacity Project Margin Fade/Gain Bonding Capacity

Specific Financial Information • • • • •

Cash Balance Receivables Balance Line of Credit Balance Payables Balance Equity Balance

Income Statement, as a Percent of Revenues • • •

Gross Profit Overhead Percent Net Profit

Other Key Data • • •

Cash Flow by Project 30-60-90 Day Cash Flow Projections Potential Project Pipeline

In addition to the financial information, ratios and performance benchmarks, there exists a significant population of other potential financial and performance ratios that can be measured by construction companies.

Financial trending/benchmarking has become critically more important during these tough times. Measuring key ratios helps firms identif y strengths and weaknesses for developing a plan to achieve dramatic performance improvement. We recommend that management identif y specific target achievement for all ratios. The company should further refine its marketing and business development plans, considering both internal and external variables, identif ying short-and long-term goals and developing a specific, identifiable and measurable action plan to obtain these objectives.

Finally, in an ideal world, this data could be assessed real time through an integrated accounting software program. Many systems already offer a management information dashboard that can be modified or developed through a report writing module.

Somerset has assisted many contractors with this dashboard development as well as benchmarking and strategic action plans for such a system.

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By Steve George, CPA

Background and Market Considerations

Today’s challenging bidding market demands unparalleled scrutiny on a company’s internal costing procedures, and more variation is seen in equipment bidding practices than in any other area of the construction market. Companies that have a keen sense of their true annual equipment pool costs seem to enjoy much more bidding success than other companies that take a ver y simplistic approach with bidding equipment or consider their equipment costs as part of their overhead structure. I have heard construction company owners state, “depreciation is not a cash cost, so why should I fig ure that into my true cost equation?” That thinking is short-sighted at best, and fig ures to make a big difference in a company’s long term success.

The old adage that you can manage what you measure is certainly true in the equipment arena, and that truth is evident over a long-term review of capital intensive contractors. The fact that best in class contractors continually monitor both their internal and external equipment costs is no coincidence. For the record, I have never seen one of these highly disciplined contractors intentionally omit equipment costs from a bid.

Equipment Costing Considerations

Equipment expenses generally fall into one of two categories – ownership and operating costs. Ownership costs consist of fixed expenses that do not var y according to the hours equipment is utilized. For example, depreciation, shop costs, property taxes, licenses and other similar costs are considered ownership costs. Operating costs consist of all other costs that var y based upon hours used.

Operating costs include fuel, maintenance and similar costs.

Casual (month-to -month) rentals of equipment should be 100 percent job costed. Equipment rented under operating leases should be included in the fleet of equipment pool costs and allo cated using appropriate hourly rates as if the company owned the equipment.

When fuel prices were ver y unstable two years ago, some so phisticated, equipment-intensive contractors used a flexible hourly equipment rate model that incorporated a fuel cost variable that was readily changeable as fuel prices spiked or dipped. This methodolog y proved ver y helpful in estimating and tracking job costs in a fluctuating fuel price market.

Best practices dictate pooling all such costs together to collectively measure a company’s true internal costs. In this way, a company can easily project its equipment cost structure and plan for appropriate costing. Here is an example of how a company might set up its equipment cost pool :

In the example above, $2,690,198 was charged to direct job costs, resulting in an over allocation of equipment costs totaling $233,144, or a five percent ROI. In the example, you can easily see by viewing the subtotals that if shop and other equipment costs were omitted from the equipment pool, the estimator in essence adds almost $673,000 to overhead costs.

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Hidden Equity?

If your equipment depreciation is calculated by using federal tax depreciation methods and lives (double declining balance method and five-year lives), your company could benefit greatly by switching to the straight line method combined with use of the economic lives and salvage values for financial reporting purposes. This can cut annual costs of depreciation in half or even more, depending on the type and use of your fleet. For example, new bulldozers and excavators generally have a 10-year economic life with a 10 to 15 percent salvage value if used in excavation work. Cranes have an even greater salvage value percentage due to the fact that they maintain such a high percentage of their value. The benefit of such change can have a two-fold impact: 1) By cutting annual costs, profits are improved; 2) a cumulative effect on equity can be realized, whereby fixed asset values are increased with a corresponding increase in shareholders’ equity.

By using economic life and salvage values where appropriate, a company achieves a greater matching of its revenue production and related costs of producing such revenues. Because depreciation is such a large percentage of the collective equipment costs, using economic lives creates a much better bidding price, which can result in more bids won when proper equipment costs are considered by all bidders.

Measuring/ Recording Utilization

Equipment Cost Management

We have seen creative rates used for company-owned equipment in order to reduce actual total equipment costs. For example, a heavy civil contractor may use a higher “idle” rate than operating rate, which forces its project managers to more firmly manage each project’s equipment needs. As project managers begin to realize the impact of the excess cost of mobilizing a bulldozer or track hoe one week earlier than needed, amazing corresponding decreases are seen in the company’s casual equipment rentals.

Without a full understanding of its true equipment pool annual costs, this subtle change would not be possible.

The more sophisticated the contractor becomes at cost allocation and moving toward bidding a project ’s contribution to net income, the more profitable that contractor will be over the long term.

In order to properly measure and job cost equipment, the company should implement a logical and cost effective way to track hours by piece of equipment, traditionally either by use of an operating hours meter or by using some other field reporting mechanism, like operator hours.

Companies should use collective annual hours totals from several recent years to project required internal hourly rates that will allow the company to achieve break even or have a reasonable return on investment in equipment. The calculated hourly rates are for costing purposes and are driven by many factors, including a comparison of rates to market for similar equipment. A general rule of thumb is that an internal rate might approximate 75 percent of the hourly rental (using monthly rental costs/standard monthly hours).

Considerations of Leasing vs. Buying

Both the administrative and operations aspects of the construction company must be considered before a decision to purchase or lease is ultimately made. On the administrative side, the structuring of an appropriately leveraged balance sheet should always be considered, especially as those that set accounting standards actively promote changes that will require operating leases to be recorded on the balance sheet starting sometime after 2012. On the operations side, by tracking hours annually, a company can decide if it should own equipment vs. lease the equipment by using inputs such as hours of use compared to the cost of renting the piece on an as-needed basis. Also of consideration is the ready availability of equipment on the rental market. The utilization hours can be an integral basis in evaluating whether to lease or buy equipment. At the end, all of the administrative and operations pros and cons must be considered on a cost/benefits basis to reach the best decision for the company, given its unique considerations and circumstances.

Equipment Fleet Needs Analysis

One question our firm is occasionally asked is, “how do I know how much equipment I should purchase annually?” It’s a great question, but it unfortunately is not asked frequently enough. Typically that question comes when a company has taken on too much debt Somerset 2.indd 23

in order to satisfy its equipment appetite, which probably means someone has told them they are acquiring too much iron. Here are a couple of easy rules of thumb for construction company leaders to use as a part of their equipment needs analysis. In a mature business (at least 10 to 15 years old) that uses economic lives and methods for its depreciation and for which revenues are relatively flat, annual capital expenditures should be about equal to annual depreciation expenses. That measure should be coupled with a calculation of net book value divided by original cost for equipment equal to 45 to 50 percent. If a company is expecting a decline in revenues, the ratio should decline slightly, which is generally accomplished by purchasing less equipment than the company incurs in annual depreciation costs. If a company is experiencing high growth, the ratio should show an increase; however, we rarely see a newness ratio exceed 55 percent for a mature contractor.

Other Types of Pooled Costs

Plant production costs for items like bituminous asphalt and concrete should be considered separately from equipment costs and pooled appropriately. Pricing on such matters is a separate issue, and modeling can be done in which the company makes an informed choice on its planned production with likely scenarios of projected production, so a contractor can figure its likely financial success of the plant, be it at estimated production or a better or worse-case scenario.

Other types of commodity rental costs can be estimated and costed effectively based on existing internal and external factors. For example, many companies that use a fleet of dump trucks as well as external truck rentals will use a factor of 90 to 100 percent of external rental rates to estimate its jobs, because of the uncertainty of whether owned or leased fleets will be utilized once project execution begins. Like equipment costing , the goal is to break even at least and, preferably, to obtain an appropriate return on investment.

Similar scenarios can be used for crane rentals or other similar items.

Summary & Wrap Up

When successful heavy equipment contractors bid on projects, they consistently bid using equipment hours. When the bid hours are projected annually and compared to the budgeted equipment expenses, a contractor has the ability to make an informed, knowledgeable choice about the company’s return on equipment investment. While there are many variables and moving parts in the annual equipment budgeting process and in an individual estimate, most of those variables smooth out over a period of time as long as the fleet is renewed at an appropriate rate and best practice estimating methods are used. The more sophisticated the contractor becomes at cost allocation and moving toward bidding a project’s contribution to net income, the more profitable that contractor will be over the long term.

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Financial

power tool$:

Contractor Tax-Saving and Deferral Strategies

Contractor Tax-Saving and Deferral Strategies We do not approach taxes as a compliance burden; we see a strategic opportunity.

Contractor tax-saving and deferral strategies is an area of special expertise at Somerset.

Contact us to uncover your tax savings. $ Transportation company

$ Prepaid expense deductions

$ Life LLC

$ R&D tax credits

$ Cost segregation studies

$ Energy tax deductions

and credits

$ Marketing/management

$ Retainage payable deferral

C corporation

$ Compensation, 401(k) balancing/

payroll tax minimizer

$ Contracts <10% complete $ Lookback interest reduction

$ Equipment leasing company $ Wealth transfer

$ Common & prevailing wage

benefit trust

$ Residential projects

$ Accounting methods

$ Off-road fuel tax credit

$ QPAD maximization

$ Alternative minimum tax (AMT)

reduction

The construction industry is unique.

Somerset understands it from the foundation up.

+

Š 2011 Somerset CPAs Somerset 2.indd 24

t Year s of Commitmen to Your Success

Ken Hedlund, CPA 317.472.2103 | KHedlund@SomersetCPAs.com

www.IndianaConstructionCPAs.com

14/03/2011 10:55:12

Are You Performing Contracts In Multiple States?

C

ontractors performing contracts in multiple states need to be aware of the Nexus requirements of state Departments of Revenue. Since many of the states in the country are hungry for additional revenue, looking at contractor activity could provide them with tax dollars. Below is a practical Question and Answer approach to multistate taxation for contractors: Question #1: How do I know if I am subject to tax in another state?

Answer #1: Each state has its own laws regarding the taxability of a contractor who is performing a contract in its state. The word used is Nexus.

Nexus is created in most states through physical presence in the state performing services through employees, agents and/or independent contractors.

Despite laws and regulations detailing these laws, there has been tremendous litigation in most states on when an out-of-state contractor is performing enough services to create Nexus, thus taxation.

Recommendation: Contact your CPA and/or attorney regarding the rules of the particular state. Be sure to contact your advisor when you are considering a proposal for work in that particular state. Your advisor can research the laws and related regulations as well as review court cases to find similar fact situations to yours. In order to bid successfully for work in another state, the tax costs related thereto should be determined so there are no surprises at the time of filing your out-of-state tax return.

Question #2: Assuming my advisor informs me that I have Nexus in the particular state, what do I do next?

Answer #2: You should have your advisor assist you in getting registered to do business in that state. Most states have registration requirements in order to legally do business in their state.

Recommendation: Notify your advisor immediately upon receiving an accepted bid on proposal work in the particular state for the very first time.

Such a notification will allow your advisor to assist you in planning to do business in the state rather than coming in after the fact and advise you what the consequences are of your actions in the state. Such an approach gives you the best opportunity to reduce your tax burden in the particular state.

Question #3: How do I determine my tax liability in a particular state once I am registered to do business in that state?

Answer #3: Most states have some type of apportionment approach to taxation in the particular state. The apportionment is typically some variation of property, payroll and sales. More and more states are more heavily weighting the sales factor. The above apportionment approach creates a fraction which represents a percentage of your taxable income in the state compared to total taxable income. Be sure to keep good records by job of the property, payroll and revenue related to each job by state.

Recommendation: Notify your advisor as soon as you are contemplating work in a particular state. If the first few contracts you perform in a particular state are loss leaders, it may be possible to make a special election to use actual accounting in that particular state. Absent such an election, the normal apportionment rules mentioned above will apply. Whether to consider such an actual accounting election in the state may depend upon the state tax rate for the state with the loss leader contracts compared to other state rates where

By Andrew J. Toth, CPA

contracts are being performed. With an apportionment approach, even if the job in the state is at a loss, tax will still be paid by the owners of the entity if the company was profitable on an overall basis during the year.

Question #4: If there are company employees performing services in a particular state on a contract in that state, what are the employer filing requirements related to that employee, if any?

Answer #4: Once an employee starts performing services in the particular state, most state governments want a piece of the employeeâ&#x20AC;&#x2122;s wages.

Technically, most states require the employer to withhold that particular state income tax from the employeeâ&#x20AC;&#x2122;s wage for services performed in that state.

Many states also have employer payroll taxes as well that must be paid by the employer related to the wages paid to the employee working in that state.

Recommendation: Contact your advisor to assist you in determining if the employer is required to withhold state income taxes from the employee wages. From a practical standpoint, many small business employers do not have the manpower to address the employee withholding issues in all of the states in which their employees perform services. Unfortunately, the Departments of Revenue of the various states in this country are hungry for revenue, thus such an argument may very well fall on deaf ears. Working with a national payroll service may be the best route to go in trying to comply with the employer state withholding requirements and employer payroll tax requirements for the particular states.

Question #5: After reading this article, what if I determine that I may have exposure for company income tax filing requirements and/or employee/employer tax filing requirements from prior years?

Answer #5: You need to contact the employee in your organization that is responsible for such tax filing matters. If you are that person, attempt to re-create the property, payroll and revenue by job and by state for each job to determine the magnitude of the potential exposure for each past year.

Recommendation: Contact your advisor immediately to assist you in the accumulation of information referenced above. Your advisor can assist you in determining if there is significant employer/employee tax liability in a particular state for a prior year. Often, we find that a combination of small levels of property, payroll or revenue in a particular state as a percentage of the total for the company, combined with low net income and low state income tax rates, creates minimal exposure to the employer in terms of dollars. That being said, if returns have never been filed in a particular state, then the statute of limitations for the Department of Revenue to examine your company and/ or the employee tax situation in the particular state never starts, thus never stops. Somerset is aware of companies being examined by state Departments of Revenue back as far as 10 years.

Summary As you can see from the Question and Answer section above, asking the right questions is critical to obtaining the right answers when it comes to determining if a particular state has the authority to subject you, your company and/or your employees to taxation. As all of the recommendations above indicate, getting a professional advisor to assist you as early in the process as possible can help to alleviate or at least minimize some of this exposure.

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By Rebecca Ogle, CPA

I

f you are like most, reading exposure drafts on proposed standards isn’t on the top of your “to do” list, not to mention responding to one. However, there are many recent developments you should be aware of that we will cover in this article. In June 2010, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued a joint exposure draft on Revenue Recognition ( Topic 605): Revenue from Contracts with Customers. The joint effort is one of many as the FASB and IASB work toward convergence of developing one set of uniform, global accounting standards.

While this article is technical, it will give you a good understanding of the impact these rules could have on your business.

The exposure draft, which can be found on the FASB website, FASB.org , was issued June 24, 2010, with comments due Octo ber 22, 2010. The exposure draft outlined changes to both the International Financial Reporting Standards (IFR S) and Generally Accepted Accounting Principles (GAAP). In IFR S, the proposed requirements would supersede IAS 18 and IAS 11 and related interpretations. In U.S. GAAP, the proposed requirements would supersede most of the requirements on revenue recognition in Accounting Standards Codification (ASC) Topic 605. Therefore, the expo sure draft would completely repeal Statement of Position (SOP) 81-1, so it caught the attention of most everyone in construction accounting familiar with this reference since it has been around for almost 30 years. The codification of GAAP gave SOP 81-1 a new reference, ASC Topic 605, but the theory remained the same.

If you know and love percent complete accounting , however it’s

referenced, you have probably read the exposure draft on Revenue Recognition and might have been one of the many to respond. In my almost 15 years of public accounting , I cannot remember this much flurry over a proposed standard. The flurry is for good reason. In reading the exposure draft, which can be found at FASB. org , I attempted to plot out how many different conclusions one could draw depending on how the contract was interpreted. The possibilities were many, and I began to wonder how a company would efficiently determine and how a CPA would effectively audit the variables and estimates that could be maintained within each contract. The estimated cost to complete will now just be one of many estimates if the exposure draft is passed as proposed.

As stated in the exposure draft, the proposed guidance specifies the principles that an entity would apply to report useful information about the amount, timing and uncertainty of revenue and cash flows arising from its contracts to provide goods or services to customers. In summary, the core principle would require an entity to recognize revenue to depict the transfer of goods or ser vices to customers in an amount that reflects the consideration that it receives, or expects to receive, in exchange for those goods or ser vices.

The core principle would require an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration that it receives, or expects to receive, in exchange for those goods or services.

The following steps are outlined in the exposure draft: IN9(a): Identif y the contract(s) with the customer. An entity would apply the proposed guidance to a single contract. However, an entity would account for two or more contacts together if the prices of those contracts are interdependent. Conversely, an en-

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tity would account for a single contract as two or more contracts if some goods or ser vices are priced independently of other goods or ser vices.

IN9(b): Identif y the separate performance obligations in the contract. A contract includes promises to provide goods or services to a customer. Those promises are called “performance obligations.” An entity would account for a performance obligation separately only if the promised good or ser vice is distinct. A good or ser vice is distinct if it is sold separately or if it could be sold separately because it has a distinct function and a distinct profit margin.

IN9(c): Determine the transaction price. The transaction price is the amount of consideration an entity expects to receive from the customer in exchange for transferring goods or ser vices.

The transaction price is readily determinable because the customer promises to pay a fixed amount of consideration and payment is made at or near the time of transfer. However, the amount of consideration can be variable and should then reflect the company’s probability weighted estimate of variable consideration (rebates, noncash consideration, penalties and other contingent amounts) in addition to the effects of the customer’s credit risk and the time value of money (if material).

IN9(d): Allocate the transaction price to the performance obligations. An entity would allocate the transaction price to all separate performance obligations in proportion to the stand-alone selling price (estimated if necessary) of the good or service underlying each performance obligation. The entity would update the transaction price over the life of the contract to reflect changes in circumstances and allocate changes in the transaction price to the separate performance obligations.

IN9(e): Recognize revenue when the entity satisfies each performance obligation. An entity would recognize revenue when it satisfies a performance obligation by transferring the promised good or ser vice to the customer, which is when the customer obtains control of the promised good or ser vice. The amount of revenue recognized is the amount allocated to that performance obligation as previously explained. A customer obtains control of a good or ser vice when the customer has the ability to direct the use of, and receive the benefit from, the good or ser vice. When the promised goods or ser vices underlying a separate performance obligation are transferred to a customer continuously, an entity would apply to the performance obligation one revenue recognition method that best depicts the transfer of goods or ser vice to the customer. Acceptable methods include an entity’s outputs or inputs and methods based on the passage of time.

The exposure draft also requires increased disclosure related to specific components used to apply the standard: Significant judgments – Entity shall disclose the judgments, and changes in judgments, made in applying the proposed guidance that significantly affect the determination of the amount and timing of revenue: • Determining the timing of satisfaction of performance obligations; and • Determining the transaction price and allocating it to performance obligations Timing of satisfaction of performance obligations – for performance obligations satisfied continuously, the following shall be disclosed: • The methods (inputs, outputs, passage of time) used to recognize revenue; and • An explanation of why such methods are a faithful depiction of the transfer of goods or services Determining transaction price and allocating it to performance obligations – information about the methods, inputs and assumptions used shall be disclosed: • To determine the transaction price • To estimate stand-alone selling prices of promised goods or services • To measure obligations for returns, refunds and other similar obligations • To measure the amount of any liability recognized for onerous performance obligations (including information about the discount rate) Performance obligations, contracts with original expected duration of more than one year – Disclose the amount of the transaction price allocated to the performance obligations remaining at the end of the reporting period that are expected to be satisfied in each of the following periods: • Not later than one year • Later than one year but not later than two years • Later than two years but not later than three years • Later than three years The comment period on the proposed revenue recognition standard ended on October 22, 2010. At the date of this writing, the effective date on the revenue recognition guidance has not yet been determined, but there are several projects under review by the FASB and IASB. The boards expect to issue several final standards in 2011 and plan to invite additional comments through a separate consultation about effective dates and transition methods for the joint projects. According to the projects tab at FASB.org, the Final Accounting Standards Updates is scheduled for second quarter of 2011. I attended the AICPA National Construction Conference in Phoenix from December 2 to 3, 2010. A representative of the FASB, Kenneth Bement, CPA, CMA, CFM, project manager, spoke at one of the general sessions. The title of his presentation was, “Revenue Recognition Initiative as It Relates to the Construction Industry.” Bement provided some insights as the FASB reviews the comments. He stated that one-third of the responses on the exposure draft were from the construction industry. He discussed the potential clarification for the definition of a construction project as a single contract unless segmenting was more meaningful. Bement also suggested a typical construction project usually results in continuous transfer, which is the determining factor of recognizing revenue as you perform the work (aka percent complete accounting ). The discussion about potential changes for the final standard left me hopeful that our clients will be able to use percent complete accounting for most contracts, and it will be straightforward to apply.

We will continue to follow these proposed rules and provide updates in our e-newsletter, Work in-Process. You may sign up to receive this information online by visiting the Newsletters page of our website – www.SomersetPros.com – or send an e-mail request to info@somersetcpas.com.

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Succession Planning for Contractors: Are Key Employees an Option?

M

by Kenneth J. Hedlund, CPA

ost business owners are continually focused the ongoing success of their organizations. They have made significant personal sacrifices and investment of time and capital. Their business typically represents the largest asset comprising their personal net worth, as well as their primary source of past and future earnings. One of the most important considerations for every business owner is to protect this asset in the short-term and maximize their overall return in the long-term on the eventual transfer or disposition of their ownership. To accomplish this, there needs to be a well-designed management transition and business succession plan.

There are many options for transferring the businessâ&#x20AC;&#x201D;including third party sale, merger, acquisition, employee stock option plan (ESOP), transfer or sale to family and others. All options and methods and the cost benefit of each should be considered. The focus of this article will be on consideration of a sale or transfer to key employees and a unique approach to do so.

Typically a core group of key employees have contributed to the success of the organization. These key employees have often been with the organization for many years, developed and maintained many key relationships and have the competencies necessary to maintain the continued success of the organization. Based on those facts, arenâ&#x20AC;&#x2122;t key employees a logical option for sale of the business?

A few of the challenges in the consideration of sale of the business to key

employees typically include lack of personal capital and financial wherewithal needed to purchase the company. In addition key employees often do not have the intestinal fortitude and have aversion to the risk associated with debt that may be required to transact a typical stock or asset sale.

These underlying circumstances typically cause many business owners to not even consider a sale to key employees as a viable option. However, there are creative approaches to effectively overcome these potential shortcomings.

To that end, we have helped many companies implement the use of setting up a new parallel company (Newco) to accomplish providing ownership to key employees. It is important to note that there are many considerations and details that need to be considered in such a plan, way too many to cover in this article. However, if structured appropriately, initial ownership of Newco can be provided for little or no initial investment or debt to the employees (See Illustration A). Newco will carry on the operations of the business. The original company (Oldco) will wind down operations over time subsequent to establishment of Newco. Eventually Oldco will only be left with cash and equity. Until Newco can stand on its own, Oldco will cross-collateralize equity and working capital to provide for banking and bonding needs. The key to make this all work from an economic perspective is that in return for Oldco providing equity and working capital and cross-collateralizing

A plan should cover the potential for a short-term solution in case of a catastrophe, as well as the more desired long-term option for a well planned out and logical transition.

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its working capital and net worth, an annual fee will be charged, often for a predefined term of typically 5 or more years, to Newco based on profitability. This annual fee can also be considered an â&#x20AC;&#x153;earn-out.â&#x20AC;? Even though Newco key employee owners obtain their ownership for little or no investment, they must perform and contribute to the success of the organization.

In theory they are providing sweat equity to satisfy the required earn-out amount that has been established. Once the predetermined earn-out has been successfully paid from Newco to Oldco and Newco has built the required equity to stand on its own, Oldco will no longer need to crosscollateralize equity and working capital for banking and bonding needs.

Illustration A

Key Employee Ownership Setting Up Separate Corp Oldco Ownership: Original Owner of Old Company

Newco Ownership: __% Old Company Owner (Individual) __% Key Employees

If done appropriately, this accomplishes the following: Oldco owners keep 100% of their ownership and cumulative equity in Oldco, including the earn-out fee that has been paid by Newco. Oldco and Newco owners share ratably by ownership in the remaining profits and equity of Newco.

In essence, Oldco owners keep the past equity and share in the future equity (see Illustrations B and C). The earn-out component that is structured as an annual fee is typically determined based on a market valuation of the company for the percentage ownership that is provided to the Newco owners.

Illustration B

Key Employee Ownership Setting Up Separate Corp Oldco Owner Equity

100% Old Owner

Oldco

Illustration C

Key Employee Ownership Setting Up Separate Corp Newco Owner Equity Newco

__% Employee Owners __% Old Owner

We have found that providing ownership to key employees in this manner is incentivizing and provides a high level of motivation. The key employee owners will think and act as owners.

Their incremental contribution to the organization based on each of their skill sets, or what often become expanded skill sets, increases success of the organization.

One of the key objectives of such a plan is that the profits increase, and the pie accordingly gets bigger. Often this will result in profit expansion versus dilution that could be anticipated in a pure mechanical calculation resulting from adding ownership. Another key benefit that is often realized is that Oldco owners will be able to rely on the key employee owners to do all the right things necessary to run the business. A valuable intangible of this is that the Oldco owners can have confidence the business is being run and, therefore, reduce the hours they would have had to otherwise be working in the business.

A primary objective of the plan is increasing wealth for all owners.

After a period of time, the key employee owners should develop increased wealth with their share of profits and equity in the organization. This can provide for overcoming what we mentioned earlier as one of the greatest challenges associated with a sale to key employees, that is creating the needed financial wherewithal and developing the necessary risk tolerance in order for the key employees to buy out the balance of the Oldco ownership at some time in the future. In effect, we have created another viable option as a potential exit vehicle for the Oldco owners that may not have existed otherwise. Also, implementing such a succession plan does not preclude from executing other potential business sale and exit options at some point (i.e., sale to a third party). In the design of the plan, it is important to leave all other options open.

It is important to note that there is complete flexibility in the design of such a strategy to meet the goals and objectives of the company owners and key employees. There are many financial and tax considerations to evaluate with such a strategy. In additional all the what-ifs need to be considered to protect the business in case all does not go according to plan.

Very thorough legal documents need to be prepared, typically including shareholder agreements, non-compete and employment agreements, etc.

As indicated earlier, there are many considerations and details that need to be considered in such a plan, way too many to cover in this article.

However, we have successfully implemented such plans and are happy to address any questions and assist with development of a succession plan for your company.

Finally, the importance of having a succession plan in place for not only ownership but continuity of management is critical. It is never too early to consider implementing a plan. A plan should cover the potential for a short-term solution in case of a catastrophe, as well as the more desired long-term option for a well planned out and logical transition. Great succession plans, such as the method outlined in this article, will take time to effect, typically 5 to as long as 10 years. Investing in developing such a plan will yield a significant return.

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Somerset's Construction & A/E Leadership Team KENNETH J. HEDLUND, CPA

317.472.2103 khedlund@somersetcpas.com Ken is the principal in charge of Somerset’s Construction & A/E Team and works closely with clients to meet their needs in the business management, audit and tax areas. Ken routinely consults with construction, architect and engineering clients on operational and efficiency issues.

Prior to joining the firm, Ken was involved in the running of a successful, closely-held business, and he effectively applies this experience to help clients make financial and operating decisions. He received his B.S. degree from Purdue University in 1982. Ken is a nationally recognized construction industry expert and speaks to numerous organizations and writes for industry publications on high-level management and operational issues specifically related to the construction and design industries. Ken is a member of the Indiana Construction Roundtable’s Mentor-Protégé Advisory Board. In 2008, Ken was named “Outstanding CPA in Public Practice” by the Indiana CPA Society. He is an officer of the Finance Council of the Archdiocese of Indianapolis ser ving as President. He is also an officer on the Executive Board of the Indianapolis Parks Foundation ser ving as Treasurer. Ken was the founding Executive Committee Chairman of the BDO Seidman Alliance’s Construction Industry Group and the Construction Accounting Network and is currently Chair of the Business Development/Value-Add Committee. Ken is a member of the Indiana CPA Society, American Institute of CPAs, Construction Financial Management Association, Indiana Subcontractors Association, American Institute of Architects and American Council of Engineering Companies.

JAY A. FELLER, CPA

317.472.2139 jfeller@somersetcpas.com Jay is a principal in our Tax Team. He joined our firm in 1991 and led our Tax Team for many years. Jay has been instrumental in Somerset’s growth over the last 19 years. He specializes in several tax areas, with particular expertise in partnership and subchapter S corporation taxation. Jay has also led several tax initiatives within the firm in expanding the tax practice in employee benefits, trust and estate, international as well as state and local taxation strategies, planning and compliance. He has been a speaker for the Indiana Bar Association’s ICLEF series, Associated Builders & Contractors of Indiana, BDO Seidman Alliance Construction Industr y Group and Construction Financial Management Association. In 2008, Jay was recognized as a Corporate Tax Super CPA by the Indiana CPA Society. Jay graduated magna cum laude from Butler University with high honors in accounting in 1983. He is a member of the Indiana CPA Society and the American Institute of CPAs.

REBECCA L. OGLE, CPA

317.472.2111 rogle@somersetcpas.com Rebecca joined Somerset CPAs in 1999 and is the assurance principal in our Construction & A/E Team. She provides clients with audit and accounting expertise that she has gained during her years in public accounting. Rebecca also specializes in offering clients recommendations to improve operational efficiencies. She received her B.A. degree in accounting and a minor in business and graduated cum laude from Franklin College in 1996. Rebecca is a 2003 graduate of the Stanley K. Lacy LEAD program. In recognition of her contribution and dedication to the CPA profession, she received the “Five Under 35” Award from the Indiana CPA Society in 2006. In 2008, Rebecca was recognized as a Super CPA by the Indiana CPA Society. Rebecca is an active member of the Indiana Subcontractors Association, the Construction Financial Management Association, the Indiana CPA Society and the American Institute of CPAs.

CHRISTOPHER J. MAYFIELD, CPA 317.472.2116 cmayfield@somersetcpas.com

Chris is a senior manager in Somerset’s Construction & A/E Team. He joined Somerset in 2001 with over 12 years of experience in the private sector as the controller for an engineering firm. Chris effectively applies this experience to help clients make financial and operating decisions. He has significant experience with INDOT and FARs overhead rate audits. Chris earned his B.S. degree in accounting from the Indiana University Kelley School of Business. He is on the Board of Directors of the American Council of Engineering Companies Indiana.

In 2007, Chris received the Sagamore of ACEC Indiana Award, which is awarded annually to a person who has helped elevate the engineering profession, created goodwill toward ACEC or the profession, advanced the cause of engineers and their issues and is not a practicing engineer. He is Somerset’s team leader for the Rebuilding Together Indiana annual event. Chris is a member in good standing with the American Institute of Architects, American Institute of CPAs and Indiana CPA Society.

STEVEN J. GEORGE, CPA

317.472.2722 sgeorge@somersetcpas.com

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Steve is a senior manager in the Somerset CPAs Construction & A/E Team. Prior to joining Somerset in 2007, Steve gained over 15 years of extensive experience providing consulting , tax and audit/accounting ser vices to general and specialty trade contractors. His extensive experience with many types of construction contractors and in-depth knowledge of heavy/highway contractors are invaluable resources in helping his clients implement best-in-class practices in both finance and operations. Steve’s career includes working for regional and national CPA and consulting firms and a Fortune 500 company as an auditor and accountant. Steve was ranked an Indianapolis 2009 Five Star Wealth Manager in Accounting. Steve graduated from Indiana University School of Business with a Bachelor of Science degree in accounting. Steve has been active in the construction community for many years. He is on the Finance Committee of the Indiana Construction Association and is active in its Leadership Development Committee. Steve has ser ved two terms as secretar y for the Construction Financial Management Asso ciation and has previously ser ved as assistant treasurer for the former Indiana Constructors, Inc. He also ser ved as a Financial Advisor to the Trustees of the Associated Builders & Contractors Apprenticeship Trust. Steve is a member in good standing of the Surety Association of Indiana, National Utility Contractors Association of Indiana, American Institute of Certified Public Accountants and the Indiana CPA Society.

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Associated Construction Publications and Somerset CPAs Construction & A/E Team invite you to participate in our webinar series.

Thursday, September 22, 2011 Strategic Bidding for Equipment-Intensive Contractors Thursday, October 27, 2011 Management Continuity and Succession for Contractors: Are Key Employees an Option?

Thursday, December 1, 2011 Year-End Tax Strategies for Contractors Thursday, January 12, 2012 Economic, Banking and Surety Update Thursday, February 16, 2012 Permanent vs. Temporary Labor Impact on Bottom Line and Human Resource Strategies

For details and registration, visit www.Somerset-Team.com Somerset 2.indd 31

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