The Virtual CFO

Six Requirements for Successfully Budgeting Projects for Construction Company Managers

Below are the six requirements for construction company management to successfully implement construction project budgeting:

1. Support from the Owner and/or Top Management
2. Project Managers Understanding How Budgets Can Benefit Them
3. Authority to Take or Suggest Corrective Action When Needed
4. People Skills
5. Negotiating Skills
6. Understanding of the Type of Work Your Firm Performs

Over the next few post I will discuss these six requirements further.

Three Goals of Budgeting for Construction Projects

Below are the three goals for budgeting individual construction projects.

1. Maximize the Profit for the Project - This is the primary goal of budgeting for individual construction projects.
2. Monitor the Progress of the Project – Budgeting allows you to monitor the progress of a project objectively. This is done by variance reporting that compares the actual expenses incurred by the project versus the budgeted expenses.
3. Create a Database of Historical Data to be used for Future Estimates, Bids, and Budgets – The end product of budgeting for projects is completed project variance reports that show how well the job was estimated, bid, and budgeted. This information can be used to improve future estimates, bids, and budgets.

The Difference between an Estimate and a Budget

The definitions below show the subtle difference between an estimate and a budget.

• Estimate - To produce a statement of the approximate cost of (Merriam-Webster Online, http://www.m-w.com/dictionary/estimate)
• Budget - A plan expressed in quantitative, usually monetary, terms that covers a specific period of time (Accounting Text & Cases, Anthony, Hawkins, and Merchant, Twelfth Edition, page 697)

An estimate is a statement of the expected revenue and expenses for a construction project. A budget is a plan of how the construction company is going to reach these expectations.

At this point, you may be asking yourself "why not use the project manager’s estimate or bid as the budget for the project". In a perfect world, the bid or estimate prepared by the project manager could be used as the budget for the project. However, we don’t live in a perfect world and in many cases the estimate does not accurately reflect the actual financial performance of the project.

This is why it is imperative that you create a budget for all of the projects your company is awarded. Your firm’s owners, project managers, and financial managers must sit down and objectively estimate what the costs are going to be for the project before the project starts.

Individual Construction Projects Must Stand on Their Own

When I say that an individual construction project must stand on its own, I mean that the project must be profitable and generate enough cash flow to pay its expenses as they come due.

This is opposed to construction companies that bid against the competition in an attempt to win every job they bid. In this situation, the contractor hopes that more of the projects they win make a profit than those that loss money. I affectionately call this the "crap shoot" bidding strategy.

I know that you can only go so far making project cash flows stand on their own because of timing issues between cash disbursements and receipts. For example, there are projects where all of the materials are purchased and delivered to the job site prior to the project’s start date. Often, the contractor must pay for the materials before they can bill the owner for the materials. In situations like this, it is virtually impossible to have the project’s cash flow stand its own.

However, budgeting individual projects and understanding each individual project’s cash flow needs will you allow you to better understand and manage your company’s cash flow during periods where the project’s cash flow does not stand on its own.

Why Budget Construction Projects? The Bottom Line

One bad job can cripple or kill a company.

This is the bottom line as to why construction companies need to implement budgeting for individual projects.

At the recent Tennessee Society of CPAs Construction Conference, one of speakers discussed how construction companies have the second highest failure rate of all businesses according to Small Business Administration (SBA) statistics (restaurants were number one). It would be safe to say that a large number of these failures were a result of jobs whose expenses were far greater than expected.

Off the top of my head, I can name three construction companies in middle Tennessee that have gone out of business because of projects that experienced severe costs overruns.

When you budget individual projects and use historical variance information in future job estimates and bids, you lower the chances that your company’s projects will experience major costs overruns.

If done correctly, budgeting for construction projects will enable each individual project to stand on its own.

The Normal Budgeting Process will not Work in the Construction Industry

The normal budgeting process will not work at a construction company because construction company’s are project driven. Therefore, budgeting construction company expected performance must start at the project level.

Under the assumptions I am using in this blog series ("Revised Assumptions for the Construction Project Budgeting Series"), a construction company has no control of the quantity of, quality of, size of, gross contract amount of the projects that are available at any given time in a competitive bid environment.

Additionally, the number of construction projects that are available for bid tends to run in cycles. This means that you will have periods where there is little or no work to bid on and there will be times when there are a large number of projects available.

Put another way, a construction company has no control over the number of projects it can bid or the number of projects it will be awarded in a competitively bid environment.

This is why it is imperative that construction company’s adopt project budgeting.

Review of the Normal Budgeting Process

I want to quickly review the normal budgeting process before moving on to budgeting for construction projects. (For more detailed information concerning the normal budgeting process, see the blog series I wrote last year entitled "Budgeting for Small Business")

Below are the steps in the normal budgeting process:

1. Sales Revenue Budget – the sales manager creates this budget based on his expectations for the coming year.
2. Production Budget – this budget is typically created by the production manager who estimates what the production related costs will be to support the sales revenue budget.
3. General and Administrative Budget – is the overhead budget that is typically negotiated between the company’s various departments.
4. Capital Expenditure Budget – is the capital expenditures the managers feel are necessary in the coming year.
5. Interest and Tax Budget – is calculated after the first four steps in the budget process are completed.
6. Cash Flow Budget – is the final step in the budgeting process that shows the positive/negative cash flows that will be generated from the budgeted revenue and expenses.

I have been responsible for or participated in the normal budgeting process at several non-construction companies. At each of these firms, the budgeting process was a large negotiation that involved sales, production, and administration. At one company, the final budget that was adopted was the 11th version of the budget. By the time we got to the 11th version, each of the six budgets described above had been changed multiple times.

The normal budgeting process will not work in construction project budgeting. In my next post I will explain why this is the case.

Perspective of the Construction Project Budgeting Series

I am taking a 10,000 foot view of construction project budgeting as I write this blog series. It is not going to be a "how-to" series but rather an overview of what is necessary to successfully implement project budgeting at a construction company.

This blog series is based on a presentation I recently made at the Tennessee Society of CPAs Construction Conference. I developed this presentation by asking myself, "what advice would I give someone concerning budgeting for projects at a construction company who was unfamiliar with the process".

To do this, I will be addressing the two major aspects that affect project budgeting: (1) the organizational and managerial considerations, and (2) functional project budgeting techniques.

Revised Assumptions for the Construction Project Budgeting Series

On September 5th, I blogged about the one assumption I was making in this series (Why Budget Projects? Assumption in this Series). While preparing for my construction project budgeting presentation at the Tennessee Society of CPAs Construction Conference last week, I added two more assumptions.

Here are the revised assumptions I am making in the project budgeting series:

1. A Majority of the Work is Individual Projects that are Competitively Bid. There are construction companies whose business model is based around routine and regular work, such as an annual installation and maintenance contracts with utility companies. In situations such as this, normal budgeting techniques can be used. For companies whose business model is based on individual projects that are competitively bid, it is wise to implement budgeting for individual projects.
2. Project Manager Compensation is Directly Tied to The Financial Performance of Their Projects. For budgeting for construction projects to be successful, the project manager must have "skin in the game" so that his income is directly tied to the financial performance of the projects. Budgeting is less likely to be accepted and supported by project managers if their compensation is only salary or based on the performance of the entire organization.
3. All Work is Estimated/Bid to Make a Profit. This is opposed to construction companies who attempt to win all of the jobs they bid. Under this scenario, the company is hoping that more of the projects make money than lose money. I like to call this bidding strategy "crap shoot bidding".

By making these assumptions, it is easier to explain the budgeting process for individual projects than trying to address all of the various scenarios that can occur in the construction industry outside of these assumptions.