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FMI Quarterly/September 2013/September 1, 2013

Volume Kills, Profit Thrills

workingplans27_imageWhen Dr. Emol Fails founded FMI in 1963, his mission was to find ways to “improve the profitability of the U.S. construction industry.” One of his first discoveries was that contractors defined success differently than most other businesspeople. Almost universally, contractors focused on accumulating a large top line (volume) on their financial statement as opposed to concentrating on establishing a large bottom line (profit).

So “Doc” set out to convince the construction industry that focusing on price structure and profit margin enhancement was a more productive business strategy than simply adding volume in ever-increasing amounts.

“VOLUME IS KING” PERSISTS

During the 60 years since then, many companies have converted their thinking to Doc’s once-revolutionary concept of doing less volume for more profit. But the volume-is-king mentality still persists throughout much of the construction industry. When asked how the business is doing, today’s typical contractor responds by quoting sales volume or backlog figures. Rarely are profit margins or changes in profitability used to express the state of the business. Most construction companies are still driven by the idea that bigger is better.

The reality of the industry is quite different. It is very common for the profitability of a construction firm to increase during a year when volume decreases. The question is, Why?

INFLUENCING PROFITABILITY

Clearly, lower volume can result in a variety of factors that influence profitability, including the following:

  • More intensive management applied to each project
  • Elimination of marginal employees
  • Focus on types of work in which the firm is most skilled
  • Enhanced productivity
  • More efficient application of resources
  • More work with long-time customers
  • Lower overhead expenses
  • Less time spent managing a tenuous cash flow
  • Less demand for fixed asset purchases

These factors, especially when added together, can result in significantly higher profit margins — large enough to more than offset a decline in volume. Although management intuitively understands how and why this phenomenon works, there nevertheless remains an irresistible urge to secure more work — unfortunately, at prices that allow for little or no profit.

One of the primary motivations in the pursuit of higher volume is a strong desire to “keep the organization together.” A company’s current team has been hired, trained and developed at considerable expense and effort. Decimating the ranks by cutting back is neither pleasant to contemplate nor to carry out. However, inaction can mean that all employees will ultimately lose their jobs if the firm can no longer stay in business.

OVERHEAD CAN BE CUT

Another reason for seeking increased volume is to cover overhead. There is a definite perception among contractors that their overhead expenses are unique and can’t be cut by another dollar. The reality is that all overhead items are variable and can be adjusted to fit the realities of the marketplace at any point in time. One of the keys to being profitable is to be the most efficient provider of service, including overhead expenses.

THE SURETY DILEMMA

There are also external factors that lead a construction company to seek more volume. Most contractors erroneously define their capacity to perform work solely by the amount of bonding credit that is extended to them. A common complaint is that not enough credit is extended on their behalf, and too much credit is granted to their undercapitalized, underqualified competitors. Unfortunately, the surety industry is plagued by competitive pressures to respond
to requests for larger and larger bond lines.

A better approach is for a company to determine a realistic business volume by asking its surety company for the amount of credit it will extend without personal guarantees. This figure represents a closer approximation of the volume of business that should be pursued.

RISKY BUSINESS

The relentless quest for volume has turned the construction industry into a risky investment arena. Average returns on equity for the larger firms in the industry are less than 19% — and with risks that are often unacceptably high and uncontrollable. These low returns on already-low equity bases are the result of small to nonexistent profit margins, which, in turn, are due to an oversupply of construction capacity compared to the available supply of construction projects.

The good news is that after 60 years of applying the theories of “Doc” Fails, we are seeing an increasing number of contractors adopt the philosophy that less is more, that profits are more important than volume, and that survival is based on establishing an equity base that can endure inevitable financial reversals.

We’ve learned a lot in 60 years. And we firmly believe that a primary strategy for the industry over the next 60 years should be to do less volume, but to do it more profitably. Remember: Volume kills, profit thrills.


Hugh Rice is a senior chairman at FMI Corporation. He can be reached at 303.398.7223 or via email at hrice@fminet.com.

 

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