CPA: How Contractors Can Protect Their Margins During Volatile Times

By Brian Kassalen of Baker Tilly

The significant uptick of construction materials and equipment costs continue to outpace inflation. Margins are tightening, and tariffs remain in an area of great uncertainty. Contractors are feeling more costing inflationary pressures, and labor shortages continue to increase. When you factor in recent international events of a geopolitical nature, the pressure only intensifies.

As a result, most construction contractors are closely watching their margins and looking at all ways to mitigate risk. Sureties are also looking closely at contractor earnings outlooks and the strength of their balance sheets. Any time profitability starts to go down and working capital starts to be minimized, sureties get nervous. However, general contractors can zero in on several key areas to mitigate risk.

Change Orders

Change orders are one area to focus on that directly affects profitability. If work is performed outside the original scope of work without a change order, it creates legal and payment risk. In fact, most contracts require written approval before starting with changing work. On the plus side, change orders may create additional revenue opportunities for contractors if labor and material markups are favorable. But change orders also take time to process, resulting in delayed payments or even interrupted workflow and crew assignments. Contractors can protect themselves by establishing a change order process to expedite changes, ensuring new orders are documented in writing by all parties.

Subcontractors

Subcontractors are also an area to watch. With the current market conditions, the risk of subcontractors defaulting is increasing. General contractors (GCs) can mitigate this risk by selecting subcontractors who are prequalified by evaluating the subcontractors’ financial stability, experience and track record, safety records, legal and compliance, and personnel capacity. To assess or prequalify subs in these areas, GCs can use questionnaires or third-party platforms. GCs should consider requirements for subcontractor bonds.

Once the subcontractors are in place, GCs need to ensure they are communicating with the subs and project owners, making sure they are ahead of any potential issues. If they are notified early of issues like scope gaps, sequencing conflicts or material shortages, they can more easily address them before they become a larger problem.

Contracts and Their Provisions

Contractors can also protect margins by protecting themselves from price escalation of materials and labor by ensuring contracts have escalation clauses or cost adjustment provisions. These allow the contract price to be adjusted if material or labor increases beyond a pre-defined percentage. If it is a time and materials contract, it is a lot easier for contractors because they are paying specifically for time and materials.

A time and materials contract may be viewed as less risk, but a good balance of different types of contracts may be preferred by credit providers. Lump sum contracts are the riskiest type of contract because they require delivery of a defined scope for a fixed price, and the owner is largely insulated from cost risk once the contract is signed, unless change orders are issued that adjust the contract price. On the other hand, Guaranteed Maximum Price (GMP) structures are considered more favorable for contractors because they share the risk more equitably.

Materials

When it comes to raw material cost increases, GCs may protect their margins with advance buying and buyer diversification. This is especially true during turbulent markets affected by tariffs. With advance buying of materials, contractors can lock in pricing. Advance buying may be easier for larger contractors who have more capital to work with and area to store materials like lumber, steel or copper wire.

Buyer diversification ensures contractors are not relying on one source for materials. Contractors can diversify based on geography, and different manufacturers or distributors. With supplier diversification, contractors have a back-up in place if their primary supplier cannot deliver an advance purchase commitment. Of course, contractors must maintain relationships with multiple suppliers at once for diversification to work. The time contractors start to run short on materials is not the time to find new suppliers.

Profit Fade

Contractors should also be on alert for “job fade,” which occurs when the projected gross profit on a project declines over time compared to the original estimate. As costs rise or productivity falls, the expected margin on the job can gradually erode. Repeated instances of job fade may indicate estimating inaccuracies or project management issues, and they can prompt questions about whether similar problems may exist on other projects. To reduce the risk of job fade, contractors should regularly review project financials, compare actual costs against estimates and investigate any early signs that projected margins are beginning to shrink.

Communications

When it comes to protecting contractor margins, clear communication is crucial in all areas. In general, as the size of the project increases, the more communication is key between contractors and the surety team. Sureties may request monthly internal financial states from the contractors and more frequent informal conversations. Communication is also critical between the GC and project manager, as well as the subcontractors.

Scaled Growth

Contractors should also be careful that they do not grow too quickly without adequate resources in place. It is a fallacy to think that a $30 million contractor that grows into a $60 million contractor will automatically make twice the profit. Contractors need the right systems in place to help scale their growth. This means having the right labor, project management team, finance team, and a strong back-office.

AI Opportunities

One area that continues to shine in the industry is the gradual integration of artificial intelligence (AI) and real-time data dashboards. Whether it is AI integration into the bid analysis or leveraging technology to give estimators better pricing, the field is slowly starting to change.

We are now seeing better use or existing technology to manage people and projects, including AI-assisted scheduling, daily reporting, and documentation. From a cash management perspective, AI can also be used to forecast payment timing and material purchases and help monitor the financial status of subcontractors. Robotic Process Automation is now easing the burden of back-office workflows and paperwork. We are also seeing an increase in robotics and automation on job sites.

While larger contractors are more likely to have the financial means to invest in AI and related technologies like predictive analytics, we expect the AI investment cost to continue to decrease in the next few years as return on investment increases. As these sophisticated technologies continue to make inroads in the construction industry, more doors will open for contractors seeking innovative ways to protect their margins during volatile times.

Brian Kassalen is a Principal and Construction Industry Leader of Baker Tilly. He has been in public accounting since 1998 and leads a team of professionals who provide audit, tax, and advisory services to clients in the real estate and construction industries. Kassalen provides leadership and strategic direction in areas of growth and team member development to the firm’s construction-focused partners and team members. He can be reached at [email protected] or 724.658.1565.