6 Reasons Profit Fade
6 Reasons for Profit Fade
By Wesley Middleton
Profit fade. This is a situation that your bonding agent doesn’t want to see. Company owners and controllers seldom use this tool, despite the fact that it can be very effective in identifying situations and issues inside your company. Preparing a fade analysis on a regular basis can help identify trends that may warrant further investigation.
What is a fade analysis? In a very general sense, it is simply a comparison of your original estimated gross margin on a job to your actual progression throughout the construction period to completion. Generally, a fade of 10% or more will result in a call from your bonding agent with questions about why it is happening. The more variability in your contract over time, the more of a risk you appear to be to your bonding agent, and the less confidence they have in your ability to estimate and manage jobs.
A Note on Fade/Gain Calculations: Avoiding a Common Error
If you have an estimated profit of 2% and your profit drops to 0%, then technically you have a 100% profit fade. The calculation should be a percentage change of a percentage, rather than the difference between 2 percentages. Let’s look at another example: If your 2% gross margin represented $1 million and the job broke even, then you’d want an explanation of the 100% profit fade. The current schedule would only show a 2% fade.
Sources of Contract Fade
When preparing a fade analysis, it is important to break it down by project manager, estimator, category of construction work, or other categories that may exist in your company. This can further isolate the cause of the contract fade. Here are six important reasons that you may be experiencing contract fade:
- An estimator who is not competent at estimating jobs and is too optimistic in his estimates, or aggressive bidding by an estimator who is struggling to win contracts.
- Change orders that are unprofitable or simply have not been approved and recorded in the accounting system.
- An under-performing project manager who is not effective in managing the costs and people on the job.
- Jobs that are outside the company’s expertise, resulting in a learning curve that causes additional costs or job delays.
- The accounting department is not coding job costs to the correct job. Having the project manager and estimator review and approve the final job costs will help in this area.
- Cost shifting, otherwise known as fraud. It can be in the accounting department or from the project manager. The project manager could be shifting costs from one job to another to cover up the fraud, or the accounting clerk could be doing the same thing. Either way, the same review process in #5 above would help prevent this from happening.
Seeing the Better Picture
Comparing the total actual costs to the estimated costs simply isn’t enough. Seeing the change in gross margin from year to year adds an additional level of analysis. A well-planned deception of systematically “shifting” job costs from one contract to another between periods may not be detected by only comparing estimated costs to actual. Preparation of the fade analysis is better supported by a well-prepared WIP or contract schedule.
For a basic contract fade analysis template, click here. (link to: http://www.middletonraines.com/contract-profit-fade-analysis-download)
“Wesley Middleton is the Managing Partner at MiddletonRaines+Zapata, LLP, a leading Houston-based CPA firm offering a full suite of accounting, tax, audit, and consulting services to the small and middle markets.” email@example.com
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