You’re looking at a project. It seems like it’s going great. The project manager tells you that the gross margin is 15%. But, when the project hits 90% completion, the gross margin suddenly plummets. Sound familiar?
You’re not alone. Unfortunately, this scenario is all too common. So, what gives? And how can you stop gross margin slippage from happening?
In this article, I’ll share:
- Factors that cause gross margin slippage
- Red flags to look out for
- How to monitor project health
- How to ask the right questions to your team
3 Main Reasons Your Construction Projects Have Gross Margin Slippage
Gross margin is one of the most important metrics for construction finance teams to monitor. It represents a project’s gross profit as a percentage of the total contract value. For example, if a contract value is $100K and the total project costs are $85K, the gross margin is 15%.
When gross margin slips, it’s because the projected costs and the actual costs are different.
Most of the time, this gross margin slippage is attributed to one thing: The people involved in the project aren’t on the same page. Either they weren’t in agreement on project costs to begin with or they didn’t communicate with each other as to when project costs changed.
There are a few specific reasons for this lack of alignment.
Reason 1: Inaccurate materials estimates
Sometimes, the project estimator misses a component or prices the wrong specifications. This results in an inaccurate estimate. If you’re using a bad estimate to build the project budget, you start off basing your gross margin on a lower set of costs. As the team uncovers additional costs, those costs eat away at your gross margin.
Reason 2: No transparency for field teams
Surprisingly, many companies don’t want field teams to know what the gross margin or contract value is. This lack of transparency can create significant issues. At a minimum, field team leaders need to know how many labor hours are in the budget and what the labor rate is. And they need to agree that the hours and rate are reasonable. Otherwise, they can go way over on labor and quickly gobble up your gross margin.
Reason 3: Poor time projections
Labor costs start with time projections. Time can be a hard thing to accurately estimate, but getting it wrong can create major profit issues.
Let’s say you’re building a high-rise apartment building and the team allocated 20 hours per unit. After the first few units, it turns out it’s actually taking 40 hours per unit. To catch issues like this, you need a process to validate time estimates early and then proactively address any issues you identify.
3 Red Flags That Indicate Gross Margin Slippage
Even if all of your projects are plagued by inaccurate estimates, lack of transparency, and poor time projects, there’s still hope of catching and correcting gross margin slippage—if you know what signs to look for.
You can detect inaccurate gross margins and monitor for slippage by watching for the following:
- Gross margins that don’t fluctuate
- Schedule changes
- Overtime hours
Red Flag 1: Gross margin stays the same every month
If the gross margin on a project stays the same every single month, it’s an indication that the data reported to the financial team is not up-to-date or accurate.
PMs get more information about a project each month, like how many hours were billed, which materials were purchased, or if any change orders were agreed to. This results in the gross margin fluctuating up or down as those changes are reported. If a task went faster than previously agreed to, the margin should go up. If a purchase order had more costs than anticipated, the margin should go down.
If you’re not seeing these minor changes throughout the project, get with the PM and find out why. Otherwise, you can almost certainly expect a sudden upswing or downswing nearing the end of a project.
Red Flag 2: Schedule slippage
We all know that projects are almost never completed on time. Longer schedules mean increased labor wages, materials cost inflation, and more.
When you’re looking at financial projections, compare the originally scheduled completion date to the newly scheduled completion date. If a project is running over the timeline but the gross margin is staying the same, ask how this is possible. Were the costs passed onto the GC or was the gross margin not updated to reflect the increased costs?
Red Flag 3: Unplanned overtime hours on a job
If a PM lets the general foreman work all the overtime hours they want, the project can easily rack up an additional six figures in labor costs. And you can wind up with a negative gross margin.
When you see overtime hours on a job, ask if they were planned and accounted for in the estimate. If not, those extra hours are eating into the gross margin. Find out why there is unplanned overtime and work to mitigate it.
Questions to Prevent Gross Margin Slippage
When you see these red flags come up, you want to be proactive about getting more accurate data from the project team.
Consider these questions:
- How much labor was done for the job? Did this match what we expected?
- Are we doing earned value tracking? What adjustments do we need to make?
- Is this overtime accounted for in the project estimate? How are we covering for the unplanned overtime? Why are we doing this overtime?
- Did we notify the GC that we’re off-schedule?
- Are we legally protected if this is a huge overage?
- Is the GC covering additional general conditions?
- Will there be inefficiencies due to a compressed schedule?
If you get everyone together and you ask the right questions, you have a better chance to proactively identify and correct issues.
Get Everyone on the Same Page to Avoid Gross Margin Slippage
The best prevention is to get everyone—field teams, project teams, and finance teams—to agree on gross margin from the beginning. This means getting everyone to agree that they can build the job for X dollars. To do this, you need a solid, standardized kickoff process and shared tools to create transparency.
Construction billing software, like Siteline, can go a long way toward preventing gross margin slippage. It creates billing transparency across organizations and reduces back-and-forth communications by 50%. Everyone from the PM to the CFO can see what’s happening with every project. Plus, Siteline makes it easy to adjust project projections by entering a few key pieces of information. It saves time, reduces errors, and helps trade contractors get paid faster.
If you want more control over your company’s financial health, check Siteline out today.
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