Marc Newman is a CPA and partner at Anchin, Block & Anchin of New York, where he co-chairs the Construction Services Group. His e-mail address is marc.newman@anchin.com.

Benchmarking Can Enhance Company Performance

Keeping an eye on financial and operational benchmarks – and creating a system that encourages employees to help meet them – can help a construction business stay ahead of the curve.

by Marc Newman

Construction company owners and managers know first-hand the challenges they face in today’s competitive market.

Dun & Bradstreet reports that more than 10,000 U.S. construction firms fail every year. And while contractors face a variety of threats, most failures result from “poor operational execution” rather than bad strategy or external pressures, according to a 2005 report by Ken Roper and Michael McLin of FMI Corp., a construction consultant based in Raleigh, N.C.

A proven way for construction company owners to manage such risks is by paying constant attention to a variety of benchmarks, both financial and operational.  Monitoring financial statement ratios and key performance indicators can greatly reduce a company’s risk of failure by serving as an early warning system for operational deficiencies that, if left unchecked, can cripple a business. And such controls should be applied not only at the company level, but also at the project and employee levels.

What are the key benchmarks for your company? While the answer depends on the nature of your business and on your particular circumstances, in most cases traditional financial statement ratios can be a valuable tool for assessing your financial condition and comparing it to other companies in your industry, as well as your own past performance.

Benchmarking data is available from the Construction Financial Management Association, local trade associations, and other construction industry resources. CFMA’s Construction Industry Annual Survey, for example, provides a variety of financial statistics, broken down by industry sector and by region, including 20 financial ratios that measure profitability, liquidity, efficiency, and leverage.

Some of the ratios include:

• Working capital turnover, which is revenue divided by working capital. This liquidity ratio tells you how much revenue that each dollar of working capital generates, a higher number generally demonstrating strength. But a very high ratio may signal that your working capital is stretched too thin and that you will need more to support future growth. In CFMA’s 2005 survey, the national average working capital turnover was 13.5, while the average for best-in-class firms was 15.1.

• Return on assets, which is net earnings divided by total assets. ROA is a profitability ratio that tells you how effectively your company is using its assets. In general, the higher the ratio, the better. In CFMA’s 2005 survey, the national average ROA was 5.2%, while the average for best-in-class firms was 11.3%.

By tracking these and other relevant financial ratios, you can see how your company stacks up against the best performers and identify opportunities for improvement. For the most useful comparison, be sure to examine data for your company’s sector and region.

Key performance indicators, or KPIs, can be a valuable complement to traditional financial statement ratios because they also encompass nonfinancial factors. And KPIs focus on the unique attributes of the construction industry. 

In its 2005 white paper, FMI and Microsoft Business Solutions examined KPIs used by “best-of-class” contractors – those in the top 25% in profitability and return on investment. The authors identified KPIs in four critical areas: liquidity; schedule variance; backlog; and work-in-process, which includes indicators measuring margin variance, project cash flow, unapproved change orders, and committed costs.

The FMI paper also outlines a “scorecard indicator,” which weighs qualitative “success factors,” such as leadership, employee morale, and client satisfaction.

These tools are not meant for a static audit. Just as regular medical checkups enable you to flag potential health problems, monitoring KPIs and financial ratios lets you keep a finger on the pulse of your business and take quick corrective action if needed.

Consider change orders. Accumulating costs on unapproved change orders represents a significant financial risk, and the longer the condition persists, the more difficult it is to treat. But a simple KPI can alert you to problems.

Dividing the total costs incurred on unapproved change orders by total forecasted gross margin tells you the percentage of your margin that’s at risk. Monitoring this figure – paying special attention to positive or negative trends – allows you to correct weaknesses in change-order management practices before the problem spirals out of control.

One other important point is that while financial ratios and KPIs offer an early warning, they don’t always reveal the underlying cause of problems. You need to dig beneath the numbers to discover these factors.

For instance, if unapproved change orders are rising, perhaps your project managers are being less than diligent in following change-order procedures. If your liquidity ratios are weakening or your cash flow is diminished, there may have been a breakdown in your invoice submission and follow-up practices.

A key to addressing these root problems is to align compensation with your business strategy. Most business processes that drive performance are within the control of project managers and other employees, so an incentive compensation system tied to financial ratios and KPIs can have a positive impact.

Effective incentives vary from company to company, but in designing a compensation plan, keep in mind that there are many ways to measure an employee’s work output or results. Identify the strategies you hope to promote, then design a compensation plan to reward the behavior that will help you achieve your goals.

Also, make the incentives specific, achievable, measurable, and easy to understand. Incentives are effective when employees understand what’s expected of them and feel that their goals are achievable. “Improving cash flow,” for example, is probably too vague. “Submitting invoices within three business days after the end of the billing period,” on the other hand, is a clear goal that is realistic and readily measured.

One of the best ways to establish appropriate goals is to involve employees in the design of your incentive program.

To further motivate employees, make incentive payments frequently. If they see results quickly, they will identify the rewards with the behavior you’re trying to promote.

And of course, monitor your program. Track the results and communicate regularly with employees to determine whether your incentive program is having an impact, and make adjustments as needed.