How is it possible that construction concerns being run by professional managers in the 21st century often run out of cash and suddenly cease operations? Most modern industrial companies have heads-up enough to file a bankruptcy and ask the court to help them work out their problems. Suddenly ceasing operations to the surprise of subs, vendors, clients, and even company top management seems to be confined to the construction industry (and small floating crap games). Why?
The Unique Nature of Construction
The unique nature of the construction business is, as they say, "the fly in the ointment".
"Construction is a multi-layered endless symphony of independent sub-contractors playing out a complex composition over many months in a highly competitive market marked by a volatile cost environment and a variety of competing stakeholders." You may want to read that again.
Wow! Under those circumstances, trying to keep track of how profitable, multiple partially completed jobs are at any one time, and trying to determine the cost to complete each job is almost impossible. That's why construction companies sometimes suddenly run out of cash.
An Approximation Based on Two Guesses
Trying to determine the exact percentage of completion of a construction project in progress is like pinpointing the exact location of a moving train.
WIP reporting by its very nature is an estimate based on two other estimates: first, the original estimate for the project and second, the estimate of the percentage of work completed at a given point in time. In addition, the process relies on accurate field reporting, which is problematic because accurate means precise and an estimate is an opinion. This inherent lack of precision in WIP financial accounting becomes even more dangerous when you realize that WIP can represent 50% or more of annual reported profits on year-end financial statements, so mistakes can mislead contractors into believing they are profitable even if they are not.
The Science of Statistics
As a consultant to construction companies and a professor of construction management, I studied thousands of construction financial statements and determined that industry-wide profits were on average overstated by more than one percent, a significant amount when you consider that profits were already slim. The research on five years of financial statements compared the profit on every project in progress when first reported in a year-end financial statement, to the profit reported on the year-end statement when the same project was a completed project. For the thousands of statements studied, the combined final profits were over a precent less than reported on interim statements, which I refer to as “net profit bleed”.