Managing the Risk of Profit Potential
Monday, October 1, 2018
Posted by: Hilary Korabik
Managing the Risk of Profit Potential
by Laura Cataldo, Baker Tilly, LLP
Do you remember the lovable children’s cartoon character Bob the Builder? His signature yellow hard hat and red toolbox are as recognizable as his famous saying, “Can we build it? YES WE CAN!” When presented with a project opportunity, many contractors quickly respond with enthusiasm like Bob’s before thoroughly considering whether taking on the project makes sense for their business.
A former professor at Arizona State University, Thomas C. Schleifer, PhD, wrote, “Many construction professionals believe they can design or build anything. The pertinent question is, can we build or design it at a profit. Construction isn’t that hard. Construction at a profit is.”1
Being awarded the project often leads to the famous adage, “The good news is we won the project, but the bad news is we won the project.” Fortunately, there is a better way to weigh projects that balances the excitement and optimism of a win with the practical need to make a profit.
When in a tough situation like this, many organizations apply a go/no-go test to assess the viability of a potential project, using criteria such as:
- Prior experience/relationship with client
- Geographic location
- Payment history
- Other likely bidders
However, this test does not include a risk assessment of profit potential. If profit potential is not already a measure in your business development efforts, consider including a risk matrix into the discussion before saying yes to the next opportunity.
This classic risk matrix is an effective tool for examining a project’s potential success.
There are many criteria that can impact project profitability, however, the four most important criteria relate to how well the project aligns with your previous project success:
- Project size
- Project type
- Geographic area
- Project owner
Here is an example of how to use the matrix to evaluate the potential risk of a new opportunity:
A design/build contractor is asked to bid on constructing a new 60,000 square foot, $7.5 million shopping complex in a nearby Chicagoland suburb. The majority of the contractor’s project experience is negotiated high-end multi-family housing construction (average project size of $3.5 million) with an area developer, who is the driving force behind the new complex. This is a perfect win-win opportunity for both the client and the company. Now it is time for the company to ask itself, can we build it? Before saying yes, it is important to evaluate the risk.
To evaluate the four aforementioned critical experience criteria that compare profitability at risk, use the risk matrix. Based on the previously described scenario, project size and type are the two key criteria to consider because they differ from the contractor’s experience.
Project size: In volume, this opportunity is almost double the contractor’s average project size. A standard rule is to consider a project high risk if it is more than 10 percent larger than past profitable projects. The key word here is profitable. A project twice as large as past profitable experience is high risk.
Project type: This project is not comparable to the type of work the company has profitably completed in the past.
Without profitable experience with projects of comparable size and kind of work, this project has a high risk of being unsuccessful, or highly unprofitable.
Using the same example as above but changing the project size to $4 million (closer to the 10% acceptable increase) and you see a considerably different analysis. With the change in the project size, it is now much lower in risk and other factors, such as relationship with the owner, project complexity and available resources (manpower, equipment, etc.) can be taken into consideration when making the go/no-go decision.
While you should consider many factors when pursuing a project, evaluating the risk of the four critical experience criteria should be part of the process. It is always exciting to think about new opportunities for your company, but be sure to keep Tom Schleifer’s advice in the back of your mind and don’t consider whether or not you can build it, but if you can build it at a profit.
“Can we build it?” Maybe.
About the author
Laura Cataldo is a senior manager with Baker Tilly, specializing in work with construction companies. She has experience in evaluating business practices and assisting with management challenges in construction-related firms of all sizes. Laura can be reached at email@example.com.