CONTROL PROFIT FADE TO BOOST BONDING CAPACITY

As economic growth has given way to recession, obtaining performance bonds at attractive rates has become more challenging. So it’s critical for contractors not only to understand what bonding companies are looking for, but also to avoid profit fade as much as possible.

The key to obtaining surety bonds is understanding how underwriters analyze construction companies. Before going through the process, a construction firm should take the time to request specific information from the surety regarding its underwriting criteria and evaluation process. In general, bonding companies are looking for the "Three Cs": Capability, Character, and Creditworthiness.

The contractor’s financial statements are the critical component, of course, but sureties are also interested in the firm’s work-in-process and completed contract schedules. The work-in-process schedule helps the underwriter determine whether overbillings and underbillings are reasonable and appropriate and whether estimated profits are reasonable based on industry standards.

Meeting or exceeding industry benchmarks gives you an advantage. Consistency over time is also important. Sureties typically review the last three to five years of completed contract schedules and compare them to work-in-process schedules to determine whether your firm suffers from profit fade. Profit fade occurs when estimated gross profit from a job declines as the job progresses. Causes of profit fade include poor estimating on the front end of the job or poor execution and unforeseen problems toward the end of the project.

Sureties are keenly interested in a contractor’s estimating abilities. Accurate estimating helps eliminate wide swings in project profitability. A demonstrated ability to avoid profit fade gives a contractor greater credibility with sureties, which means better rates on performance bonds.

Here are some tips for avoiding profit fade:

• Be conservative. Rising profits toward the end of a job are preferable to profit fade, even if the net result is the same. Aggressive estimates up front may come back to haunt you if you consistently ratchet down net profits at the end of each job. Note: It’s also important to avoid significant profit "gains" at the end of jobs. Although bonding companies prefer conservative assessments of gross profit, they also want those assessments to be realistic.
• Avoid adjusting costs downward until the job is at least 60 percent complete. If you’re able to purchase materials at a discount, for example, don’t reduce your estimate right away. Keeping some of this gain in your "back pocket" may protect you against fluctuating labor costs (but major cost savings should be reflected earlier).
• Avoid job borrowing. Sureties will check to see if you’re pre-billing some jobs (for cash flow purposes) to compensate for profit fade on others. This generally raises a red flag.

Note that sureties analyze profit trends based on type of work, type of contract, project manager, and estimator. A contractor can plan more effectively by looking at data the same way. Is your firm better with residential or commercial work as opposed to civil or municipal jobs? Have you had greater success and margins with cost-plus contracts than fixed-price contracts? Do particular project managers or estimators have poor records? Sureties drill down for this type of detail and respond accordingly.

Understanding what surety companies are looking for is an important first step. Nobody likes surprises. Avoiding profit fade will not only improve your overall business management, it will also go a long way toward building trust with sureties and helping you achieve the best rates for performance bonds.