Operating Leverage and Break-Even Analysis for Contractors: The Construction Industry Is Vulnerable during Recessions. Competition Limits Price and Cost Flexibility, and the Construction Cycle Is Volatile. Both Borrower and Banker Should Understand and Employ Operating Leverage and Break-Even Analysis to Quantify the Risk

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Economic cycles are a fact of life in the construction business, and those who are successful pay a hefty tuition in this industry's school of hard knocks. After all, as Confucius said, he who does not economize will have to agonize. This article discusses why profits are so volatile in construction and what must be managed in order to break even.

Formula for Distres

The great American unionist Samuel Gompers warned that the worst crime against working people is a company that fails to operate at a profit. We working bankers learned early in our accounting and finance classes that profit is the difference between revenue and expense, and the surefire way to improve profit is to increase revenue and/or decrease expense:

Revenue--Expense = Profit

Increased revenue--Decreased expense = Higher profit

Boosting revenue and cutting expense is easier for some than for others, especially in the construction field. Consider the two variables that drive revenue: price per unit and quantity of units:

Total revenue = Price per unit x Quantity of units

Ambrose Bierce's The Devil's Dictionary defined price as value plus a reasonable sum for the wear and tear of conscience in demanding it. In good conscience, a contractor could raise prices, but the highly competitive nature of construction means that other hungry contractors are likely to match or undercut the contractor's construction prices. Worse, the industry is further restricted in price flexibility by the use of fixed-price contracts, and the typical contractor wins a construction contract only by bidding the lowest possible price. Adjusting prices on a current contract is constricted by the change-order process--basically, modifying the original contract's price--so boosting prices is not a feasible strategy for a contractor competing for work in a fixed-price bidding environment.

Ben Franklin warned to "beware of little expenses; a small leak will sink a great ship." Construction can add up to a boatload of costs, but reducing them is not easy. Let's try, anyway, by stating the obvious--that total costs are the product of cost per unit and quantity of units:

Total costs = Cost per unit x Quantity of units

To win a bid with the lowest price, the contractor usually has to minimize costs. So how can the contractor reduce costs any lower than the minimum?

The contractor's fixed-price bidding environment substantially reduces both the price and cost flexibility that other businesses have in the traditional profit strategy. Neither price nor cost is easily changed, so the contractor's strategy choices are limited to ensuring that the contract price is maintained and that costs are contained. In effect, with a tacit ceiling on revenue and a floor on costs, the contractor's odds of increasing a job's profit are far less than the odds of the job's profit being reduced because of unexpected costs.

On top of the price and cost limits, contractors must survive the construction industry's cyclicality. The construction cycle is extremely volatile from year to year, and generating enough revenue to break even is even harder when sales are unpredictable from one year to the next. Let's look at some measures that quantify the volatility and break-even for contractors. How much will changes in sales impact profits, and how much revenue is needed to break even?

Operating Leverage

Operating leverage measures the impact of changes in sales on profits. All things being equal, if sales rise 10%, how much will profits increase? If a 10% increase in sales results in a 25% rise in profits, that is an operating leverage of 2.5x.

However, financial gravity can be painful because a 2.5x operating leverage means that a 10% decline in sales would reduce profits by 25%. Worse, companies doing business in industries characterized by both high operating leverage and volatile sales will be vulnerable to erratic profits. …