Business functions across the gamut are tied to financial statement results: everything from hiring, equipment purchases, salaries/bonus, financial credit, to surety credit. For this reason, many of the risk factors in the category “Accounting Procedures” have high importance for contractors. We could easily make the case that financial statements have (or at least should have) the greatest influence on a company’s decision making.  

The Risk Victim
Conway Remodeling, Inc. (CRI) is a relatively young contractor who has been in business for six years. CRI has historically performed 80% residential and 20% commercial remodeling. Commercial projects are relatively small and almost never consist of more than two or three units of an office building.

During the most recent year, CRI took an opportunity to perform a large commercial project. Instead of the common two or three unit remodel, CRI was in charge of remodeling an entire five story office building. Since the commercial work was more sizable, management felt the carpentry work, which was typically subcontracted out, could be self-performed.  Using historical financial statements, management determined that the carpentry could be performed at a profit.

The Risk Impact
CRI’s management relied on their historical financial statements to make a decision, which is usually a good practice; decisions should be made by gathering the most information available.  However, just because a company has prepared financial statements does not guarantee that the information is accurate. The financial data could be of poor quality and relying on incorrect financial data is just as bad as guessing.

As is the case with many small contractors, CRI did not allocate some indirect costs to projects or to their labor burden rate.  Instead, the costs were kept as General and Administrative because they were not believed to be significant.  When management determined carpentry would be profitable, they used financial statements that didn’t properly allocate workers’ compensation premium to each project. Thus, they didn’t realize that the carpentry work would add significant costs and was not as lucrative as expected. If management had the correct labor burden rates and allocated costs correctly, they would have determined the margin was too small and continued to subcontract out carpentry.

The Lesson
As CRI’s workers’ compensation insurance policy came to a close, the insurance carrier came in for a final audit to determine the audit premium. Overall revenue had grown only slightly, so CRI expected the audit premium to be rather small. However, there was a fundamental change in the structure of CRI’s operations. Almost twice as much in wages was paid as a result of self-performing the carpentry work. Thus, workers’ compensation insurance was going to be twice as expensive and this would all be reflected on the final audit. CRI was shocked to learn that their audit premium for workers’ compensation was $30,000 and, as standard, was due in 30 days.

We mentioned that financial statements are the linchpin for decisions throughout the entire company. In addition to performing the carpentry work, CRI had made several other bad decisions based on the financial statements. Additional labor was hired, not enough cash was banked to cover the audit premium, slightly higher Christmas bonuses were paid to reflect what appeared to be a good year, and more commercial jobs were bid using the estimates from the last job.

In the above exhibit, CRI would have made a better decision if they used high quality financial data. By installing two controls, CRI could have had high quality financial statements:

1. Performing a monthly insurance audit: The monthly audit makes adjustments to the premium in order to reflect the year-to-date difference in estimated and actual wages. 
2. Use approprate labor burden rates: If CRI’s accounting system tied the indirect cost of workers compensation to wages paid, the calculations used to estimate profit margin would have signaled management to subcontract out the carpentry work. 

If both controls were in place, either would have sent off a red flag early in the project, or even before the project was bid. Unfortunately,  many contractors don’t install these controls until they are burned the first time.  

We can’t overstress the importance of controlling your “Accounting Procedure” risk factors. Our Free Construction Business Analysis reflects this same level of importance. Many contractors who perform a Business Analysis expect to score very high. However, they often receive lower than expected scores due to weak accounting procedures. Strengthening the business practices that control accounting procedures will have a large impact on decision making and help ensure that more earned revenue is sent directly to net profit.

This weeks Case ‘n Point looks at the question on all our minds, “Is risk management doing its job?” Our real-world example isn’t based on just one story. We’ve encountered this scenario so many times that we’ve provided the quintessential example. As always, the names have been changed to protect the innocent parties.

The certificate of insurance description box must read: “Jake’s General Contracting is named as general liability additional insured.”

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THIS CERTIFICATE IS ISSUED AS A MATTER OF INFORMATION ONLY AND CONFERS NO RIGHTS UPON THE CERTIFICATE HOLDER. THIS CERTIFICATE DOES NOT AMEND, EXTEND OR ALTER THE COVERAGE AFFORDED BY THE POLICIES BELOW.

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If the certificate holder is an ADDITIONAL INSURED,  the policy(ies) must be endorsed. A statement on this certificate does not confer rights to the certificate holder in lieu of such endorsement(s).

The Risk Victim
Xcavator Inc has been in operation for just under a decade. Its strong reputation places it on top of local GCs’ calling lists when excavation and grading work is needed. Unfortunately, management is a bit closed-minded to installing risk control procedures.  Xcavator Inc has been lucky during its last few years of growth and has grown a little cavalier, mostly due to effects of the success paradox. But all games of Russian Roulette must come to an end.

The Risk Impact
While grading for a public works project, Xcavator Inc hired a third-party to off haul dirt from the construction site. The expense for off hauling dirt wasn’t part of the original contract, but Xcavator received a verbal change order from the public agency’s construction manager to incur the extra cost.

The bill for off hauling came to $20,000 and Xcavator Inc added the additional expense to its next invoice. But the public angency rejected the extra cost, stating that it hadn’t approved the change order. Xcavator Inc tried to produce a valid change request, but since the order was verbal, none could be produced. And to compound matters, the construction manager who had given that verbal order was no longer with the agency.

The Lesson
Faced to absorb the $20,000 expense, Xcavator Inc management set out to lay blame. Ultimately, the superintendent had blame for ordering the hauling company to begin work. With proper controls, there should have been at least two responsible parties: the superintendent making a request and the project manager approving the request.  Lack of a written change request should have been a red flag for one or the other responsible parties. This weakness would have been uncovered by the MyRiskControl system during a review of the Contract Non-compliance risk factor.

This story helps illustrate how Enterprise Risk Management shadows its own success. Xcavator Inc learned a hard lesson. Whether it begins to get serious about installing risk controls has yet to be seen. But even if it does, the reward for installing controls after a disaster is greatly reduced. However, if the controls were in place from day 1, we would never know the value Enterprise Risk Management can have.