You’ve heard the phrase “What happens in Vegas, stays in Vegas,” but our recent presentation on Construction Enterprise Risk Management is too important to leave behind. For the many contractors not at the conference, we’ve got you covered. David Druml sat down to record his speech for the blog.

David Druml had two goals for the talk:

1. Present a simple, clear introduction of ERM for beginners
2. Provide easy, actionable steps for contractors who feel the ERM process is not within reach.

If you find yourself in either of these groups, I encourage you to watch the video and take action.

Now, risk awareness is easy. With a free MyRiskControl account, you and all your employees can begin to read about the many risk factors that may affect your operations and can take simple steps to strengthen and secure your company.

The 13th Annual AGC/CFMA Construction Financial Management Conference was held on October 22nd and 23rd at Caesar’s Palace in Las Vegas, Nevada. The conference provides “programs and workshops designed specifically for financial professionals in the construction industry“. The hour long session was presented along side David Allison CPA, Construction Practice Leader at CBIZ & Mayor Hoffman McCann P.C.

1. Negotiate with the RATE, not PREMIUM

Contractors are very busy and like to get right to the point. “What’s it going to cost me?”  Cost translates directly into premium.  However, the smarter question would be, “What is my rate?”

RATE

Negotiating with the RATE places the contractor in a better position. For example, ABC Contractor Inc. performs 10% more work than last year. The insurance carrier explains that the 10% PREMIUM increase is entirely due to the increased business. That makes sense. However, contractors strive for continued savings. A larger EXPOSURE usually means your can negotiate a lower RATE. Ignore the PREMIUM when negotiating insurance and focus on lowering the RATE.

2. Compare the RATE Year-to-Year

Be careful. Although the RATE is a better number for comparison from year-to-year, it can also be affected by LIMITS, COVERAGE, CLASS, and LOSS HISTORY.

LIMITS

Lowering LIMITS and COVERAGE may leave a company exposed. In our Business Analysis, one of the risk factors examined is “Ignoring Insurance Needs”. When money is tight, contractors often fall into the trap of reducing or canceling coverage altogether. Every reduction can cause a gap. The small savings today may result in a large expense down the road. LIMITS and COVERAGE should be analyzed on a needs basis and not a price basis.

3. Be Prepared for the Final Audit

At the end of the policy period, most liability policies will have a final audit to adjust the estimated EXPOSURE with the actual EXPOSURE.

AUDIT PREMIUM

Final audits can cause a great deal of heartache. If a contractor hasn’t been properly accruing insurance expense, what was a good year could turn sour when the AUDIT PREMIUM hits. Inaccurate insurance accrual is identified by the risk factor “Inaccurate Accounting.” AUDIT PREMIUM shouldn’t be a slap in the face. During the entire year, the accounting manager can determine the expected price of the AUDIT PREMIUM by comparing overall revenue to the estimated EXPOSURE. This was the subject of a recent Case ‘n Point article.

In reverse, the MINIMUM EARNED PREMIUM is designed to catch overestimating. Contractors may try to reduce the RATE by increasing their EXPOSURE (i.e. estimate $25 million, lock in a low RATE, then end the year with only $15 million in sales). However, insurance carriers have placed MINIMUM EARNED PREMIUM conditions in the insuring agreement to avoid this type of gaming. Avoid making optimistic estimates as the consequence will hit harder than the savings.

Final Thoughts
Insurance renews once a year. Since you can’t be an expert, brush up on the details when your renewal comes around so you can speak to your broker with confidence, and ensure they are getting you the best deal possible.  In summary, we’ve provided three quick tips you should incorporate into your insurance purchasing process:

1. Negotiate with the RATE, not PREMIUM
2. Compare the RATE Year-to-Year
3. Prepare for the Final Audit

and 1 more for good measure…

4. Don’t leave renewals to the last minute.  Talk to your broker at least 30 days before renewal to ensure he is working in your best interest and has scoured the market for the best deal.

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.

With respect to business, a risk factor is defined as an activity, practice or condition that can cause financial harm. Risk factors vary by industry.  For example, smoking is a risk factor in the medical world, specifically related to the health of an individual. It does not apply to a construction business. Likewise, failing to have a job cost system in place is a risk factor related to a construction business, but certainly is not a risk to an individual. Risk factors are also different across businesses. A risk factor related to overstocking perishables in a restaurant due to poor inventory control does not apply to construction. Poor humidity control is a risk factor in a flower shop but not in a restaurant.

As you can imagine, there are many different types of risk factors and for the most part they are specific to an industry.  Some risk factors are really important because the harm they can cause is great.  Other risk factors are of lesser importance because the harm they can cause is not so great, thus having a smaller impact. To actually determine the impact a risk factor can have (its importance), takes years of case study. But suffice it to say, importance varies.

What also varies is a contractor’s perception of the importance of various risk factors. Interestingly, the risk factors that a contractor usually thinks are important are the ones which it has experienced. While those the contractor thinks are unimportant are the ones it has yet to experience, and some of those can actually be very important.

Focus on Expertise

Now a case in point:

The particular contractor I mentioned at the beginning of this article was a General Contractor (the word “was” is telling). One of the risk factors he determined was of no consequence is taking on new types of work without prior experience. Another was estimating without historical data. In the months to come, this contractor decided that it could make more money by doing the rough carpentry work (framing) of buildings by itself rather than using subcontractors.

In California, there are separate companies that do framing and that is all they do. It is very competitive and the cost is simply driven on how fast carpenters can put lumber in place. This GC proceeded to bid three large school projects. Now it had done schools before, but never the framing. I personally advised against the approach indicating that the estimating staff did not have experience bidding framing work, that the estimating staff did not have any historical information on hand to rely upon, that the personnel were not in place to do the framing, and that the company had no prior experience doing the work. Well, this particular contractor looked at themselves as a risk taker. Indeed they were. The net result was as follows:

1. The contractor couldn’t man the jobs with experienced tradesmen.
2. The tradesmen they did hire ended up quitting because the quality of the work was so awful.
3. The agency made them do the work over because it was so shabby.
4. The union ended up picketing the sites because the GC was taking on framing work as a non-union contractor
5. The estimating department did not anticipate the rising cost of lumber because they were not connected into the framing world and did not know that dramatic increases were coming; thus they paid much more for lumber than budgeted
6. The estimated amount of labor hours was insufficient.
7. On one of the three jobs they had to ask another framer to step in to do the work because they could not put together the resources; the framer charged much more than what the GC had in its original bid.
8. All of the jobs were severely delayed resulting in liquidated damages and preventing one of the schools from opening on time for the fall classes enraging parents against the Agency.
9. The contractors money was held by each Agency for damages.
10. The contractor could not meet financial obligations.
11. The General Contractor finished the jobs, then dissolved and did not pay the subs and suppliers and did not have financial resources to go back to do punch list items or repairs.
12. The bonding company stepped in to pay subs and suppliers left hanging and to complete punch list and repair work.
13. The contractor went out of business. Game over.

This particular GC was in business for over seven years and had been quite successful. However,  GCs work on very tight margins. The contractor could ill afford to lose large money on the framing, but they did, and it cost them their business. That was all based upon risk factors that the contractor did not consider of importance.

Contract Review

Let’s look at another case in point:

A contractor performed steady work in a niche market and historically made good money, however it didn’t have a contract review procedure in place. In fact, this contractor had signed a contract without having reviewed it completely and was unaware of the insurance requirements. One of the requirements was for $5MM of pollution coverage, but the contractor only had $1MM in place. The contract was for repair of 450 balconies on a 40-story apartment complex. It had done this type of work on large structures before, but never for a building that did not have air conditioning.

During the summer months it became unusually hot while work was underway and many of the 450 residents had to keep their windows open because of the stifling heat, even while the contractor was chipping and grinding out the old concrete that needed repair. Concrete dust invariably drifted into some of the apartments. Simultaneously, the owner had given notice of eviction to a lawyer. To get back at the owner, he banded a bunch of the residents of the apartments together convincing them of great rewards, and proceeded to file a lawsuit against the owner for allowing cancer causing silica dust to harm the health of all of the residents. Since a lot of the residents were old, having little funds, and had little to do with their time, they had nothing to do but listen to an evicted attorney. Once the thought of cancer causing dust was put in their minds, even the invisible bothered them.

During that time, one of the residents who had chronic respiratory problems was hospitalized even though work was not being performed at the time near her apartment. This just fueled the claim that all the residents were being exposed to a major health hazard, even though open windows were being covered with a filter cloth. Unfortunately, the court approved the suit as a class action with all 450 residents represented. The owner in turn tendered the suit to the contractor only to find out that the contractor did not have $5MM of pollution coverage in place as called for in the contract. The contractor had no choice but to reject the tender and the owner began to pick up the attorney’s fees to defend itself.

Well, since the owner’s counsel was sure that they would ultimately recover the attorney’s fees from the insurance carrier, they showed up at every meeting and at every appearance with a fleet of staff attorneys, no less than four each time. The attorney’s fees for the owner went through the roof. Since the owner did not know if its own insurance carrier would even cover the fees or whether the contractor’s insurance carrier would eventually be forced to do so, the owner began to withhold large sums of money from the contractor’s payments. As a result, the contractor’s cash flow was severely impacted. The attorney’s fees grew to over five hundred thousand dollars and it surely looked as if the $1MM coverage limit would be exceeded. With little other options, the Contractor began making plans for a new company.

During this time, another risk factor came into play, one that contractors often pay little attention to, namely, computer backup. The contractor had a backup system in place for its server, but it wasn’t being checked. Well, the server went down. No problem, call the computer guy it fixed., right? Well, it wasn’t that simple, the hard drive had crashed. No problem, get another drive up and running and use the backup to restore it. Big problem, there wasn’t a procedure in place to check that backups were running properly and a backup had not run properly for almost a year.

The computer consultant tried to retrieve the data to no avail. Now the contractor has several problems going: (1) not getting paid on its largest job making the contractor go deep into its line like it never had before thus causing the bank to become so concerned as to request current financials, (2) unwillingness to bid additional bonded work because the owner did not want to be personally liable for bonded jobs if the company was to fail, (3) inability to provide work-in-progress reports or financial information to the bank or surety therein casting doubt (4) making the staff turn over to a completely manual process having lost all of its historical data and unable to resurrect current financial information, (5) and countless sleepless nights. Could it get worse? No, it got better.

After a month of down time Intel was able to recover the data, the contractor was able to produce financials, the accounting staff was able to get caught up, the class action lawsuit was dismissed after the owner’s attorneys had built up close to $750K of fees, the contractor’s carrier picked up the tab only causing the contractor to lose the $25K deductible, and the contractor did not have to start a new company, nor go broke. But what did it cost him?

Well, historically, this contractor made $250K in profit year after year. At the close of the fiscal year containing all of the problems, the company recorded only $24K in profit and opted to make up for the business lost during all of the distractions by taking on a big job in a different type of work. The jury is still out.

Moral of the Story

So, the contractor experienced the simultaneous consequence of uncontrolled risk related to two risk factors, one important one: review of contracts, and one not so important: computer backup. You can see how the consequence of two risks working together can cause havoc. Not being able to produce financials when both the bank and bonding company want to see them during tenuous times could have turned disastrous. But that is how risk works. The overall consequence of risk in a business is rarely the result of one uncontrolled risk, but instead, normally multiple uncontrolled risks working together. Sometimes the overall consequence may be caused by risk related to just a couple important risk factors, or maybe a lot of not so important risk factors, or maybe a mix of important and not so important risk factors. Any combination is possible and any combination can be a knock out punch. The graph below explains how.

We’ve established how risk factors vary in importance, and we’ve established that the overall consequence of risk in a business is almost always the result of the risk associated with multiple risk factors. We’ve established how contractors rarely recognize the ones that can and will hurt them, and we’ve established that even though a risk factor may seem of little importance it will usually work in conjunction with others to cause an overall consequence. In other words, we’ve established that even though a risk factor might only cause a small amount of financial harm when uncontrolled, all such risk factors do matter.

So the real question becomes: How do we lower the potential consequence of risk related to a multitude of risk factors in order to prevent loss or potential failure? The Answer: Adopt an Enterprise Risk Management (ERM) method of running your business. The ERM process identifies risks factors that might otherwise be unknown, establishes a way to assess the level of risk with respect to each risk factor, and determines what kind of controls need to be put in place to minimize risk and the potential consequences.

For a thorough understanding of ERM visit the about risk section of MyRiskControl’s home page. Take the available tours to learn how MyRiskControl helps a contractor implement practices, systems or procedures to control risk and then monitor risk on an ongoing basis. There is no question that implementing ERM in your company requires a change in philosophy, a change in thinking, and a call to action. But with ERM, you don’t have to do all the work yourself, it gets spread to the staff, and MyRiskControl makes that easy. It is the only total enterprise-wide solution to identify, assess, analyze, control and monitor construction risk. And remember, just because you choose to ignore risk, risk won’t ignore you.

He shared with me how cash flow had put him out of the construction business. His claim to fame was the installation of high end custom wood work in plush offices and homes. As he became bigger, he just was not prepared for the cash flow crunch that he would experience. He shared with me his frustrations at getting paid from General Contractors who always had an excuse for not paying, and he used a few choice words. It was obvious that he had experienced what has put so many companies out of business, a cash shortage. He indicated he was making good money, and I believe that because custom millwork brings a good margin and there is not a lot of competition for highly specialized woodwork. He had different types of wood shipped in from all over the world and he shared with me how even though he was profitable, when he pursued the bigger work, cash flow became too much of an issue and he was forced to reinvent himself. This certainly is a familiar story.

There is a basic collection tenet that states “the longer the bill is outstanding, the less the chance of collection.” Although this particular construction company was able to collect its money, the bill was outstanding just too long, often up to 90 days according to his description. This brings us to the importance of conducting cash flow projections. You see, if he had been able to project the cash demands for his company, he may have found the cash resources in advance to continue it. That is why it is imperative to continually assess the timeliness and the probability of collecting open accounts receivable. This is particularly important in the construction industry because of the sizable dollar amounts that can be withheld. It is also important to recognize that the longer the bill remains outstanding the more likely you could be talking about a bad debt, and that possibility needs to be taken into account in cash flow projections as well.

Particularly in tough economic times as we are now experiencing, each owner, developer, and general contractor has to be scrutinized before doing business with them and finding out that they themselves have run out of cash. Since it is difficult to accurately predict when down cycles will come and go, a continuous aggressive collection effort will assist in increasing cash flow and lowering doubtful accounts. Therefore, accounts receivable personnel and/or project management must regularly meet with senior managers to discuss potential collection issues that might arise. If a contractor does not regularly perform this task, it will usually fail to react fast enough to manage potential cash shortages. Failing to do this exercise over a long period of time can result in overstated receivables and a misrepresentation of the financial strength of a company, potentially misleading management, banks and bonding companies. Since bad debt expense directly impacts the bottom line of the financial statement, a bank or surety may believe it was misled in its credit decisions by the contractor’s failure to reveal the bad debt in advance. When a bad debt expense suddenly arises after being uncollectible for a long period of time, key bank and bonding relationships may be damaged.

The summary of all this is that cash is king, and failing to perform cash flow projections is a major risk factor in industries that experience fast moving cash like construction. To lessen the risk of potential harm, a contractor must project speed of receipts, have meetings to identify potential collection problems, try to recognize bad debt in advance and aggressively collect open accounts receivable. Only by doing cash flow projections can you take all these factors into account and avoid a surprise cash flow shortage. In the case of my new contractor acquaintance, every story has a silver lining. He decided to go into high end millwork as a manufacturer only. Now he gets paid up front for the expensive woods he uses and gets paid within 30 days as a vendor having a much needed product that is not easily found elsewhere. Hurray for him, he avoided being another one of the many construction companies that have simply failed by running out of cash, even while making a profit.