The amount of money tied up to build work is the right basis for calculation. In other words, we need to charge for renting out our working capital. Contractors rarely catch up on project cash flow. Additionally, there are no guarantees on the accuracy of our estimate, the project going well or that payment will be made in a timely fashion. Hence, we have to charge a larger percentage than most other industries on our financing (lending money to) of the project.
To calculate a proper project ROI on a project, the following factors are needed:
▪Amount and timing of assets including cash outflow (uses)
▪Amount and timing of cash inflow (sources)
▪Gross profit dollars (reward)
Note that the return on investment for a construction firm starts at the project level. Without profitable projects, a contractor’s business cannot be profitable.
We recommend construction firms use AROI as a preliminary pricing model. Our research has confirmed that using a return-on-investment calculation at the bidding stage is a “good operating practice”. Contractors use this among other factors (such as backlog and competitor’s statistical history) to set price. It keeps them away from bad pricing decisions and overly optimistic projections.
Contractors use this same formula to ascertain the return on a completed project’s financial performance. Additionally, looking at a department’s year-end results in ROI terms starts a healthy conversation. These exercises are valuable.
This type of approach has other benefits. As the ROI of a construction firm’s projects improves, so does the balance sheet and profit-and-loss statement. There is less debt and cash flow drag on the company. This is a very efficient approach.
At present, the top quartile of contractors earns approximately a 40 percent (and above) return on assets according to U. S. banking data. This means that they are highly successful in a financial sense. One reason—they use thoughtful financial practices to keep them profitable.
Getting compensated fairly with less debt and cash flow drag allows contractors to continue to attract good people, partners and projects, and to upgrade internal infrastructure. The importance of using ROI for a predictable future cannot be ignored.
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- Stevens Construction Institute, Inc.
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