Construction firms grow organically. The start-up contractor hires help as he or she goes along adding overhead as needed to handle the expanding workload. In other words, they are "backfilling" after the work comes in. This is organic growth because it grows out of need as a natural adaptation, and the work is already in-house before overhead is put on. The constantly ringing phone and ever-expanding stack of unopened mail forced a growing framing sub-contractor to hire his sister-in-law to manage the office so he can stay out on the job and make money--organic growth.
Organic Growth
- As our framing contractor's reputation grew so did his workload. His sister-in-law couldn’t keep the books, produce a payroll, pay the bills, go to the bank, and answer the phones all at the same time so she hires an assistant with some knowledge of QuickBooks.
- Years past and eventually our framing contractor spent more time in the office putting together bids, ordering lumber, buying tools and equipment, and establishing relationships with General Contractors and owners who know his work. So he hired a foreman to take his place in the field and a secretary to handle his schedule, correspondence, and phone traffic.
You can see where this is going. You've probably been there. This is organic growth wherein increasing overhead and hiring after the work comes in is a profitable strategy.
The Business Cycle
After expanding for years, our framing contractor entered a stable phase where his existing organization easily handled their considerable volume of work. Inevitably, however, the cyclical construction market turned downward and the overhead in place began to chew up the now diminishing cash flow. Without even considering “right sizing” (because to him it seemed like downsizing was moving backwards), our framing contractor decided to trim his profit margins and bid more aggressively for new work, enabling him to maintain the company he had built and was rightfully proud of. However, the new work required additional tools and equipment as well as a new project manager to oversee the whole effort. Unexpectedly the slimmer profit margins evaporated into losses and cash flow diminished. Backfilling before the work comes in, in an attempt to capture new work gives way to “front-filling”, and the non-organic nature of need driven overhead growth no longer automatically right sizes the organization when work falls off. Less cash is available to support the overhead in place, and an organization begins to struggle and can gradually go out of business. Our hard-working framing contractor didn’t notice until it was too late. This scenario is repeated over and over again in the construction industry—which has the second highest failure rate of all industries in the country.
Flexible Overhead
"Right-sizing” means - adjusting the overhead to fit the business – not chasing business to support overhead that is no longer needed.
"Overhead can be generally referred to as the cost associated with running a business. It can be typically categorized into two groups: indirect overhead costs which are not specific to any particular job, and direct overhead costs which are project specific... Flexible overhead, a new concept for the construction industry, advises construction companies to have a certain portion of their indirect and direct overhead costs easily adjustable."
(The Secrets to Construction Business Success, Thomas C. Schleifer, Mounir El Asmar, Routledge, p.14)
If overhead can be organically backfilled behind need, it seems logical that when that same organization goes through downward cycles, overhead could be shed organically. Wouldn’t it be great if certain portions of overhead (labor, equipment, real estate etc.) when no longer needed, would simply melt away. No drama. No personal wrenching. No punishment. Just a natural melting as the function is no longer needed. It can! That is what flexible overhead does.
What Does Flexible Overhead Look Like?
- Short term leases on some office space.
- Temporary personnel in some clerical, administrative, and accounting functions.
- Equipment leasing rather than purchasing.
- Managers hired with specific company growth and performance goals associated with their continued employment.
Right Sizing Not Downsizing
"Flexible overhead is not nearly as painful as downsizing. Under the concept of flexible overhead, contractors should engage a percentage of all overhead cost in a manner where costs can be turned off and the expense ceases in a week or less. In some cases, expenses cease in one day.... Flexible overhead prepares a construction enterprise to do 15%-25% less volume at any given time, while at the same time preparing it to do 25% or more work and have no permanent increase in overhead risk either way." (The Secrets to Construction Business Success..., pg. 63)
If our framing sub-contractor had made an arrangement in advance with his sister-in-law to send her home if and when the work slowed down, he'd sleep a lot better at night.
This is merely an introduction to “Flexible Overhead”. Study this process in greater detail and put at least some of these leading edge concepts into place now during a growing market in anticipation of the next downward cycle. (Unfortunate reality check: If economic conditions and global political developments continue as they are, A market cycle may be sooner than we would like.)