Construction is a fast-growing industry that attracts investors with favorable terms. However, it often happens that the once-started construction is not complete. Unfinished buildings are quite a common thing due to insufficient investment and a lack of profits. It is just that these projects turned out to be unprofitable. Therefore, it is very important to start the construction with profitability and the volume of investment calculations to find the right scheme for managing the construction process.
How to achieve success in this industry? How to calculate the profitability of a construction project? To do so, you will need to estimate a lot of indicators and find out the main causes of losses using Finoko construction service.
What is construction profitability?
The profitability of construction is an economic indicator measuring the company’s returns. It is important to evaluate two types of profitability in a construction business: the current profitability of the company (for example, per month or quarter) and the profitability of all construction projects. The company’s profitability indicator is determined over a certain period and evaluates how efficient all work over this period has been. The project profitability is determined from its beginning, and all the work done in one project is evaluated. The complexity and peculiarity of construction projects are that each construction can turn out to be profitable, and the company itself can be loss-making. Let’s discuss in detail how it is possible.
Profitability in the construction industry is calculated by common formulas. At the same time, this indicator can be evaluated on several following levels:
- By the plan,
- By the estimation of the cost,
- Actual.
The profitability of the cost estimation is calculated by dividing the planned accumulation by the estimated project cost. It is expressed as a percentage.
Here is the formula:
Rcm = (PA / estimated cost) × 100
Rcm is a cost estimation profitability indicator
PA – accumulation according to the scheduled plan.
The planned profitability of a construction project is calculated by dividing the planned profit and the contract price.
Here is the formula:
Rpl = (Ppl / CP) × 100
Рpl is a planned profitability indicator.
Ppl — planned profit
CP — contract price.
The actual project profitability is calculated after all the construction work is complete. It is determined by dividing the actual profit, taking into account all penalties and savings, by the actual cost of the constructed facility. It is also expressed as a percentage.
Ra = (Pa / Ca) × 100
Ra — actual indicator
Pa — actual profit received
Ca — actual price of the construction.
Usually, the construction companies calculate the planned profitability, which makes it possible to evaluate the target goals — and the corresponding cost.
You can assess the financial stability of the company differently. To that end, we take the profitability of all company’s assets. You need to divide the net profit by the average value of all types of assets in the company.
The profit margin is another relative parameter that evaluates a worthwhile project. The profit is divided by the volume of all sold products, services, real assets, etc.
What is the reason for the losses, and why do companies stop construction? Actually, the factors that define the success of the construction business are well known. But the owners of construction companies do not always pay attention. A correct approach and proper calculation are crucial here. Only such management can lead to good results. Building one house is long-term work that can last a year or more. The management system in this industry should be built efficiently — for years to come.
Revenue in the construction business
Revenue in the construction industry is the money received for the implementation of the project. They are transferred to the company’s account. The generation of revenue is the main goal of every business. Customers pay for the project according to the cost estimate. In construction, it is considered an indicator of efficiency. If the revenue grows, the company gets a reputation as a stable and reliable business.
You can judge the capabilities of the company based on the funds received. In the case of an excess and increase in sales, the company requires hiring new staff, or, on the contrary, a reduction in production. Also, revenue covers payments to the budget, and all expenses that may be associated with current activities. It turns out that revenue is an indicator that demonstrates the company’s performance in terms of money.
Revenue in the construction business can be of several types:
- Cost estimate revenue is calculated based on the project documentation. The amount includes all funds that should be used to pay off expenses and create sources of incentives.
- Planned revenue. It is built based on the expected results from the approved work plan.
Construction revenue is calculated on the basis of actual data — the inflow amount that was received for fulfilled obligations.
The company’s revenue is taken into account when calculating profitability.
Profitability of a construction project and the company’s profitability — what is the difference?
To calculate the profitability of the company, you need to take into account all types of activities. In the construction business, you can calculate the profitability of the construction project as well as the profitability of the company itself. And these are different indicators. The former evaluates the specific project, and the latter assesses the profitability of the company.
The following tools are used to conduct a financial analysis of the company’s activities:
- Balance sheet structure.
- Company’s liquidity and solvency.
- Financial stability and independence.
- Company flows level.
- Study of financial transactions, including revenue and costs.
The company’s profitability reflects the real situation — if resources, investments and assets are properly used. For this reason, the profitability indicator is considered relative. It is calculated according to the following:
The amount of profit (all types) before tax is divided by all types of assets that are used to generate income.
Data for the financial analysis of the company can be taken from public external sources. Most investors looking for investment options use this information.
A company’s profitability is an important indicator necessary for evaluating its efficiency. The indicator shows how much revenue a business can receive if it uses the current amount of assets and resources. The potential level of profit with an increase in investments is also estimated.
The company’s profitability study is carried out with two main documents:
However, it is possible to include other parameters to obtain the most accurate and clear picture of the analyzed business.
Profitability of construction and indicators by areas
Conventionally, the profitability of construction is divided into two types — profit margin and return on assets. Indicators for each one are determined separately.
Profit margin:
- All types of profit – gross, net, operating, and margin.
- Gross and net profit costs are taken into account.
Return on assets evaluates the following indicators:
- Total assets.
- Equity.
- Investment.
- Turnover.
The efficiency of the company’s sales and other operations are evaluated with the profit margin. That is profit from all types of income.
Profit margin
It is calculated as the ratio of profit and revenue from core activities:
PM = NP /R
PM — profit margin taking into account net profit.
NP — net profit.
R – revenue from company activities.
It is important to calculate the net profit since the marginal one is not suitable here due to the difference between operating revenue and current costs. But it is necessary to take into account the contribution margin since it is a reserve to cover emerging costs.
Return on assets
The parameter shows how efficiently the business’s assets are working. It is one of the main parameters for assessing the profitability of all activities:
RA=NP / ((А BOP + А EOP) / 2)
NP — net profit
А – assets at different periods of the study.
Investors should assess the return on assets to study businesses so that their money could generate income.
Return on equity of own investments
It allows you to calculate the profitability of investments of the company’s owners.
The calculation formula is the following:
Roe=NP / ((OE BOP + OE EOP) / 2)
Roe – profitability of own funds of the company, shareholders’ equity.
NP — net profit.
OE – company’s investments.
Studying this indicator is a must.
Return on equity from investment
It allows you to evaluate how effectively the third-party invested funds are used.
The calculation formula is the following:
Ric = OR / ((IC BOP + IC EOP) / 2)
Ric — return on raised capital,
IC – investment capital,
OR – revenue from company activities.
Investment capital also includes figures at the beginning of the period (BOP) and at the end of the period (EOP) under study.
Return on current assets
It allows you to assess the company’s ability to receive real income and profit in standard activities.
The calculation formula is the following:
Rca = OP / ((CA BOP + CA EOP) / 2)
Rcа – profitability of current assets,
OP – profit received from different types of activities,
CA – current assets.
The listed indicators are a standard set of ratios that allow you to calculate the profitability of the business. Obviously, the difference between the profitability of a construction project and the company itself lies in completely different goals, parameters, and so on. You cannot assess the general picture of all activities of the company by calculating the profitability of a construction project.
If necessary, a more detailed study of indicators and the company’s analysis is carried out.
The difference between the cash and the accrual methods in construction
The company can opt for cash-basis income and expenses accounting or an accrual basis method. Put it otherwise, data on cash inflows to the cash desk or a current account are used. Construction companies more often choose to account for income and expenses on an accrual basis. What is the difference between these accounting methods?
It is in the periods in which income is recognized:
- In the accrual method, income is reflected in the period when the event occurred resulting in the receipt of funds. Regardless of whether money was actually received.
- In the cash method, the funds appear on the account immediately on the date they are received at the cash desk or bank account.
Expenses are also accounted for in different ways:
- In the accrual method, expenses are reflected in the tax period where the event was present, regardless of the actual cash outflows.
- In the cash method, they are reflected after the actual payment is received.
Automation of construction profitability assessment
It is important to control the profitability of both the company and each project in the construction industry. To collect the necessary data, you need to correctly classify income and expenses at the moment they occur. Accounting process automation will ensure a one-time entry of data into the accounting system to quickly generate financial statements and management reports. Finoko’s data flow management system with an ETL will help project managers and company management to always be aware of the current situation with the incomes and expenses of each object and the entire company. A ready-to-use set of reports for a construction company will significantly reduce the time to launch a contractor’s financial management system.