There seems to be some mixed messages being communicated in the bonding world regarding surety credit. On one hand the surety underwriters are getting nervous about their clients balance sheets, suggesting they look elsewhere for surety credit. On the other hand there are surety companies with capacity willing to take on struggling companies because the company has stabilized, are well managed and possess a backlog of work to move forward.
The upside for sureties willing to take on a more risky customer is that they will have earned a client that would have never moved if things were booming. However, a company's Work in Process (WIP) report becomes a crucial determinant factor during both boom and bust markets for a company to obtain surety credit.
The WIP report is perhaps the most important report a contractor has to manage the profitability of the jobs it has in the backlog. Surety underwriters, on a per job basis, want to see the original contract amount, revised contract amount (takes into account any approved change orders), original estimated cost on a given project, and the original estimated gross profit.
In establishing estimated gross profit, projected job costs should be any direct materials and equipment used, direct labor, subcontract labor and some indirect labor costs. Examples of those indirect charges are reflected in payment taxes, group insurance, vacation & holiday pay, retirement contribution, equipment expense, shop supplies & small tools, safety supplies and training, maintenance and warranty, pre-employment physicals and depreciation. It's essential to account for all of these costs to establish a realistic, estimated gross profit number. Estimates are just that, estimates, and a completed job seldom hits exact estimates.
The next two lines on a WIP report, cost incurred to date and the all important revised estimated cost to complete, are contractual to daily project management and sometimes even to receiving surety credit. The contractor, as well as the surety needs to know at any given time what the ACTUAL projects costs are on a project (not what was estimated). Once actual costs are defined, true cost to complete can be calculated. Cost to complete enterprises of all direct and indirect items stated on bonded and non-bonded jobs.
The reason these two columns are so critical is that they communicate the profit fade or profit gain on a project. Is the job ahead of the estimate, or are profits margins shrinking? If the project is losing money, what can be done right now to right the ship? Sureties will measure this difference. If a trend is determined that a company's projected estimates average a gross profit of 15% on jobs, but actual gross profit comes in regularly at 10% when the job is complete, there may be a problem with estimating or problems being able to make the margins needed to generate profit, let alone cover overhead.
In light of the current compressed margin environment prevalent in today's highly competitive construction market, overhead can quickly depletes profits. A company's income statement classifies this as general and administrative expenses. This is why sureties require a completed contract schedule to be included in year-end financial statements. Ultimately, sureties tie WIP schedules to completed contracts to establish how close project estimated gross profits were to actual gross profits.
When qualifying for a bond when the balance sheet does not necessitate merit the credit, certain sureties will place more emphasis on the WIP if it possesses all the elements mentioned above, and reflects a profitable backlog. For example, a company may have a backlog that takes it into July, but does not have the capacity to cover overhead. If overhead is calculated to be 15% of sales, gross profit numbers must be tracking in the 15% range just to cover expenses, not to say anything in regards to profit. If a company's current backlog can at least conservatively cover expenses, an argument can be made for obtaining surety credit on a particular job.
Maintaining and having an up-to-date WIP is an essential management tool not only from a surety's perspective, but also just as important to a company – providing a functional tool to assess the profitability of a project, establish trends, and manage daily operations . Diligent adherence to a WIP program empowers a company's capacity to react and make necessary adjustments to obtain the projected profit margin in both stable and challenging economies.