Dee Davis (00:34)
Good morning and welcome to the Management Under Construction podcast. I'm Dee Davis.
Brad Wyant (00:39)
And I'm Brad Wyant and today we're going to talk about the art and science of cost management. So this episode is going to focus on how managers estimate costs, track them, and compare the plan versus actual costs to make managerial decisions. We're not going to talk about the impact of design, design changes, or other outside influences on cost. What we're going to talk about instead is called managerial accounting. It involves ascribing dollars and cents
cost data to real activities to find opportunities for improvement. Dee, tell me about your experiences with cost management that don't relate to design changing, to things coming down from the top that are obviously going to have design cost impacts.
Dee Davis (01:19)
In my life previous to construction, I did real estate and real estate is all about cost. It's all about markets and costs and commissions and paying fees and figuring out cost estimating upfront, way upfront. So the role that I played in the real estate market most of the time was in escrow. And we spent...
a tremendous amount of our time estimating costs.
it can be very tricky because you can get yourself in some real trouble if you're not very good at estimating.
Brad Wyant (01:54)
Yes, you can. It's certainly a challenging area. That's why the people that do it get paid some pretty big bucks. My experiences with cost estimating, especially managerial accounting have to do with, well, there's this attitude in the field, it's gonna cost what's gonna cost, right? If we just do the work that's supposed to happen, then it's gonna be fine, right? Not necessarily. There are so many implementation inefficiencies, opportunities for cost savings by...
shortening the amount of time that something sits on site or that something is on rent for your job, that's paying attention to the dollars and cents of things that are in your control outside of design are really worth it, especially in construction management. So let's talk more broadly about what managerial accounting is and how we apply it in the construction space. So what is managerial accounting? Financial accounting, to contrast it,
is something we've discussed before. It follows a strict set of rules are called a GAP generally accepted accounting principles. They are checked by the SEC as well as by professional auditors so that investors can make apples-to-apples comparisons between companies and so that regulators can hold everyone accountable with the same set of rules. So that's financial accounting.
Set of rules, governments involved, accountants say it has to be this way. That's financial accounting. Managerial accounting, on the other hand, does not follow such a strictly defined set of rules. It's more make it up as you go. But you still have to follow the rules you set for yourself and your organization. The goal of managerial accounting is to measure reality using financial data with the sole purpose of giving decision makers information that they can use to make good managerial decisions.
So if you come up with a system, for instance, of tracking how many pieces of plywood you use on your job site and how many pieces of plywood you should have used, then that rule doesn't have to follow some company policy unless there is one. It doesn't have to follow something written in some accounting textbook. It just has to work and accurately measure reality and whether you needed to use that many sheets of plywood or not.
So let's talk about planned versus actual analysis. This is one of the main themes in managerial accounting. How often do we on projects analyze how much the work cost relative to our estimate? I never have in real time because as we all know, the feeling of the next thing coming down the pipe is so urgent that it's hard to sit and take the time to say, well, did that really cost as much time and as much effort as we thought it did? But someone should be doing that work in the central office to determine how well we estimate work.
Trends can be developed. Lessons learned about how we implemented a certain system can be shared with the rest of the company. On large jobs with repetitive activities, this analysis can be extremely helpful. Say you're building 20 miles of road, for instance, like George might be our listener who called in. If you haven't heard that, go take a listen. We got a call in from one of our listeners in the infrastructure industry, and we gave him a response to one of his questions.
So let's say you're building 20 miles of road and it's going to take two months and you start tracking your planned costs versus your actual costs on a weekly basis. Well, you might notice that trends emerge in the data and you might decide to act on them. Let's say you're spending 10 % more on asphalt than you thought you would, for instance. You might decide to investigate whether you're throwing away material. If you're not and there's no other waste in your process that you can find, you might want to update your cost projection and inform your stakeholders
so that there isn't so much of a surprise at the end of the job. That might be a leading indicator of, we didn't get our estimate right. We need to figure out what happened. Why are we spending so much on asphalt? Or we need to go back to the books and say, hey, we got this wrong. Here's how much it's actually going to cost. What are we going to do about it? So that's a plan versus actual analysis example.
Dee Davis (05:34)
I think where I see this the most in construction is we tend to measure plan versus actual, with cost codes, right? Is that where you're going next?
Brad Wyant (05:45)
Yes, that's definitely the way that we use cost codes is for the sake of plan versus actual.
Dee Davis (05:51)
Right, cost code accounting, the problem and the challenge there is you're assuming that people are coding things correctly.
Brad Wyant (06:00)
I wasn't going to go there quite yet, but let's talk about it now. The thing is that when we're on the job site trying to get the job done, a common practice that we've all seen and heard of is ascribing cost to whatever bucket does not have all of its money used up yet. And while this is a practical way of getting through a job, it doesn't do anybody any favors in terms of
analyzing how you performed as a company versus how you thought you were going to perform. And broadly speaking holds the organization back from achieving the goals that it wants to of estimating costs more accurately. Hopefully somebody's using that data or not using it in the case of many companies, I'm sure, because they know this practice occurs.
Dee, how do you think you solve that problem? It's one of those things where everyone's trying to keep their head down, not get it shot off by their leaders. When you go planned 50 % over in one category and planned 50 % under in another, every project executive I've ever heard of is going to want to drill down into your job and figure out what's going on with you, not what's going on with the estimate or what's going on with...
something else they're going to start with you and treat you as a problem which can be very stressful.
Dee Davis (07:07)
What I see companies do is hope it all works out. The office tells you go code your time this way. And it's mostly time. It's kind of obvious when you get materials or equipment in the wrong category on your cost coding, that's sort of easy to vet out because it's some POs and you're like, hey, wait, that's not an asphalt vendor and the asphalt code, that's something else, right? But it's labor that's tricky.
with being coded in the right place and where I see it start to go awry out in the field is when the change order start coming in. Because you get a change order that maybe it's not just more of what you've already been scoped to do, it's something completely different. And you don't have cost code set up for that. You don't have a budget set up for that. So where do you put the time? Well, I'll put all the time on this code and I'll go pull it out later. Sure you will.
Well, bullets are whizzing over your head. You're not going to be doing that. And that's where it goes awry. And then pretty soon your budget's all cattywampus and you're 20 % over here and 30 % over there. it's really hard to recover from that. Companies tend to not make it easy to adjust a cost code set once it's set up for the job.
I know that companies that I've worked for, you gotta go fill out a bunch of paperwork. You gotta do budget revisions. You gotta move money from this code to that code. You gotta do all this stuff to make it work. And it can take a lot of time and energy that you don't have right now because you're in the pit trying to get this stuff done. So one thing we can do is make it easier to add some codes.
for change order work so that we're at least categorizing things properly.
Brad Wyant (08:47)
Certainly, and if you are in that position of trying to make the call between making a decision that is expeditious and making a decision that gets you correct on your budgeting, I would encourage you to try to, as expeditiously as possible, make the decision that makes the budget right because it's going to serve the company's interest. It's going to make you look good It's going to be right the first time. It's a much better way to go.
finding a way to be faster in whatever accounting system your company uses is beneficial here. And if your company uses a accounting system from the 1990s, as many of us can relate to, then it's all the more reason to say, I would do your accounting right if you would just give me something that worked from the century. But that's just my two cents on that. So moving on from plan versus actual analysis, let's talk about activity-based costing.
ABC is the acronym for this that gets thrown around in managerial accounting all the time. Activity-based costing is about spreading overhead out across other groups by measuring how much overhead each activity uses rather than ascribing a flat rate. So let's say, for instance, that you run an equipment rental company and for whatever reason you decide to only rent those big dozers, the ones that you see on heavy infrastructure projects,
and indoor social lifts, those itty bitty ones that are electric and plug-in and all that. Let's also say that you have a mechanic shop that you use to maintain your equipment. It's January 1st, you need to come up with a new rental rate for this new calendar year. You might simply pool your repair costs for the past year, however much you spent on your mechanics and renting the shop or the lease that you hold on that area, the tools and the materials and so on, and divide that by the number of machines that you own,
divide that by the number of hours in the year and use that as your markup on whatever your loan for each piece of equipment is. Let's say you pay the bank $200 a month on each piece of equipment, you divide that by 22 for working days and you mark that up with some other amount that's just fixed for your whole shop cost. That would be pooling your overhead. But in activity-based costing,
You would go through your service logs to figure out how much your two types of equipment cost to maintain and assign each type of equipment their own markup for repair costs. So let's say your dozers are really expensive to maintain because they're big, they're hydraulic, they've got enormous diesel engines, and your scissor lifts are very cheap to maintain. They just have rubber tires that need replacing every now and then and maybe every 20 years you replace a battery. You would ascribe a larger markup
for your mechanics and your repair costs to the dozers and a smaller markup for the scissor lifts. You could develop a different set of overhead cost structures for each piece of equipment. Sounds pretty logical, right? Well, let's use the counter example to prove why this is a very good way of doing things. Let's say that you don't use activity-based costing. Let's say you pool your repair costs across your dozers and your scissor lifts. Well,
your dozers are going to be much cheaper to rent than everybody else's on the market. And your scissor lifts are going to be way too expensive because you're paying for more cost to repair those scissor lifts on each rental than you would otherwise. What that means is your dozers are going to be out on rent all the time because they're going to be cheaper than everybody else's and they're going to require even more maintenance than last year because they're seeing so much use. While your scissor lifts are going to collect dust, they're not going to get rented because they're going to be too expensive.
So next year, next January 1st, you're gonna run the same calculation. Your overhead's going to have exploded and you'll again divide it across the scissor lifts and the dozers and you're gonna come up with the wrong numbers again, which is gonna keep you in the red. So you can go further. You could keep going into things like insurance. You could go into how much time your people spend putting things out for rent by selling them on the phone.
But be warned, because there's a point at which the cost to make measurements about cost information exceeds the savings you might stand to recoup when you implement a change based on that data. So trying to measure the amount of time that your salespeople spend selling your scissor lifts versus selling the dozers, unless there's a huge difference and there's a lot of cost in that activity, probably isn't going to be worth your time. Knowing where that point falls of when to stop measuring and when to
look deeper is something that's going to require judgment and experience certainly informs it. There's no equation that the managerial cost accounting people can give you that's going to tell you where that point is until you come up with all the data. And then they could tell you, yes, that was too much research or no, that was not too much research. anyway, some nerdy jokes here.
Dee Davis (13:18)
Well,
it's interesting that we're talking about this today because I was listening to another construction podcast earlier today and they were talking about some of the similar things that you're talking about here. The topic was indirect costs. And they were talking about all the different things that make up indirect costs for contractors and the list is long folks.
In fact, I was thinking we should do our own episode on talking about a lot of those indirect costs because this is where contractors of all kinds have a tendency to get it wrong. They have a tendency to undercut themselves and not account for all the things that are truly part of their overhead. overhead isn't just oh, I'm going to slap 10 % or 15 % on the top of everything. And it's all just going to magically be covered.
Well, maybe it is, maybe it isn't, it depends a lot. How many of those dozers do you have versus how many of those scissor lifts do you have? And what you're talking about is you're talking about doing a full burdened assessment on every piece of equipment type, right? Unless one is significantly different from the other, this model dozer verus is that model of dozer may not be significantly different.
but certainly there's a significant difference between a dozer and a scissor lift. figuring out what all those itemized costs are and having a fully burdened indirect cost for that thing, and you charge that cost to your job. So if it's your scissor lift, you own it, you maintain it, and...
you're a contractor and you send it out to job number 123, job number 123 needs to be paying rent for that, says your lift for every day they have it. Daily, weekly, monthly, however you wanna charge that, you need to know what that is. Otherwise, you're just giving it away for free. No different than if you lent it out to another project entirely.
Brad Wyant (15:11)
there was a case from business school that went deep into activity-based cost accounting. And it was about hospitals and how there was a study done by a particular hospital that tried to figure out how much we're really spending on these kinds of procedures versus that kind of procedure. How much are we charging? Are we charging the right amount? And they found that they were definitely not charging the right amounts in many, circumstances at their peril. And
This same story plays itself out across other businesses. I would strongly recommend if you're in a position to do so, looking closely at the rates that you come up with and trying to come up with as accurate rates as possible using activity-based cost accounting because it's going to save you missing big things when it comes to the nuts and bolts of your business.
Dee Davis (15:57)
It's very similar to when you're pricing a change order, making sure that you account for all the things that account for costs against that change. It's very similar. There's things that you don't see, they're not tangible, that impact your ability to do that work for X number of dollars. Maybe it's elevated heights, maybe it's weather conditions or things that are in your way. There are things that
You can't just look at a plan and go, I'm running a pipe from here to there. It's going to cost this much. You have to go out into the field and look at it and say, ⁓ there's all these other things that are going to impact what I'm doing. Doing a proper change order and accounting for all those things you can't see and touch necessarily off a piece of paper even when you're talking about labor burden rates.
There's things that you can't see and touch like benefits, PTO, stuff like that. How much does it cost you to have a marketing person? It's more than just their wage, right?
Brad Wyant (16:51)
So speaking of margins, let's talk about another theory in managerial accounting called contribution margin. A good way thinking about this would be to say that it's the profit side of the coin for activity-based costing. If activity-based costing talks about the costs and trying to get the markups right for that, contribution margin is talking about how much of the gain that you get from any activity came from which parts of that activity.
What managers try to do in contribution analysis is figure out how much money each product or service contributes to the bottom line profits of the organization. This sort of analysis helps managers decide which products or services to keep offering, which ones to work on, improve, and which ones to drop if constraints arise. So the most obvious examples that are not in the construction business here play into companies that make products. Let's say I make Barbies and GI Joes.
and for some reason or another Barbies are way cheaper to make than GI Joes, but I seem to be making the same amount on both and I price them at the same amount.
ascribing my profit margin to each of the contributions that the Barbies and the GI Joes make is what we're talking about in contribution margin, figuring out how much profit each of those products give me. returning to the world of construction, a contractor might use contribution margin calculations to determine what market to bid in. Let's say you're a GC that builds Class A commercial offices, GMP pharma plants, and public schools.
You could use contribution margin accounting to determine how much the projects in each category contribute to your bottom line and decide whether to stay in those businesses or not. You might find, for instance, that the accountants and the compliance staff that you keep on staff for the public school work costs so much that you would be more profitable if you only worked in offices and pharma plants. Or you might find the inverse to be true.
point of contribution margin analysis is to figure out what you're really making money on so that you can prioritize your work and seek to improve profitability in the areas where you have most to gain. A good example of this is that I worked at a firm very early on in my career that realized its sweet spot, quote unquote, was jobs that were of a certain dollar amount. I think it was 40 to 50 million dollars. And what they realized was that
in those kinds of jobs, they had one superintendent, two project engineers, and a project manager for half time that were all spending as much time as they were supposed to be spending on that job. Nobody was getting burned out. Those people were going on to their projects after that one successfully, and they were really in a wheelhouse as far as the profitability of those projects. The system that they had built around doing jobs of that size meant that they were churning them through
quickly and that they were doing the best of their suite of different jobs that they were doing. Whereas the big, glamorous, fancy jobs where they ended up pulling a bunch of resources in from the accounting and the sustainability department and where they had paid people overtime a ton and where there were people getting burned out and quitting.
those jobs seemed profitable because it's, ⁓ well, look, we got this great prestige of this. We made a lot of money. Look at the dollars and cents. There's a big check at the bottom of line for us. Yeah, but if you compare that to how much effort we put in on those jobs, it wasn't worth it. It was a great analysis that someone did, and it steered that company in the right direction, I'm sure, to become profitable in the long run because while it felt like those really fancy projects were
making them money because it looked like they were having a big impact to profitability. were also sucking a lot of resources away that weren't being accounted for. So using this mindset of managerial accounting to go deeper, to investigate the numbers that you're seeing when you do simple calculations is a great way of getting to the facts about your organization, your project, your company to figure out where you're really making your money and where you aren't.
It's the kind of thing that a more professional organization does to stay in business. Somebody who goes out of business perhaps in the first five years of trying to make it as a contractor is not going to go through these kinds of analyses.
Dee Davis (21:01)
Yeah. I can definitely say that, in my experience as a contractor, I noticed that this company that I was working for, we always separated the underground and our cost codes from above ground, right? And then in our above ground work, we'd have, first floor, second floor, third floor, whatever the underground work. We lost money on every single time.
every single time, we never once made money on it. job after job, I'm like, come on, what is going on? And I started really digging into what was happening. And I called the estimators and I said, hey, can you send me your native spreadsheet so that I can see not just the results of your estimate, but see your formulas and everything. I found a mistake in their estimating. They were using an Excel spreadsheet to do the math.
which is fine, as long as it has the right formula. And it didn't. And I called him up and I said, hey, did you realize that the reason that we're losing money every time we dig a hole is because the math is wrong on the underground? And they were like, what?
Brad Wyant (21:57)
Mmm.
Dee Davis (22:12)
we've been using this spreadsheet for years and I'm like, well, you've been losing money on underground for years. And I've noticed this pattern on my projects where I'm like, how could we get it so wrong every time? I mean, it's not enough to tank the job because percentage wise, it's relatively small compared to everything else, but still, how are we getting it wrong every single time? So,
just paying attention enough to realize that, every time we do this thing, it's not working out for us. We're not making money. Now I have to use the whole rest of the job to make up for all the money that I just lost in the underground. That's not a good place to start a job. Underground always goes first. So you know right away between losing money on the BIM and losing money on the underground.
I had a number of jobs where we started off 20 % in the hole, in labor. That's not fun to recover from.
Brad Wyant (23:04)
Holy cow.
and Dee
correct me if I'm wrong, but the only way that you would have caught that kind of ⁓ error is if you were comparing the actual cost versus the estimated cost as you went, right? Which is another activity of managerial accounting.
Dee Davis (23:20)
Absolutely. And because we consistently broke our cost codes out and separated underground, plumbers, they got an underground line item, fitters, they got an underground line item. If we had duct work, they got an underground line item they had labor material cost codes. It all went in there so that I could see let's say I had 200 hours. Well, I spent
280 hours every single time.
And on top of it, we didn't own our own excavators. We had to hire them out. Sometimes I could get the excavator for what I had in my estimate. Sometimes it would go over. And again, the math was wrong. When you calculate how many cubic yards of dirt you're moving, removing, hauling off,
bringing in whatever, all those things that you're doing with the dirt, you've got that math wrong every single time. If you think it's 200 cubic yards and it's 250 for digging it, for hauling it off, for bringing back clean fill, you're wrong three times.
Brad Wyant (24:19)
And that's not a managerial accounting error you're talking about. That's just somebody wrote their spreadsheet wrong to calculate the amount of dirt. Right?
Dee Davis (24:26)
no, this was not an accounting error, but ⁓ proper accounting found the error. It found it, identified it so that we could look at it and say, whoa, whoa, wait a minute. And that company's practice was not to give the project managers, how do I say that? they gave the project managers the results.
Brad Wyant (24:33)
Exactly.
Dee Davis (24:49)
not the raw data from the estimates. So I would see in a summary spreadsheet of some kind, I had this many cubic yards of dirt, but I didn't see how the soup was made unless I went back to the estimator and said, show me the ingredients to the soup, show me the recipe. And I'd have to sit there and have them walk me through it because it was all in software that I didn't have.
and I didn't have any access to it. So they didn't give me the native files.
Brad Wyant (25:18)
If I know one estimator if I know any people that work in that business Getting them to give you this kind of data to sit with them and to have these kinds of conversation can be a very culturally challenging thing because You're basically saying hey, this isn't right. Let's talk about it, which is a challenging conversation. So you've got to find a way to do that while also getting the results you want and Being candid obviously support to be candid, but just to do it in a
way that makes them know that you're not coming for their job, you're not mad at them, you're just like, hey, we have a problem. Try to make it about us, try to make it about the company. I think that there's something we have room to improve on. Let's talk about it because some estimators are great about it. Some of us are like, yeah, I don't get to see the results of this very often. I'd love to talk to you. Others are like, yeah, you must be wrong. Forget you. Go pound sand.
Dee Davis (26:04)
Well,
there's some ego involved. This is their work. Just like we're very protective of our work and can be a little egotistical about our own work. This is their work product and they take a lot of pride in it. I haven't met an estimator yet who isn't so busy. I don't know how they do their jobs. I would jump off a cliff if I was an estimator. These folks work so hard.
They really truly do. I've never met an estimator that isn't working their buns off all the time. So the amount of work that they have to put out on a regular basis, I'm astonished that they're able to remember. I'll come back, this is months later. They did this job like six, eight months ago, maybe a year ago. And I'm coming back going, wait a minute, this isn't working out.
they can remember a lot of the time, which I'm astonished with as much work as they do. But yeah, it's not about coming after them and saying, hey, you screwed this up or did this wrong or, it's not about that. It's about what happened. Let's understand what happened so that we can not repeat it, hopefully. And if there is some kind of gross error like that, let's fix it. Now we know.
We can choose to continue to estimate underground incorrectly as a company if we choose to. If we say that's our loss leader, okay. But at least we're aware of it now. Now we understand why it's happening and how to fix it if we choose to fix it.
Brad Wyant (27:11)
So in summary, sort of, okay.
So to wrap up sort of the concepts we covered here, plan versus actual analysis, exactly what Dee was just talking about. Did we spend what we thought we would? If not, why not? Take a closer look. In Dee's particular case, the accounting that she did led her to an estimating error, but it might be something else. It might be that you really are spending that much more than you thought you would, and you need to find a different way to explain to the client that's gonna just cost more money than you thought.
The next concept we covered was activity-based costing, ABC. This was the scissor lifts and the dozers. You don't want to pool your overhead when your costs are very dissimilar. The dozers cost ton, the scissor lifts cost very little. You end up pooling that overhead and your dozers get too cheap, your scissor lifts get too expensive, and you don't ascribe the correct costs. So your dozers get rented too much, your scissor lifts get rented too little, and you don't make money.
Lastly, we talked about contribution margin, the idea that you want to examine for how much given input, how much output do you get? Are there different activities that your company, that your project, that your group undergoes that have different rates of contribution margin to your bottom line? If so, which ones are the ones that you want to keep doing? Which activities do you want to keep engaging in? And which activities do you not want to engage in? Because they're not contributing to your bottom line as much.
All these principles can help you run your business more effectively, more profitably, and help remove a lot of internal conflict about what's really going on in your organization. If you go make these measurements, if you figure out what's going on within your organization and try to make good decisions based on that information, your whole team's gonna get on board with you, and they're gonna feel a lot better about the direction you're going.
Dee Davis (29:10)
choosing the right cost accounting method for you and your situation and your company and paying very close attention to your costs. That's what's gonna make you be that contractor that's still standing five years, 10 years later and somebody who doesn't make it past your three because they just weren't paying enough attention the cost accounting
If you're small enough, you can have one job that makes a difference between whether you're here today and gone tomorrow. So you don't wanna be that contractor. We're here to make money. This is not a charity, right?
Brad Wyant (29:44)
Very much so.
Dee Davis (29:45)
Thanks everybody, we'll see you next time.
