RUNNING A PROFITABLE CONSTRUCTION COMPANY: REVISITED BREAK-EVEN ANALYSIS

PEER-REVIEWED PAPER RUNNING A PROFITABLE CONSTRUCTION COMPANY: REVISITED BREAK-EVEN ANALYSIS By Joon H. Paek 1 ABSTRACT: Many companies have a tendency to spread out their operations into branches and/or separate corporations. The construction industry is a good example. With work being slow in some areas, it is sometimes more profitable to spread out the company into different areas in order to absorb more work and therefore create branches to the main office. When this is done, it is important to centralize these branches and analyze them as a whole to help the corporation. In this process, the break-even analysis can be used to help analyze the operations. Consideration for a corporation having one or more branches involved in several projects takes time and teamwork. The team that is organized to help in the decision-making process needs a plan to determine how the project will affect the company and other jobs that are already in progress. With one corporation having two or more branches, it can be difficult to figure out where the company as a whole needs to be in order to turn a profit. The team must consider what each branch is doing in volume and what their break-even points are. This comes down to an important point of this research, which is where to break even before the profit consideration is made. This research provides an exemplary application of the break-even analysis to an actual construction company with one or more branches. INTRODUCTION Construction companies face many challenges when determining the type, size, and location of the jobs they should become involved with. Each project is like a custom item that is built to serve a special need, so there are many decisions to be made before deciding whether to bid; for example, what type of labor force is available for the job, where the job is located, whether it is possible for the company to handle the size of the job while keeping up with their current work, the difficulty of the project, etc. (Hendrickson 1989). Traditional break-even analysis in its most basic form is the point at which operations just break even, neither making money nor losing money; and, changes in operations are evaluated according to their effects on this point. Traditional break-even analysis is used to analyze a company and show what it can do to analyze itself. It does not take into consideration all of the factors of several different district operations and bring them into a 1 Prof., Dept. of Archit. Engrg., Yonsei Univ., Seoul, 120-749 Korea; formerly, Asst. Prof., Dept. of Constr. Mgmt., Univ. of Nebraska, Lincoln, NE. Note. Discussion open until November 1, 2000. To extend the closing date one month, a written request must be filed with the ASCE Manager of Journals. The manuscript for this paper was submitted for review and possible publication on January 20, 1999. This paper is part of the Journal of Management in Engineering, Vol. 16, No. 3, May/June, 2000. ASCE, ISSN 0742-597X/00/0003-0040 0046/ $8.00 $.50 per page. Paper No. 20092. whole, to analyze the company as one unit. In the past, construction companies with separate branches had a tendency to be more decentralized. Now, however, with the economic times being tougher and money being tighter, it is important to subsume all of the branches into one to keep the company alive and profitable (Newnan 1991). In this research, break-even analysis is revisited by analyzing all the branches of a corporation as a whole. Break-even analysis utilizes two types of cost input fixed and variable costs (Schmenner 1988). An example of a fixed cost would be paintbrushes. Before painters can paint a building, they must have paintbrushes. Whether they paint one house or a dozen with the brushes, the expense has already been incurred and is shown as a fixed cost. In this research, however, revisited break-even analysis is distinguished from former research by bring cost, volume, margin, and profit to see how the company can do better as a whole instead of simply analyzing each branch to see where improvements can be made individually. Costs that are defined as variable are seen to change on an exact predetermined basis with volume. When there is no output, variable costs are zero. The input material and the time required to make a unit these give rise to variable costs. For example, the specific quantity of a certain type of paint which the painters use in painting a house is the variable cost. The more houses they paint, the more paint they use; the quantity used is a function of the output (Riggs 1982). 40 / JOURNAL OF MANAGEMENT IN ENGINEERING / MAY/JUNE 2000

RESEARCH OBJECTIVES The main focus of this research is to analyze the separate branches of a construction company and see how the company can do better as a whole; by figuring out what volume they should be striving for in order to achieve the best net gain, the company s profit picture can be helped (Cooper and Kaplan 1991). The approach is broken into three objectives related to how the revisited break-even approach can affect a company. A case study is used involving the Actual Construction Company our hypothetical name whose two branches will be referred to as Branch A and Branch B. The three objectives are as follows: 1. The first objective is to give the reader a basic understanding of the traditional break-even analysis and how the revisited approach is different, as well as what it can do for a company of one or more branches. 2. The second objective is to show the reader how the revisited approach to break-even analysis is used with a company of one or more branches. The main idea here is to show the differences in the breakeven points and explain the reason for a gap. 3. The third objective is to give the reader an approach to solve the problem of the gap in the breakeven points by using the break-even analysis as a forecasting tool to forecast where the branch needs to be the following year in order to improve the company s profit picture. path above the break-even point and how it is affected by those factors that are controllable. HYPOTHETICAL ILLUSTRATION For example, let s assume that the break-even chart shown in Fig. 1 represents the management s best judgment about one district s profit prospects for the coming year. Up to $25,000,000 in volume, as shown in Fig. 2, the work can be handled with their current resources of equipment and people. If they do $25,000,000 worth of work they expect to make a net gain of $2,000,000. However, because of local fund shortages, that is about the limit of their regular market, as they see it, for the coming year. This may not set too well with them because normally they would expect to do about $30,000,000 of work and make over $3,000,000 of net gain, as shown in Fig. 3. The current cutbacks in the local market are not expected to last forever, and meanwhile, there appears to be an opportunity to pick up some additional work in an adjacent state. Here is where the revisited break-even analysis can be applied into the decision-making process of the construction company with branches, and use the analysis as a forecasting tool to improve the company s profit picture. By using the current year s figures one can RESEARCH METHOD The method used in this research was to renew a current practice on break-even analysis done by many traditional construction companies. Many of the principles used in that practice were carried over into the revisited practice, with modifications done to the case study to help understand by comparing and/or contrasting two branches of a corporation. This is referred to as the revisited approach to break-even analysis in the construction business. THEORY OF TRADITIONAL BREAK-EVEN ANALYSIS Break-even analysis gets its name from the break-even point, which is the point of capacity or volume at which operations pass from profits to losses or vice-versa (Schank 1989). One of the first things a business will discover about the break-even points is that they are not rigid or static. They change with every decision of the management. The break-even volume changes when the margins are raised or lowered and when the efficiency of the operation rises or falls (Zimmerman 1984). It changes when there is purchasing or selling of the equipment and it changes every time there is an altering in the overhead spending. Actually, the break-even point is only of academic interest. Companies are interested in the profit FIG. 1. One Branch s Break-Even Chart FIG. 2. Case for $25,000,000 Volume JOURNAL OF MANAGEMENT IN ENGINEERING / MAY/JUNE 2000 / 41

forecast the necessary volume of the future projects that would result in profit. When the break-even points are found, the management can make decisions on where to move the equipment and the people for the best productivity and an efficient operation. The Public Highway Department of a local government agency plans to let all of the major contracts for a large construction program at a special letting next month. The prices for this work, which is similar in nature to the work normally performed by the Branch, are expected to be high enough to offset any loss in efficiency. The major problems are the tight schedules and the size of the jobs. In order to be competitive and to meet the schedule, it will be necessary to field an additional fleet of equipment. The engineering depreciation of the needed equipment and the increase in the overhead spending caused by this expansion are reflected in Fig. 4. If they get one job, they will have to buy an entire new spread of equipment, and they can expect to do about $10,000,000 worth in additional volume. If they get two jobs, they will have to buy some more equipment, and so on. As shown in Fig. 5, every additional dollar spent on fixed costs on all operations means one less dollar for the profit. If they look closely at the overall effect of getting just one of these out-of-state jobs, it becomes apparent that they will now have to do $30,000,000 worth of volume to make a $2,000,000 net gain, as shown in Fig. 6, whereas prior to increasing their capacity they could have made $2,000,000 up to the point where they hit $30,000,000 in annual volume. Actually, it would be worse than doing $5,000,000 in volume for nothing because their investment would have increased. They would have to earn more dollars to get an equivalent rate-of-return. Fig. 7 shows the potential for increasing their rate-ofreturn on investment. The net gain above the $25,000,000 in volume is shaded only where the rateof-return (not dollars) would be equal to or better than what it was at the $25,000,000 volume before expanding. If they received one out-of-state job, their rate-ofreturn would not improve until they did at least $32,300,000, total volume for the year. Likewise, if they got two out-of-state jobs and increased their fixed costs to handle them, they would have to do at least $35,000,000 worth to improve their rate-of-return. FIG. 3. Case for $30,000,000 Volume FIG. 5. Case for Decreased Revenue due to Increased Fixed Costs FIG. 4. Case for Increased Fixed Costs due to Equipment FIG. 6. Gain Case for $30,000,000 Volume with $2,000,000 Net 42 / JOURNAL OF MANAGEMENT IN ENGINEERING / MAY/JUNE 2000

purpose of this study to determine why Branch B is not at the level of output as Branch A and to forecast a break-even point for Branch B. Branch A Here are some figures from Branch A s operation history. One year Branch A had a volume of $18,351,000 with a net gain of $2,044,000, or 11.1% of the volume. By subtracting the net gain from the volume, the total cost of the work is obtained: FIG. 7. FIG. 8. Costs Case of Increasing Rate-of-Return on Investment Case for $25,000,000 Volume with Increased Fixed In Fig. 8, there has been enough margin added to handle one out-of-state job; the company would still make $2,000,000 at the $25,000,000 volume point. By working backward from the condition graphed here, a revisited break-even analysis could tell what margin the company would have to put in these out-of-state bids in order to make or beat the minimum of a $2,000,000 gain on a $25,000,000 volume. Of course, there are other alternatives that could be investigated. If the company raised its prices and does not get any of the out-of-state jobs, it might still be able to do something to improve the profit picture. The company could transfer some surplus equipment and people to another Branch, and lower the fixed costs to make more money on the reduced $25,000,000 local market. CASE STUDY The following application of this study is an example that will compare two branches of a huge civil construction company. At their request, we will call it the Actual construction company. The branches will be referred to as Branch A and Branch B. It is the Volume $ 18,351,000 Net Gain $ 2,044,000 Total Cost $ 16,307,000 The costs came from the overhead, which equals $600,000, and equipment expenses totalling $2,018,000. Overhead $ 600,000 Equipment Expenses $ 2,018,000 Total $ 2,618,000 In break-even analysis, importance is placed on the cost of owning the equipment, which would equal the overhead plus the equipment expenses, as shown above. The $2,618,000 figure is referred to as a fixed cost, because if production was shut down temporarily these costs would still continue. It is important to determine what Branch A s variable costs are because it is important to see what the ratio of variable cost to volume is. Here the variable cost is computed by subtracting the fixed cost from the total cost: Volume $ 18,351,000 Net Gain $ 2,044,000 Total Cost $ 16,307,000 Fixed Cost $ 2,618,000 Variable Cost $ 13,689,000 This variable cost number itself is not important, but the ratio of variable cost to volume is very important number in break-even analysis. Variable Cost $13,689,000 Volume $18,351,000 0.746 for the year This number is saying that, on the average, each dollar s worth of work the company did cost them 74.6 cents in variable costs. The variable cost can be referred to as job costs less equipment expense. The total cost consists of the following: overhead, equipment expense, and variable costs. Therefore, at a $18,351,000 volume, the total cost is $16,307,000. Fixed Costs $ 2,618,000 Variable Costs $ 13,689,000 Total Cost $ 16,307,000 Another important number in the break-even analysis is the contribution factor, which gives you an idea of what is left over to work with. This number is the complement of the variable cost over volume ratio: JOURNAL OF MANAGEMENT IN ENGINEERING / MAY/JUNE 2000 / 43

Variable Cost $13,689,000 Volume $18,351,000 0.746 1 0.746 0.254 (100) 25.4 cents As shown above, for every dollar s worth Branch A does, it leaves them 25.4 cents available for fixed costs and profit. After figuring out the fixed and variable cost and the contribution factor of Branch A, it is possible to figure out the break-even point. Since the break-even point is, by definition, that volume at which operations pass from losses to profits, all that is necessary to find this point is to find out how much volume Branch A had to do at a contribution rate of 25.4 cents per dollar of volume to just cover their fixed costs of $2,618,000. In other words, the break-even volume times the contribution factor is equal to the fixed costs: Break-Even Point Fixed Costs $2,618,000 Contribution Factor 0.254 $10,307,000 This means that Branch A broke even at $10,307,000 volume for the year being analyzed. Branch B Branch B had a volume of $15,267,000, with a net gain of $523,000 or 3.4% of the volume. By subtracting the net gain from the volume we get the total cost of the work: Volume $15,267,000 Net Gain $ 523,000 Total Cost $14,744,000 Branch B s costs, which come from the overhead and equipment expenses, are as follows: Overhead $ 700,000 Equipment Expenses $ 2,264,000 Total $ 2,964,000 Therefore, Branch B had $2,964,000 in total fixed costs. Also, Branch B had $11,780,000 in variable costs, which was calculated by subtracting the fixed costs from the total cost. Total Cost $ 14,744,000 Fixed Costs $ 2,964,000 Variable Costs $ 11,780,000 Using the calculated variable cost, the ratio of variable cost over volume for Branch B equals 0.772. Variable Cost $11,780,000 Volume $15,267,000 0.772 for the year So, on the average, each dollar s worth of work Branch B did cost them 77.2 cents of the variable cost. Branch B s contribution factor can now be figured to be 0.228. Variable Cost $11,780,000 Volume $15,267,000 0.772 1 0.772 0.228 (100) 22.8 cents For every dollar s worth of work Branch B does, it leaves them with 22.8 cents available for fixed costs and profit. For Branch B s break-even point, the calculation for the amount of volume obtained at a contribution rate of 22.8 cents per dollar of volume, in order to cover their fixed costs of $2,964,000, is as follows: Break-Even Point Fixed Costs $2,964,000 Contribution Factor 0.228 $13,000,000 Branch B will break even at $13,000,000 in volume for the year being analyzed. COMPARISON AND CONTRAST The question is, Why is there a big gap between the break-even points? Branch A broke even at $10,307,000 whereas Branch B broke even at $13,000,000. This leaves a gap of $2,693,000. Table 1 shows some comparisons of figures between Branch A and Branch B. The main reason is either that Branch B did not get as much margin in their bids or else that they did not perform as well on the job; because Branch B s variable cost ratio is 77.2 cents per dollar s worth of work, or 2.6 TABLE 1. Comparison of Business Data between Branch A and Branch B Category (1) Branch A (2) Branch B (3) Variable cost/volume 0.746 0.772 Net gain ( 1,000) 2,044 523 Net gain/volume (%) 11.1 3.4 Volume/equipment value 1.74 1.39 Net gain/equipment value (%) 19.3 4.8 FIG. 9. Branch B s Profit Picture with Branch A s Variable Cost Ratio 44 / JOURNAL OF MANAGEMENT IN ENGINEERING / MAY/JUNE 2000

cents higher than Branch A. If Branch B had achieved a 0.746 ratio, the same as Branch A, they would have made $923,000 on their actual volume of $15,267,000, as shown in Fig. 9. These two reasons are the most straightforward approach to view the situation from the management s standpoint, but it must be viewed from a different perspective. Even though it looks as if Branch A is doing much better than Branch B, in point of fact this is one of Branch A s best years. Branch B could be having an off year and they also carry a larger proportion of old, low-production equipment, which costs them too much in engineering depreciation. A manager must look from all perspectives at the question of why one branch is doing better or worse than the other, because there are many hidden obstacles to be uncovered before a decision can be made. There can be quite a few reasons for the gap in the break-even points between Branch A and Branch B, but a substantial portion of this was due to the fact that Branch B just did not do enough work for the amount of overhead and equipment they were supporting. BREAK-EVEN FORECAST As an example of how to use the break-even analysis as a forecasting tool, this research will use Branch B to make a forecast for their tenth year. It indicated that year number seven was the best year they have had until recently. Here is Branch B s performance for nine years. This track record might be used in preparing forecasts of future profits. Based on Branch B s experience through year nine, it should be possible to forecast the Branch s results for year 10. Branch B History Year Variable cost/volume 1 0.907 2 0.851 3 0.876 4 0.807 5 0.804 6 0.780 7 0.772 8 0.792 9 0.809 Average Ratio 0.822 The first thing to consider is Branch B s fixed costs for the coming year. Branch B would already have an overhead budget and equipment budget; yet to verify this, some simple projections should be made for these costs. Assuming a continuation of this trend, it looks as if they will hit $790,000 for combined overhead in year 10. Their annual equipment expenses have been more erratic, and since this number can be estimated rather closely for any planned equipment changes, it is recommended that $2,250,000 will be used for real projections. After the fixed costs have been taken care of, the following question comes up: What kind of year are they TABLE 2. Anticipated Net Gain for Branch B (Next 10 Years) Volume (dollars) (1) Net gain (2) Gain/volume (%) (3) 17,000,000 0.00 0 18,000,000 0.178 0.99 20,000,000 0.534 2.67 22,000,000 0.890 4.05 24,000,000 1.246 5.19 26,000,000 1.602 6.16 28,000,000 1.958 6.99 30,000,000 2.314 7.71 going to have? In the absence of any specific knowledge about the work, the nine-year average of the variable cost/volume ratio, which equals 0.822, will be used. There is now enough information to make a break-even forecast. Overhead $ 790,000 Equipment Expense $ 2,250,000 Fixed Costs $ 3,040,000 Variable Cost/Volume 0.822 Contribution Factor 0.178 With a fixed cost of $3,040,000 and a variable cost ratio of 82.2 cents on a dollar s worth of work, Branch B is expected to have a contribution factor of 17.8 cents. As soon as Branch B has enough volume to cover their fixed costs, they can apply that contribution to the net gain. However, up to the point where they breakeven, the contribution goes toward paying their fixed costs. With an estimated $3,040,000 in fixed costs, the company will have to do approximately $17,000,000 in volume just to break-even. Break-Even Point $3,040,000 an Estimated $17,000,000 0.178 However, since corporations are interested in profits, a closer look should be made at the range of possibilities beyond the break-even point. Table 2 shows the anticipated net gain on volume up to $30,000,000. To summarize this forecast, Branch B would have to do more than a $30,000,000 volume to make 8% net gain on volume. This could be a goal to strive for in year 10. CONCLUSION Because it looks at the cost, volume, margin, and profit, the revisited break-even analysis is an efficient way to analyze a company and its branches. These areas of the company are combined to give a better look at how to estimate what to do with each one in order to calculate a break-even point to strive for in the next years of operation. The revisited break-even analysis is not some magical formula that will solve all of the problems a company may face, but it can surely give man- JOURNAL OF MANAGEMENT IN ENGINEERING / MAY/JUNE 2000 / 45

agers a way to break down the problems and solve them for the future. ACKNOWLEDGMENTS This research project was successfully completed with the continued efforts of many organizations and individuals. The writer expresses the sincerest gratitude to the Actual construction company that participated in this research and gratefully acknowledges the Engineering Research Center for providing funding to support this research effort. The writer also wishes to express much thanks to the reviewers, whose numerous suggestions were most helpful. APPENDIX. REFERENCES Cooper, R., and Kaplan, R. (1991). The design of cost management systems. Prentice-Hall, Englewood Cliffs, N.J., 39 40. Hendrickson, C. (1989). Project management for construction. Prentice-Hall, Englewood Cliffs, N.J., 123 145. Newnan, D. G. (1991). Engineering economic analysis, Engineering Press, San Jose, Calif., 45 52. Riggs, J. L. (1982). Essentials of engineering economics, McGraw- Hill, New York, 234 235. Schmenner, R. (1988). Escaping the black holes of cost accounting, Horizon Publishers, Bountiful, Utah, 66 68. Schank, J. (1989). Strategic cost analysis, Prentice-Hall, Englewood Cliffs, N.J., 156 166. Zimmerman, V. (1984). Managerial accounting: An analysis of current international application, University of Illinois Press, Urbana- Champaign, Ill., 143 145. 46 / JOURNAL OF MANAGEMENT IN ENGINEERING / MAY/JUNE 2000