Month: October 2015

Secrets of Bonding #111: WIP Quiz

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 When it comes to Bid and Performance Bonds, nothing may be required more often than financial statements and WIP schedules (Work In Process aka Work On Hand).  For mood music, click here.australian-whip

The WIP schedule could be required monthly for active bidders.  Certainly, the construction company management team monitors this critical info.  It tells the tale of how things are going, and where they’re headed. Profitability is revealed.  It is a preview of the upcoming Profit and Loss section in the next financial statement.  Poor results on the WIP schedule equal low Gross Profits on the next P&L – and maybe a net loss.

Let’s look at a couple of examples and see if you can spot what’s going on.  For the sake of illustration, we’ll use an abbreviated format.

On each of the following WIP schedules, compare the expected profit upon completion to the original profit estimate.

Joe Shmoe Construction

Project

Current/Revised Contract Amount

Original Gross Profit Percentage

Billed to Date

Costs to Date (Including change orders)

Revised Remaining Costs to Complete

1001

$1,000,000

10%

$700,000

$602,000

$202,000

Is the current profit projection more or less than originally expected?

  1. More
  2. Less
  3. Exactly right

 

Global Construction and Gutter Cleaning

Project

Current/Revised Contract Amount

Original Gross Profit Percentage

Billed to Date

Costs to Date (Including change orders)

Revised Remaining Costs to Complete

4321

$1,000,000

10%

$700,000

$602,000

$410,000

Is the current profit projection more or less than originally expected?

  1. More
  2. Less
  3. Exactly right

 

Dummenhappie Contracting

Project

Current/Revised Contract Amount

Original Gross Profit Percentage

Billed to Date

Costs to Date (Including change orders)

Revised Remaining Costs to Complete

007

$1,000,000

10%

$700,000

$630,000

$270,000

Is the current profit projection more or less than originally expected?

  1. More
  2. Less
  3. Exactly right

 

Got your answers?  Let’s go over these:

Joe Shmoe originally projected $100,000 profit (10% of $1,000,000).  Now it has nearly doubled! (602,000+202,000=804,000.   1,000,000-804,000=196,000)  “a. More”

Global starts with the same numbers (to help illustrate our point), but the costs are different.

(602,000+410,000=1,012,000   1,000,000-1,012,000= -12,000)  Not only has the profit margin slipped, it exceeds the contract amount resulting in a projected overall loss. “b. Less”

And finally Dummenhappie.  This one is amazing!  They are about ¾ of the way through the project (actually 70%), and right on target profit wise. The expected profits and total costs are exactly as predicted before they started the work.

(630,000+270,000=900,000   1,000,000-900,000=100,000)  “c. Exactly right”

Think about that. This answer “Exactly right” means prior to actually starting the project, they accurately predicted the exact number of labor hours.  Do you think the reality of the project might be somewhat different from the prediction?  Maybe they will hit unexpected obstacles and things will go slower (higher labor costs).  Or they may find more efficient ways to perform the work as it progresses (lower labor costs).  The cost of material purchases can also vary.  Get the point? It’s hard it imagine any project in which the costs can be perfectly predicted in advance.

indy-whipSo what’s going on here if Dummenhappie isn’t brilliantenluckie?  Our assumption is that the contractor has failed to RE-estimate the remaining costs to complete.  They are still relying on the original estimate – not analyzing the actual “costs to complete” during the life of the project.

Relying solely on the original cost estimate is a dangerous and weak practice.  The contractor may be unpleasantly surprised if unanticipated costs (such as labor inefficiency) have eroded the profit margin.  The worst part: They won’t know about it until the end, when it’s too late to make a correction!

Surety underwriters will detect if the remaining costs are not being reevaluated.  It reflects poorly on the contractor’s management practices.  It also means their profit projections may be totally unreliable.

The solution is to keep accurate records of the labor and material costs that go into each job, and periodically reevaluate (re-estimate) the remaining costs to complete. 

You can have a lot of fun with WIPS!  We’ve just touched on one part in this article. The analyst must not only review the profit trend, but also the method of calculation to confirm that accounting procedures are appropriate.

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!  Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

Secrets of Bonding #110: Contract Additions – Is More Always Better?

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USUALLY more is better. 

  • “Would you like more ice cream?”
  • “Congratulations on your raise!”
  • “Honey, we’re pregnant!”more2

The same is true when it comes to construction contracts.  It is not uncommon for the scope of work to be modified. The project engineer may have discovered a problem and they will pay the contractor to fix it.

There could be a desire to expand or enhance the project, resulting in an increased contract price.  These additions occur routinely. Sometimes there are also “deducts” meaning an amendment that reduces the contract amount.

Additions to the contract mean more revenues for the contractor – it’s a good thing, unless unexpected problems pop up.

In this discussion, we are talking specifically about bonded contracts.  Whether public or private, prime or subcontract, our comments herein apply.

more3Bond Amount vs. Contract Amount

Surety bonds, Performance and Payment Bonds on contracts, are all similar but may have important variations.  It is common for the bond to adjust upward to follow an addition in the contract amount.  This means if the $1,000,000 contract is increased by amendment to $1,200,000, the bond is increased so that 100% coverage is maintained.

Not only does the bond increase, the adjustment is usually automatic.  Most bonds say there is an automatic increase with no obligation to inform the surety of the change.

When the surety is required to accept the additional exposure, they are entitled to be paid for it.

The Downside of Contract Additions

What could possibly go wrong to spoil this perfect picture? You have a contract and “Poof!” it just got bigger!  You provided a surety bond and “Wham!” it automatically adjusted to the new amount!  All good!

  1. One problem that can occur involves the additional bond premium. The subject is sometimes complicated, but the short version is that the surety will charge for the increase.  If the contractor fails to include the additional bond fee in the negotiation for the amendment, the bond fee will come out of their profits instead of being passed on to the project owner as is normal.
  2. A second issue can arise in connection with the automatic bond increase. Sometimes it doesn’t happen.  Some bond forms state that contract increases in excess of a stated percentage (e.g. 20%) must be pre-approved by the surety.  This is to prevent the surety from being pulled into a contract amount far above the original support level. If the surety refuses to accept the increase, the contractor will have the difficult / unpleasant task of seeking a new surety and possibly paying twice to bond the project!  Doesn’t get much uglier than that…

Subtletiesmore1

On the subject of the bond fee, some sureties demand payment when the contract increase occurs.  The thinking is, “We have the exposure now, why not get paid?”

Other companies may wait until the contract ends and net out additions and deducts, then charge for the net increase over the original bond amount.

You may also run into companies that charge for increases, but do not net out or give refunds for contract deductions.

If you want to know what to expect in these situations, you must ask for written answers from the surety.  These fine points are usually not stated in writing in advance – but are worth knowing.  With contract additions, it’s what you don’t know that can hurt you.

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!  Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

Secrets of Bonding #109: Surety Letters – You Get What You Pay For

Steve Golia2 Comments

A Surety Letter can be used like a bid bond.  It may be required by private owners (and General Contractors in connection with subcontracts) as a means of assuring the contractor / bidder can provide a Performance and Payment Bond upon award of the project.  Private owners are not the only ones who use this procedure.  You may even run into this requirement on public jobs.

The Surety Letter is a statement of the principal’s (contractor’s) ability to provide a surety bond.  They may seem like an easy and useful alternative to a bid bond.  After all, it’s a letter. That has to be easier than a bid bond!

Cost

Theoretically, bonding companies are entitled to charge for bid bonds.  They are binding financial obligations and sureties occasionally pay out claims on these.  The industry practice, however, is to waive such charges.

When it comes to the surety letter, there is no financial obligation.  They are usually issued for no charge.  You can’t make a claim on one, and they are not a guarantee that a P&P bond will be provided.

So when a surety letter accompanies a proposal, exactly what does the project owner get?

The key points are:

  1. Sufficient Authority  Who wrote the letter? The best letters are written directly by bonding companies on their letterhead.  This is important because the author can bind the surety company. If they say they will provide a P&P bond, you can take that to the bank.  Less effective letters may be written by individuals who are not direct employees of the bonding company and who may not be able to legally bind them. Hint: The letter is stronger if a power of attorney is attached.
  2. Escape Hatch Typically these letters have a disclaimer that says there is no promise to provide a P&P bond. It may say the underwriter reserves the right to approve or disapprove performance bonds based on the client’s circumstances at the time the bond is requested. (Question: Do bid bonds have an escape hatch?  See below *)

What does all this mean? When a surety letter is used, it always proves one thing: The contractor has some form of a bonding relationship.

However, depending on the content of the letter, it may not include any form of commitment.  Such letters are an “indication of bondability” leaving the reader to speculate whether a P&P bond will follow.

dependability

To what extent can the project owner rely on a surety letter?  Considering most are only an “indication,” not much!  Bid bonds are binding obligations assumed by sureties, and claims can be filed against them.  If they both are available for little or no charge, which would you rather have?

* Answer: Bid bonds never contain an escape hatch.  If, upon award, an acceptable P&P bond is not provided, the surety will likely face a bid bond claim.

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!  Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

Secrets of Bonding #108: Work On Hand – So Mysterious and Beguiling

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mysterious-eyesThe confusion is amazing.  Why is this subject so mysterious and perplexing for many professionals?

Let’s start with something really simple: What is “Work On Hand” for a construction company? 

This is a crucial question because when you get bid and performance bonds, there is always an aggregate capacity limit, which is calculated using the Work On Hand (WOH).  So you MUST know how to figure it.

Do you see the correct definition?

  1. The incomplete portion of all bonded projects
  2. The incomplete portion of all projects
  3. The unbilled portion of all bonded projects
  4. The unbilled portion of all projects
  5. All contract costs
  6. Contract price minus costs
  7. Original contract price minus costs incurred to date
  8. Contract price minus approved (by architect or owner) billings
  9. Contract price (including change orders) minus current estimate of total costs
  10. The sum of open (undecided) bids plus the unbilled portion of all projects

You like them ALL?!  They sound pretty good, but unfortunately… none are correct.  The bonding definition (that’s used throughout the industry) is based on the accountant’s approach.  It’s mysterious. And only one answer makes sense and is correct.

Dive In

If you have followed our articles, you know that billings are not part of the answer, even though many contractors like to use this approach.  They may choose #4 “The unbilled portion of all projects” because of their need to monitor cash flow.

To rely on this approach, you must depend on the project owner to PAY CORRECTLY based on the degree of completion.  In other words, when you are 50% complete, you should be paid 50% of the contract amount. To continue this fallacy, therefore, when you make your last billing to reach 100% of the contract price, you must be complete with the actual work.

The problem is that the project owner does not know the cost of the remaining work, which defines the degree of completion.

Challenging question: How reliable would it be to use billings to determine the WOH if the project was unprofitable? (costs exceed the contract amount)

The Truth Revealed

Accountants tell us that the degree of completion and the remaining WOH are defined by costs.  The reason? It is because regardless of the state of the billings, the project is not complete until there are no more costs left to incur.  When the job doesn’t need one more brick or hour of labor, it is 100% complete.

The Secret Formula

WOH consists of the following:

  • Current estimated costs to complete on all projects, plus
  • The full amount of new contracts just started, plus
  • The full amount of undecided bids and contract proposals

Beguiled no more! If a contractor says “The job is going well. We are already 60% billed!” You say “Great, are your cost projections within budget?”

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!  Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

Secrets of Bonding #107: Surety vs. Fidelity, The Cage Match

Steve GoliaLeave a comment

Surety. Fidelity.

They’re both bonds, they come from the same family, but can they get along?cage-match2

To some, this timeless battle is mere entertainment, a Cage Match for the ages.  We’d like to put this question to rest once and for all. Which is more important? Which is more beneficial? Do companies need both?

A surety bond is a guarantee of performance. For example, the state of New Jersey is guaranteed that a construction company will faithfully perform its building contract. 

A fidelity bond protects a business from acts of employee dishonesty. 

Which is More Important?
One could argue that fidelity is more important because EVERY company would benefit by avoiding the impact of employee theft / dishonesty.  Companies have been ruined by such crimes. Examples:

Worker nets $400,000 in refunds. After mastering the furniture company’s phone and mail-order system, Suraj S. started issuing himself refunds for purchases made by customers. Suraj would cover up his rampant refunding by altering inventory records. In less than a year, he stole almost $400,000. 

Security expert finds — and exploits — $1 million hole in company’s internal controls. It’s not an unheard of scenario: A company hires a former “professional” thief as a theft-prevention specialist because of real-life expertise in the security field. In this case, a former embezzler, Barry W., was hired at (name withheld), Inc., as a “theft-prevention specialist.” Rather than protection, Barry ended up writing himself checks on company stock — signed with a signature stamp of a co-worker — cashing the checks, then destroying the canceled checks that were returned to the company. He made false entries in the company’s books to cover his actions. Before being caught he stole a staggering $1,138,334!

For contractors that depend on public works contracts, surety bonds (bid, performance, payment) are essential.  The company cannot survive without them. However, they may survive without a fidelity bond.

Should a Company Have Both?
Let’s stay with the construction company example, but this is true for all firms that have cash flow running through their accounting department. Fidelity bond underwriters know it is often the trusted employee who commits the act of theft. It is simply because they are in the best position to steal. It is not uncommon for a theft scenario to reach astronomical levels as it drags on for years, undetected. 

cage_match

Added Bonus
Does having a fidelity bond help a company qualify for a surety bond or vice versa?

The underwriting of fidelity bonds includes an evaluation of internal controls, such as money handling procedures, monthly account reconciliations and annual audits.  The issuance of surety bonds involves the analysis of accounting procedures, financial performance, quality of management, operating history, and many other factors. Having the appropriate fidelity controls in place, and actually having a fidelity bond, are pluses for the surety underwriter.  We may conclude that surety bond clients are natural candidates for a fidelity bond, and the opposite is also true for those companies that need surety bonds in order to operate. It helps both ways.

There you have it: Surety and Fidelity can co-exist in harmony at last, each proud of the role it plays. 

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!  Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.