For the past several years, the construction industry has been hit hard by a general lack of work in the private sector, and more recently, the public sector. With less work available, competition has been fierce, resulting in lower bids on projects and ultimately less revenue earned by contractors.
To make matters worse, project construction costs have not decreased in proportion to the loss in revenue. For example, material and fuel prices continue to rise, as do employee benefits such as health insurance. With decreased revenue and increasing costs, how can you maintain gross profit margins in today’s environment?
An often overlooked answer is to focus more closely on equipment utilization: how effectively you are using your entire equipment fleet to generate revenue. Your equipment fleet is likely the largest asset of your business. Are you getting a reasonable return on your investment?
How to measure equipment utilization
A quick way to measure equipment utilization is with the following formula:
Sales volume (construction revenue less materials and subcontractors) ÷ Gross fixed cost of equipment fleet
This ratio represents the amount of revenue generated per $1 investment in equipment. The goal should be to produce a ratio of at least 1.0—the higher the ratio, the better. If your ratio is less than 1.0, it’s very likely you have idle or unproductive equipment.
At a more detailed level, think of equipment utilization in terms of operating at or near full capacity. For example, you may believe that a specific piece of equipment can reasonably attain 1,700 hours of use in a given year. If its actual hours of operation were 1,020, the equipment was operating at only 60% capacity. Now, expand that same type of budget-to-actual comparison for the entire fleet. Which units are productive and which units are mostly idle? Those contractors who have figured out how to close the gap are the ones maintaining or increasing gross profit margins.
Why is improving equipment utilization so important?
There are three main types of equipment costs: operating, maintenance, and ownership. In general, operating costs (i.e. fuel, grease, and wear parts) tend to be variable while maintenance (i.e. repair labor and parts) and ownership costs (i.e. depreciation and licensing) are fixed.
Many contractors focus too heavily on the variable costs, ignoring the significant impact fixed costs have on their business. At the end of the day, a contractor’s ability to spread both variable and fixed costs over a greater number of hours will result in a lower cost per operating hour, enhancing profitability. But when hours are limited (as in today’s economy), the productive units in the fleet bear more of the fixed cost burden, resulting in a higher cost per operating hour.
The bottom line is fairly simple: equipment hours generate revenue for the business. The more productive the equipment fleet, the more revenue generated, and the stronger the likelihood that gross profit margins are maintained or increased. However, when hours are hard to come by, more emphasis should be on reducing the fleet size to match the work level that is available.
If you would like to better understand and manage equipment utilization, please contact us. The Real Estate and Construction Industry Team is dedicated to helping contractors achieve their goals.
Chad Zeller, CPA is a co-leader of the firm’s construction and real estate industry team. His experience includes supervising audit and tax engagements of a varied client base, including general and specialty trade construction contractors, real estate developers, manufacturers, transportation companies, and service businesses. He is skilled in projections, consolidations, accounting systems, tax compliance, and financial statement analysis.