In his "Smart Business" column, Jim Olszytnski reviews some reasons why contracting businesses fail.

This headline repeats the title of an article by CPAs Robert Davidson and Martin Maguire that appears in an online publication called Journal of Construction Accounting & Taxation. The full article can be obtained from the Web site www.davidsonandgolden.com. (Click the “Publications” icon, then scroll down to “Articles.”) Although aimed at construction contractors, it’s nonetheless a good read with many lessons for drilling firms as well. Here is an abridged version of the biggest reasons for failure.

1. Growing too fast. Project managers get spread too thin, inexperienced employees get promoted, controls are not adequate. The authors warn that a growth rate of more than 20 percent could be a problem.

I’ve seen this plenty of times in my own experience. Lions have been known to gorge themselves eating 100 pounds of meat at a sitting from a big kill, because nature has wired their brains to understand it may be a long time before they eat again. Contractors have some of that in them as well. Anyone who’s been through lean times has trouble resisting the urge to gorge when work is readily available. But this is a recipe for disaster.

A much better tactic when work is plentiful is to select those jobs you can comfortably handle — and MAKE MONEY on! A mystery of the construction boom of the 1990s (which still is taking place in some regions and construction sectors) was why there was so much work, yet contractor profits were stagnant. This defies economic law. It’s because contractors tend to think mainly about keeping busy, rather than making money.

2. Obtaining work in a new geographic region. Logistics are tough. Labor supply, subs, suppliers, codes, lien laws, permits, labor laws, tax rates, weather and soil conditions may be dramatically different.

The grass always seems greener somewhere else. During construction slumps of the 1980s, I used to get calls once in awhile from contractors asking me where the hot markets were. They were ready to pick up and leave at a moment’s notice.

Usually, I’d discourage them. If they couldn’t survive in a market they knew, no way they’d make it among strangers. All they would do was buy a bunch of work and thereby mess up the market for everyone.

3. Dramatic increase in single job size. If the largest contract you’ve ever handled was $100,000, you could get in big trouble trying to manage a $1 million project. Same with a contractor who’s done million-dollar jobs suddenly bidding on a $10 million bonanza. Here again, the gorging kicks in.

To break into dramatically larger jobs, the authors advise trying to hook up a joint venture with a contractor experienced with such projects.

4. Obtaining new types of work. Residential and light commercial projects tend to have similarities, but the experience curve gets steep as you step up the ladder in size and complexity. Most astute craft workers can adapt fairly quickly to different materials and techniques. What can kill you, though, is the added paperwork, layers of bureaucracy and especially, increased risk on large projects. As I’ve stated numerous times in this column, I’ve never met a contractor who went broke because he didn’t know how to do the work. But I’ve encountered scores who went belly up for lack of business sense.

If you want to diversify, start small and learn the ropes before tackling bigger projects of a kind you’ve never handled before, say the authors.

5. High employee turnover. Common sense tells you this is no good. Never forget that estimators, project managers and foremen are critical to the well-being of any trade firm. Treat them well.

“My way or the highway”-type management is common in the drilling industry, but tends to drive good people away. Successful contractors eventually must learn to delegate and learn from subordinates who just may have new and improved ideas about how to get things done.

6. Inadequate capitalization. It’s not just how much you spend, but how you finance it. Too much short-term borrowing can kill you.

“Many business owners underestimate how much money will be needed, not only to start the business, but also to sustain it as it struggles to gain financial strength,“ explain the authors. “Tangible working capital less than 5 percent of annual revenues and a poor banking relationship will contribute to severe cash flow issues.

“Also, the manner in which a contractor finances his long-term assets can significantly impair its ability to continue operations,” they continue. “In an industry that relies so heavily on working capital, taking on significant current debt to purchase equipment can hamper the company’s ability to obtain a bond. A contractor who purchases several hundred thousand dollars of equipment and finances through a short-term loan, has just reduced its working capital by the entire cost of the equipment.”

7. Poor estimating and job costing. Bid too high, you won’t land the work. But you also can get killed consistently leaving 5 percent to 10 percent on the table. Some of this problem may be tied to the estimating software you are using.

What’s that you say? You don’t use estimating software? You still use the old pencil on the back of the envelope method? Maybe that’s part of the problem.

Poor estimating is, of course, the logical consequence of lousy job costing. On every job, you need to make comparisons between actual costs and those assumed by the original bid. Where large variations occur, you must probe for the reasons why and strive to eliminate the discrepancies in the future.

8. Poor accounting system. A lot of this is tied to the accounting software you may be using. It ought to provide monthly financial statements based on the percentage of completion method with detailed contract schedules, say the authors.

“Also, the accounting system should provide for phase coding, identification and allocation of indirect costs, and produce variance reports,” they advise. Without timely and accurate financial information, no contractor can make sound business decisions, especially with regard to the issues addressed previously about diversifying into larger jobs and new kinds of work.

9. Poor cash flow. Beware in particular of labor-intensive contracts, where you are liable for hefty payroll expenses before you receive first payment from the contract. The authors offer several useful strategies for improving cash flow in such cases, including:

• Negotiate additional mobilization and payment terms into the contract.

• Front-load the bid quantities to get the owner to help finance the contract.

• Negotiate the amount held into re-tainage if possible.

• Pre-qualify contract owners.

• Issue billings in a timely manner. (A home repair firm I’ve done business with for years routinely waits several weeks before sending out invoices for work they’ve done. Then they give the customer 30 days to pay — in reality much more, because customers can be as much as a month late before they get around to sending out a late payment notice. Although this company delivers good work and service, their trucks and equipment tend to be run down. I suspect the lackadaisical approach to cash flow is a big reason why.)

10. Buying dumb stuff. Ego purchases or luxury items like vacations homes, fancy cars, speculative real estate and other investments may seem like great ideas during a windfall, but if the investments turn south, your construction business may end up funding the sinking venture.

One of the most common excesses I’ve seen contractors indulge in is to move into a “Taj Mahal.” Everyone enjoys a nice working environment, and there even are some business efficiencies to be gained by moving your shop to a modern, spacious facility. But before you go upscale, do some hard numbers crunching that asks how you will finance your plush palace if business drops in half during the next downturn.