Business Matters: Government vs. private sector contracting

Although some construction companies get all the work they need in the private sector, many develop a mixture of private and govern ment work. Since the flow of government dollars is fairly steady, these companies will increase their government work when the economy is slow and migrate back into more private work when the economy is booming. And if your company is small and you want to grow you need to seriously consider grabbing a slice of the government work – whether it be city, state or federal.

But getting into government work is not as easy as it may sound. The rules are different, the margins slim and the competition tough. There are no handshake contracts. You don’t market your company on the golf course and you have to run your company and your jobs exactly the way the government dictates or you won’t even qualify to bid.

Financials and bonding
“For government work you have to have an extremely strong balance sheet, all the necessary bonding and incredible liquidity,” says Rick Macchiarulo, CFO for Tully Construction, Flushing, New York. “Without those it’s virtually impossible to secure major government projects. That’s a major barrier to entry for a lot of small companies and something they have to develop over time. A lot of smaller companies wind up subbing for us because they can’t get the bonding.”

Each state has different requirements when it comes to prequalifying contractors, but most follow a similar formula. To work for the Texas Department of Transportation, contractors have to requalify every year, says Larry Wagner, chief financial officer of Infrastructure Services in Houston. This involves completing and submitting a lengthy questionnaire that shows your financial capability, equipment assets, resources, relationships with vendors, the experience of the owners and key personnel and the types of work you’ve done in the past. “But the main thing they look at is your financial ratio,” Wagner says. “It works out to 20 times your working capital, fully audited, of course. So if you have $10 million in working capital, that means you can do up to $200 million in work for them.”

Bonding requirements can vary considerably on private sector contracts, but by law almost all government agencies require bid bonds, performance bonds and payment bonds on any public project, according to the National Association of Surety Bond Producers. These bonds protect the owner of the project (the government or the public) against contractor failure, and since mechanics liens can’t be levied against the government, they protect laborers, material suppliers and subcontractors against non-payment.

Low-bid, low-margin business
In the private sector a strong working relationship or a good track record can win you jobs even when your prices aren’t the lowest. In government jobs that doesn’t happen. Everything, by law, goes to the lowest bidder; and that can put a real squeeze on profit margins or turn small errors in bidding into big financial setbacks.

“We don’t make much money on government work,” says Rebecca Fitzsimmons, vice president of finance for J.H. Rudolph & Company, Evansville, Indiana, a company that performs a mixture of public and private sector work. “There’s not much profit in it. It’s very competitive.” Margins are better on the private side, but the public jobs also help pay for overhead which can help the company be more competitive on the private side as well, she says.

Nonetheless, there are companies such as Tully that do government work almost exclusively. For them the key to keeping margins from being squeezed in a low bid environment is to run a rigorously efficient operation with no mistakes or loose ends, to watch cash flow and to manage change orders, Macchiarulo says.

Cash flow
The good news about government jobs is that you will get paid. The bad news is you may not get paid as fast as you’d like.

“If you bid these things properly you get the cash up front,” Macchiarulo says. “But there are times when you’re 60, 90 or 120 days out there and that ties up your cash flow. If you bid a job where you think you’re going to make 10 percent or 15 percent profit and the government agency is holding 10 percent retainage – you’re paying taxes on retainage that you don’t have and paying taxes on percent completion funds that you don’t have. So it’s quite frustrating. Some agencies are better than others and by and large you have no write off, but some will punch list the life out of you.”

Change orders
The contractors we talked to all used the change order process to gain back some of the ground they yield to the inevitable low-bid profit squeeze of government jobs. While it occasionally happens in the private sector that a contractor does a little extra work, goes the extra mile at no charge to keep a valued customer, such a strategy is financial suicide in a low-bid environment.

“Don’t be afraid to ask for the change order,” Wagner says. “Understand what it is you are being asked to build and when you run into change conditions or when extras are asked for, be sure to document it, capture your costs and request a change order. The way I think of it is you bid the contract, but you build the change order.”

In addition to helping improve the profitability of a project, change orders can sometimes bring in new business. “You never know when you’re digging a big hole in the ground what you’re going to come up with,” Macchiarulo says. “But we’ve got a lot of incidental business and a lot of sundry revenues from these surprises, such as jobs from Con Edison or Verizon. When you have to reroute underground lines many of those jobs are lucrative and we’ve seen a significant drive in margin and cash flow from these sundry jobs.”

But the only way to benefit from these surprises is if you have established relationships with these companies, the flexibility and strength to respond quickly and supervisors who know what they’re doing. Otherwise, Macchiarulo says, “It can be a disaster.”

Rising material prices
Escalation clauses in contracts allow you to adjust prices for unanticipated increases in material costs. Some government agencies allow them, some don’t. But in the past three years prices for asphalt oil, steel and concrete have soared, leaving contactors without escalation clauses to bite the bullet.

Asphalt oil has tripled this year, Fitzsimmons says, and while Indiana disallows escalation clauses, the DOT in neighboring Kentucky allows them. “Over the past year it’s been challenging because all of our vendors increased costs. But because we’re locked into long-term contracts with the state of Indiana, we’re not allowed to pass those increases on to them.”

Disallowing escalation clauses is counterproductive for both the state and the contractor Fitzsimmons says. “Escalation/de-escalation clauses are a win-win situation for both sides because you can take the risk out of the contract and the state doesn’t pay you for carrying the risk. But at the same time if the prices go down, the state would benefit. So they should be able to pay less on contracts because they’re not paying the contractor to bear that risk.”

And prices are so volatile right now that asphalt providers won’t even let the company lock in a price for the length of a job, Fitzsimmons says. “At best they may let us lock in a price – or give us a price not to exceed – for the next three months.”

Women and minorities
Of all the hoops the government makes contractors jump through, one of the most difficult is the requirement to hire a certain number of subcontractors that are disadvantaged business enterprises, or DBEs – companies owned by women or minorities.

For contractors the will is there, it’s just finding qualified DBEs that’s proving to be the challenge. “In this area, DBE entities are really hard to find,” Fitzsimmons says. “The state of Indiana was apparently not compliant, so now they’re coming down on the contractors. There has been a lot of work on the issue, but to find subs that meet the requirements is just tough.”

In Texas, Wagner says finding DBEs is not as difficult, but the state is strict about paying them. “They’re stringent on the payment requirements and the DBEs know it. If you get the least bit behind with them you’ll get a note from TxDOT.”

Nonetheless DBEs are a key component to successful government contracting and their influence is only going to grow.

Sometimes another hurdle for contractors who want to work for the federal government is the Davis-Bacon Act. Put into law in 1934 the Davis Bacon act requires contractors to pay the “locally prevailing” wages and benefits to workers and mechanics for federal contracts in excess of $2,000. The law is designed to protect local construction companies from being undercut by cheaper outside labor, which is fair enough, but it can be burdensome for non-union companies trying to compete in states or cities with a strong union presence.

One mistake contractors sometimes make in complying with Davis-Bacon is to pay a per-hour wage and a per-hour cash equivalent value of benefits, rather than separate the wages and the benefits. If the worker earns $16 an hour and qualifies for $4 an hour in benefits, the contractor can, according to Davis-Bacon rules, just pay the worker a combined sum of $20 an hour. This may look like it saves paperwork, but it can be a mistake, says C. Ray Smith, president of Fringe Benefit Group, an Austin, Texas-based company that helps employers administer benefit programs. In the lump sum scenario, you have to pay payroll and all relevant taxes and deductions on the full $20 an hour. But if you separate out the benefits, you only pay these taxes and deductions on $16.

“Although there are variances, the additional cost to the employer for these taxes is typically around 25 cents on every fringe benefit dollar paid in wages,” Smith says. “What this means is you could reduce your total weekly payroll costs by an estimated 6 percent.” The Fringe Benefit Group provides a free online calculator that can help you better estimate your own numbers, available at this site.

Networking and marketing
In the private sector, there are no rules or regulations that limit how you market your services to your customers. Whether it’s a golf outing, tickets to the big game or traditional sales and networking, you can do whatever you think works.

Not so in government contracting. The rules vary depending on the state or agency, but in general, the kinds of relationships you can develop with government employees is restricted. “We’re not even allowed to give them so much as a ball cap,” Fitzsimmons says.

This is understandable in that it’s necessary to keep the bidding process fair and to prevent graft or corruption. But it can also sometimes interfere with contractors’ ability to educate government officials about new technology and new and better ways to do the work.

Opportunities to educate officials do exist, but government officials don’t do business on the buddy system. You have to learn the ground rules first. Municipalities are usually less strict about the rules of engagement than state or federal officials.

Contractor associations, however, can be a big help. By representing a group of people, rather than just one individual company, associations can do a better job of representing your interests with elected and appointed government officials.

Don’t sell – listen and learn
Nonetheless, government agencies and contractors have to communicate. What contractors coming from the private sector have to understand it that this communication is not a sales pitch but rather an information gathering process.

“There’s a tremendous amount of opportunity for contractors as governmental agencies start to downsize and look for ways to outsource the work that they do,” says Eric Turner, a 38-year veteran at Caterpillar and a city councilman at large for Peoria, Illinois. “But they have to be aware of the capabilities of the agencies. In order to get that exposure the contractor needs to call on public works directors and fleet management directors at these various organizations and find out what type of things are being cut from the budget that the contractor can pick up and do. That’s key.”

A case in point Turner cites is Peoria’s decision to outsource snow removal. The city was paying for machines that got little use eight months out of the year. “So they decided to contract with local contractors whose machines would be down in the winter anyway and use those contractors to remove snow on an on-call basis. The cities didn’t have to buy new machines and the contractors got the business.”

Smart contractors will attend city council meetings and keep their ears to the ground. You need to know when changes are coming and how the municipal budget process works; then position your company and plan your equipment utilization accordingly, Turner says.

For small companies looking to get into the government market Macchiarulo thinks partnerships make the most sense. “I would recommend they initially establish a joint venture relationship with a firm that’s already doing government work. Rather than just jump in, they should partner with someone and see how that relationship works, how the dynamics work with public authorities, rather than try to bid alone,” he says.

Turner recommends several things: build a track record, put everything you have into finding or developing DBEs, finish your projects on time and don’t disappoint either government officials or politicians. “The worst thing that happens to some of these private contractors is not finishing project on time,” he says. “That track record sticks with you in the public sector beyond what you would believe. Contractors have to understand the pressures that are put on politicians.”

What the market’s doing
If there is an upside to government contracting it’s that there is so much money moving around. Between September 2005 and August 2006, TxDOT alone let about $5 billion in contracts, according to TxDOT’s website.

In terms of growth and opportunity, private and government sectors are extremely favorable right now, but for different reasons, says Serena Tse, senior vice president and senior research analyst at GE Capital Solutions, which provides leasing and lending services to contractors.

On the private side, residential housing is clearly slowing. But non-residential construction is booming with double-digit growth across all sectors. In the second quarter of 2006 commercial space is up 16.5 percent, office is up 18.4 percent, manufacturing is up 32.6 percent and power plant building is up 27.7 percent. In addition, the government financing market experienced steady growth of 8 percent to 10 percent anually from 2004 to 2006; which points to a strong opportunity in this area, Tse says.

Historically, non-residential construction has been much more cyclical than public construction because of the nature of economic cycles vs. government spending cycles, Tse says. Because of the passage of SAFTEA-LU last August, highway and street construction picked up during the 2006 summer construction season, increasing 17.6 percent in the second quarter of 2006 vs. 11 percent in the first quarter of 2006 and 6.6 percent in the second quarter of 2005.

Tse predicts that non-residential construction will continue to be favorable, although probably not at the high growth rates seen this year. She also sees positive news for the government sector because of pent-up demand and the timing and magnitude of the highway bill funding.

While there is funding discretion at the government program level, there is also project-specific funding as well as annual allocations so the money will likely flow out at a steady pace, Tse says. Still, the new bill provides an average of 30 percent more funding over the previous bill so contractors should see a meaningful increase. Due to the age and capacity limitations of the current infrastructure in the United States, it looks like highway and street construction will continue to increase, she adds.

Serious software
In assessing your strength or fitness to bid on government work, no agency is going to judge your ability to dig a hole or pave a road – your crews’ craftwork skills. Where you have to show strength is in the realm of office work, including financial statements, bonding and cash flow management. Knowing on a day-to-day basis how your costs are panning out and how well your crews are meeting the schedule is crucial.

That’s where getting serious about the level of software you’re using can help. Traditional accounting and scheduling software can take you to a certain point. But there’s a new breed of software that provides a more integrated and vastly more detailed look at your business. These software programs automate and integrate everything from the bidding and estimating process through scheduling, time sheets and day to day execution to change orders and long term financial planning. And they provide multi-layered views of projects in any number of time frames – daily, weekly or annually.

“Our program can look at a volume of earthmoving and tell you if you made money on it today, or if it measures against a plan, and whether or not you need to take corrective action tomorrow,” says Alistair Johnson-Clague, president and CEO of the software company Hard Dollar.

Clague cites four pillars of every project – time, cost, resources and cash – and says too often the boss, the accountants and the supervisors aren’t seeing the same data, don’t understand the others data or are sitting around while the data from each of these four areas is massaged into a form that everyone understands. And that can take weeks. By the time the numbers are crunched and a meeting called, you may be losing money and not know it. With integrated software solutions like Hard Dollar “everybody can see how the project is performing day by day,” Clague says.

In the low margin world of government contracting, having this ability to do instant course corrections is crucial. “Good execution and operational excellence are fundamental for good financial performance,” Clague says. “And operational excellence flows from good information. You can keep your people in the dark, or you can give them the tools to enable them to do the job.”

Integrated software programs also provide a host of other benefits. You’re less likely to make mistakes in bids because the program will flag unfilled boxes. They also enable you to look at a job from a unit-price standpoint – which is often how government bids are structured. The government is also more consistent and standardized with their internal processes and having a program that allows you to synchronize your paperwork with their requirements helps as well. And change orders can be documented and their impact on scheduling, cash flow and profits can be calculated as soon as the data is entered.

Hard Dollar’s program is customizable to meet a wide variety of requirements. Training is done both in person and on the web and the trainers are people with real world construction experience, Clague says. Pricing is set by the number of users. For more information, visit this site.