Low Industry Margins, Adversarial Pricing Models & Financial Fragility

Interlinked with the issues of productivity, predictability and structural fragmentation covered above, is the nature of the commercial returns model seen across industry. Total output for UK construction is in excess of £100 billion per annum. While there is no definitive measure of financial performance across the industry or sectors within it, recent published results of many listed UK construction businesses, as well as the high level of insolvencies and financial failures in the industry, would indicate that blended margins, especially when viewed on a long-term trended basis across economic cycles, are very thin relative to many other industries.

Low profitability is a long standing problem for the industry. It was cited by Sir John Egan in his watershed report Re-Thinking Construction (1998)12 in which he stated a deep concern that "the industry as a whole is under-achieving. It has low profitability and invests too little in capital, research and development and training". KPMG13 analysed the finances of many of the UK's major contractors which revealed that the financial position of many firms remains uncertain despite the industry emerging from recession. Operating margins, a key performance indicator had fallen by almost 60% from 2.8% in 2010 to an average of 1.2% in 2013.

The industry has recovered further since 2013 however margins remain under pressure. Construction News, produces an annual survey of the Top 100 UK construction contractors. The latest available survey (for 2015) indicates that the average operating margin for the Top 25 fell from 2.5% in 2014 to 1.2% in 2015. The overall figure for the Top 100 was slightly better with firms seeing their average operating margins fall from 2.4% to 1.9%.

The annual industry survey of construction KPI's from Glenigan14 paints a slightly more positive picture. Glenigan reported a median operating profitability for 2014-2015 of 2.8%, and that conditions in the sector were improving; however recent figures from ONS suggest that the sector has (technically) entered recession as the result of a combination of factors, including on-going uncertainty arising from the recent referendum result. Overall, the ONS figures suggest that conditions in the sector are becoming increasingly challenging which has further implications for profitability.

In times of growth, it is observed that margins in some parts of the supply chain increase significantly, underpinned by limited delivery capacity relative to demand for their particular goods and services. However, this does not offset the longer-term structural margin position, particularly when factoring in periods of under-utilisation and the risk of losses due to market led input cost movement or their own or others' delivery failure after the point of fixing a price. In periods of lower economic activity, margins appear to collapse, which is exacerbated by an accepted industry practice of taking on 'loss leader' work as a way of keeping cash flow running and hoping bottom line losses are offset by a future upturn and improved margins. The tendency for self-employed labour to have a 'floating price point' adds to the variability of pricing experienced in the industry and the potential for exploitation, both by the labour force itself and also those businesses who contract them depending on where the cycle is.

The low level of cost predictability referenced on page 16 is not just a problem for clients but is also one for industry itself in that the initial planning and estimation of margins prior to work commencing is undermined and put at risk by variances that occur for all the reasons outlined above.

The use of competitive tendering is widespread throughout the industry and there appears to be very low usage of more collaborative and integrated design, procurement and construction delivery models. Clients tend to fixate on lowest initial tendered price and this is often perpetuated by their advisors, who, in a traditional procurement model, are implicitly employed (at least partly) to manage a fixed and adversarial transactional interface between clients and industry. The cost-based procurement model often hinders the ability to focus on value, outcomes or performance if appropriate weightings are not made.

Adoption of more collaborative or incentivised commercial engagement models appears to be limited to certain clients that have either large scale infrastructure projects or have a delivery programme where longer-term outcomes and benefits are driven by harnessing process improvement and commercialising the benefits of large scale demand that can be committed to with a reasonable degree of certainty.

The reality is that many clients, especially in the real estate development sector, are simply conditioned to operating in an adversarial way with industry and do not see a case to move to more collaborative and integrated approaches for fear that a lack of commercial tension will impact their own financial outcomes. In many instances, the unavoidable conclusion for both clients and industry is that in competitive tendering, whoever wins a project is often the party that has made the largest mistake in pricing it!

This leads on to an analysis of how industry appears to drive higher commercial returns after setting its 'entry price'. The industry has a reputation for being a cash flow rather than margin led sector. The derivation of this is difficult to pinpoint, but seems to have been driven by the fragmentation described on page 17. The multiple and tiered sub-contracting interfaces within the industry and between industry and its clients has generated a further non-value add process whereby some businesses higher up the supply chain will use other businesses' money lower down to temporarily support and enhance their own cash flow. Many consulted as part of this review referred to the payment practices within industry as poor, with a tendency to rely on extended payment terms. There is also often an imperative to maximise the final differential between internal and external value, not just the cash flow differential between what is received and what is paid out. This drives a culture of set off, counter claim and dispute.

Accepted industry traditions include such measures as payment retentions and liquidated damages held by one party pending timely and proven completion and defects rectification. In reality these are reflections of poor expectations of the industry's performance, but are also often abused to drive adversarial positions that lead to cash flow strangulation between clients and industry and the further cascading of issues down the industry supply chain.

There are some unfortunate but thankfully not endemic commercial behavioural issues associated with peaks in demand in the industry. These reflect a level of industry opportunism that perhaps is seen as the quid pro quo for the difficult times seen in downturns. These issues include instances of anti-competitive practices as well as unilateral, end of negotiation period price escalation at a point where clients are unable to change their strategy. None of this helps bond the relationship between clients and their advisors with the supply chain but in reality these stresses are simply a by-product of the dysfunctional commercial arrangements that exist.

Clients' propensity to change their mind (sometimes reinforced by advisors who do not drive the right level of discipline and impact analysis) as well as the need to overcome omissions or errors in tendered designs, are both used as a major source of widening entry margins. Just as many clients may be expecting failure from industry, industry often expects clients and their advisors to be masters of their own downfall by instigating revised product definition or other types of project change. With any form of adversarial contractual interface, this eventuality will often drive uncertainty, dispute and can be used to mask completely unrelated performance issues. Client change however, does not appear to be the root cause of the woeful productivity position set out on page 13.

Despite more recent measures in construction contract drafting to make the impact of change more transparent and allow better client decision making, the need for many clients of the industry to vary their requirements either in response to their own volatile end user demands or more worryingly due to mistakes in the early project planning process are often seen as an accepted part of built asset creation.

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12 Egan Report - Rethinking Construction - The Egan report, 1998, The Construction Task Force, Sir John Egan.

13 Cash position and margins unsustainable for the construction industry, 2014, KPMG.

14 UK Industry Performance Report based on the UK construction industry key performance indiicators, Glenigan, 17 September 2015.