Too Much of a Good Thing
Our construction industry is enjoying a robust rebound since the depths of the Great Recession, (2009-2012). Residential, commercial, industrial, public and private sectors are all participating, and the future looks pretty good. When the government finally gets its long overdue infrastructure program on track, the boom will be reignited for another round of industry prosperity.
So, What’s the Problem?
The disruption of the banking industry and the resulting reduction of construction financing were the obvious causes of the construction market downturn at the beginning of the decade. But, isn’t everyone participating equally in the current recovery? So, why do so many small to medium sized contractors continue to be in financial distress?
From 1975 to 1986 I ran the largest international consulting firm serving the contract surety industry. My company assisted in the resolution or salvage of hundreds of distressed or failed construction firms completing bonded contracts that the contractors were unable to fulfill. Just about all of the companies who failed were successful companies who surprised everyone (including the surety) when they folded. How could companies who had been successful for 20, 40 or more years collapse under the weight of what appeared to be profitable contracts?
Causes of Contractor Failure
“A study of the events and decisions that caused hundreds of companies’ difficulties identified five recurrent and industry-wide elements of risk to potential profit or failure. The common elements of construction business failure are:
- Increase in project size
- Unfamiliarity with new geographic areas
- Moving into new types of construction – (to grow, contractors often change from one type of construction to another, add a new type of work to their existing specialty or expand their geographic area. The learning curve can be very expensive.)
- Changes of key personnel
- Lack of managerial maturity
…By far the most common element among contractors who failed is a dramatic increase in the size of projects undertaken.” (Managing the Profitable Construction Business, Wiley, Thomas C. Schleifer, Ph.D, Kenneth T. Sullivan, Ph.D, John M. Murdough, CPA)
History Repeats Itself
Why am I writing about causes of failure at a time when construction is booming? Because the common elements of construction business failure take place during profitable years—success precedes failure. Now, as always, is the time to be on guard. So, we should all ask ourselves the following question: what do the failed contractors we were dealing with back in the 1980s have in common with the financial distress we are witnessing during this current recovery? Here’s a review of our findings:
- Again, in their eagerness to participate in the recovery, many smaller to medium sized contractors are growing too fast and absorbing risks they don’t recognize.
- Growth is initially costly so, without realizing it, contractors who are eagerly participating in the current recovery are, at the same time, eroding their capital base to high-risk levels. Growth require a considerable capital frontload, retainage mounts fast and within a matter of months can become too large for the company’s capital to handle.
- Taking on new projects while trying to ensure profitability by not expanding overhead causes contractors to spread their management too thin. This leads to reduced productivity causing an erosion of gross profit rather than an expansion of net profit.
- The solid foundation of accumulated management expertise that established contractors enjoy is negated when they attempt projects they have limited experience with.
- The current recovery has tempted some contractors to expand beyond their normal geographic area. We summed up our 1975 to 1986 experience as follows: “A change from the geographic area in which a contractor normally works is almost as common an element preceding failure as the change in project size. The differences in methods, procedures, regulations, and labor conditions can be significantly different and expensive if not planned for.” (Managing the Profitable Construction Business)
- Finally, the entire industry is at increased risk in this current growth market as competition for labor dramatically dilutes the skilled labor pool.
Are you putting your company in danger? In our 40+ years-experience, we found that most of the contractors who failed had no idea of the risks they were taking. In fact, they thought they were doing great and didn’t see the hidden risks lurking in growth.
Audit your own company. Watch your capital. Look carefully at the productivity of your skilled labor force. Are you maintaining the quality of your work? Are you too deeply involved in work that does not reflect your company’s accumulated expertise? Is your management traveling too much? Living in motels? Dealing with strangers? Are you borrowing more money than your balance sheet can support? Do things feel a little out of control? Watch for the signs. It could save your business.