The Changing Nature of Business in the Construction Industry

The nature of the construction industry  is changing, and a major driving  force for this change is what is often referred to as the commoditization of construction services resulting in margin compression for construction firms. Whether evolutionary or revolutionary in nature, these forces will drive some contractors out of business. Those who thrive in the next generation will not just survive; they will master change and remodel  the industry.

A few years ago, we heard everywhere about the “Perfect Storm” that had come down hard on the economy and tossed the ships of the construction industry around like so many toy boats. We sud­ denly-it seemed sudden,  anyway-learned the housing market was overbuilt, oversold and over­ leveraged. We learned, whether we wanted to or not, about short selling, subprime lending, hedge funds, bundling, credit default swaps, margin calls, quants, derivatives and Ponzi schemes, all with the amazing abilities both to make money and to make money vanish into thin air. The bubble was so big, it covered the globe. Until it burst, most of us thought  things were going well- we were in the “good old days” of the construction industry  In hindsight,  we were watching  the buildup  of forces that would unleash an economic tsunami, the Perfect Storm that left the Great Recession in its wake. If that was not enough,  there were real tsunamis, earthquakes and major storms to deal with that cost lives and the global economy untold billions of dollars, yen, Euros and Yuan. To this economic  epic, add political grandstanding and deadlocks, leading to even greater uncertainties in the markets and the future of global currencies and debt. Real-life experience in this economy seems more than enough to put action movies out of business.

If the story of the beginnings of the Great Recession are starting  to sound  like modem  history, that is a good  sign.  Nonetheless,  we are still living through  it. The forces that ripped  through the economy  will continue  to reverberate across the globe for some  time to come. The world is forever changed. Yes, there are signs that things are improving, but we still have continuing  high unemployment despite more people finding jobs. Banks are making loans again, but only to the best, lowest-risk customers with more stringent regulations and equity demands. The construction industry  has shrunk 30% or more since its highs in 2007 due to loss of employees and less avail­ able work. Some companies have gone away; most have just gotten leaner and meaner in order to survive a highly competitive, tight market. The economic outlook calls for continued slow growth, in large part because most of the problems that made headlines in 2011, including the global debt crisis, as recent downgrades  of Euro-zone credit ratings indicate, are still with us in 2012. Global financial markets are still precarious.

Owner  organizations  have also downsized  their internal  engineering  and  construction depart­ ments to accommodate  more moderate  corporate expansion  plans as we discovered in the “FMI/ CMAA Eleventh Annual Survey of Owners,” 2010:

  • More than half of all owners say they expect to either resume hiring in 2012 (10%), 2013 or later (14%), or never (28%).
  • 28% of responding owners say they expect never to resume hiring. However, a significant minority do report plans to hire in 2010 (20%) or 2011 (22%). In the view of more than half of all owners, diminished staff resources are a permanent condition.

The result is that owners expect greater support from construction service providers, and they want the lowest price possible. That often means changing construction delivery methods:

  • 55% of owners describe their approach to construction  execution as “most like design-bid­build.
  • 24% said they took “a blended approach,” and about 18% said their approach was “most like design-build.”
  • For large projects, however, the dominance of design-bid-build  seems to be eroding, with only 47% of owners reporting using that method, compared  to 24% reporting a blended approach,  and 21% saying their approach was most like design-build. (Ibid.)

For owners, it is a buyers’-market bonanza where purchase of construction services is beginning to resemble online purchasing,  like Amazon, Groupon™, eBay® or even the Chicago Mercantile Exchange. The information  revolution has given purchasers more information than ever, and large owners are more sophisticated, with a ton of technology at their fingertips. Thus, there is growing pressure to look at construction as a commodity purchased on the open market for the lowest bid.

Is it the future  of construction to battle it out in bidding  wars or to become another  product sold on eBay? Likely not in the near future, but there is a growing sense that the road out of the Great Recession will not land us back in some imagined “normal” state. The Perfect Storm and its aftermath  have changed  the course of the future for the world and for construction.  We are not going back to the market of 2007. There are a number of economic forces coming together to put increasing pressure on margins and, in many cases, change how construction gets done. Whether one thinks  of these changes as evolutionary  or revolutionary  is academic, but  to ignore change in favor of “doing what we’ve always done” is naive and dangerous  for a company’s continuing existence.

The industry  upheavals  have put  a severe strain  on contractor  profit margins,  which in better times typically range between  2% and  5%. More recently, studies  have shown  sharp  drops  in profitability  for contractors,  approaching a meager 1% , and  negative numbers  becoming  more frequent. Those results are unsustainable for the health of the construction industry. The question at this point is not whether  or not contractors  will go out of business in this economic environ­ ment, but how many and how soon? Then there is the other side of the coin; even in these tough conditions, there are contractors making money. How do they manage this countertrend? For one thing, they are firms that are not content  to sit on the shore and watch the world go by.

Is Construction a Commodity?

Although we don’t expect to see construction procurement go the way of eBay anytime soon, there are already reverse auction sites for construction procurement. To say the least, this practice has not been endorsed  by major contractor  organizations. Savings to owners have not been demon­ strated,  and there are a host of problems associated with the open-bid  approach.  Construction is different from products and services sold online. Most contractors,  and even most owners, would say construction services are not  commodities.  Buildings and  the construction process are too complex to be considered  commodities.  Construction is a professional service requiring different mixes of skills, capabilities and technical specialties that make each service provider unique.

A commodity  is defined as a product  or service that is relatively the same no matter the source or provider. Commodities  are “fungible”; that is, one product  can be exchanged  for another.  Most commodities  are  traded  on  an open  market  where  the  price is largely decided  by supply  and demand.  (However, speculators  temporarily boosting demand  or suppliers  reducing output  until the price goes up can artificially influence both supply and demand,  for instance.)

The contractor’s perspective includes the fact that each contractor  is unique with services dif­ ferentiated from its competition. For instance, contractors  have different experience levels, safety records, abilities to get the project built faster, or better customer  relationships and communica­ tion systems, to name just a few areas of differentiation. The owner looks at the project and says, “Here are the bid  package and  drawings.” The contractor  that can deliver on the details of the contract  for the lowest price wins the job. That simple,  right? No, of course not, as anyone who has entered into a construction contract will tell you. Otherwise,  it might look more like a simple purchase order -x bushels of wheat at current market prices for May delivery:

One major area of choice for owners  with a project and contractors  offering services is seen in · the area of delivery  methods. The  choices and  variations  of delivery  methods  have increased considerably  over the last two decades. If low bid/design-bid-build appears to be more prevalent these days, it may have more to do with lack of information  or just the idea that owners are going to take advantage  of a desperate  contractor  market  and  push  for the lowest price. Multiple op­ tions exist, including  design-bid-build (D/B/B), design-build  (D/B), construction manager (CM), construction manager-at-risk  (CM/GC) with a guaranteed  maximum  price, or, the more recent addition,  integrated  project delivery (IPD). Optimally, the owner will make an educated choice to address the specific need.

One of the reasons there are so many delivery methods available is that the more traditional D/B/B approach  was not yielding the desired  results. D/B/B has a tendency  to be contentious,  pitting owner against contractor  as one tries to outsmart  the other, often ending in court cases. This may not be the situation  with every D/B/B project, but the current cut-price  market has greater poten­ tial for contentious change orders, poor quality and unsatisfactory  results.

Over the past few years, we have heard contractors and even some owners caution against blindly focusing on low price for construction. Responding to our recent survey on construction delivery methods,  one contractor  commented:

Bidding has become stupid with contractors  pricing at extremely low levels. Why? To keep their men working and maintain cash flow.

Owners are very aware that this is a good time to get the lowest price for projects, but some are cautious:
Everyone is doing more with less, less human  resources as well as lower profit margins. The economy  has produced  a great bidding  environment for owners relative to pricing; however, it does not come without  risks- mainly quality of work and subcontractor sol­ vency A significant value is placed on contractor  pre-qualification with the hopes that the subcontractors selected  will last throughout the project.  (Owner  Project Manager, large university system, responding  to the “FMI/CMAA Eleventh Annual Survey of Owners”)

According to William Terrasi, director, enterprise  project management,  DTE Energy, just getting more bidders does not assure getting the best contractor  for the job:

You’ve got to be careful what you wish for. To put it simply, sometimes  you are exposed to a real gem that you never knew about, and other times you get a lot of pretenders, and we don’t need more pretenders.  Whatever  their niche was, they need to stay there. (FMI “Win/Win Project Delivery”)

Despite what most owners know by experience and, for many, what their favored delivery method would  be, we have found  more owners, at least temporarily, have returned  to something  more like D/B/B. According to our 2010 survey of owners, nearly 55% have gone that way for project execution.  (See Exhibit  l) However, when asked which construction procurement method  they used, nearly the same amount selected low bid compared  to select bid, and 29% still chose negoti­ ated project procurement. (See Exhibit 2) These figures indicate that the majority of owners still recognize some differentiation  among  delivery methods  and contractors.  Low-bid procurement does not guarantee best value or even lowest price at project completion.

The pressure from owners to treat construction procurement as a commodity continues in struc­ tures that are characteristically  not as complicated  to build, have more or less standard  designs and prototypes,  and many builders  have the capability and expertise to build them, thus making the market highly competitive. Examples include:

  • Housing (residential and multifamily)
  • Warehouses
  • Chain stores/retail
  • Office buildings (excluding high-rise, skyscraper)
  • Lodging
  • Schools

To say that  the above list more closely fits the definition  of a commodity  is to say all housing, warehouses,  etc., are the same or nearly so. However, building structures in each of these catego­ ries can have a wide range of special designs and features. Owners can also have different needs, like scheduling concerns  or site requirements.  Some contractors  will be more experienced  and capable than others, depending  on the special requirements.

Even those owners wanting to treat construction services as commodities when in the purchasing phase want unique  buildings,  something that sets them apart from the competition.  That’s the case for community schools and housing. Commercial owners want their buildings to be differen­ tiated from the competition  to offer their own unique  experience or support their brand in some way. But need and  price can alter some  of these differentiators. Sometimes a good, serviceable building will suffice when a community is facing a sharp increase in student  population  without a significant increase in tax income.  A store chain may be able to modify vacant buildings to suit its needs. Companies  keeping expenditures low may decide that this isn’t a good time to build a building with marbled  halls and customized  offices. In tough times, owners may be willing to modify their needs and desires in order to get the building at a price they feel is affordable. First, they want it all, and they will try to get it by looking for the lowest bid from contractors.

Construction projects  that  would  not  readily fit any description  of commodity  might  include those  that are characteristically  complex,  have unique  designs,  include  innovative  technology, present difficult building conditions, or are mission-critical or significantly large in scope, such as:

  • Medical buildings
  • Research facilities
  • Power plants and other utilities
  • Bridges
  • Oil platforms
  • Chemical plants
  • Stadiums
  • Museums
  • Concert halls
  • Water and wastewater plants
  • Highways and roads

Building types not as likely to be treated as commodities are still subject to owners looking for the lowest bid, but the bidders must be pre-qualified. Savvy owners are looking for best value. Among the reasons for this include  the cost of poor quality and  missed schedules  for large projects.  If a contractor  fails in the middle  of a stadium  or power  plant  project,  the cost in lost box office receipts or production  is extremely high. Structure  failure in any of these projects is potentially catastrophic.  The risks are too high for owners to take the chance that the lowest bid is not the best-qualified  bid. Owners building  most any type of project should  feel the same way. But when times are tough, they are willing to take the chance that the contract will protect them from risk; and contractors  hungry  for business will cut prices even at a loss.

Reducing cost by soliciting the lowest bid in a design-bid-build delivery method is not the only way owners are seeking  to reduce  the cost of construction, but  it still predominates,  according to comments  received from panelists of FMI’s Nonresidential  Construction Index Report. In the first quarter  of 2012,  we asked panelists what  they are seeing owners do to reduce and control project costs. There are a range of things owners are doing to reduce costs, but most of the comments  from construction industry  executives focus on changing  delivery methods  and pressur­ ing contractors to get the lowest price possible. Among the most questionable methods,  several contractors note  the increase of bid shopping. The following is a sample  of comments  on what owners are doing to control costs:

  • Cost is not an issue to owners. Bids are coming in well below estimates due to excessive competition  and lack of backlog from some contractors.
  • Rebidding multiple times to shop contractors.
  • Bidding in the street so they get low numbers.
  • Becoming CMs themselves and using multiple primes.
  • Change comes slowly in the Northeast. We are seeing more competitive lump-sum bidding and less CM-at-risk.
  • It has become a much more mixed result where certain owners who are more inclined to seek true life-cycle value are staying with or going back to the value proposition and quality-oriented  contractors who can demand a fair margin on the work. Otherwise,  there are still many developers and owners who know that contractors are desperate; and if they look diligently, they can get these contractors to compete to get all subs driven to a bottom number  and the GC themselves to bid with a zero fee, sometimes less, in hopes they can bargain more from the suppliers and subs after award. This has resulted in GCs defaulting, and I suspect we will see more of both GCs and trade contractor  defaults this year. Buyers, beware!
  • The greatest frustration is that there appears to be only nominal consideration  of the risk they are accepting when they award work to substandard  trades. The concept of paying for value and workmanship have gone out the window, and low price wins 99 out of 100 times.
  • We are seeing the public sector in our areas finally get onboard with early selection of theCM/GC.
  • We have seen a huge increase in bid shopping.
  • We have seen several clients that have traditionally hired CMs for CM-at-risk work, based on qualifications only, go to a system where qualifications are the first step. Then, providing fixed fee and general conditions percentages or lump-sum amounts is ultimately the deciding factor. Others are hard bidding work vs. selection and negotiation.
  • We are seeing heavier use of BIM and prefabrication.

Is the construction industry  returning to the dark  ages where  relationships,  collaboration  and the idea of value are retreating into the shadows? Certainly, contractors and owners are taking on more risk when low price is the only criterion  for awarding the contract.  As commented  above, “Buyers, beware!” We should  also add,  “Sellers, beware.” Owners  may be buying  a Yugo when they wanted  a Ford  or a Lexus. The result is potentially  a great increase  in legal disputes  and contractor  bankruptcies, which is good for the legal sector, but not the best construction delivery process.

Return of the Master Builder Concept

Not all owners are moving or regressing to design-bid-build or low-bid methods of procurement. According to our recent NRCI survey, the move to design-build delivery is more prevalent; yet owners still push for the lowest price. However, owners are also more willing to consider alter­ native materials and methods to save money, especially as material costs have continued to rise throughout the recession-one more concern that reduces profit margins for contractors. Inter­ estingly, there is another trend, especially for midsize and smaller contractors; owners are involv­ ing CMs and contractors earlier on in the project in the design or even pre-design phase. Along with the move toward integrated project delivery (IPD), some have likened this to a modem ver­ sion of the ancient Master Builder concept.

The use of qualified owner project managers (OPM) to serve as clerk of the works-mandated on large public projects in Massachusetts, for example-adds an upfront cost that increases ini­ tial price to reduce final project cost. Further, the OPM challenges the contractor to validate all elements of a project budget, the contractor’s margin and the project cost structure. The savvy contractor is learning to anticipate project audits, pre-audits and onerous review of margin oppor­ tunities. The construction industry is challenged to come to terms with an acceptable level of risk and return for the contractor to preserve long-term industry health. Without attractive margins and profits, ultimately the financial health of contracting is in question. There are limits to the margin compression squeeze being applied by buyers of construction services.

In response to tife need for cost certainty and best value, the industry has developed robust and sophisticated pre-construction services. The delivery of high-quality, professional pre-construc­ tion is mandated for the owner to attain project objectives at maximum value and the E&C pro­ viders to earn respectable margins. Onerous, abusive and punitive contractual terms and pricing schemes are unsustainable. Effective “free markets” must arrive at an equilibrium.

The real risk in the low-bid squeeze play is that, even though  owners are taking advantage of a highly competitive  market,  those providing construction services will play the game and do the best they can to make up for winning the bid with negative profit projections by cutting comers, increasing  the cost and number  of change orders and billing for any extras possible. Some cost recovery methods  will be legitimate, some not, but  the contractor  wants  to make money on the project. Contractors  that do not play the game well risk going out of business. This type of atmo­ sphere of contentiousness and deception is bad for business and something  the industry  has been working for years to improve. Therefore, there is some real potential of the construction industry returning  to the dark ages.

On one hand,  the return to something  more like the Master Builder concept protects owners from process inefficiencies and contractors  playing games that add cost to the project and the risk of going over budget  and schedule.  At the same  time, the move to using more design-build, CM/ GC and IPD, and generally bringing  the contractors  and all service providers to the table prior to design and construction can reduce risk and improve project success for all involved. Not all own­ ers, nor all contractors,  are ready for this, but for larger, complex projects, this is the future-or what appears to be one of the best possible futures-for the industry  and one that ultimately can be more effective in reducing costs.

Changing for the Future

As we work our way out of the Great Recession, owners that have projects to build will continue to want the lowest price and best value. There appears to be a growing bifurcation in the market, just as we see in the economy in general. Those in the middle will be squeezed the most. So what can contractors  do to survive and thrive in this future? The fact is that there are contractors  mak­ ing reasonable profits even in the downturn.

The following is a list of areas that are yielding benefits for contractors:

    1. Become more strategic: If owners have more information about the contractors and construction process, contractors need to have more information about their potential customers. At the same time, contractors need a deeper understanding of their own processes, methods and all costs.
    2. Build closer relationships  with customers: This isn’t just a matter of a salesperson  taking the customer out to dinner or playing golf anymore. Buyers need to have confidence in their contractors.  They need better ideas of how to accomplish their goals. Contractors must understand those needs and more, long before estimating and bidding a job.
    3. Develop IT as a profit center: The goal here is to make the IT department a profit center, not just a group that fixes computers and installs new software. Project management, productivity tools and tracking software for job progress and cost reporting will help
      get waste out of the system and reduce costs. Understanding and using BIM has become a necessity rather than just a nice-to-have gimmick. Improved communication in the form of software and hardware from smart phones and tablets to jobsite cameras and regular discussions among project managers, the field and clients will not only help build relationships, but also reduce the time it takes to get things done. Even installing and making full use of a CRM system will help track business development efforts and customer information.
    4. Be specialists in strategic market niches: To avoid being more like a seller of commodities, become best-in-class specialists. Best-of-class contractors know their customers’ business and add value. While most forecasts and market discussion consider broader construction  markets, there are many submarkets and market niches that can
      be profitable. Thinking strategically, a contractor may even be able to carve out its own market niche with few competitors.
    5. Self-perform more work: Self-performing contractors are often the most profitable. They offer benefits to customers in having more control over schedule, price and quality and,

if they are productive, can make greater margins with their own labor. As labor shortages return with the economy, those companies  that can best recruit, manage and mobilize labor will have the edge.

  1. Know how to innovate, accept and manage risk: The modern  trend in business has been to avoid as much risk as possible by shifting it contractually or otherwise to others-who in turn move it on to others and so on. While it is important  to avoid risk, the cost ofshifting risk can be expensive. More contractors are working to get a deeper understanding of all the sources of risk in their work and, wherever possible, accept and manage the risk themselves. When done effectively, risk management can become another profit center.
  2. Embrace change: Most of the firms that were surprised  by market changes were either not paying attention or ignoring what they knew was happening. Sometimes one has to believe his or her own eyes and data and make the necessary changes to adjust to market forces. In a recent paper by FMI, “Adjust, Adapt, Act: Winning Stories from the Post-
    2007 Construction  Industry,” Michael Vickery, senior vice president of BakerTriangle, is quoted as saying, “If as a company we were positioned today the same as five years ago,we were either wrong then or are wrong now, because the market is uniquely different.” Itis important  to have a company culture and a reputable company history, but if the firm is to have a great future, it has to make changes. Recognizing those needed changes early can mean the difference between a competitive edge and falling in line with the low bidders.
  3. Become productivity experts:The construction industry is often chided as being unproductive and behind  the curve of high-tech manufacturing  sectors. However, more contractors are breaking out of that mold and looking for ways to employ technology and processes like BIM, prefabrication and modularization  to gain on productivity, safety and workforce changes.
  4. Be greener: It is not only important  to understand owner needs and wants for more sustainable projects, but it is also time that contractors learn how to be more sustainable in their own business. Reducing waste and carbon footprint will not only provide a good example for others, but also reduce cost in a world where key materials are becoming scarcer and regulations stricter.
  5. Be collaborative and service-oriented: While it seems to go against the grain of low­ bid, price-slashing markets,  thinking more like partners and service providers will be an advantage over time.

Conclusion

Be the Future of Construction not the Past

It does not  take a crystal ball to see that  the world  will not  return  to pre-2007  conditions.  It has been and continues  to be a tough  recession, and memories are not so short  that we will see a credit-fueled building  boom anywhere  on  the horizon.  There are many  trends  and  economic forces that are here to stay: sustainability  and green construction, reduction of energy use, indus­ trial technology  use, consumer  buying power and the Internet  consumer  market, scarcity of raw materials,  and growing populations.

The beginning of the recession saw many companies  hunkering down to try to wait it out; others saw opportunities for change. Competition will continue to be fierce, especially for those who fol­ low the crowd and get in line. Owners will continue  to be demanding, although  we expect more will return  to best value based on qualifications and experience rather than just low, low prices.

The thriving contractors of the future are dynamic innovators in all aspects of their business, mak­ ing them attractive partners for the owners who need, want and value professional construction services.

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