Insights > Adapting to the Lower Margin Environment

Adapting to the Lower Margin Environment

Construction Industry - Strategy

This article first appeared in Catalyst Construction Journal

The economy moves in cycles, waxing and waning between periods of growth and contraction. In periods of growth, business is booming and there is an abundance of work from which to choose. In downturns, however, such as the one that we may be facing, new business tends to dry up as the amount of work shrinks. As a result, prices plummet and the value of skilled labor decreases as contractors outbid each other and project margins contract.

The construction industry tends to lag several months behind the overall economy. Contractors have yet to experience impacts of COVID-19 and will need to prepare accordingly to remain competitive and viable.

In the construction industry, these impacts are not always felt at their onset. By nature, construction is late cycle with projects often scheduled long in advance. In fact, the industry tends to lag behind the overall economy by 12 to 18 months as contractors bid out projects and line up work that can span months or even years into the future. This means that many contractors have not yet fully experienced the economic impacts of COVID-19 as they continue to work through their existing backlog.

The slowdown, however, could be coming. The nonresidential real estate market has historically been led by the private sector which has accounted for more than 20% of all nonresidential spending since 2010. As businesses reevaluate their real estate needs due to workforce changes, demand fluctuations, and the pivot to remote work, more and more companies are hitting pause on major construction projects, if not canceling them altogether.

This tightening of the purse strings is also apparent in the public sector. Although the public sector has consistently grown over the past two decades, the events of this year could lead to a disruption in public infrastructure projects over the months and years to come as lower tax revenues constrict public budgets. Government stimulus through the Paycheck Protection Program along with banks loosening lending standards on existing credits have improved near-term confidence; However, the Architecture Billing Index (ABI) continues to trend below 50, with July 2020 dropping as low as 40, indicating lower design activity and fewer construction opportunities in the future. To put this into context, the trough of construction spending lagged the ABI by approximately two years during the recession of 2008. If history repeats itself, contraction in construction will likely appear sometime in 2021 as corporations and municipalities pare back on capital expenditures as a result of diminishing earnings and declining tax revenue.

As the backlog inevitably begins to run out many contractors will face a fork in the road: either lower prices to win more (though potentially less desirable) work or reimagine their business to set themselves apart from the competition. Choosing this first path will result in “chasing” or “buying” work, where contractors price projects so low that they are essentially giving work away. Many contractors will choose this route as fewer opportunities in the market yield a more competitive bidding environment.

The trouble, however, doesn’t end there. Following the recession of 2008 when private construction began to subside, many contractors worked through their backlogs and lacked the ability to find new and meaningful work. As the economy began to improve several years later, these same contractors found themselves in a newly competitive environment where they had no choice but to chase lower margin work to fill backlog.   As backlogs got filled and the economy improved, more projects came online and bid prices improved in turn. Contractors with full backlogs at low prices had difficulty taking on more work because as their work increased so did their need for working capital. Low margin work did not generate significant free cash flow, leading to working capital issues in order to ramp up on higher margin work. Without robust cash management contractors faced insufficient financial projections, which for many affected bank and surety relationships. As a result of poor budgeting and implementation, overhead costs drove low profit margins even lower. During this time, many contractors encountered problems completing projects and had to back out of work or, in worst-case scenarios, close up shop.

On the other hand, companies that choose to reinvent themselves will not only set themselves up to win higher quality work in the short term, they can also accelerate their recovery through improved business functions and reduced overhead. This means focusing less on top-line revenue growth and more on holding onto profit margins through time-tested alternatives.

One such alternative is reducing overhead costs. Rent, utilities, travel, and fuel all factor into the price of doing business and therefore drive up a company’s overhead rate that a project must recover. Reducing these costs not only can save contractors on many regular expenses, but also can result in the ability to lower costs organically since the cost to keep the lights on has gone down. Owning instead of renting equipment is one effective way to keep costs low. This is especially true of slightly older yet perfectly functional equipment, which can yield impressive savings and enable lower prices.

Another method of adapting to the shifting landscape is to strengthen a contractor’s workforce and implement measures that yield more productive teams. This may include planning projects more effectively, ensuring that materials are ready and available in advance of crew arrival, staffing with the right people, and incentivizing crews to work more efficiently. Improving project efficiency will inevitably result in lower costs and allow contractors to lower prices while earning the same margin. When the market returns and prices can be raised, these recognized efficiencies will yield improved margins. It is important to ensure, however, when lowering cost assumptions that productivity has indeed risen.

A third method is to enact a short-term compensation reduction for field workers or product teams. This method can be risky – especially in a competitive workforce – but, if done right, it can support a contractor’s path back to health.

Finally, contractors should leverage their existing relationships to remind customers of their value proposition. Being able to deliver quality projects on time and with less need for rework can and should mean that contractors are able to charge higher prices for their services. Being upfront about the true cost of the work rather than submitting change orders will also go a long way to attract and retain customers.

COVID-19 has made it abundantly clear that businesses must think creatively in order to weather the current storm and plan for long-term viability. In the construction industry, this means using the current economic landscape as an important opportunity to reassess your business model and make some important changes that will allow you to win the right work without sacrificing your margins. Adopting a robust risk mitigation strategy that is designed to prevent the need to exit projects that are incurring additional cost and productivity issues will be an important tool to set yourself above the competition and avoid chasing work.

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