A Flawed Business Model
Thomas C Schleifer, Ph.D.
Construction organizations often select projects to fill their growth goals, satisfy their need for immediate cash flow, capture work near their headquarters, keep their crews busy, serve owners they have worked for before, and/or explore new types of work. The only thing that really matters is do they carefully analyze whether their company is a good fit for the job under consideration.
In this series of messages, we will demonstrate that a construction company’s capacity, expertise, and managerial maturity are the areas of capability that must fit well with the demands of the job under consideration. Profitable project selection evaluates size, duration, type of construction, and payment reputation of the owner. It then tests a company’s ability to handle the magnitude of each risk factor. It is critical to weigh job risk factors against a construction company’s current capabilities.
I published research results decades ago that the construction industry suffers the second highest failure rate in American industry, right behind restaurants. The failed firms simply ran out of money and lacked the capital to sustain projects they were contracted to complete. In the past I have blamed this failure on contractor’s poor business management skills, sloppy accounting, and too ambitious project selection. I stand by that research, but my ongoing study has added further insights.
Although contractors are notoriously “seat of the pants” business managers, they are competent and clever builders that have the guts and gumption to start their own business and, most often, see it through to a long-term successful conclusion. Why, then, do so many of them, large and small–legacy and new, unexpectedly run out of capital and close their doors?
Flawed Business Model
Throughout the many years that my company completed projects for sureties whose clients had collapsed mid-project, the contractors I met and worked with were surprised and shocked that they had run out of money. These contractors were intelligent, often well educated, always competent builders who, it seemed to me, had all fallen into some unseen trap. I never considered them incompetent or unscrupulous. No, there was something else at play here and, only recently, has further study made it clear to me.
The construction industry has labored under a flawed business model since the beginning of the twentieth century.
By the time lawmakers had finished writing the government contracting laws intended to curb their own corruption back in the 1920s, they had created the low-bid business model that became the standard for the construction industry.
- Low-bid contracts fixed the price that the contractor would be paid regardless of how long it would take or what it cost to finish the assignment. It also institutionalized competition between contractors based on estimated pricing (sometimes best guess) while ignoring which contractor was the most competent.
- These laws also gave life to the progress payment method with 10% retainage where the contractor ended up financing the cost of a construction project throughout its duration rather than the client paying for the construction of their own building, highway, or bridge.
Contractors Are Not Selling Assets
- Contractors should not see themselves as constructing fixed assets and selling finished products to the end users.
- Under the proper business model, contractors provide construction services (expertise) to clients who own the fixed asset and finance its construction.
- Contractors do not sell finished projects, like their developer clients do. They provide expert services for a fee. They should not be required to finance the project because they don’t own the bankable asset.
- In fact, the current generally accepted construction business model was forced on contractors by lawmakers trying to cover their own misdeeds and gradually became accepted by everyone as “contracting”.
Fee For Services
McKinsey & Co. would never agree to assume the financial risk on a proposed business transaction they were hired to evaluate. That, of course, would be insane. Contractors do it all the time. They just don’t see it from that perspective.
Contractors fail so frequently because they simply run out of working capital. They run out of money because the business model they are forced to follow limits their access to capital. They don’t own the assets they are building.
- Bankers rarely lend to contractors based solely on the company’s financial statements but prefer to encumber the assets of both the company and its owner.
- Project owners will not pay for any part of the fixed asset under construction until the contractor can prove that portion is completed, paid for, and unencumbered. The contractor is forced to front the ongoing cost of construction.
This can’t continue because it makes no business sense for contractors to be financing assets they do not own. I predict, recommend, and am working towards a radical change in the construction business model. It must happen because the model is not sustainable. Mark my words. (The current trend towards 5% retainage is a step in the right direction.) More next week.
For a deeper look into the strategic project selection, read more here: SELECTION
For a broader view into why the construction industry has the 2nd highest failure rate, read more here: FAILURE
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