Thomas c Schleifer, Ph.D.
I can hear you. I know what you’re thinking…
“DE-flation?!!…I thought we were worried about INFLATION! Rampant cost inflation in materials and wages is the topic du jour – isn’t it? What’s this about DEFLATION?”
Let me explain: this current series of blogs on managing cash flow during down markets reminded me of research I conducted years ago on the self-inflicted debilitating effect on cash flow and profit caused by our competitive instinct to chase top-line growth in down markets as an antidote to shrinking in size.
When cyclical construction markets turn down (and they always do), contractors are unwilling (or unable) to accept less work for any prolonged period because of the common cash flow management practice of “front-loading”. Since just about every contractor uses this practice to one degree or another, everyone competes for scarce work by competitive bidding. This competition during a declining market causes profit deflation often eradicating profit altogether in an industry noted for slim margins in the best of times. Larger companies with more robust capital outlast the mid-size and smaller contractors in this competition often putting less efficient competitors out of business. This is an undeniable fact a lifetime of research has verified.
It’s All Good
Current industry news tells me that construction firms are trying to make up for any pandemic business interruption by aggressively pricing work across the entire industry. Everyone seems to believe that the industry has squeezed past the pandemic and will avoid any negative impact simply by keeping busy. Optimism abounds.
Until It’s Not
At the same time, and in the same publications, economic and industry prognosticators predict a slowing (if not a shrinking) of the construction market in 2023 and possibly beyond. In order not to dampen contractor’s enthusiasm, however, I notice that the experts are using tried and true euphemisms like “flat market” or “less robust growth” or “market growth pause” or “maturing markets”. When most of us smell waffling, we tend to ignore negative market predictions and continue aggressively down the competitive bid growth road.
And Fall Into The Trap
As the calendar is about to turn the page on 2022, we find ourselves already in the “future”. The market “flattening” predicted for 2023 and beyond is already happening and many contractors are falling into the low-bid growth trap even as I write these words. What worries me about this low bid growth cycle is that the negative effect on cash flow is going to be turbocharged by the most dramatic cost inflation in wages and materials in generations. If you think margins are already tight wait until you’re trying to complete low-bid contracts in 2023 and wages and materials are up another 15% or more.
Three Card Monte
Construction professionals are often fooled by this game of Three Card Monte. Since the initial cash flow from the next contract is needed to cover the dwindling cash flow from the front-loaded job that’s winding down, it’s critical that there is a next job. Over time, however, the gradual erosion of available capital by unprofitable “low bid” jobs forces the less efficient operator to seek more and more jobs that provide larger amounts of initial cash but also tend to be less profitable in the long run. Two of the Monte’s three cards are cash while only one is profit. If we are not careful, we lose track of our own sleight of hand and forget where cash ultimately comes from.
We Interrupt This Program
I have inserted this blog into our series on flexible overhead as a cautionary tale. We are entering the “flat” construction market predicted by the experts, and we are already in an aggressive competition for new business in 2023. The erosion of profitability is often a self-inflicted wound. Maybe the construction industry did squeeze by the pandemic without fatal injury but maybe the worst is yet to come. Our industry has settled into being priced as a commodity and profit margins have never been thinner. When my brother and I went into business 60 years ago, we’d bid jobs with a 20% profit margin built in. Today even the most efficient contractors are lucky to take away 3 to 5%. There’s no longer room for “reckless” low bids followed by relentless after bid cost inflation.
Managing for Profit
If my career could be given a title it would be – “Manage for Profit”. Because a construction contracting “going concern” depends on cash flow, contractors are naturally always searching for the next job which often morphs into managing for growth. This takes our eye off the profit ball. A lifetime of research proves this to be the primary cause of contractor failure.
Next week we will get back to flexible overhead.
For a deeper look on how to surviving the coming economic storm, read more here: FINANCIAL MANAGEMENT & RISK
For a broader view into choosing the right project, read more here: PROJECT SELECTION
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