The Secrets to Construction Business Success

Thomas C. Schleifer, Mounir El Asmar

• Publisher: Routledge
• Year: 2021
• ISBN:
  9781000504101
• Edition: 1
• Topic: Business
• Subtopic: Construction Industry
• Index: Business

With a daunting industry-wide business failure rate, construction professionals need to manage risk and finances as effectively as they manage projects and people. The Secrets to Construction Business Success empowers contractors and other professionals to defy the long odds threatening their stability, growth, and very survival. Drawing on the authors' more than eight decades of combined experience turning around failing firms, this book provides a masterclass in structuring, managing, and futureproofing a construction business. Chapters on measuring and responding to dips in revenue equip executives to recognize and respond to the warning signs of financial distress while chapters on succession planning ensure that organizations survive their founders' departures. Sample documents and tools developed for the authors' consulting practice offer field-tested solutions to organizational structure, forecasting, and accounting challenges.

A steady source of guidance in an industry with few constants, The Secrets to Construction Business Success makes an invaluable addition to any industry leader's library.

Part I Structuring a Construction Business

1 The Basics of Construction Business Success

DOI: 10.1201/9781003229599-2

The construction industry has changed dramatically over the years and continues to become more sophisticated, employing new technologies and innovative processes at an astonishing rate. Construction has also moved closer to becoming a commodity, which is a primary reason for profit margins being low compared with historic norms. Lower margins increase risks, allowing less room for error. Profit enhancement in the future will depend primarily on productivity improvements and efficiency, as well as integration in design and construction to streamline the delivery process and reduce inherent waste.

Management decisions are arguably the most critical determinant of the success or failure of a construction business. However, many construction professionals believe their company loses money or fails because of other reasons such as labor problems, weather conditions, inflation, interest rates, cost of equipment, tightening or shrinking of the market, or simply bad luck. None of these alone are primary causes of contractor failure. They significantly contribute to financial distress once a poor management decision is made, but are not the basic causes of failure. Failure is often not a result of factors or conditions over which management has no control. Company leadership is responsible for structuring a company that is flexible and can withstand fluctuations in labor and market conditions, equipment and financing cost, and so on. Moreover, leadership has a critical role to make decisions that do not expose the company to such variability and risks unnecessarily.

Even if a company is successful, management cannot drop their guard. Growth or simply ongoing operations involve change, which has risks associated with it. Therefore, past success is not an indicator of future success. When a company expands in size, takes on larger projects, or goes after projects of different kinds or in different territories, these activities require good management decisions to reduce the risks inherent in such change. An enterprise may be doing fairly well, or even very well; however, the organizational stress of growth or change can cause weak components to become fatal. Change itself must be managed to control risk.

There seem to be many ways to run a construction enterprise successfully, perhaps as many ways as there are companies. In reality, there are only a few ways to structure, operate, and manage a construction business successfully while controlling business risks. Success requires appropriate structure, proper organization, direction, planning, and risk recognition.

At a high level, a construction enterprise has only three primary functions: getting the work, doing the work, and accounting for the work. In other words, the key functions are (1) estimating and sales, (2) construction operations, and (3) administration including finance and accounting. These three functions are separate and distinct but equal in importance. To be managed appropriately and effectively, they should be analyzed separately, with time and energy budgeted to each function. One key individual must have direct responsibility for each of these three functions. It is not unusual for a small enterprise to have one person handling operations while another person handles accounting for the work. Neither is it unusual for one person to handle all three functions; however, the functions remain distinct. Responsibility must be recognized. Some may consider one of these functions to be more important, but neglecting any of these three functions is courting failure. They are equally essential to success. Individuals who accept responsibility for one or more of the three primary functional areas of management are key to the organization whether or not they own a piece of the company. The leading individual must believe he or she is ultimately accountable for the success of their functional area and accept responsibility personally, not as a functionary or an executive but as a “principal” in the organization – with ownership or not.

The success of a construction business starts with avoiding failure (Figure 1.1). Understanding the reasons why construction businesses fail is the best way to prevent unnecessary loss. The investigation and resolution of hundreds of construction company failures has generated a significant body of knowledge on the subject. The events and decisions that precede the failure of a construction business can be categorized and quantified to define the most common root causes. The following section discusses the five primary elements commonly found when analyzing construction business failures.

Figure 1.1 The success of a construction business starts with avoiding failure.

The Five Primary Elements of Construction Business Failure

One of the most interesting phenomena is the fact that the events and decisions that cause or contribute to a construction business failure take place during the company’s profitable years. To look for the causes within the difficult years (i.e., when a company is losing money or breaking even) is to study the result and not the cause. It is easy to be misled in a study of bad years because losing operations can generate unusual events and decisions, even if the contractor is unaware of the impending loss.

The events and decisions that precede the failure of a construction company generally take place one year to three years before the first financial statement that shows a break-even year or a loss. A study of the events and decisions that caused hundreds of companies difficulties, identified five recurrent and industry-wide elements contributing to risk and often resulting in failure. The primary common elements of construction business failure are:

1. Significant increase in project size
2. Unfamiliarity with a new geographic area
3. Moving into a new type of construction
4. Changes in key personnel
5. Lack of managerial maturity

Each of these key elements will be discussed using examples of how they affect an organization and its ability to make a profit.¹

Usually, decisions to grow the business are consciously made, and the events are recognizable and may appear to be routine business occurrences. Many contractors deciding to take on a very large project, to expand into unfamiliar locations or to establish a new type of construction, may not see such decisions as dangerously risky; with proper planning and controls, they don’t need to be. There is no suggestion here that a contractor should fear growth or other changes. What is expressed is that at least one and usually two or more of these events or decisions preceded the failure of a large number of contractors and that there is an inherent danger in these elements. A complete understanding of the risks involved is necessary when encountering them. When two or more of these business changes are undertaken at the same time, they are often lethal.

Element #1. Significant Increase in Project Size

The most common element among contractors who fail is a dramatic increase in the size of projects undertaken. The change to larger projects usually occurs during profitable years, and problems sometimes develop even before the first large project is completed.

Undertaking larger projects is a natural part of the growth of a construction company; the order of magnitude addressed here, however, is two times or greater the previous largest project. The size of a project relative to the size of the company, and relative to the size of its normal or average projects, has a definite and direct relationship to profit potential.

When a construction enterprise is operating at a profit, doing a certain average-sized project and a certain top size, there is no reason to believe that it will profit if it takes on dramatically larger work. A construction firm may be able to build a project that is two or three times larger than it normally does; however, the issue is whether they can build it at a profit. If a company can construct $1-million road projects or buildings, it may be able to construct a $2-million or a $3-million road project or building and get the job done. But the critical question is: will it make a profit? Making a profit on a job twice the size of a company’s previous largest project would be unlikely. Making a profit from a job three times greater than the largest ever built is almost impossible without additional financing resources and a tremendous amount of careful planning, all of which is unlikely without outside help. Getting additional resources might be possible, but how would a contractor, with no background on projects of such magnitude, determine what resources would be needed? Without previous experience, how could they carefully plan the work? Contractors who normally do top-sized jobs of $1 million, $10 million, or $100 million would be working in an altogether different environment than the one they are equipped for if they took on a $3-million, $30-million, or $300-million job.

Let’s consider an example from a case study conducted by the authors. A contractor’s previous largest project is $1 million and usually has two or three additional jobs at any given time of $300,000 to $1 million and a number of smaller jobs under $300,000 each. The company’s annual volume is $3 million, and it is generating a comfortable profit. When work dried up and backlog fell off dramatically, they went after larger and larger projects. They were able to capture a $3-million project, and in their estimation their problems were over for a while. In fact, their problems were just beginning. Let’s look at the impact on their organization. Previously projects took about a year or less to complete. On average, one of their larger projects started about the time another finished and a third was at its midpoint. Normally, on this company’s projects near-completion, there were considerable retainage, while the ones in the middle stages were generating large monthly payments, and the ones starting up were producing good cash flow through front-loading. By handling jobs in sizes they were accustomed to, which normally were in varying stages, the company not only had a reasonable cash flow but also had the time and resources available to look after all of its jobs and keep the jobs profitable.

Contrast this with the $3-million job. At first, the front-load was terrific, but the retainage mounted fast and, within six or eight months, became a higher amount than the company had ever had on all jobs combined. By the end of the job, the retainage amount was strangling the business, and the project took longer to finalize than anything they had ever undertaken. While the project type was similar to the organization’s previous work, they were surprised at the level of inspection and supervision they were subjected to by the architects or engineers.

On larger projects, municipality, state, and lender inspections generally have more red tape than smaller jobs, which may be more than management is familiar with or more than what field staff can effectively handle. Work rules are often more comprehensive on larger jobs, and security and safety requirements broaden.

The larger project, although similar to other jobs the organization had performed, was not within its experience or capability to finance. The company got the job done, but making a profit was another story. With losses out-of-pocket and huge retainage outstanding, the company could not pay its bills and is no longer in business.

Element #2. Unfamiliarity with a New Geographic Area

Unfamiliarity with a new geographic area in which the contractor has not worked is a common element preceding construction business failure – almost as common as the change in project size. A contractor’s primary area maybe one county, half a state, five states, or a whole country. Regardless of size, the primary area is the area in which the organization has regular operations, has developed comfortability, and has been profitable. While there are many good reasons for a company to expand into new geographic areas, such as normal growth, lack of work in their primary area, and special opportunities, the risks must be recognized and planned for. Again, the question is not whether the organization can build a similar product in a different location. Rather, it is whether this activity will result in profit.

With time, an organization becomes accustomed to working in a given area and can easily assume its type of work is performed the same way everywhere. Yet the differences in customs, methods, procedures, regulations, work rules, and labor conditions can be significantly different and expensive if not planned for. Examples are numerous. Consider a merit shop contractor bidding outside its area without knowing in advance that the work would have to be performed using union labor. Or, in certain areas of the country, it is common to install underground pipe practically underwater while specifications in other areas require complete de-watering. In some states, it is almost impossible to keep full crews during the first week of the deer-hunting season. There are even some areas where local suppliers will give their best prices and services only to local contractors. Regulatory requirements and inspections may differ greatly between a city center and the suburbs, or in a neighboring county.

Without even going into geological and weather conditions, there are enough potential differences to cause a prudent contractor to ensure they know what they are getting into when taking on work outside their customary area. Local help, such as a joint-venture partner or new area-based personnel, may be needed to facilitate the project. Compounding the problem, a contractor often takes a distant project, much larger than anything they have built in the past because it wouldn’t pay to take projects of their normal size so far away, which of course magnifies the risk.

Element #3. Moving into a New Type of Construction

Contractors sometimes change from one type of construction to another, or add a new type of work to their existing specialty. Companies may change, for example, from highway work to sewage treatment plants, from heavy industrial to tunnel work, from low-rise to high-rise buildings, or from office buildings to hospitals. The need for research and planning before embarking on a new type of construction work is well recognized by contractors. What is often underestimated is the entrance cost, i.e. the costs associated with the learning period during which an organization adjusts to performing a new type of construction work. Hiring a person who masters the new type of work may not be enough. Companies often complete one or more losing jobs before they can execute a new type of construction profitably. Unfortunately, some companies do not survive this period.

Contractors are more specialized than they realize. Some construct several types of projects, for instance, but perform and profit better at one kind. Some may call it luck, but it’s probably because they are better at pricing and constructing that type of work. Contracting organizations usually start and remain with types of construction in which they have the expertise. Further, they will base growth and success on the continued perfection o...