Experts Make Money
July 7, 2023
By Thomas C. Schleifer
Because too many construction projects are priced through a low-bid auction process, contractors have only minimal control over their selling price. Expense inflation over the extended life of a project is hard to control. With more and more owners considering construction a commodity causing downward pressure on selling prices, and with persistent inflationary trends in expenses, construction profit margins are in serious jeopardy. “Buy high - sell low - and make it up in volume” is once again becoming the order of the day in construction. Even if you’re running fast while growing rapidly that business model eventually catches up with you.
The Expertise Business Model
Acquiring business by submitting the lowest bid has forced savvy contractors to fashion new profit models. They recognize the limitation that a low bid selling price puts on profits and pivot to their expertise to support margins. The performance of an operating entity, such as a manufacturing plant, improves with repetition. In construction, however, ongoing business is made up of new projects that differ to some degree from all previous projects. As a result, construction organizations do not usually have enough repetition from project to project to accrue expertise in particular types of work. It is easy to become a “jack of all trades and a master of none”. However, if we “stick to our knitting” and select projects that most closely resemble work we have completed profitably, we can exert some positive control over margins. In other words, the more experience we have with similar projects, the greater the likelihood of successfully estimating, producing, and completing at a profit, and accumulating expertise.
Many contractors rely on optimistic estimates and ideal conditions when they pull the trigger on projects they want. They believe that they must take the work that the market offers and then figure out how to make money after the project is underway. Often, hoping they can eke out a profit on the “extras” that get added during the job because they can charge “retail” for those upgrades. Research data, however, suggests that contractors only consistently make money on projects they have experience with. Contractors recognizing their own expertise and using that self-knowledge to guide careful project selection consistently turn out to be the most profitable.
Which Projects Make Money?
- Size - Construction companies produce projects of varying sizes with varying results. (Small, midsize, and large are used here as relative to each firm’s average project size.)
- Small projects (some performed as a service for regular clients) lead to high profit as a percentage of sales. However, there are usually not enough small projects to support a mature organization.
- Midsize projects consistently earn reasonable profits and are the projects a construction company thrives on.
- Large projects are popular because they help contractors reach critical mass. However, they almost always earn less profit as a percentage of sales than midsize projects and too often lose money because too many companies lack the capacity (expertise and capital) to tackle a project much larger than they are used to handling.
- Type - Like project size, prior experience with the type of project is a most important factor in successfully proposing and delivering a project profitably. It’s again a question of expertise. For example, if an organization has been successful constructing relatively straightforward warehouses and strip shopping centers and then decides to attempt their first sewage treatment plant, they would obviously lack expertise on this type of project. The likelihood of successfully pricing and producing the work would be extremely limited resulting in huge risk compared to an organization that regularly builds treatment plants.
- Location - Because construction work is produced slightly differently across various parts of the country, expertise is often geographic and impacts the contractor’s likelihood of making a profit. Local contractors are experts at local issues such as labor availability, subcontractor evaluation and reputation, and other local customs that may impact how the work is managed or performed.
- Expertise - The number of members on a project team with direct and relevant experience (expertise) in the type and size of a project dramatically improves the project’s success potential.
- Complexity - When a design is unusual and falls outside the direct experience of a construction company, there is considerable project risk in pricing and producing the work because it exceeds the institutional expertise of the company.
(For more details on these five elements see Ch 1 in The secrets To Construction Business Success, published by Routledge)
Experts Make Money
Low-bid acquisition and persistent expense inflation continue to test profit margins in the construction industry. Savvy contractors know to bet on their own expertise to save their bacon. Many contractors believe that “we can build anything”. They are mistaken however if they believe “we can make money building anything”.
If you think through, most of us intuitively know that the only way to ensure profitability is to limit our company's growth to the type, size, and location of projects we have already proven our ability to make money at. Trust your gut.
Merchants Response - Vice President, Claims Manager Jay Farley
We’re seeing Dr. Schleifer’s cautionary observation that “[e]ven if you’re running fast while growing rapidly, that business model eventually catches up with you” play out in two ways:
- Companies have simply grown too quickly – with sales revenues that are twice their operational size. These companies are stretched too thin, especially considering the many well-known challenges in construction right now, which is resulting in defaults and claims.
- When these companies do fail, we’re experiencing extraordinarily high resultant losses. Operational voids within these companies are leading to underbidding relative to actual expenses, overbilling relative to completed work, extensive defective work, large amounts of outstanding payables, and severely delayed completion.
These issues, combined with historically high completion pricing in the market, are causing surety losses to far exceed industry probable maximum loss figures – and in a number of cases reach the penal sum of the performance bond with additional losses on the payment bond.