Risky business: why so many contractors fail

By JOHN SCHAUFELBERGER
University of Washington

Construction is a risky business, and construction managers often lack the necessary business management skills to survive. While good cost estimating, project planning and scheduling, and project management skills are essential for success in construction, so are good business planning and management skills.

Over 10,000 construction firms failed in the United States in 1997, up from 8,000 failures in 1990. The business failure rate in construction is about 30 percent greater than the national average for all industries. These statistics provide a measure of the risk faced by construction managers and highlight their need for good business management skills.

Problem Areas. What are the problem areas that cause contractors to get into financial difficulty? Some are external, such as economic downturns, but construction managers must understand that construction can be cyclical, and that they must develop contingency plans for changes in the market. Many, however, are internal and within a contractors ability to control, as explained below.

Pursuit of Volume. Volume, not profitability, often is used as a measure of a contractor's success. Rarely are profit margins, return on equity, and changes in profitability used to describe the condition of a construction firm. This constant pursuit of volume may lead to accepting lower profit margins on projects because of intense competition. Rapid growth also stresses the firm's management systems and may spread management too thin to monitor adequately the performance of individual projects.

Lack of Comprehensive Business Plans. Some contractors do not have business plans that guide their business decisions. They simply react to the market. Business planning requires an understanding of the market, how construction procurement decisions are made, and the competitive advantages of the firm. This knowledge is essential in the selection of services to be offered, the selection of market area and focus, and the selection of people and equipment required. In addition to understanding the market, the contractor must understand the firm's financial condition and devise strategies for financial success.

Ineffective Financial Management. Contractors may not understand their firms cost structure, which results from inadequate accounting systems that do not provide needed detailed cost data. In other cases, they may not manage their cash flow requirements properly or are not adequately capitalized and must resort to unplanned borrowing of capital. Another problem is the use of working capital to finance equipment purchases, reducing the firm's ability to finance its cash flow requirements. When asked about their financial condition, some contractors must refer to their bookkeepers or accountants, because they have little involvement or understanding of the financial side of their businesses.

Unrealistic Prices. Price must be based on actual cost data plus a mark up to cover indirect costs and provide a profit. Estimating labor productivity is the greatest risk in developing a cost estimate for a project. The firm's accounting system is the best source for this information. This requires that cost data be captured in sufficient detail to provide a data base that can be used to support preparation of cost estimates. Contractors who do not understand their labor costs often incorrectly price their work. Some rely on historical rules of thumb or establish unrealistically low prices to attract customers or to provide work for their employees.

Slow Collections. Many contractors are late submitting invoices to customers. Customers typically do not pay until they receive an invoice allowing the contractor to continue to finance the work. Failure to receive timely compensation for work performed puts a severe strain on a contractor's working capital and can lead to severe cash flow problems.

Poor Internal Communications. Poor internal communications between project sites and the home office plague many construction companies. Consequently, there may be little warning of project execution problems or financial difficulties. In most cases, it takes only one or two disastrous projects to bring down a company. Early warning is essential if corrective action is to be taken in time.

Inadequate Marketing. Many contractors do little marketing, but focus on selling their services. Marketing involves everything a company does to retain and attract customers. Hard selling is of little value unless the firm has a reputation for quality customer service. Many contractors have difficulty packaging and presenting winning proposals, whether written, oral, or both. Good presentation skills are extremely critical to effective marketing.

Poor Human Resources Management. Construction firms succeed or fail based on the quality, skills, and motivation of their employees. This critical function often is overlooked by many construction managers. Quality team members must be recruited and given the skills needed to provide excellent customer service.

Unplanned Leadership Changes. Unplanned changes in leadership can be devastating to a construction firm, whether it be from retirement, illness, death or resignation. Succession planning is essential to ensure continuity of operations. This issue needs to be addressed in the firm's business plan. This is particularly important in family-owned businesses.

Solutions

To be successful, construction firm managers must understand their customers expectations and achieve them while earning a profit. They need effective business plans that are understood fully by all their employees. These plans can be quite sophisticated or rather simple. They should address the following questions:

• What is our current situation?
  
• What do we want our future to be?
  
• What might inhibit us?
  
• What actions should we take to achieve our objectives?

This involves assessing the external environment to determine opportunities to be exploited and threats to be addressed and the internal organization to identify strengths to be built upon and weaknesses to be addressed.

Company goals and objectives must be developed and resources allocated. These may involve enhanced management systems to accommodate a growing workload, increased capitalization to provide needed working capital, improved accounting systems to provide weekly or monthly cost data for each project, selecting a different mix of customers to target, and employee skill enhancement.

The business plan needs to address financial, marketing, and human resources issues. It provides a framework for future decision-making and helps each employee understand his or her role in making the company a success.

To be successful, construction managers must realize that their firms will survive only if they provide value to their customers and that value is provided with superior business practices, skilled people to deliver quality services, and a good working environment to motivate their employees. Posturing their companies for success requires careful planning and periodic evaluation to ensure responsible individuals have been given adequate resources to achieve desired goals and objectives.

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