Smart Business: The Bigger They Are, The Harder They Fall
FMI Corp., the well-known construction industry consulting and research firm, recently published a scholarly analysis titled: “Why Contractors Fail: A Causal Analysis of Large Contractor Bankruptcies.” It’s filled with examples of large general and specialty construction companies that went under, such as The Austin Co., Dillingham, Fishbach & Moore, Morrison Knudsen and many others.
In general, size is not an asset in the construction field the way it is in so many other industries. There are relatively few economies of scale compared to many other businesses, and far-flung operations tend to raise overhead without providing commensurate value to the company or its customers.
The FMI study examined 80 case studies of large contractors that suffered a major financial crisis, many of which resulted in bankruptcies. It can be obtained by contacting them via www.fminet.com and is worthwhile reading, but if you don’t want to invest the time I’ll briefly summarize its content as follows:
• Construction is an inherently risky business, and the people who get into it are risk takers by nature.
• Contractors are susceptible to financial difficulties due to high leverage. Leverage in this context doesn’t necessarily mean debt, but also the fact that the nature of the business allows contractors to do a lot of business with little equity or capital reserves. This means when a big project turns bad, they can end up owing more money than they can hope to pay off.
• Workforce issues present a conundrum. Skilled field labor and project management are in short supply, and once a contractor is lucky enough to recruit good people the pressure is great to keep booking work even at little or no profit to keep them on the payroll.
• The hard bid process allows little margin for error in cost estimating and marshalling of resources. Bid too high and you don’t get the job. Bid too low and you lose money. Or, you cut so many corners trying to eke out a profit that it impacts your ability to do the job right, which in turn makes customers reluctant to hire you in the future.
• Construction is a notoriously cyclical business that rises and falls faster than the overall economy. Contractors fluctuate between being over-committed and scrambling for work to keep people busy.
• Construction is hyper-competitive, because there are few barriers to entry. Unemployed trade workers frequently seek jobs on their own, almost always by underbidding everyone else.
• Construction contractors have little ability to create demand for their services. They are largely at the mercy of market conditions. Likewise, project timing is dictated by owners’ schedules, making it difficult for contractors to plan and manage resources.
• Most construction executives come from a project management rather than a business background. They are good at building things but not at managing finances.
• Customer and project selection is often done by “gut” feelings or desperation rather than systematic analysis. Contractors desperate to keep up the income stream end up taking jobs they’d be better off turning down.
Contractors tend to be ego-driven individualists who walk a fine line between self-confidence and over-confidence.
Authors Hugh Rice and Arthur Heimbach have a lot more to say, including a lengthy excursion into psychobabble that I think is a weakness of this otherwise fascinating document. Yet, I think a pertinent issue that they did not address is at the heart of this subject.
That is the question of what is the optimal size for a construction company? I serve as editorial director of Plumbing & Mechanical magazine, which for many years has published an annual list of “Pipe Trades Giants,” which ranks the mechanical contracting industry’s largest firms by volume. Over the years, many of the companies that made it to the top or near the top are no longer in business. Sometimes their collapse was shockingly abrupt.
Moreover, in the 1990s roll-up consolidators and utility holding companies went on an acquisitions binge trying to create national or regional mechanical and electrical contracting powerhouses. These were industries ripe for consolidation, according to all the Wall Street calculations. Some of these consolidated companies reached more than $1 billion in annual billings, but virtually all of them eventually met with miserable failure. (Ironically, some companies were split off and sold back to their original owners for pennies on the dollar compared to their original purchase price.) Bigness seems so jinxed in the construction field, it makes some people wonder why any contractor would even want to grow too much.
The biggest reason no doubt is that while there’s often a negative correlation between size and profitability, volume does put a lot of money in a lot of pockets at least for awhile. Owners and managers who run the biggest companies tend to enjoy more pay, perks and prestige than smaller contractors and their staffs.
Another reason probably has to do with a factor cited by the FMI study as contributing to large company failures – contractors are at the mercy of market conditions. Sometimes growth is not planned, but happens as a result of a booming market and contractors trying to make hay while the sun shines. As volume increases, so does bonding capacity, borrowing ability and employment opportunities. This leads to a chain reaction enabling contracting companies to become even larger. At some point the momentum takes on a life of its own and it becomes hard to stop the compounding growth even if you were so inclined.
Still … the vast majority of specialty contracting done in this country is performed by local or regional companies. Your field certainly embodies this characteristic. Local contractors have formidable advantages of market knowledge, labor access, business relationships and community ties.
Something I’ve noticed happening in the mechanical contracting field with increasing frequency is that a large mechanical contractor will move out of its turf and joint venture a project with a local company, bringing to bear its bonding capacity, buying clout and other economies of scale while benefiting from the local advantages just cited. This is probably a wiser way for specialty contractors to pursue work far afield than trying to stretch their own resources.
The question originally posed remains unanswered: What’s the optimal size for a construction contracting company? I don’t have a clue what the answer might be, and it may be unanswerable. If any of you have opinions about this, I’d love to hear them and share them with our readers. Contact me at email@example.com.