Some thoughts on “Government innovation tsar says contractors should be making 5% margins”, by Jordan Marshall, Building Magazine, 7th June.
Keith Waller is quoted in the article above as saying that shifting margins from for contractors 0.5% to 5% is a good thing. I agree. It would help lift the existential fear that lurks in the industry.
The article suggests that these margin improvements should be made on the supply side, rather than the client side. Making such a dramatic shift in margins will require significant efficiency activity in the contractor organisations. That activity will need funding in some way.
As I see it there are four broad funding routes open to existing contractors (that might be augmented by R&D tax credits), each with its own challenges.
- Re-investing profits: This route is open to all with positive balance sheets and profits. However, investing in-year profits will tend to reduce profits (PBIT) further, depleting the cash available for dividends and interest payments. Investing through this route requires patient investors. Alternatively, companies could dip into their reserves. With a long history of low margins, this will, in the long term will lead to reductions in the cash balances on which many contractors still depend.
- Raising new funds: This could be achieved in a number of ways – new injections from venture capitalists or external investors (as we’re seeing in the off-site housing sector), return to the market to re-finance, approach the debt markets, or the banks. For each of these pathways, patient investors and a strong business case evidencing the ROI (dividends and interest) are important. If the investment programme can move gross margins by 4.5%, then it should be a no-brainer, right? But do we have the business cases to support that sort of ROI? If they exist, they should be collated and shared. But there might be some competitive issues around publicising business cases to protect savings already made?
- Public funds: The Government, through the UKRI and Homes England has invested heavily in promoting the Transforming Construction agenda. Government RD&I (research, development and innovation) funds are typically directed at projects at relatively early TRLs (1-7), leaving the commercialisation to the companies (see 1 & 2 above). Homes England are supporting the transforming construction agenda through loans to projects that are delivering through DfMA, helping to stimulate and maintain demand to support DfMA activity. These investments are welcome, and do support change. However, funds may not be available to all contractors and projects to allow them to up their profit margins. Would the Government be happy to support the development of another DfMA factory, or another machine learning system to leverage big data? Another drawback of Government funding of RD&I activity is the need to share the IP developed. This might act as a disincentive to take this route.
- Pre-competitive collaboration: Contractors work together to develop the tools, processes, and knowledge to all grow their margins. In this way, the burden is shared, and everyone benefits. While this seems like an attractive model, some contractors have already begun their efficiency journeys and are reaping the rewards. They may be reluctant to spend their money again, aiming instead to capitalise on their head start. For those left behind, opportunities remain to collaborate together, and/or with supply chains, to deliver a platform-based approach to construction.
This view presents a relatively bleak picture of the chances of all of our contractors getting to 5% under their existing delivery models. There are rational reasons for not making the necessary investments to make the jump. However, there are also existential reasons to do so. Indeed, Directors have a fiduciary duty towards their shareholders to protect their long-term interests. They should be looking ahead to understand and respond to the threats and opportunities in the market.
Where the business case of the specific investments can be demonstrated, investment should follow. But, in a world of abstractions (e.g. ‘digital will save us 20% of costs’) demonstrating the clarity, and specificity needed to develop such a business case can be a challenge. Companies chasing funding will need to undertake appropriate analysis of their existing practices, and clearly identify the benefits of specific changes proposed. If they do so, the opportunities to reach that 5% margin could well be within reach. Which would be great news.
But then what?
We’ve ended up at the position of wafer thin margins through round upon round of competitive bidding under common value auctions for work. When faced with this same situation, which of our 5% margin contractors will be tempted to shave 0.1% off to win the work? Perhaps 0.5%? The cycle begins again.
Delivering and maintaining these margins calls for strategic, ongoing investment by contractors in process and (where relevant) product improvement (a point made well by Prof Hedley Smyth, UCL). If they aren’t already doing so, contractors should be communicating this need for ongoing investment, and the associated benefits, to their investors through their accounts.
If our existing contractors won’t make these investments, there are others lining up to do so.