Polypipe’s Adrian Farley, a member of the Constructing Excellence Procurement Forum, asks some provocative questions about profit margins.
A longer version of this blog was first posted on the Constructing Excellence website here.
Adrian Farley
Both the Latham and Egan reports identified areas where the construction industry could make improvements in the way that it worked. Both of these had one eye on the clients’ satisfaction as a driver behind their implementation, and on bringing better processes and practices into the sector.
But the Egan report also set a target for the improvement in profits (raising them by 10% year on year). It did not suggest how this was likely to be achieved – and a look at the trading figures in the last five years would demonstrate that this is one target that has been missed by some way.
Construction needs to be a profitable activity. We look at major skill shortages as a huge threat to productivity. But have we not got the skilled labour because we stopped investing in the last couple of decades? We stopped investing because we were not making enough profit.
There are other key topics surrounding construction at the moment as well as skills shortages. Take your pick from health and safety, sustainability, innovation, environment, social value, responsible sourcing, performance gaps and so on. How are we going to deliver better social value or sustainability without a certain amount of investment?
But unless someone somewhere is making a profit, that investment cannot happen.
The top 100 construction companies produced the following financial results in 2014:
Total Revenue £58,447,000,000 (Yes, that’s £58bn)
Total Net Profit £871,600,000
Average Margin 1.49%
Since 2009, the figures show a history of declining margins, which is quite ironic if you think how low they were to start with. And this on the back of falling revenues for those in the top 100, where the total turnover has dropped by £10bn in that same period.
How is the construction industry supposed to be funding the vast array of requirements on margins of 1.49%?
Meanwhile, a brief examination on the profit margins of various larger private sector construction clients reveals profit margins ranged from 4.73% to 43.28%.
We are trying to reform the construction industry, and various reports have been commissioned to this effect (Latham et al). In all of these reports, we have yet to include a measure that insists on the profitability of the project.
“Is it possible to work collaboratively to procure a project that meets the client’s wishes within budget, and still make a relatively acceptable return on project investment? It has to be.”
Surely, in isolation, a project bid and won at less than cost is an insolvent project? You would not want to trade with an insolvent company, so why do we accept this within the construction industry on a project-by-project basis?
Is it possible to work collaboratively to procure a project that meets the client’s wishes within budget, and still make a relatively acceptable return on project investment? It has to be.
Constructing Excellence has been considering this question within its Procurement Forum. For me, the question is, “do we need to insist on the profitable construction of all building projects and for this to be demonstrated within the tender submissions?”
I think it is imperative that we allow for a reasonable profit figure to be achieved. Not just so construction companies continue to exist, but that they can also then develop the necessary skill base that enables us to build with both innovation and with the right collaborative mindset. If we achieve this, we may find that meeting our Construction 2025 targets will become easier.
What margin is acceptable will be the next question. For me I think it is more than reasonable to expect companies to make a minimum of 5% net profit in the immediate future and for that target to be raised to 10% over a period of time.
Forcing companies involved in construction to make 10% should not just lead to them paying themselves bigger bonuses and driving better cars. If you make a decent return, then for my part I believe you have a social duty to train and develop your people so that the industry has the skills to move forward with confidence.
We have to act now or we will not be able to build beyond a certain activity level as we will not have the resources or knowledge available.
The next question is: can we do this and the one after is: how do we achieve this?
Adrian Farley, key account director for Polypipe, is a member of both the Procurement and Collaborative Working Forums with Constructing Excellence
Adrian,
A sensible and well argued piece of work. Yes of course it is possible for a project to be delivered to cost and programme targets and make a profit. We have an unwritten condition within our single source framework that the contactor must include a minimum 3% profit over and above any gain share achieved through the project. Does it always work? No, but it sets out with the project in the right place, and I would certainly want to know if our contractor was not making a profit on our projects! Can anyone replicate this? Yes of course they can, though certainly in the public sector it needs a complete culture change from cost to value and beyond.
Making profit is a good thing, but why focus on Return-on-Sales as the appropriate margin to look at? Why not Return on Investment or Net Assets? Construction is an industry with relatively low capital requirements. Unlike Adrian’s Polypipe, contractors don’t have to build factories or hold months of inventory.
There is no real logic as to why a company should make a particular return-on-sales percentage. Why should a contractor expect to make more profit just because a client chooses more expensive finishes?
I think if you look at return on assets the numbers paint a very different picture about the profitability of the industry.
And if we want to be radical, let’s look at return-on-staff-cost, because that is the real investment contractors make, and on which it is reasonable to make a return.
A very sensible and well argued article. It is essential that contractors, supply chain and consultants make profits derived from positive margins on the work they do. Profit is the ultimate measure of successful business along with long term survival. Contractors can survive on relatively small margins if cash flow is positive as this means they do not need to employ their own capital for the benefit of the client. Once cash flow is negative then small margins are totally inadequate. With the demands on resources today then my view is that contractors need a margin approaching 10% to remain viable and meet all project demands.
Excellent article. As a contractor’s QS I’ve been preaching this for years. The manner in which contractors end up getting most of their work (i.e. the bidding process) is deeply flawed and requires a major overhaul. Awarding to the lowest bidder is, on the face of it, great for the client but is in fact the genesis of most disputes and litigation. Every project has a correct price and adopting a more collaborative approach between the parties in determining the correct price will lead to a better, more efficient and, importantly, less litigious environment for us all to be part of.