Chapter 2 briefly describes the common causes of construction business failures. The next several chapters will provide a complete description of the elements of contractor failure, how to avoid them, and actual case studies of contractor failures related to the elements. This chapter concentrates on the most frequent cause of contractor failure, which is undertaking projects that are much larger than a contractor is accustomed to doing. There are times when contractors will feel pressured to take on larger projects, but there are serious reasons that contractor should stick with what has made them successful.
For instance a start-up company will typically grow for a number of years until it establishes a size that the founder(s) are comfortable with or have targeted. In this case, attempting larger and larger projects is required to find and establish a comfortable size. Obviously this is one of the risks related to start-up companies that are breaking into the market. These growing pains are difficult to avoid and are a large part of the reason that start-up construction companies have an extremely high failure rate. Continuing to take on larger projects during a short growth period magnifies the start-up's risks.
A common reason an established firm attempts an enormous project is due to lack of work. A contractor can run out of work for a lot of reasons: declining market, increased competition, higher interest rates, or local construction moratoriums. When backlog is down, larger projects seem a quick way out. If the size jump isn't too great, the risk is probably better than the alternative of completely running out of work. But as the size increases, so do the risks. A project fifty percent larger than any previous one carries much less risk than a project two hundred percent larger.
Failed companies have used all the excuses for taking on the final big project: “A close client wanted us to bid on it”; “The job was right next door to our office”; “We had an in with the owner”; or, the worst one of all, “We adjusted our bid after we were informed of the other bids.” Often the reasons for taking on much bigger jobs are opportunistic and the risks are far too great for any of these reasons to make good business sense.
3.1 LIMITS OF GROWTH
One of the main reasons contractors take on jobs larger than previously attempted is because the industry is highly volume driven. Taking on much larger projects to achieve rapid growth or expansion is highly risky. For every business, regardless of the industry, there is a limit to the rate at which it can grow safely. The problem is finding that limit before passing right through it. Organizational resources are stretched to the limit when increasing sales require a seemingly endless increase in people, financing, equipment, operations, and space.1
Determining the limits of expansion is not easy because there are few rules or restrictions. In fact, there are some highly respected management specialists who don't believe that there is a limit to expansion. But people should hesitate about extreme growth, because there are enough companies that no longer exist in the industry even though they were household names during their meteoric rise. While critics may point to specific reasons for each of these failures, the fact is that rapid growth itself is dangerous: not always fatal, but always a risk.
There are fundamental financial constraints to healthy and sustainable growth. The management of growth requires careful balancing of sales objectives with the firm's operating efficiency and financial resources. Cases in which companies have overreached themselves at the altar of growth have filled the bankruptcy courts. The trick is to determine what sales growth rate is consistent with the realities of the company and the financial marketplace.2
Each entrepreneur has limits to his abilities, available resources, and capital. Each organization is capable of doing just so much. During periods of rapid growth, construction companies change dramatically; they really become new untested organizations with a lot more work to do. The prior organization that was such a success is gone forever. If an organization is to grow, its management must grow. Note that growth does not mean more of the same, growth means to change. The organization's growth must be qualitative, not just quantitative.3 Qualitative organizational growth takes time and needs to occur prior to sales growth. It usually takes more time than it takes to capture larger projects and, almost universally, construction companies increase management after additional work is on hand, not before. Growth for the sake of growth is risky in any business, but growing in the construction business by taking on projects two to three times larger than anything done before is by far much riskier.4
3.2 INCREASED RISKS WITH LARGER PROJECTS
Primarily, the increased risks involved in drastic changes with larger project sizes can be attributed to the lack of experience. An organization with a profitable track record doing projects of a certain size cannot simply assume they can profit from a project of any size (Figure 3.1). Some might disagree and say, “I used to do much smaller jobs than I do now and I'm still making money.” This may be true, but how long did the evolution take before becoming profitable? There is a big difference between having money in the bank and making profit; this will be discussed in a later chapter. A company may be able to double the size of their projects, but that does not mean they should double it again and again. A geometric growth rate might sound impressive, but it typically turns out disastrous. It is difficult for a contractor to know just how large a jump in project size can be attempted at modest risk. However, it is appropriate to understand the nature of the risk and how to evaluate it before staking the business and its future on a giant project (Figure 3.2).
Figure 3.1 The Size of the Projects a Company Bids Should Be Closely Aligned to Its Profitable Experience with Similar Work. Big Isn't Always Better for a Construction Company.
Consider the story of a construction company that averaged annual revenue of sixteen million dollars in commercial and multiresidential work. They had been in business for 15 years and had experienced steady growth from their success. They had been doing two or three major projects a year along with a lot of smaller work in a two-county area of their state. Their average-size project had grown proportionately as the company grew. The largest project to date had been $6.5 million, but they considered anything over $3 million a major project for them. One-third of their volume was small jobs, many under $500,000. Profits were always good, and development in their area was on the upswing.
When an out-of-state developer announced plans to put up a luxury condominium in the company's area, the contractor's estimator sent for the plans. When the contractor and estimator saw the size of the project, they almost sent the plans back immediately, but hesitated. The project was enormous for them, they guessed about ten million, but as far as they could tell, they were the only local contractor bidding the job. The other bidders were larger contractors from out of the area or out of state. They felt they had a real competitive advantage and decided to bid the job. They had three major projects underway at the time, but only one was bonded. Since it was almost complete, they were able to get approval from their surety for the bid bond, which was very large for their company.
The design was first class all the way, and as the bid date neared, it became obvious that the project was closer to $12 million, higher than the $10 million initial guessed. They had some difficulty getting their prices together since some of the specialty items were from distant suppliers and sources they had never dealt with before. The size of the electrical and mechanical work on this project precluded the ability of the local subcontractors that they were used to working with. This created some difficulty for the estimator because he was dealing with strangers on some very sophisticated systems and controls. He had to be sure that everything was included but not duplicated. There was a last-minute snag on the bonding, but a hastily arranged meeting overcame that and they submitted their final price at $11.8 million. During this overwhelming period the estimator recalled passing on several small worthwhile projects.
The contractor had taken into consideration the owner's specification requirement of having a full-time project manager and a field superintendent. But, he thought he would not need both of them for three or four months until the project got rolling. However, immediately when the job started, the owner's full-time field representative insisted that both positions be filled from the first day on-site. The company had three key field superintendents running their three major projects, one of which was nearly completed. The contractor put his best superintendent on the job as project manager and another as superintendent. This left one superintendent to run two major projects and finish up the third. The contractor figured he would help out also. When the project manager began to lay out the new job for excavation, he was reminded by the owner's representative that the specifications called for a licensed surveyor to lay out the project. The contractor began to see that they were in an entirely new game.
Once underway, both the contractor and his estimator had to spend what seemed to them an inordinate amount of time at site meetings, updating schedules, and reviewing shop drawings and submittals. The shop drawings were a particular problem because, in the past, the company had never been required to formally sign off on shop drawings. They reasoned, correctly, that if they were going to sign off on all submittal and shop drawings, they had better review them carefully. It took a lot of time, and they eventually hired a draftsman to handle the preliminary review and coordinate the submissions.
The contractors’ assumptions that the client would overlook some of the specifications he considered to be excessive also became costly. The contractor was required to hire an on-site project engineer even though he didn't believe he needed one. He also didn't think that he would have to follow the strict emergency and first-aid requirements laid out in the specifications; the owner's representative wasn't as laid back with the requirements.
The payments on the project were very slow, and the contractor became frustrated when he was unable to get through to anyone with authority at the developer's home office. Eventually, after using up all of his line of credit to finance the project and keep the job moving, he threatened to stop the job if he wasn't paid quicker. This quickly got the attention of the developer, and the contractor was invited to the developer's home office. Over an elaborate lunch, a senior member of the firm (who happened to be an attorney) explained that they would do their best to pay him as they paid everyone in their normal course of business. But, the developer made it clear that another threat to stop the job would result in the contractor's termination from the project. They weren't happy with his progress (at this point the project was thirteen days behind schedule). The developer warned him to expedite the work to avoid any disputes over losses the owner might incur if the project was delivered late. The contractor went home and managed to arrange a little larger line of credit and continued to push on.
The contractor's two key people felt they were overworked with the large project, which was outside of their expertise and comfort zone. As the job progressed, the level of activity and number of tradesmen were more than they were used to or were comfortable with. The constant presence of the owner's representative and his staff (which had grown to three people by the height of the project) consumed a lot of the project manager's and superintendent's time, and they became very apprehensive.
The figures on the project started to slip, and the contractor was pushing the project manager pretty hard. There was plenty of other work in the area, and the project manager was genuinely apologetic when he quit. He explained that he simply couldn't handle the pressure. There wasn't a replacement for him in the company and with so much work in the area, little chance to hire from outside. So, the contractor promoted the superintendent to project manager, and a good foreman was made superintendent. The contractor was surprised when the foreman was approved as superintendent by the owner's representative. What the contractor didn't realize was that the owner's representative knew he could get more out of a contractor if the field management was not particularly strong.
By the time the project was two-thirds completed, the contractor knew he had a substantial loss on his hands. He didn't know if his bid was too low because it had not been a public opening (the bid was actually within 1 percent of the second bid). He was not sure if his bank would extend his line of credit further, and his cash flow problems were mounting. These financial problems were compounded because the two major projects underway when he started the big one both had finished poorly. He knew that the poor performance on these projects was the result of taking his best men off the jobs to man the larger project. He had expected his less qualified superintendent to do both projects and close out a third at the same time. The contractor hadn't been able to help the overworked superintendent because he had to spend all his time at meetings and solving problems on the big job.
About this time, the contractor came to another realization; he was in the middle of a construction boom in his area but was running out of work. He was doing fewer small jobs than ever because his estimator hadn't had time to bid them. They'd let the small ones go. Yet these smaller projects had always been profitable and were now sorely missed. The larger job was the real problem. Just after getting the big job a $3 million job was available from one of their best clients. They spent a great amount of time putting a bid together but were shocked when they couldn't get a bond for it and had to pass. In the past this was their averaged size job but now they were only able to get bonding for smaller jobs because they had tied up all of their bond credit on the large project. They needed work badly and were promised additional bonding as soon as their year-end statement was available. Their internal reports revealed exceptionally high receivables from the big job, and the surety was getting nervous.
When the financial statements came out, they weren't good. The disproportional payables dried up most of their cash flow. Tight money had caused the big job to lag. Several subcontractors complained to the owner about nonpayment, and the owner put the bonding company on notice of the payment problem. Finally, once the contractor's credit dried up he couldn't pay his bills and was eventually forced out of business.
3.4 CASE STUDY REVIEW
It cannot be said with certainty that if the contractor had passed up this one big job, he would have been in business today. But given the favorable construction market in his area, he certainly didn't need it. This example is particularly poignant for that reason. The contractor was profitable and positioned in a good marketplace. At the time he bid the larger job he didn't need the work. It was quite natural to look at the circumstances of being the only local bidder and see a competitive advantage. The only problem was the size of the job. The fact that he originally guessed that the job would be about $10 million when it turned out to be $11.8 million indicates that he was outside his realm of experience. His biggest job ever was $3.3 million, and he forgot that when he looked at that one for the first time he guessed it would be $3.8 million. The job was in the contractor's own backyard and involved the type of construction he did best. The only thing out of the ordinary was the size. Being out of his realm of experience he could not foresee the impact on his other work, his cash flow, his bonding capacity, or his profitability. He had no way of knowing that the second bidder was only one percent higher, so that wasn't the problem. He simply did not realize the tremendous risk in taking on a construction project that is substantially larger than anything the organization had done before. There are enough cases similar to this one that signals the devastating risks related to when contractors take on large jobs beyond their experience. The trick is to find the organization's niche in the business; that niche includes the project size they do best.
There is tremendous risk in taking construction projects that are substantially larger than anything an organization has done before.
A construction organization should be cautious of building large organizations with fixed overheads in a fickle marketplace.
3.5 UNDERESTIMATING THE SIZE
A common occurrence in the construction industry is underestimating the size of the job before the job is even estimated. When an organization is bidding work considerably larger than they are used to, there is a tendency to relate the work items to the scale of the work to which the company is accustomed. This is particularly true on work that is not taken off by units such as setting up equipment, cleanup, and so forth. If you are estimating man-hours from your own experience, you may forget or not realize that the equipment on the project is three times as big as normal or that the building, road, or bridge is twice as large as those with which you usually work.
The first precaution in considering much larger projects is to carefully review the bidding process. If the estimator lacks experience with the size of the project, they need to make sure they are not scaling down the project in their minds to conform to their expectations. A utility contractor, whose largest previous job was $2 million, captured a $4.3 million sewage treatment plant renovation project. Six months later, they were awarded a $7.6 million job with the next two bidders at $9.2 and $9.9 million. An extensive study of the entire bid was undertaken by the surety company's consultants with the cooperation of the contractor, and there were no major mistakes or arithmetical errors. Yet when the bid was carefully analyzed and compared to an independent takeoff by a qualified estimator, it was determined, quite to the amazement of the contractor, that almost every line item was low. There wasn't a single sizeable mistake, but literally hundreds of separate items were consistently low. Although it was the same kind of work the contractor always did, no one who prepared the bid, or in the company for that matter, had ever worked on a job this size. They simply scaled the entire job down in their minds to coincide with their experience and expectations. In fact, the scale on the drawings for this large sewage treatment plant was smaller than any scale on which the organization had ever bid. The blueprints, of course, were the usual size since they were photoreduced by the designer, which is not uncommon in this kind of work, and the estimators had properly noted the correct scale in their quantity takeoffs. They simply estimated too low in too many places. The size of the loss put this otherwise successful company out of business. Years of hard work and successful projects were all shot on one job that shouldn't have been attempted in the first place because it was too big for the company. They had been in business for over 40 years.
The second area of concern involves doing the job once you get it. Again, organizations with no experience in larger projects often downscale the job in their minds and believe they can run it with as few people as they typically would their everyday work. They need to determine how many key people this job will tie up, and for how long, and then take a look at what other work they have and how that will be affected. The impact of tying up key people needs to be evaluated as well as the inability to go after additional normal-size work in the marketplace. If there is little work around, of course, that is less of a concern, but someone has to ask the hard questions: Can the key people really do this job and make a profit and do they have any experience with this size work? If additional people have to be hired for the project, the risks grow. The ability and loyalty of new people are untested. If they don't work out and need to be replaced mid-project, another set of problems develops.
A third area of concern is variation in costs that may be unexpected as job size increases significantly. Even unit costs that are normally familiar to a particular contractor may vary considerably in the larger project and it becomes extremely important to use information resources like RSMeans to assist in predicting those costs.
Also remember that the owner's representatives, designers, and inspectors will probably be more used to the size of the project than the company's field management. As seen in the case study presented earlier in this chapter, the project management team got over their head with the technical requirements of the project and quickly became frustrated.
3.6 OWNERS AND RETAINAGE
The risk of undertaking a larger project is increased with an unfamiliar client. It's always important to know something about an owner, but if a company is out of work and desperate, an unknown owner probably won't change the decision to attempt a larger project. It's prudent to find out something about their payment procedures and reputation while determining the impact on the company's cash flow.
Take a realistic, if not pessimistic, look at the length of time the job will take and ensure that you have accurately planned for retainage rates. If there is a reduction in retainage when the job is 50 percent complete, determine whether this is definite or at the owner's option and/or dependent upon owner satisfaction. A retainage reduction cannot be assumed. Remember that holding back retainage is considered prudent by many owners, and if there is any question at all it is much easier not to pay than to pay. Determine the effect if the reduction is not received. If retainage is payable only after final acceptance, take a hard look at how long it will really take to collect even when dealing with a friendly owner. This planning should take place before the bid goes in, not after the project is awarded. Be realistic about how long it will take to collect retainages and the effect on the company's cash flow. Well-managed companies predict how much cash they will need at various times in the future, and then attempt to raise that amount before it is actually required. At the very least they make plans for securing the cash when they need it.5 Huge outstanding retainages are common among distressed construction enterprises that find themselves at the mercy of their bank lenders or sureties.
3.7 ALLOCATING TIME
Once a larger project is undertaken it is critical to give it the time it deserves as it will represent a significant portion of total volume. However, top management also needs to look carefully at allocating time and not forgetting about the other work on hand. The other projects may be smaller, but they may be and should continue to be the company's bread and butter. An organization seldom wants to lose the profits small jobs generate, and may not be able to afford the losses they could produce from lack of attention.
3.8 ALTERNATIVES TO TAKING ON LARGE PROJECTS
What are the alternatives for a contractor if he is running out of work because of a declining marketplace? The hardest alternative to sell in the construction industry is to do less work. It just isn't in the nature of most contractors to accept such a notion, but it is a very viable alternative. Cutting back overhead and becoming a smaller business to suit a declining marketplace is very realistic. If the entire market in an area is soft, then all of the contractors will be looking for work. Larger contractors who don't usually compete with smaller ones will be going after the smaller work. Bidding within a normal or smaller project size has far less risk than shooting for larger work. The problem, of course, is that an organization's volume will necessarily drop with the smaller projects. It is difficult and unlikely to hold volume with a larger number of smaller jobs because in a soft market there are fewer jobs and more competition. To get these jobs at a profit or at least at the break-even point, an organization can only hope to capture a share of them.
Another alternative would be to expand the company's work area and look for work in their best project size and market niche elsewhere. The risk involved with geographic change is discussed in Chapter 4, but this option can be explored and balanced against the risk of going into a very large project. Unfortunately, most construction businesses aren't very flexible. They aren't set up to expand and compress with the availability of work. A general contractor who was originally a concrete contractor is a good example of being flexible; every time work slowed down, the contractor would take a few concrete subcontracts to keep him busy.
A construction organization should have “flexible overhead” and be cautious of building large organizations with fixed overheads in a fickle marketplace. A portion of overhead needs to be flexible, that is, overhead that is easily removed, like short-term leases on some equipment and some temporary personnel in administrative positions. It is prudent for a construction enterprise to maintain 20–25 percent of their total overhead in a form that it is easily shed. Instead of hiring permanent office staff each time a company expands, it can utilize the services of temporary placement services until the new organization is assured or expands again, maintaining some portion of overhead staff on a nonpermanent basis that is easy to let go if work slows down. The same can be done with vehicles and equipment fleets with a portion on short-term rental rather than purchased, allowing much greater overhead flexibility.
It's the permanent overhead that cannot be easily reduced that requires construction companies to compete for sales in a declining marketplace to the point of desperation. Bidding with little or no profit on the work just to support overhead magnifies risk and in a declining market can be suicide. Some construction executives are convinced overhead can't be let go, particularly people, but also equipment, because it will be needed when the business cycle turns around. It is a compelling argument, but if the company does not survive a down market the argument is defeated.
Business is about recognizing, minimizing, and managing risk. It's not about maintaining size or maintaining potential for a future market. Every construction enterprise must operate in its current market by using past experience to navigate. Large construction projects have substantial risk and are to be avoided if the company lacks the experience.
There seldom will be occasions when, for whatever reason, an organization will determine to undertake a job much larger than anything they have ever done. Hopefully, they will consider all of the alternatives and weigh the risks involved, and if they decide to move forward, develop a course of action and stick to the plan.
3.9 CONCLUSION
We have spent more time in this chapter cautioning against taking on projects substantially larger than the organization has experience with than we have on how to cope with them. This is quite deliberate because the risks are so great that they should be avoided if at all possible. If a company takes all the precautions suggested here, there is still no guarantee they will succeed. Don't believe that a five-story building is like five one-story buildings any more than one $5 million job is like five $1 million jobs. Experience in one project size does not prepare an organization for similar projects twice the size. An organization must learn first how to crawl, then how to walk, then how to run, and finally how to fly. Leave out a step and they may learn how to fall, from a considerable height.
CHAPTER REVIEW QUESTIONS
What is considered a big job?
A project two times larger than previously completed
A project five times larger than previously completed
A $50 million project
A $500 million project
When is a good time to attempt a project that is double the size of the largest project previously attempted?
Never
During tough times
During prosperous times
During a time in which proportionate resources are available to manage the risk of the project
Why did the contractor feel the company would be competitive on the luxury condominium project in the case study?
They were the only local contractor bidding on the project.
They had a great relationship with the developer.
They were willing to do the work to keep the business running.
They were the most well-known contractor available.
In the case study, what was the reason that the big project destroyed the contractors company?
The contractor's estimator made a bid that was too low.
The contractor's management was insufficient.
The owner's representative made extreme demands.
The contractor wasn't able to get additional credit to pay bills.
All of the above
Flexible overhead would consist of which items(s) (circle all that apply)?
Yearly building lease
Temporary staff
Purchased equipment
Short-term leased equipment
CRITICAL THINKING AND DISCUSSION QUESTIONS
Why should a contractor limit the growth of their business?
Is it in the nature of contractors to limit growth? Why or why not?
What risks are involved with taking on a large project?
What does it mean to underestimate the size of the job before the job is even estimated?
How can a contractor minimize the risks with taking on a large project?
