Australian Constructors Association Calls Out Excessive Risk versus No Rewards in 2023-07 Publication
With the profitability and sustainability of the Australian building sector highly questionable (profit margins averaging 1% and liquidity at just 5%), the dysfunction of this large sector of the Australian economy is clear. The cause is that rules of engagement are fundamentally flawed. The result is the continuing insolvencies plaguing the industry and impacting the overall economy. In many ways this is exactly what is being mirrored here in Canada and in Alberta.
The Australian Constructors Association recently published a report entitled “All RISK-No Reward” in July of 2023, which reads as follows:
All RISK – No Reward
Fixing the Building Industry’s Profitless Boom
This report – at a glance:
Building firms are entering administration at more than twice the rate of other industries. This reflects some deeply troubling financial conditions. Profit margins have fallen to 1% and liquidity to 5%. Over half of all large builders now meet a technical definition of insolvency.
Why is Australia’s building sector so dysfunctional? Because the rules of the game are fundamentally unfair and drive builders broke.
Healthy markets need two things to function properly: (1) that the buyer knows exactly what they want, and (2) that the seller knows exactly how much it costs to produce. Under these conditions, the normal rules of commerce work well. Buyers specify their requirements upfront and sellers put a hard price on them.
The typical vehicle is the ‘fixed price contract’ and it works well for buying a fleet of cars or an office lease. This model does not work well for transactions with high uncertainty—say, a building project. It fails because the fixed price contract transfers all the uncertainty in cost and design onto the seller. When those risks are realised, they are funded out of profits.
The model of total risk transfer across the building sector has produced a deeply unstable industry—systemically weak financials, a myopic focus on the short-term and an adversarial culture. A lawyer’s playground. This is a bad outcome for everyone. Builders are in constant survival mode, struggling to eke out a margin. Clients are in a constant battle to maintain feasibilities in the face of recurring disputes and variations. In the worst case, the builder collapses and the client is forced to retender an incomplete project, wiping-out its profits.
There is a better way. Win-win construction contracts are becoming commonplace in other corners of the industry such as infrastructure. Their value in delivering more certain and better outcomes is proven. There are three key ingredients:
» Involve the contractor in the design process at the earliest opportunity – this not only delivers firmer costs but also usually a lower price.
» Do not set a formal cost at the start—invest in developing a price jointly with a contractor and consultant before launching into delivery.
» Consider incentivising collaborative out-performance – use a ‘pain-share/gain-share’ model to share risks and rewards among the parties.
These lessons apply to both public and private sector clients, but government must show the way. All public building works should be procured with these principles in mind – because a profitable building industry is in everyone’s interests.
Australia’s building sector is broken:
Building is one of the largest and most important sectors of Australia’s economy, responsible for delivering the wide range of structures that make up our ‘vertical’ built environment. This includes houses and other residential dwellings, as well as the many types of non-residential buildings such as schools, hospitals, shops and offices.
Australian building firms directly employ 350,000 people but indirectly create employment for a further 530,000 through its subcontractors, consultants and the broader supply chain. Through their activities, building firms were responsible for creating $155 billion in value for Australia in 2021-22.
Yet Australia’s building sector is clearly broken.
Building firms enter administration at a rate more than twice that of other industries (see Figure 1). These insolvency statistics are the symptom of a much deeper financial dysfunction within the Australian building sector.
Data from credit rating agency Equifax reveals that profit margins in the building sector have fallen from around 3% to below 1%. Liquidity has fallen from 15% to below 5%. Perhaps the most concerning data point is that more than half of all large builders are now carrying current liabilities in excess of current assets—a technical definition of insolvency.
How is it that one of the largest and most important sectors of the national economy could have become so dysfunctional?
It is not enough to point to the competitiveness of the Australian building market. Many industries are fiercely competitive, yet margins are often healthy and insolvencies contained. Professional services firms, for example, enjoy pre-tax profit margins four times as high as builders, while suffering one-fifth the rate of insolvencies.
Something else is going on.
Market failure in the building sector:
Occasionally, though, they fail to work as advertised. The reasons why are well understood by economists.
Markets function best when the buyer knows everything they need to know about how the product will perform, and the seller knows their production costs. This implies a level of certainty and transparency that allows production risks to be priced. It also helps if there are many buyers and sellers, and the product is easily substitutable, so that parties can enter and exit transactions easily. These are the conditions of an efficient, competitive market.
It will be clear to anybody familiar with construction that these ‘win-win’ conditions rarely apply to a building project. Two features of Australia’s building sector mean that it almost always fails to operate like a normal, well-functioning market:
» Unquantifiable risks—the building process is laden with uncertainty. There are risks related to approval processes, design, ground conditions, weather, input costs and third-party interfaces. Many risks cannot be known with confidence at the time of contracting – they can only be quantified through the process of construction. The ultimate cost of a project is therefore subject to great uncertainty, which makes it very difficult to price with accuracy.
» Lock-in—it is very costly for parties to a building contract to exit the transaction once the contract has been let. From the client’s perspective, the significant costs and additional risk associated with switching contractors makes the proposition commercially unviable. As a result, building contracts are virtually never terminated except in the case of insolvency or, in rare cases, a serious dispute.
This structure creates the conditions for some deeply dysfunctional industry dynamics. The most prominent and problematic of these is the fixed price contract. It is natural that parties will seek to minimise their exposure to the unquantifiable risks inherent in building. Yet under a fixed price contract, this entire burden of risk is transferred to the builder. And because building is normally a ‘buyer’s market’—due to high levels of competition—contractors tend to accept that burden in order to secure revenues. However, if enough of that risk is realised, the builder is faced with an unenviable choice – put pressure on the supply chain or make a loss.
Occasionally, construction becomes supply-constrained and a ‘seller’s market’ emerges. Under these conditions, contractors are often able to manage their own risk exposure by simply refusing to participate in a fixed price regime. In these circumstances, it may be difficult for clients to deliver even the most feasible and well-financed projects. The only alternative is to offer the contractor a more attractive risk allocation, such as a ‘cost-reimbursable ’contract. However, an unconstrained cost-reimbursable contract can create the opposite risk for the client—the uncertainty of final cost may make the project ‘un-bankable.’
The ‘locked-in’ nature of a building contract also creates problems. Often the only option is to resolve difficulties that arise through a dispute process which negatively impacts all parties – clients upstream, main contractors in the middle, and subcontractors and suppliers downstream.
These are the dynamics of a failed market. They have led directly to the adversarial and litigious approach to building in Australia and are the direct cause of the industry’s poor financial performance and high rates of business failure.
These dysfunctional dynamics are also a key cause of the poor productivity performance of the construction industry. Without sustainable financial performance, contractors are unable to make the necessary investments to drive innovation.
Achieving sustainable value in the building industry requires transforming this lose-lose conflict into win-win cooperation – a challenging though not impossible task.
Correcting market failure in the building industry:
No contract can account for all the unexpected events that will complicate a building project as it unfolds, but it can incorporate mechanisms to encourage the client and contractor to resolve them fairly and reasonably. The overriding goal of contracting must shift from a focus on transferring all risks to the contractor at the outset—particularly unquantifiable risks—to establishing the rules by which the parties will jointly manage these risks as they inevitably arise throughout delivery.
Resolving these issues in practice has attracted considerable interest from experts in economics and law. The literature offers a clear conclusion: collaborative procurement strategies are almost always preferred to fixed-price contracts for projects with high uncertainty.
While a wide variety of arrangements and contract forms are available to promote win-win outcomes, a few simple principles create the conditions for success.
It is becoming routine for these principles to be applied to civil infrastructure projects across Australia and overseas. Several forward-thinking vertical building clients, including the NSW Department of Health and the Department of Defence, are also capturing the benefits of these more mature procurement practices.
The two-stage competitive Early Contractor Involvement (ECI) framework is one popular model that has been repeatedly shown to outperform traditional fixed-price delivery models by facilitating a high level of interaction and collaboration between contractor and client. Under this model, a builder is contracted to participate in the planning and design phase separately to the subsequent delivery contract. Once the design is settled and an accurate price is determined, a separate contract for project delivery can be let to the same or different contractor.
The ‘Managing Contractor’ (MC) model is a variation on this theme. Under this model, a contractor is competitively selected to collaboratively manage the full lifecycle of the project with the client. The contractor typically only performs management and advisory services, subcontracting all design and construction functions to third parties in close consultation with the client. Unlike a conventional fixed price contract, the client reimburses the contactor for reasonable payments to subcontractors while separately paying the contractor a management fee.
While a smaller aggregate buyer, government is best positioned to lead the way. Public sector clients are less constrained by the market and present a much more consolidated group of buyers. The government, as sovereign, also accepts a responsibility to leverage its spending for higher goals. This ‘fiduciary’ role is well accepted in other areas of public policy such as indigenous participation, training and diversity. It should be extended to productivity by requiring collaborative procurement models on all publicly-funded projects.
By committing to these new rules of engagement, government clients will not only improve their relationships with the supply chain but will also drive positive change in one of the economy’s most important and troubled industries. Changing these practices will create the conditions for improved productivity and a healthier industry. Value for money, in the fullest sense of the word, will be significantly enhanced for the taxpayer.
A profitable construction industry is in everyone’s interests and should be a key priority for all governments.