By Tom Schleifer, Ph.D.
Consider also listening to the NASBP Podcast with Dr. Schliefer.
Table of Contents of articles provided below
Thirty-fifth Crisis - Era Message to Contractors: Reader Questions and Answers Published December 18, 2020
Thirty-fourth Crisis - Era Message to Contractors: New Year's Resolutions Published December 9, 2020
Thirty-third Crisis - Era Message to Contractors: Thanksgiving Break—Will There Be a New Normal? Published November 25, 2020
Thirty-second Crisis - Era Message to Contractors: Election Aftermath Published November 11, 2020
Thirty-first Crisis - Era Message to Contractors: Profiting During Business Cycles Published October 28, 2020
Thirtieth Crisis - Era Message to Contractors: Why Partial Recovery Is Not Enough Published October 14, 2020
Twenty-ninth Crisis - Era Message to Contractors: Reader Questions and Answers, Part 6 Published September 30, 2020
Twenty-eighth Crisis - Era Message to Contractors: Reader Questions and Answers, Part 5 Published September 23, 2020
Twenty-seventh Crisis - Era Message to Contractors: Reader Questions and Answers, Part 4 Published September 16, 2020
Twenty-sixth Crisis - Era Message to Contractors: Global Perspective Published September 9, 2020
Twenty-fifth Crisis - Era Message to Contractors: Reader Questions and Answers, Part 3 Published September 2, 2020
Twenty-fourth Crisis - Era Message to Contractors: Construction Market Developments Published August 26, 2020
Twenty-third Crisis - Era Message to Contractors: Reader Questions and Answers, Part 2 Published August 19, 2020
Twenty-second Crisis - Era Message to Contractors: Reader Questions and Answers Published August 13, 2020
Twenty-first Crisis - Era Message to Contractors: Refining the Timeline Published August 5, 2020
Twentieth Crisis - Era Message to Contractors: U.S. Economic and Construction Market Update Published July 29, 2020
Nineteenth Crisis - Era Message to Contractors: Implementing "Flexible Overhead" Continued Published July 22, 2020
Eighteenth Crisis - Era Message to Contractors: Embracing and Implementing "Flexible Overhead" Published July 15, 2020
Seventeenth Crisis - Era Message to Contractors: The Concept of "Flexible Overhead" Published July 8, 2020
Sixteenth Crisis - Era Message to Contractors: Preparing for the Next Construction Market Cycle Published July 1, 2020
Fifteenth Crisis - Era Message to Contractors: Market Brief—Recommended Defenses Published June 24, 2020
Fourteenth Crisis - Era Message to Contractors: Construction Market Downturn's Impact on Profitability Published June 17, 2020
Thirteenth Crisis - Era Message to Contractors: The Dynamics and Patterns of a Construction Market Downturn Published June 10, 2020
Twelfth Crisis - Era Message to Contractors: The Potential and Timing of Recovery Published June 3, 2020
Eleventh Crisis - Era Message to Contractors: The Ripple Effect of this Economic Disruption Published May 27, 2020
Tenth Crisis - Era Message to Contractors: The Construction Market—Recovery, Timing, Profit Published May 20, 2020
Ninth Crisis - Era Message to Contractors: The Construction Market—Bracing for Long-Term Disruption, Published May 13, 2020
Eighth Crisis - Era Message to Contractors: New Worksite Protocols: The Impact, Published May 4, 2020
Seventh Crisis - Era Message to Contractors: The Long-Term Outlook, Published April 29, 2020
Sixth Crisis - Era Message to Contractors: Impact of Back-to-Work Restrictions, Published April 22, 2020
Fifth Crisis - Era Message to Contractors: Pace of Recovery-Impact on Construction, Published April 16, 2020
Fourth Crisis - Era Message to Contractors: Time Is Not On Our Side, Published April 10, 2020
Third Crisis - Era Message to Contractors: Why a Measured Response and When?, Published April 10, 2020
Second Crisis - Era Message to Contractors: Immediate Measured Response, Published April 9, 2020
First Crisis - Era Message to Contractors, Published March 25, 2020
Thirty-fifth Crisis - Era Message to Contractors: Reader Questions and Answers
An excellent question and observations from a reader suggests to me that we need to explore in more detail at least one of the items listed in the last Crisis-era Message under the heading “New Year’s Resolutions”.
Reader’s Question: Dr Schleifer, I think your 10 new year’s resolutions are great. If the construction industry could widely and successfully implement the changes you discussed it would have an incredible effect on the industry. You said you will be discussing the points in upcoming articles so maybe you will get to this, but I have a question about the first goal you listed: “We will let “low-bid” contracts become an historical curiosity. No reasonable business manager would bind their firm to a contract designed to squeeze every last nickel out of their profit margin.” How would you advise contractors to practically do this? Bid lists have been steadily growing and creating a buyers’ market the last 3-4 months and it only seems to be getting worse. Accordingly, I foresee 2021 being a buyers’ market and leading to more low bid procurement, not less. Companies are getting desperate to fill backlogs to create some security for their companies so I wonder how there could be widespread abandonment of the low bid method. Owners obviously want it and it seems like they will have all the leverage in 2021. If it were 2018/2019 (sellers’ market filled with more owners wanting projects done than contractors able to do them) it would be easier for me to visualize contractors successfully demanding alternate procurement methods to low bid but given the current circumstances it’s hard for me to visualize. I would love to hear what you think.
Answer: I like the above reader’s observations and I agree with them. Some background of the topic may be helpful: Alternative delivery methods such as CM, CMAR, DB and various hybrids have been around in the construction industry for a long time but during the early 2000s their use expanded. Many owners and buyers of construction services were on board with alternative delivery methods because they were beginning to realize the pitfalls of the low bid delivery method. Alternative delivery lost ground during the 2009-2012 construction market decline because during a down cycle construction becomes a buyers’ market. The construction market returned to a sellers’ market again during the 2015 to 2019 as market growth stimulated the rebound towards alternative delivery methods again. The current persistent pandemic will drive another buyers’ market and alternative delivery methods will lose ground again but the industry should not give up on reforming delivery methods.
I continue to emphasize alternative delivery methods and recommend against low-bid procurement because in every construction market downturn margins suffer and the construction business failure rate accelerates. My concern is that we do this to ourselves and it is preventable. In a low-bid down market bid lists grow out of control and every project looks like the last job available, so the profit comes out of the work as contractors attempt to maintain their size (annual sales) from a shrinking market, which is mathematically impossible unless half the other contractors agree to shrink their size twice as much. In serious market downturns we often experience aggressive bidding that might be referred to as a “feeding frenzy”. I have been trying for years to convince construction professionals that if the market shrinks 10% or 15% and we contractors also shrink our size 10% or 15%, margins could be supported. I also maintain that doing less work is better than taking work at a loss.
In short, I cannot in good conscious support low bid construction, even during a declining market, even though I know the sentiment falls on deaf ears, particularly among buyers of construction services. However, I will use this reader’s question (without names) in this crisis message and explain this in greater detail in hopes that some contractors and owners may listen. The message is: when the market declines it is better to cooperate with the market than to fight it because you can’t win. That is precisely why I developed the Flexible Overhead process which makes downsizing during the periodic construction market downturns painless. These are not unexpected downturns. Construction market downturns have been occurring regularly since WWII on average every 10 years--some shorter, some longer. Therefore, when they occur they may be a surprise but cannot be considered unexpected.
Thirty-fourth Crisis - Era Message to Contractors: New Year's Resolutions
2020 has been an unusual year to say the least. Starting with a growing construction market that was anticipating a huge infrastructure bill coming out of Congress and struggling with a critical shortage of skilled labor, the year was suddenly interrupted by an outbreak of the nastiest contagious virus since the 1300s, when the black plague decimated one third of Europe’s population, killing 20 million people and ushering in the Dark Ages.
Since March of 2020, the COVID-19 virus has killed more than a quarter of a million Americans and continues to spread at an ever-increasing rate. It goes without saying that life as we knew it at the beginning of the year has been altered in some very unexpected ways. Certain segments of the economy, such as travel and entertainment, have been decimated while the stock market continues to roar and our industry, although it slipped a few gears, hasn’t collapsed.
Each segment of the economy has had its unique reaction to the events that are shaping 2020.
Restaurateurs are bobbing and weaving; airlines are feeding at the government trough; hotels and amusement parks have laid off thousands of workers; retailers are challenging Amazon for online sales; and the construction industry has been taken to school.
Here’s what we learned in the school of 2020:
- Growth is not a permanent state of affairs.
- The construction market is volatile, given to sudden swings from growth to contraction.
- Growth is not always good.
- Size and longevity do not guarantee continued prosperity.
- There is no “too big to fail” in construction.
- Fixed overhead is dangerous.
- Traditional low-bid procurement should be a thing of the past.
- Public infrastructure work is unpredictable.
- The assignment of risk is a dangerous game.
- Litigation is never the answer.
New Year’s Resolutions
If 2020 taught us nothing else, it taught us that we have to change our way of thinking about how to manage a construction enterprise. There is no reasonable explanation for the failure rate of construction companies (second only to restaurants), beyond ineffective management. Ineffective management begins with inaccurate beliefs. Inaccurate beliefs are long held convictions about the construction business that everybody believes are true but are not true. The series we just completed on why megaprojects fail revealed fundamental management beliefs that caused the failure of many megaprojects and construction concerns throughout 2020.
In 2021 we should all resolve to identify the inaccurate beliefs and take the following corrective actions:
- We will let “low-bid” contracts become an historical curiosity. No reasonable business manager would bind their firm to a contract designed to squeeze every last nickel out of their profit margin.
- We will no longer enter into contracts that assign all the financial risk to the contractor.
- We will no longer allow the market to see contractors as undependable and slightly sleazy.
- We will no longer default to litigation as our resolution methodology.
- We will get paid on time and as agreed. We are entitled to our money.
- We will no longer take marginally unprofitable jobs in the name of growth because we know that top line growth for its own sake just shrinks the bottom line.
- We will see adding fixed overhead as a risk factor rather than a sign of success.
- Capital preservation and growth will become our number one priority.
- In volatile markets we will recognize the wisdom of flexible management and flexible overhead.
- We will stick to our knitting and avoid work we are not expert at.
- Successful work is profitable work.
- Profitable work begins with procurement.
- An unrealistic bid backed by a bad contract cannot produce profit.
- Litigation never accrues to the contractor.
- A bad start always leads to a bad ending.
These are the issues we will explore coming up in December.
It is our mission to encourage construction professionals to reexamine long held beliefs and make changes that lead to increased profits, capital preservation, and a new degree of enterprise stability.
Thirty-third Crisis - Era Message to Contractors: Thanksgiving Break—Will There Be a New Normal?
The construction industry will come back. While there has been considerable disagreement between my forecast for the duration of the construction market slowdown and many of my readers, we all agree that better days are ahead. The question I am addressing now is will we go back to business-as-usual or will some things be a little different (or a lot)? There are already articles predicting lasting social changes such as: air travel will take a while to comeback, business air travel will be permanently reduced, and numerous elements of social and business life will alter. Is there any reason to believe that the construction industry will remain unchanged?
Well before the pandemic crisis, technology was remaking how we do so many things in the construction business that most of us should be accustomed to unanticipated changes. However, we are an industry that has been accused of resisting rather than embracing change. And not that long ago were described by an owner’s group as an industry having to be forced to implement change. What the potential changes may be after the market rebound will be addressed in subsequent messages. The purpose of this brief “Thanksgiving Break” message is to introduce the subject to those who may need some time to adjust to unwanted, and some will say unwarranted, changes.
Changes come in all sizes from minor to significant and, occasionally, substantial. There is at least one positive thing. Changes that stick will be for the better. The reason that can be predicted before the changes are known is that changes that are not for the better almost always get weeded out before they fully develop or not very long after they prove to be ineffective. The reason I bring this topic up is to suggest that there is little reason to resist change. Jim Collins tells us in his book Good to Great: “Good is the enemy of great”, and he goes on to say, “Few people attain great lives, in large part because it is just so easy to settle for a good life.” If you substitute the word “business” for “life” you get the full meaning of what Collins goes on to explain. To get to great from good there has to be change and, conversely, good without change eventually diminishes.
In past construction market cycles the industry came back relatively unchanged so the research model suggests the same will be repeated at the end of this cycle. However, the cause of the US economic downturn that resulted in this construction market decline was unique and the interpretation of the construction market cycle model is impacted. If the experts predicting practical and cultural changes in the US resulting from the pandemic are correct, those changes need to be superimposed onto the model and their impact evaluated. My initial appraisal suggests there will be changes in the construction industry. The next step will be an assessment of the potential changes and the likelihood that they will be temporary or permanent. Please assist with this research by sending me any possible industry changes you think might develop.
Thirty-second Crisis - Era Message to Contractors: Election Aftermath
The election tells us very little about the near future construction market. We are no closer to knowing when the construction market will rebound now that the election is over than we were before the election. There were three things affecting the timing of the construction market rebound before the election: A COVID-19 vaccine, the amount of federal construction spending, and stimulus funding. It is hard to see how the outcome of the election will affect the timing of the development and eventual distribution of a vaccine so it remains a race that is critical to the US and world economies, and subsequently, to the rebound and normalization of the construction market. There were some ambitious projections before the election that federal construction spending would be increased and current commentary suggests that may still happen during the lame duck session, however, those are just speculations. Additional stimulus funding seemed likely before the election but the big question was when? Now that the election is over the uncertainty about the timing has, if anything, increased and it remains anyone’s guess.
The timing of additional stimulus is important because the construction market follows the US economy. There is consensus among economists about the need for another round of funding to prevent further economic decline but the stimulus may be DOA. The funding seems to have become a political football. The dispute over how much to fund does not seem to have been settled by the election, at least until inauguration day, and delaying stimulus funding risks recessionary pressure. There are some economists that feel the US economy will do all right without additional stimulus but a large majority are saying it is critical to continued recovery. The unknown is whether the opposing sides will agree on an amount of stimulus spending before January 20 or if we will have to wait until the new administration is in place. Either way the question remains, when will stimulus money gets into the hands that will spend it into the economy?
Economists are saying that the improvement in household spending over the last few months has been, in part, supported by the first round of stimulus funding. However, they warn that is running out and economic recovery will level off or decline without additional funding. If the economic recovery stalls, the construction market will be negatively impacted. The need for increased federal construction spending is important to help offset the drastic reduction in state and municipal construction spending resulting from their reductions in tax revenue. If we are able to get both additional stimulus funding and increased federal construction spending it still will not bring the construction market anywhere near its 2019 high. For that to happen municipal, state, and private construction spending would have to stop shrinking.
Other industry news is not encouraging. AGC reports that at least 75% of their contractors have experienced project cancellations or postponements. Also affecting our market is the fact that a considerable number of multibillion-dollar projects across the country have been canceled or postponed for lack of funding. Just a sampling includes: $8 billion highspeed train LA to Las Vegas; $10 billion Foxconn LCD panel factory in WI; $9 Billion Honolulu Rail Project just to name a few.
What I see is with a number of jumbo projects canceling or being postponed, the big contractors will trade down and the downward domino effect will take place. When I mention billion-dollar projects I get email from contractors saying they have no interest because they are not involved in that size work. They problem is when jumbo projects are taken out of the market, those very large contractors need to find something else to keep busy. They take other size projects and the domino effect of a declining market begins. When the very large firms take smaller projects, other contractors need to take smaller projects and so on down the line. When the billions mentioned above are taken out of the market there is simply less to go around and these three delayed or cancelled projects addressed earlier are just a drop in the bucket. The market will be down this year several hundred billion dollars which makes the critical question, what can we expect next year? Guessing doesn’t help, but science, measurements, and calculations do. The current problem is lack of accurate information and the information we do have keeps changing, However, we can still learn from what we have. Unfortunately, all the current changes are for the worse which verifies beyond doubt that the start of the construction market rebound we need is not in sight. That will not happen until the it stops declining.
Some of you think I’m too negative and that things are looking up in construction. I get emails asking, “Why don’t you look at the bright side?” I do and I will report it when it happens. I received a note the other day saying, “OK, you have been right so far, but the construction market’s getting better.” I wish that the communication had included some the data that indicates it is getting better. I saw a survey recently that reported that 90% of architecture, engineering and construction firms say they have experienced project delays or cancellations. If architects and engineers slow down, construction can’t be far behind.
Risk management in the construction industry includes cooperating with the market. Obviously, that means planning for the anticipated market, which means “sizing” to the market. Unfortunately, sizing involves overhead expenses which are made up of plus or minus 90% personnel costs. The opposite of risk management is to attempt to maintain sales and size in a declining market by trying to capture work of a different type, size, or in an unfamiliar location at any price. The selling price of construction goes down in a declining market, so it is hard enough to profit from the cheap work available. Under these circumstances, performing less cheap work well and at a modest profit has less inherent risk than capturing and performing a greater amount of cheap work. It is a matter of measuring and calculating risk. A declining market has built-in, unavoidable risk. It is advisable to avoid magnifying the unavoidable risk by adding avoidable risk to it.
Thirty-first Crisis - Era Message to Contractors: Profiting During Business Cycles
Why are business cycles in the construction industry so painful? Because we can’t control them. Data has been collected on US economic cycles since 1854 and the ratio of expansion periods to contraction periods has improved dramatically since then. We have enjoyed prosperity because our nation has spent a lot more time in a growing economy than in a shrinking economy. Then why the pain during a down cycle of the construction market? Because profits reduce dramatically, and losses occur more readily. During market declines, some contractors end up giving back some of the hard-earned profits made during expansion. This seems to be widely accepted as the norm because we can’t control the market. However, we can control our reaction to it.
Market downturns are, for the most part, unforeseen which further complicates the issue. The primary cause of this is because we aren’t looking for them. We can’t really claim that market declines are unexpected in that they have occurred, on average, every 10 years since WWII. There are choices: We could train ourselves to see them coming. We could listen to experts that see them coming. Or, after seven or eight years of growth, we could expect a decline any year after that. Market cycles are NOT a surprise. What is surprising is that when asked, some construction professional do not know that the construction market is cyclical in spite of the statistics that confirm it. We might as well embrace the reality that it is the only market we have. I use the term “embrace” deliberately because to disdain or reject this fact flies in the face of reality.
How should we operate during an expected downturn in the construction market? We have proven that operating the same during a declining market as we operate during a growing market doesn’t work. So the next logical question must be to determine if there is a way to prosper in a down market? If there is, it will mean adjusting our operations which means change, and we all know how monumentally difficult change is.
I will stop here because to prove the above within the bounds of acceptable statistical probability took years of research. The objective is to establish that that the industry is cyclical, and that in order to profit when transitioning between cycles it will be necessary to adjust how we operate. If you are with me this far, you should have enough information to make some decisions. Contractors who understand these realities will find a way to succeed, even if by trial and error.
The solution that I developed, “Flexible Overhead”, took years of research. The initial solution was developed in two years. However, because it included downsizing, an element so distasteful to contractors, the research was continued for another three years looking for a solution that would be easier to accept. It took that long to discover and prove that this was the only total and viable solution. If you care to know more about how and why to use the Flexible Overhead processes (which have been discussed in prior messages) it can be found on the website, letstalkbusiness.net. Click on “manual” and go to “Managing Overhead” in the Table of Contents.
Thirtieth Crisis - Era Message to Contractors: Why Partial Recovery Is Not Enough
Now that I opened the flood gates, I get it. Nobody wants bad news sent to their in-box. Washington says things are fine, the press passes along whatever they feel like, and there is always something that sounds positive. I am buried in questions asking: If the economy is going in the right direction and the stock market seems to agree and employment is improving why shouldn’t we [contractors] just wait it out? Some add “why should we believe you?” My answer to the second one is: If you don’t believe me you are not alone. Many do not, but they are no worse off than those who do believe but can’t bring themselves to downsizing their businesses because they worked so hard to grow them. If my research is correct, the consequences for both groups will be the same. And if I am wrong there will soon be plenty of work for everyone.
The construction market is unique in that during the entire recovery process profits are minimized by industry-wide aggressive pricing. Until full recovery is reached (when the construction market reaches the size it was when this started) the industry will suffer reduced profits from aggressive pricing competing to capture the lessor amount of work available. This occurs even in portions of the market less impacted by the downturn because firms from the worst hit segments of the market begin to compete in the less impacted portions, driving margins down. In addition, buyers of construction services recognize the pressure on pricing and expect (some demand) participation in the reduced pricing.
The US economy will recover eventually, and you already know my projections. So as an exercise let’s examine a very optimistic projection. If the US economy has a full recovery tomorrow, when will the construction market have a full recovery? I think we all agree that it will not be instantaneous, that the construction market is not in “lock-step” with the economy during these cycles. You can decide for yourself when the construction market will rebound. Research confirms that the construction market lags the economy by 12 to 18 months and, if the US economy recovers tomorrow, the construction market should fully recover between November 2021 and April 2022. The importance of a “full” recovery of the construction market cannot be overstated because until that happens the aggressive pricing continues, stalling the return to previous profitability.
In this best-case-scenario, a fully recovered construction market is still a long way out. If you don’t think the US economy will be fully recovered tomorrow you can adjust to your beliefs and you have a target date of your own. I am guessing someone will question the 12 to 18-month lag, (explained in earlier messages) however, it is just arithmetic. It is the average lag time of the prior seven major cycles in eight decades. If you don’t believe the lag time, use your own estimate. I am fairly certain you will find that the construction market’s full recovery is still too far out to ignore and do nothing.
What matters most in making these projections is not how accurate they are but how much risk they entail. The measurement of risk (as explained in earlier messages) is the likelihood of the occurrence (odds) and the magnitude of the penalty. If you plan for the recovery optimistically and recovery is later than planned for, it is difficult to deal with because it means reduced profits will continue at a time when you have already suffered months of reduced profits to arrive at the optimistic (wished for) projected recovery date—a high risk scenario. If the downturn is considerably longer than planned for, it can become threatening to the financial stability of the company which is obviously a huge risk. (A magnitude of risk that most business people would not deliberately undertake.) If recovery happens sooner than a conservative projected date, it is easy to deal with and, therefore, modest risk.
The objective is to protect the organization during a downturn by conserving cash. The steps one would take planning for a short downturn are generally smaller than the steps that would have been taken in planning for a longer downturn. Planning for an optimistic recovery date exposes the organization to greater risk. The whole issue comes down to risk management. The responsibility of top management is to prioritize the lower risk choice over any choice influenced by emotion. In a market cycle downturn, there are no easy choices. Just huge risk, high risk or modest risk, which is why emotions (wish list) have no place in these business decisions. I am accused of being pessimistic, but I prefer realistic because the safest choice in these circumstances can be proven mathematically. We cannot adjust for the “pain level” or emotions involved in each choice because it will always lead to the easy-way-out, and would be misleading, unprofessional, and unethical.
The “full recovery” issue presents the exposure. During the worst of the downturns there is still a lot of work and no one will debate that margins on that work suffer during the decline. When the US economy begins to recover, the amount of work available continues to decline (lags) for a considerable length of time until funding begins to become available for an increased amount of work. That normally starts slowly before gaining traction and causing new projects to begin to be designed and those already designed to be brought back to life. This eventually stops the market decline and begins to build it back, but not overnight. Building to full recovery takes time which can be approximated as roughly proportional to the depth and length of the downturn. These are difficult to measure as the data, the dollar amount of construction put in place, takes months to become known. Additionally, any number of economic events can slow or accelerate the recovery. With this level of uncertainty and the magnified risk, optimistic planning makes little sense. Caution is the only prudent approach, which means cutting back early.
One of the reasons so few construction organizations take steps towards downsizing in the first six months of a declining market is because the work on hand was priced during the growth cycle. The work is profitable and, for the most part, business-as-usual. While the first six months of a downturn is the ideal time to downsize and begin conserving cash, there is little motivation to do so. Often optimism prevails, where “wait and see” seems like the best choice. What I often hear is: “We’re still making money so what’s all the fuss about.” - “If we grab one or two more jobs maybe the market will come back.” - “We can ride it out.” – “Why is everybody making such a big deal about a little slowdown?” It’s almost like some believe the problem is solved because there was no problem.
NEWS FLASH: (First Time) From a recent article in a national publication—"…industry firms are now beginning to believe that the resulting [COVID-19 construction] market slowdown will not begin to recover for another year.” More on this next message.
Twenty-ninth Crisis - Era Message to Contractors: Reader Questions and Answers, Part 6
Reader’s Question: Dr Schleifer, My trade association and my lawyer say that I will be paid for the cost of the new COVID protocols I am forced to put in place. From what you said in your message last week, it sounds like you are saying we will not be reimbursed for these costs. Why do you think that and what do you suggest we do about it?
Answer: You are not alone in challenging my answer to the question last week about the costs of complying with the required COVID jobsite protocols. There were a lot of challenges and some not as courteous as yours. Just to clarify, I did not say “we will not be reimbursed for these costs”. What I did say, based solely on past experience, was: “Whether contractors will be compensated for them (COVID costs) is a legal question and I am not an attorney. I do have some concerns”. I went on to explain that after exposure to thousands of construction claims they don’t’ always turn out as expected. I suggested that “collecting for these unforeseen costs is not a sure thing, that results will vary from project to project, and when you will collect is also an issue”.
I stand by these comments because I consider a risk like not being compensated in full, no matter how small you believe it is, to be too serious to discount. I firmly believe that the only prudent course of action under these circumstances is as I stated last week: “I suggest that you strictly adhere to the letter of, and intent of, the COVID job-site protocols and requirements and that you make every effort to minimize the costs of these requirements as you would any other project activity. I recommend that you manage and plan the financial aspects of your business assuming you will not be compensated for these costs and assume that if you are compensated you may collect long after you have a critical need for the cashflow. Scrupulously manage all costs on all projects and consider reducing the cost of doing business because cashflow will likely be tight unless or until you have strong indication that you will be compensated in a timely manner.”
I clearly said “might” not be compensated in full, which I stand by, and the ultimate test for anyone who says you “will” collect would be to ask if there are any odds associated with the issue. Unless it is 100% certain, it is “might”. Some may be satisfied with 99%, but I am not sure that is prudent when you are betting your business on it because, for some firms, the costs are enough to cause losses. My concern stems from the reality that few people have been exposed to as many construction claims as I have. Over more than a decade my surety consulting firm dealt with thousands of financially destressed companies nation-wide for sureties and, as you might imagine, these businesses had numerous claims of every description. We had to report on the circumstances and often participate in the resolutions. Our experience was that there was no sure thing, which is probably why we call them “claims”. I realize that much of this is a restatement and sincerely hope that this is responsive to your question. Please feel free to contact me directly if you feel the need to discuss further.
Reader’s Question: Tom, You say this is a market cycle and that the construction market has always been cyclical, so if this is just another cycle won’t we just get through it like we always have?
Answer: Market cycle means a period of market decline followed by growth, or a period of market growth followed by a decline which this current circumstance obviously is. The reason it is referred to as a cycle is that it happens periodically and, in the case of the construction market, regularly (about every 10 years). The cause of construction market cycles is an alteration the US economy (or adjustment, as economists refer to it), which is the cause of this construction market cycle. The fact that the US economic downturn was caused by a unique event, the COVID-19 pandemic, does not change the definition of this as a construction market cycle, nor does the unique event change the predictable impacts on the construction industry, other than the cost of the on-site COVID protocols required.
The recovery of the construction market is dependent on the recovery of the US economy, therefore, in order to project the recovery of the construction market we need to study the cause of the US economic downturn. For each cycle there are underlying causes like the recession that started in 2008, which is often referred to as the US subprime mortgage crisis. This is the eighth major construction market cycle since World War II and research on the prior seven cycles has provided a model of how the construction market reacts to changes in the economy during both the decline and the recovery stages. With the new model we are now able to accurately project how the construction market will react and when.
Specific to your question, “won’t we just get through it [this cycle] like we always have?” The answer is, “YES we will” which is exactly what I was hoping to prevent with these Crisis-era Messages to Contractors which began in March. The results of how we got through the prior cycles were not pretty. The cycles caused our industry to suffer severe reductions in profit along with serious financial distress and an unfortunate number of construction business failures. When it became obvious that the construction market was entering another downturn cycle, this message series was intended as a warning that we needed to react quickly to avoid going through what we always have. Our industry reacts poorly to a declining market with most contractors unwilling to downsize without a fight. The “fight” is aggressive pricing in an attempt to capture as much as possible of the lesser amount of work available. This drives profit margins down and leads to some inappropriate decisions.
Change of Schedule: This is an appropriate juncture to reduce the frequency and coverage of these message because I find myself repeating solutions. The solutions are distasteful within our industry and data about the length of the recovery is unpopular so there is less to write about. This is apparent by the number of associations that understand the content but are unwilling to circulate the messages saying, “they are just too negative for our members”. In an effort to keep in touch with those who have a continuing interest or questions, the messages will be reduced to twice a month for a while. The next will be in mid-October. In the meantime, keep the questions coming and feel free to contact me directly if you need to talk.
Twenty-eighth Crisis - Era Message to Contractors: Reader Questions and Answers, Part 5
Reader’s Question: COVID job-site protocols are costing us and slowing our productivity. A number of trade associations have studies that indicate costs may be as much as 30%. If project owners pay for these unforeseen conditions, we will make a profit on the existing work. Do you think we can count on change orders for these costs?
Answer: I don’t think anyone disagrees that there are costs associated with the required COVID job-site protocols or that they were unforeseen. Whether contractors will be compensated for them is a legal question and I am not an attorney. I do have some concerns. Over the many years my former firm represented sureties in the completion of bonded projects, we were exposed to thousands of claims against project owners and few turned out as initially anticipated. We collected information from the contractors and their attorneys on their evaluation of the likelihood of success, the amounts they expected to collect, and when they expected to be paid. Our experience was that many of the claims that were considered solid lost and as many that were considered weak won. Those that succeeded were seldom in the amounts claimed, and most took twice as long as initially expected.
No one hopes more than I do that 100% of contractors involved receive change orders in the full amount of their costs plus the associated overhead and profit. Some have suggested that if a few win then all will win, but I have not heard anyone say that if a few lose then all will lose. My speculation is that collecting for these unforeseen costs is not a sure thing, that results will vary from project to project, and when you will collect is also an issue. Unfortunately, I have also seen claims that were won long after the firm failed for lack of cash flow.
I suggest that you strictly adhere to the letter of, and intent of, the COVID job-site protocols and requirements and that you make every effort to minimize the costs of these requirements as you would any other project activity. I recommend that you manage and plan the financial aspects of your business assuming you will not be compensated for these costs and assume that if you are compensated you may collect long after you have a critical need for the cashflow. Scrupulously manage all costs on all projects and consider reducing the cost of doing business because cashflow will likely be tight unless or until you have strong indication that you will be compensated in a timely manner. To do this will require downsizing which, while distasteful, is better than the alternative. If you do collect in the future, great. However, business must be managed in the present. Borrowing to cover the cashflow is not an option, because if you do not collect, or do not collect enough, or do not collect for a long time it magnifies the problem by digging a deeper hole. (Please no questions asking if I think this situation “fair”. If project owners have to pay, they may ask the same question.)
Reader’s Question: You say the construction market follows the [US] economy which, if it continues at the current pace, appears to be doing fine and the stock market seems to agree. Why are you so pessimistic about a construction rebound?
Answer: The pandemic resulted in a serious setback to the US economy and the fundamental drivers of the economy (full employment, consumer spending, etc.) will not improve overnight. That the stock market has done as well as it has is fortunate but when the economic fundamentals don’t respond as vigorously and as quickly, the stock market may (will likely) undergo another correction.
In the ninth crisis message I explained that: Two things are required to support the construction market: The need for something to be built and the ability and willingness to pay for it. A decline in the US economy slows expansion in the private sector which reduces the “need” for new construction. In the public sector the “need” for construction such as infrastructure continues through an economic decline, but reductions in taxes and fees stall the funding of public construction.
When the economy slows, funding and borrowing capacity in the private sector suffer from reduced sales and profits. Funding sources that remain available go unused by a reluctance to spend and caution to conserve cash. One of the first things to be cut is capital spending, which results in the loss of construction funding.
In the 24th message I added some specifics: A combination of unemployment and business news indicates certain worsening economic conditions that will affect both the need for and funding of construction projects in the short and long-term future.
The need for new hotels, movie theaters or amusement parks may take years to revive. The need for airport expansion, office space, shopping malls and cruise ship terminals will not be needed for some time with the potential that the need may be permanently altered. There is no telling what will happen with sports venues, public transportation, and convention facilities in the near and long-term future. The list goes on, but you get the point.
I know that my messages from the first might sound pessimistic, but they were projections using a construction market decline model that, as has become obvious now, was accurate; or may be described as realistic. Construction work will continue throughout the downturn. Just not enough to satisfy the industry’s appetite which drives profits down. The construction market will rebound when the need for and the ability/willingness to fund coincide.
It is possible and logical for the industry to profit during the market decline, but it would require adjustments to our way of conducting business which few are interested in.
This crisis has become routine so in the near future I will be adjusting these messages to every two weeks and eventually monthly.
Next week: Reader’s Questions and Comments. Send questions/comments to firstname.lastname@example.org.
Twenty-seventh Crisis - Era Message to Contractors: Reader Questions and Answers, Part 4
Reader’s Question: Dr Schleifer, Three of our major projects were delayed in April. Two continue to be indefinitely delayed and the third has canceled. We managed to grab two smaller projects, but our aggressive pricing is already backfiring on us. Sales for the year will be down at least 25% and while a few projects are doing all right, we have consumed our profits from January through mid-March and without a miracle we will have a loss for the year. We have cut all non-essential costs and furloughed a clerical person. Some of our construction people have been with us 20-plus years and I can’t afford to lose any of them. Any suggestions?
I wish I had the option to avoid this question and, while it will be no consolation, you are not alone. There are others, worded differently, but the same problem. This crisis will impact most construction enterprises but some more than others depending on type of work and the level of competition in their market. For the same reason, a small number may not be impacted at all or to a minor extent. You have an advantage in recognizing this early because others with the same exposures are moving forward based on hope more than logic.
It sounds like you already know that chasing more work to fix the volume reduction is not a viable option. Again, you are not alone. Available projects from here on out will be subject to aggressive competition, aggressive pricing and offer limited profit at best so attempting to maintain sales (top line) magnifies the risk and will not work. It is akin to using gasoline to put out a fire. I use the expression: “more cheap work is just more cheap work”. I understand that you are convinced that you cannot afford to lose any of your key people. That said, I can assure you that unless you have serious cash reserves that you are willing to spend, losing money this early in the crisis exposes your firm to running out of cash before the recovery or not having the ability to finance your firm’s growth when more work becomes available.
I spent more than ten years researching solutions to the problem and discovered only one. No business can or should lose money if there is an alternative. You have 75% of the work you planned on and that work has potential profit within it. It might be modest profit but it is profit and, at some point in your firm’s history, the dollar value of that 75% was your total sales. I venture to guess that you made a profit executing that amount of work in the past. To profit from that amount of work now you have to reduce your cost of doing business to roughly what is was then. You can take the percent of sales your overhead was last year and reduce your current overhead to that percent of the amount of work you have on hand. Overhead has to be adjusted.
May I take this opportunity to apologize in advance if this sounds insensitive. I have been in my own business my entire career and always agonized over having to lay off employees, even if it was for cause. I know how it feels.
I can’t tell you where or who to cut because you alone are intimate with how your organization functions. You also know that a construction company’s overhead is 90% or more employees. The other overhead costs always have some waste in them that should be cut, but not enough to matter. What I can tell you is that reduction is critical and the most effective approach is to cut more rather than less because you are dealing with the survival of the company and the continuing employment of the 75% of the employees who remain. For example, if you have 10 employees in question and need to cut 25% which is 2.5 people that means three people not two. There are several reasons. Things often get worse before they get better. The extra 50% of the cost of this one employee of ten is 5% of the total and way more than can be risked under these circumstances. If two are laid off and later another, it creates a serious morale issue with the remaining seven. Cutting more rather than less is a prudent safety precaution and far less emotional stress on all concerned to do it once rather than twice.
There is and always will be the argument that the work on hand needs to be completed. I am widely published saying “the production of the work according to plans, specifications and schedule is critically important and that includes schedule”. In these circumstances the customer is the primary concern, but if the company does not survive, the project will not be finished by the current contractor. To assure performance, the cutbacks need to be made in advance and progress will be affected--projects may be delivered late. I have heard before: “There must be an alternative”. If anyone finds one, please send it in. Always cut more than less. Like all business decisions the prudent safest course of action that minimizes risk is always better than what is expedient. No professional has the luxury of choosing what is emotionally easier.
The selection process of who gets laid off was raised in another question and that answer applies here as well. Reader’s Question: Tom, What’s the first step in cutting overhead? Is it last in/first out or is it a functional redesign? What do you recommend?
There are obvious financial advantages to cutting overhead sooner rather than later, and there are some practical issues that operate in favor of the production of the work. Who gets laid off is a decision that senior management is stuck with. Last in/first out to some people is considered “fair” and others consider it arbitrary and unnecessary. This is clearly management’s choice. Absent any contract or legal requirements, under these circumstances what is best for the organization would be based on merit. My experience is that the best employees remain based on skills and value. This leaves a highly motivated and skilled team that have, in many past cases, exceeded expectations and set records for execution, profitability, and schedule. This is perhaps the best result in a bad situation.
Losing highly trained and skilled people that the firm has an investment in cannot be avoided, however, the replacement of these positions may not be as difficult as imagined. A market recovery takes time and at the end of the downturn there are many unemployed to choose from. When I addressed this point at a seminar during the 2009-2012 recession the regional CEO for a national firm raised his hand and said: “As I think about what you are saying, there are a few managers I would not miss too much, and now I am thinking that if I lay them off I may actually have the opportunity to upgrade some of these positions when I replace them during the recovery”. I think that best sums up what I was trying to say on the topic.
Next week: Reader’s Questions and Comments. Send questions/comments to email@example.com
Twenty-Sixth Crisis - Era Message to Contractors: Global Perspective
I was going to start this message off with a positive note that perhaps we might be leveling off or at least might be seeing a little light at the end of the tunnel, but had to temper that because as of this writing the stock market was having its worst three days since 2008. We have had a difficult six months, and I think most agree that it would be nice to get off this roller-coaster. Fortunately, the economy always recovers which leaves us with the question of when. It is almost impossible to plan around the unknown, but that is where we are. We need to work with the limited information we have. The minimum length of the construction market downturn indicates most construction enterprises will be downsized. Some voluntarily and hopefully profitable. Other involuntarily and painful. The latter will be less profitable with some losses. You will find detailed information about those issues in prior messages.
The depth of the downturn will primarily be affected by its length which is the element we know the least about. The best gauge is the US economy with various predictions out there for recovery to gain traction sometime after the second quarter of next year or later. That would put the rebound of the construction market well into 2022 at the earliest. At this point in the cycle the profitable work coming forward from the strong pre-pandemic market is being completed and aggressive competition for the lessening amount of work will drive margins down. The decision to downsize is overdo and no action is a decision to challenge the market. Enlightened firms will voluntarily downsize with a total concentration on managing risk and maximizing profit from the lesser amount of work. It is critical to discover the volume the firm can profit at because it can then profit throughout the unknown length of the downturn. The next target we will be looking for is a relaxation of aggressive competition when the construction market grows back to or near 2019 size which is likely a year plus away.
All of the world economies have experienced the deepest contraction since WWII and for the first time the US economic condition is connected to a global recession, therefore, projections of the recovery will be impacted by international issues. Starting in the middle of the last century, the developed nations began to interact with each other commercially. While imports were common prior to that, a more complex supply chain of both raw materials, manufactured goods, and components resulted in almost a dependence on efficient and fair trading among nations. Our trading partners are universally suffering the same cause and effect of this pandemic as we are and the varying rates of their economic recoveries can impact the recovery of certain sectors of our economy which can have a domino effect on other sectors. There is no precedence for this and, therefore, no model to project from. What we are left with is following activities in other nations that may impact aspects of our recovery and then speculating on potential interactions that may evolve.
To name just a few of the international economic issues of interest, in no particular order:
- The Organization for Economic Cooperation and Development 37 member nations combined economic output was 9.8% lower in the second quarter this year than the first which is the largest decline on record. To put that in perspective the previous record was a 2.3% decline in 2009.
- Global output is on track to fall 5% this year. (Lost output is lost)
- The pandemic hit developing country economies around the world especially hard. This is the deepest global peace time slump since the great depression with an estimated 400 million jobs lost world-wide.
- The economy in India declined a record 23.9% last quarter with unemployment at 23% in April and May improving slightly in June.
- While manufacturing in Germany is recovering slightly, manufacturing jobs were reduced by 11% in June.
- Saudi Arabia ARAMCO delayed plans to boost oil production along will billions of dollars in planned investments.
- Royal Dutch Shell PLC and BP PLC cut dividends to preserve cash.
- Bank of England predicts their economic recovery at the end of 2021.
All of this may be complicated by signs of unrest with other nations such as:
- Continuing tension and confrontation with Iran.
- Russian pilots harassed a B52 over international waters last month crossing within 100 feet of our airplane’s path which was the second incident between our military forces in a week.
- Israel and UAE signed a bilateral agreement on economic, cultural and investment issues; a potential first step for peace in the Middle East, but of concern to their neighboring countries.
- Tension with China continues over trade disputes and strong objection to their military expansion into international waters.
- These global threats while the US defense spending is at a low of just 3.3% of GDP
Our economy is impacted by uncertainty and when you combine this with a contentious election just two months away, violent protests across the country, and national debt approaching 100% of GDP it is difficult to forecast when to expect a healthy economy. Enlightened construction professionals will brace for the worst case and celebrate if it does not last that long
Next week: A Return to Reader’s Questions and Comments. Send questions/comments to: firstname.lastname@example.org.
Twenty-fifth Crisis - Era Message to Contractors: Reader Questions and Answers, Part 3
Question: Dr Schleifer, With less work at slimmer margins, I’m not sure how anyone will “continue to profit”. Seems like a contradiction. Can you explain.
Background and Answer: I hope by now everyone realizes that the 2020 US construction market will be less than 2019. “That is debate as to how much less as the data takes time to be announced, and we still have four months to go. The general speculation is 6% to 10% less and my estimate is greater than 10%. ( Doge reports “The US commercial and multifamily construction starts plunged 22% during the first six months of 2020”)The good news is that much of the work in 2020 was procured in the favorable pre-pandemic market and should be profitable; less the costs of the new COVID job-site safety protocols unless they are reimbursed. (Reimbursement is not a certainty and, if that develops into a legal battle, fees could be as much as the costs being requested.) The reduction in available work in 2021 is also being debated with the most optimistic projection remaining at 5% to 8% less than 2020 with other projections at more. As to when the construction market may turn around and begin to recover, the optimistic projections are during the third quarter of 2021 with worse case projections well beyond that, into 2022 and potentially longer.
Suffice to say there will be less work for at least another year from now which means every construction enterprise will voluntarily downsize (which is unlikely) or aggressive competition for the lesser amount of work will drive down margins as it has for every downturn since WWII. Companies that refuse to downsize will maintain their overhead, fight for the lesser amount of work and, if history repeats itself, will suffer reduced profits; some will incur losses, and the business failure rate will increase.
Aggressive competition often leads to some optimistic pricing at break even or worse which many contractors will decline to participate in so they will reluctantly be forced to downsize, will settle for a reduction in profit percentage, attempt to maintain their overhead as long as possible and may eventually be forced to reduce overhead or suffer losses. Others will do the same thing but cut overhead immediately. These firms will earn modest profits through the downturn and if it gets any worse than anticipated will reduce overhead again.
There are also a reasonable number of contractors who have embraced the flexible overhead concepts and will reduce overhead immediately and painlessly while maintaining their core management team untouched and productive. These contractors will willingly downsize in the normal course of business, treating this crisis as just another cycle in their cyclical industry. They will earn reasonable but reduced profits and will avoid losses by resisting cut-rate work and downsize further if necessary. It is difficult to know how many firms are in this category because the only information available is that immediately after the 2009-2012 recession the requests for information about flexible overhead climbed sharply and the dozens of seminars on the subject were crowded. The requests for information are climbing sharply again with firms determined not to go through another cycle in the future unprepared.
Few construction firms will break any profit records during this market cycle. Some enlightened firms that refuse to take cut-rate work will struggle but earn modest profits. Others will downsize immediately and profit through this downturn without struggle because for them this is “business as usual”. Some will do neither and potentially suffer losses. It will be interesting to learn how many in each category, but that data will not be available for years. I hope this is responsive to your question.
Question: When you say “those that are financially weakened during the downturn” - isn’t that everybody? How can anyone profit during this sudden market contraction?
Answer: Many construction enterprises profit during market contractions. Our industry, unlike most, has a wide variance in earnings with the difference between the highest profit and lowest profit firms being more than double. It defies logic that a firm performing the same type of work in the same area with access to the same resources would generate twice the profit of another but that is the case. Some firms are conservatively managed maintaining some cash reserves, and on the other end of the spectrum some operate almost entirely on borrowed funds. The financial “strength” of a firm is a combination of the earnings and how the earnings are managed. In a downturn this reality defines the distinction between the “staying power” of firms that can afford a reduction in profit and even some modest loss and still be profitable for the year, and those that cannot.
It does not matter if it is a high or low earning company, if it has no losses during a downturn and reduces its cost of doing business (overhead) when necessary, the reduced profit that each earns improves its financial condition (just not as much as it would in a healthy market). Therefore, even the weak firm going into a downturn can marginally increase equity (unless the interest expense on the debt of the weak firm is extreme). While there are no definitive studies to prove it, there is an assumption that the higher earning firms are better managed which would be a distinct advantage in navigating through a market decline. This advantage implies that in a downturn a well-managed firm might be more skilled at minimizing the inevitable reduction in margins than a lessor earning firm.
Companies financially weakened during the downturn may not be able to fully participate in the recovery when it occurs if they cannot finance the cashflow requirements of growth. These realities combined with the information in the answer to the first question above demonstrate that not all firms are financially weakened during a downturn.
Next week: A Global Perspective.
Twenty-fourth Crisis - Era Message to Contractors: Construction Market Developments
During the two weeks of answers to readers’ questions there were developments that impact the subjects we have been discussing causing an interruption of the Q&A. Media and construction industry reports are beginning to verify concerns about the length and depth of the construction market recovery. In earlier messages we reviewed what it takes to produce a healthy construction market: The need for something to be built and the willingness and ability to fund it. A combination of unemployment and business news indicates certain worsening economic conditions that will affect both the needs for and funding of construction projects in the short and long-term future.
The need for new hotels, movie theaters or amusement parks may take years to revive. The need for airport expansion, office space, shopping malls and cruise ship terminals will not be needed for some time with the potential that the need may be permanently altered. There is no telling what will happen with sports venues, public transportation and convention facilities in the near and long-term future. The list goes on, but you get the point. Fortunately, people will always need a place to live and we need roads, utilities, energy, etc. There is a perpetual need for construction, but it has to be funded. Federal work can continue because they can print money but states and municipalities that have and continue to suffer tax reductions cannot. The Fed may step in but not to the extent that will satisfy the construction industry appetite. As discussed in earlier messages having “some” construction work to do does not work for our industry because we prosper only during a growing construction market. When the market declines even a little, aggressive competition for the lesser amount of work drives profits down, and if there is a lot less work, it can drive profits out. We will never need to prepare for a zero market, but a 90% or 80% market is destructive.
There is no doubt that there will be less work this year than there was in 2019 but much of that backlog was priced during good times and fortunately should be profitable (less any costs associated with new safety protocols). The larger issue is that some areas of the economy are doing OK while other areas are slow or have not begun to recover which will extend the construction market downturn. It is becoming clear that the construction market decline will likely extend through 2021. Therefore, anyone intent on maintaining their size will have to compete aggressively for the lesser amount of work which means drop their prices and participate in driving down industry-wide profits. It would be a little less destructive if other construction firms would voluntarily give up a quantity of their market share so those intent on maintaining size can accomplish that, but unlikely.
The construction market is following the model developed from prior cycles so what has changed? Nothing. The media has caught up to the reality that the recession has momentum and most construction professionals can now see it coming. Some are just not sure what “it” is but all seem to agree that it is not good. “It” will be an industry-wide construction market downturn similar to the 2009-2012 market that most of us can remember. Additional details will unfold as the economy and construction market progress.
A review of the announcements of some of the latest economic and construction market developments will demonstrate why the Q&A was interrupted for this construction market update:
~The Labor Department reports long-term unemployment, for 15 to 26 weeks, rose by 4.6 million, the highest since 1948. University of Chicago researchers estimate 32% to 42% of American job losses during the pandemic will be permanent. Cornell University survey discovered that 31% of recalled workers had been laid off again.
~8/17/20 WSJ: …unemployment claims data suggests many businesses continue to shed jobs and …the economy probably has not reached the point where it can enter a sustainable recovery without additional support…
~8/8/20 WSJ: The degree to which schools are able to open matters (to the economy). There are upwards of 24 million working parents with children under 18, and most in jobs that can’t be done from home.
~WSJ 8/9/20: Without more money from the federal government, states and local governments will almost certainly have to cut their budgets and lay off workers, increasing the ranks of the unemployed.
~WSJ 8/12/20: Corporate purchases of air travel down 97% and only 10 % of companies surveyed will allow international travel within next three months. Some business travel may be lost forever, and corporate flyers make up 15% of passengers but 40% of revenue and on some flights and as much as 75% of the profit.
~Various studies predict between 6% to 8.5% GDP decline in 2020 barring another wave of virus. Federal infrastructure spending continues to be uncertain. Caterpillar 31% drop in sales. Komatsu 25% decrease globally. Boing--no jetliner demand for at least three years. Municipalities warn of layoffs due to falling tax revenue. Half the 22 million jobs lost not replaced yet. Bank of England does not expect their economic recovery until 2022.
There is no room for denial. A nation-wide vaccine tomorrow will not bring the construction market back soon enough to avoid the required reduction in the the cost of doing business essential to getting through this. Cooperate with the market decline by cutting overhead in an effort to profit during it or fight the market decline in an effort to capture a greater share of a less work. The risk differential is too great.
Next week: Continued response to questions and comments from readers. Send questions/comments to email@example.com.
Twenty-third Crisis - Era Message to Contractors: Reader Questions and Answers, Part 2
Question: Dr Schleifer, If our industry lags the economy by 12 to 18 months and the economy is still headed downward so that recovery is at least a year away, does that mean it’s two and a half years before we even start to recover? And how long is the recovery cycle? That is, how long will it take to return to 2019 levels?
I was tempted to avoid this question because the subject is complicated and it requires a long response, but there were a number of similar inquiries about the timing. There seems to be some confusion possibly because I address the lag time in so many different contexts and readers may not clearly differentiate between the “US economy” and the “construction market”. The foundation of this topic is that the construction market is cyclical and follows the US economy almost in lockstep but lags it.
When the US economy cycles down, the construction market continues to grow (or flatten out) for a minimum of one year (the lag) and then cycles down. The reason is that the majority of the construction projects in progress and those already funded continue through completion; and the average length of construction projects, being plus or minus a year, continues to provide revenue for some time.
When the US economy cycles up, the construction market continues to decline for a minimum of one year. Economic recovery begins to stimulate new construction, but it takes time to decide which new projects will move forward and additional time to design the projects. It also takes time to fund them, to seek approvals and proposals, and to contract for the projects to be constructed before the projects generate construction revenue. As the construction market begins to grow again, it takes a minimum of one year for it to rebound to its pre-downturn size.
Both the lag at market decline and the lag at market recovery vary depending on the length of the cycle and the amount of the market decline (depth). The “lag times” I use are the averages of the major downturns since WWII converted to a median range. I leave out the shortest and longest lengths because they are extreme and would distort the results rendering them of limited use. The current range I am using (which may change after the downturn we are in) is 12 to 18 months at both the decline and recovery. (In this current ongoing research the calculated range changes almost monthly as new information is applied, but I do not publish it because I believe an ever-changing range will add confusion, which seems to exist.)
In this crisis the construction market, which usually prospers for some time after an economic downturn, declined rapidly because of delayed and canceled projects. This lag, which is favorable to the construction industry, was the shortest on record. You might call it the “good lag”. (The recent short lag is an “outlier” which will dramatically change the average if it were applied.)
Response to First Question: …does that mean it’s two and a half years before we even start to recover? No if you mean US economic recovery. Unknown if you mean construction market recovery. Technically the US economic recovery may have started, but each time it reverses, as it has been, it is a new start date for these projections. Further detail below.
Response to Second Question: …how long will it take to return to 2019 levels? As the economic recovery progresses and becomes a certainty, canceled projects will begin to be reconsidered and ideas for new projects germinate, but nowhere near what it takes for the construction market to rebound. The US economy is “recovered” when the Gross Domestic Product rebounds to the pre-pandemic amount at which time the limited pace of the construction market recovery will strengthen and with pent-up demand progress to full recovery at 2019 levels.
These two 12 to 18 month average lags may appear to mean 24 to 36 months, however, the construction market recovery initiates during the US economic recovery and the two overlap to a varying extent. There are too many variables to get into here but the adjusted average time between the start of a major US economic downturn and the recovery of the construction market is 18 to 36 months. Until some of the variables unfold there is not enough data to forecast the length of the two cycles in the current circumstances. Additional stimulus funding could shorten the time but, at this point, probably not very much.
These are averages only and are not projections of the current downturn. However, as I have been saying for months, the minimum projection is long enough to plan for:
- the amount of available work to diminish
- aggressive competition to drive prices down
- industry-wide profits to shrink.
These conditions demand defensive action.
The questions allow readers to steer the conversation and because there is not enough space to get to all of then we will continue next week.
Next week: Continued response to questions and comments from readers. Send questions/comments to firstname.lastname@example.org.
Twenty-second Crisis - Era Message to Contractors: Reader Questions and Answers
Question: Tom, You say less work/less risk. That’s a hard concept to sell. Could you elaborate on how you would plan the top line if you were running a construction company during this pandemic?
Answer: The construction market, like most markets, functions logically and is, therefore, predictable. In a growth market there is an increasing amount of work available with the same number of contractors competing for it which reduces the pressure on pricing and produces a seller’s market (through natural commercial dynamisms). In a seller’s market prices escalate and profits grow.
The opposite occurs in a downturn. When the same number of contractors compete for less available work, a buyer’s market develops and the selling price of work goes down with (self-inflicted) aggressive competition for the lesser amount of work. Profits suffer as contractors fight vigorously to maintain their hard-earned size or to at least capture as much work as possible. With less work to choose from contractors tend to expand the area they work in and many feel they have no choice but to go after whatever work is available even it is not the type of work they are normally successful at. Both of these changes compound the risk, further reduce profits, and escalate the potential for losses at a time when profitability is already suffering.
I say less work/less risk because under declining market circumstances, loading up a cheap work, or taking work outside a firm’s normal area or of a different type seriously magnifies risk in an already high-risk business. If I were running a construction company during a downturn (as I have in the past), I would look for work in areas and in type that I am almost always profitable at. History assures that construction profits will shrink across the board in a downturn, so I know I am going to have to reduce margins to get any work. Therefore, I need work that I know I can execute well, and if I work hard, I may be able to squeeze another point or two out of it, particularly if I have the time to concentrate on it. For that reason, I don’t want a lot of cheap work and I certainly don’t want cheap work in an unfamiliar area or of a different type than I am use to because the odds of improving on bid profit are nil.
While some would never use the term “too much work”, there is such a thing in a down market (and in a growth market). I am reasonably sure we all agree that project profit is directly proportional to the amount of time and effort put into pricing, execution and attention to detail, all of which improve with less work and suffer with too much work, particularly when selling prices are falling. To drive home the point let’s recall that prior to 2008 our industry put in place nine hundred billion dollars of construction in a year at record high profits and went on to do the same at one trillion dollars. During the subsequent recession, our industry again put in place nine hundred billion dollars in a year but at record low profits.
We seem to excel as long as we are doing more work than we did the year before. But when we produce the identical amount of work but it is less than we did the year before we suffer reduced profits. It does not have to be logical—it is fact. Why? The business model based on continuous growth does not work in an industry with a cyclical market. When the market downsizes, we have to downsize with it. If there is less work available and a contractor insists on maintaining size, he or she is going to have to take the work off another contractor who will then have to get that much smaller. However, other contractors don’t give that work up without a fight, so the price war begins. I hope this is responsive to your question and I welcome comments.
Question: Dr Schleifer, You say that during this downturn, buyers will be adjusting prices downward and margins will be slim. What do you suggest we do about that?
Answer: As I discussed above, during a down market aggressive pricing drives prices down and buyers of construction services (owners) know that. In a downturn it becomes obvious when jobs put out for bid immediately experience an increase in the number of bidders and bid spreads (the difference between low and high bidder) get farther apart. I periodically monitor the numbers of bidders and bid spreads around the country using a formula that defines the market and assists in projecting which way it is trending. In a good market you might see three to five bidders and very tight bid spreads. In a down market 15 plus bidders is common and 20 or more happen. Bid spreads widen to as much as double or more. Owner’s reactions are what you might expect. During the 2008 recession numerous public and private owners that had been using Construction Management, Design Build, and other alternative contracting methods switch back to lump-sum bidding. While the reasons seemed obvious, I studied the issue and was told consistently by owners, their representatives, and other buyers of construction services, in one form or another, that construction had become a buyer’s market and the best way they could see to take advantage of it was to go out for bids and save money.
As to what I suggest we do about it: There has been a huge effort for many years by Simplar Institute at Arizona State University and others to explain and promote to owners and buyers the value of alternative contracting methods such as “Best Value” and other methods. The construction industry has been slow to get behind this movement but if contractors would unite they can prevail. My opinion is that the best way to promote alternative contracting methods is to explain and define the many short-comings and disadvantages lump sum bidding has for owners. The “low bid gets it” method is long past its “use by” date. I hope this is responsive to your question and I welcome comments.
The questions allow readers to steer the subjects addressed. There was not enough space to get to all the questions so we will continue next week.
Next week: Continued response to questions and comments from readers. Send questions/comments to email@example.com.
Twenty-first Crisis - Era Message to Contractors: Refining the Timeline
Consider also listening to the NASBP Podcast with Dr. Schliefer.
(Readers, Please send questions and comments for next week to firstname.lastname@example.org.)
We know how we got here, but I am not sure we all agree on where we are. According to the front-page headline of the July 31, Wall Street Journal, the “US Economy Sees Record Downturn”. The article goes on to explain the signs of a slowing recovery. Experts are telling us that a vaccine might become available to the general public by the end of 2021. I added the emphasis to “might” because it is frightening to think about waiting that long--and because we cannot build a business plan around the uncertainty of “might”. To better understand the timeline let’s start with what we do know: The construction market will begin to recover after the US economy rebounds.
When the economy recovers some but not all of the cancelled projects that are already designed will re-enter their funding phase. If funded, they proceed to proposal and contract phases which takes some time before resulting in construction revenue. In the last recession these were called “shovel ready”, and we all know they did not restart overnight and were not nearly enough to fuel a construction market rebound. Late in recovery public and private entities will be able to consider new projects but it will take time to agree on, select, design, fund, permit, propose on, and contract for them. Each phase can last weeks to months, is subject to delay, and initially there are too few projects to support a rebound--which history tells us will take 12 to 18 months.
The largest stimulus funding in modern history is keeping food on the table and the stock market seems to appreciate it. However, the stimulus funding is not able to maintain or produce employment which is critical to advance an economic recovery. The alarming question is, will the stimulus outlast the pandemic, or will the pandemic outlast the stimulus? The stimulus was designed to buy time and each package was a short-term remedy for a long-term problem. We should not confuse what was created to support the economy as a substitute for the real economy. We need to put less emphasis on the pandemic, which we cannot control, and more emphasis on navigating our businesses through it, which we can control.
Our focus should be directed to what is occurring now such as the Labor Department reports that 30.2 million people are receiving some form of benefits and last week GDP had its steepest decline in 70 years. The completion of backlog nation-wide is outpacing new construction work entering the pipeline. The experts agree about the depth and length of the pending economic downturn. Until the industry approaches pre-crisis size the selling price of construction will go down, a buyer’s market will develop, profit margins will suffer, and risk will increase.
The standard industry reaction to a construction market downturn is to capture as much work as possible in an attempt to maintain the size of the company, keep the organization intact, and retain as many team members as possible. This approach should be incorporated into a long-term strategy and business plan. You need to project how long this will last and estimate how much it will cost in order to calculate if you can afford it--and for how long. As to how long, the lead indicator, the US economy, has not begun to recover so you already have a range. If the US economy recovered tomorrow the the lag time until the construction market recovers begins. If economic recovery begins early next year as some predict, construction rebound will take that much longer. This is enough information to develop a strategic plan to navigate this crisis. One consideration should be if you cannot support existing overhead for the duration, why carry it part way? Test the wisdom of taking low-margin work for the sole purpose of maintaining an organization that will be oversized during the entire downturn and during the entire recovery, both of which may turn out to be longer than estimated but will not be shorter. What should be avoided is hanging on to overhead for a long time and eventually having to lay off anyway. We do not have the luxury of waiting because these business decisions need to be made now—we are four months into a construction market downturn. It is a responsibility that comes with being in charge.
No one can justify the risk of taking work in a different location or of a different type or size in a declining low-margin market. Taking on a lot of low-margin work increases risk by the quantity of work alone. Taking less low-margin work and reducing overhead decreases the risk in two ways: less exposure with less work and the work will be executed by the best of the best of your former organization and team because no one lays off the best of the best—they layoff the good and keep the best. The quality of most organizations goes up as they downsize.
We are in a construction market downturn that will become deep and long. How you will produce the work when this is over is not the major concern. What is critical is how you are going to profit during the downturn. If you are financially strong when the market finally recovers gearing back up will take care of itself. You also will not need to be concerned if the downturn runs long because you will simply continue to profit. There will be less competition at full recovery because there will be business failures during both the decline and recovery, but you won’t be one of them. Those who are financially weakened during the downturn will not be able to finance the increasing amount of work at recovery because growth eats cash. Trying to maintain the size of a construction company when the market shrinks is a self-defeating proposition.
Next week: Response to questions and comments from readers. Send your questions or comments to email@example.com.
Twentieth Crisis - Era Message to Contractors: U.S. Economic and Construction Market Update
Here we are 20 weeks after the mid-March economic crisis began with the V-shaped recovery off the table and a resurgence of the virus a continuing threat. There are still some positive thinkers out there with one saying last week, “What about the improvement in consumer spending?”. I agree it was nice to see, but with consumer spending having been so seriously diminished, the only thing you can say about the improvement is that consumer spending is still seriously diminished. Improvement is not “recovered”. The US economy is in recovery, but it has a long way to go before it stimulates the construction market which is still declining. It is possible that the word “recovery” is being confused by some to be the goal when it simply means the time needed for recovering.
The construction market lags and will continue to lag the US economy by 12 to 18 months. The critical point to recognize is that the construction market does not begin its recovery until the US economy “recovers”. They are not parallel, but sequential. My current preoccupation with the US economy is an attempt to project when it will recover. Because that is when the construction market will “begin” recovery, starting the clock on the 12 to 18-month lag. It was my intention to list current US economic data, but decided against it because you read and watch the news and while you may not keep a written list, you know the information is not positive enough to indicate very much recovery progress. The construction market continues to decline and will get worse before it gets better. The next milestone I am trying to project is when the construction market decline will bottom out.
Knowing the US economy is improving is of limited value to plan with unless it includes how far along it is or a projection of when it might recover. It is too early to project the length of the recovery beyond a range which for now is too broad to be of use. What can be said is that the timing of the US economic rebound is more than the six-month benchmark presented in the 15th weekly message and combined with the 12 to 18 month lag, the construction market rebound is 18 months out. I am inclined to use a range of 12 to 24 months and refine it periodically as new data becomes available.
I use a series of “what if” scenarios to assist in developing adjustments to the projected range:
- Significant resurgence of the spread of virus and/or improvements in testing, tracing, and treating it
- Development of an effective vaccine distributed across the US
- Distribution of the vaccine throughout the developed nations of the world
- Political uncertainty in the US and the results of the congressional and presidential elections in November
- More stimulus funding from congress, or less
- Worsening of geopolitical tensions with China
- Delayed development or ineffective vaccine, or (the unthinkable) no development of a vaccine. Time is critical as business failures and strain on the economy could reach a tipping point into depression
- To a lesser extent than above but positive for the economy-the potential for liability protection for businesses against COVID related lawsuits
A refresher on why and how the construction market lags the US economy may be in order. When the US economy enters a disruption (on average every 10 years), the construction market continues to prosper because the projects in process and most of the backlog are designed, funded and contracted for which, because of the average lengths of projects, provides 12 to 18 months of continuing work. This work, priced during the healthy economy prior to the decline, is profitable. While the work is being completed the amount of work being designed and funded declines. As a seller’s market causes aggressive competition for the less available work it drives pricing down and profits suffer. Construction enterprises are then subjected to both diminished sales and diminished profit while their cost of doing business, being difficult to reduce, continues. When the economy recovers it takes 12 to 18 months to design, fund and contract for new work.
I am regularly accused of being a pessimist in the interpretation of economic information which is not the case because this is the interpretation of years of research into every construction market downturn since WWII. The dynamics of each downturn were similar and, in most cases, the same. The model developed prior to the last downcycle was live tested in the 2009-2012 recession and accurately predicted each stage of that declining construction market. Resistance to reacting sooner continues today, particularly because the unique cause of the rapid deterioration of the economy makes this appear different to some. However, the model is in lockstep projecting this market.
The reason I am chronicling this weekly is in hopes that by the next downturn cycle the industry will use it to prosper during the decline, recovery, and following growth market. We do not have to lose money in a market downturn.
Next week: Refining the Timeline.
Nineteenth Crisis - Era Message to Contractors: Implementing "Flexible Overhead" Continued
The construction market downturn mentioned in the first crisis message on March 18, was projected in the second message to continue through the year and was defined in the third and subsequent messages as getting worse. Four months later, July 6 headline in ENR: “Market Optimism Crashes in Wake of the COVID-19”. Does anyone need more convincing--“wait and see” is no longer an option. History repeats itself and, as explained in several prior messages: (A) There should be no surprise that profits will suffer as the market declines, and (B) Fighting to maintain sales in a declining market invites huge risks and potential losses. Some have already cut overhead, others will follow, and some will absorb excess expenses for as long as they can. All these options are painful. I have experienced them personally and feel for those that are forced to make these difficult decisions.
Now is the time to recognize the benefits of flexible overhead and determine to use the process when you are finally ready to put overhead back in place. Those who use flexible overhead have been turning off these expenses quickly, easily, and painlessly whenever they are not needed. Since the development of the flexible overhead concept in 2014, the non-permanent portion of overhead is easy to increase and even easier to decrease.
The flexible overhead concept that was introduced in message 17 and the its implementation, explained in message 18, is continued here. The processes described last week for implementation in all office functions and departments is similarly used with the shop, yard, and field. Firms that fabricate portions of their work off site like HVAC, sprinkler pipe, etc., generally operate a shop facility. As their business expands, they typically enlarge the shop and add equipment, which is expensive and permanent, and when work slows, the costs continue. An element of the flexible overhead concept referred to as “the judicious use of overtime” is the alternative along with outsourcing. Many self-performers would never consider outsourcing a portion of their work, particularly to a competitor, but it is a valid method of dealing with short-term or initial uncertain expansion—and it works.
Overtime, often avoided, is a valid method to self-perform short-term opportunities or uncertain expansion. The standard objection: “I can’t make money at time and half” is in error. Numerous studies have verified that getting to and from the face of the work at the start of shift, breaks, lunch and end of shift, etc., means the productive time an eight hour day in construction (depending on the study or size of project) is plus or minus 6.6 hours or 82.5% productive time. An hour overtime is 60 minutes of work or 100% productive time. At two hours overtime the numbers get even better. There is a cost, but no where near the expense of putting on additional permanent overhead. The only appropriate time to put on permanent overhead is when expansion (growth) is reasonably certain to be long-term. Short-term expansion can also be dealt with by adding a second shift. Construction is generally considered a daytime activity and, because it is uncommon, few will even consider shift work. One approach is to use only a small hand-picked crew and, to the extent possible, do primarily the most repetitious work at night which utilizes the existing facilities and equipment to supplement the day shift. Deciding to try it is much harder than doing it. A second shift works as well in the field and the process is cost effective when utilized for permanent expansion. In both cases there is a cost, but not near as much as the continuous cost and risk of more permanent overhead.
Self-performers like general, masonry, concrete, contractors usually have storage yards; some particularly large including full-time supervision, yard people, and truck drivers. I was told by a Midwest contractor “these employees know where everything is, how to handle it, and where to delivery it so we can’t just let them go when work slows”. For this seasonal contractor work slowed to a crawl every winter and there were nine yard employees, with only three actually needed in the winter. Six were let go during November, maps were made of the yard over the winter, locations were labeled, and GPS was installed in the delivery trucks. Two people were hired the following April, three in May and with improved efficiency, supervision, and a little overtime seven people have handled the yard for the last several years. As mentioned last week, flexible overhead is as much a state of mind as it is a process. Getting people, who are used to doing something in a particular manner, to consider a new method is 90% of the effort. Once understood no construction person has to be shown how to do it. It comes naturally, they understand efficiency, productivity, and it is their company. They know “instinctively” what to do and how to do it. The use of part-time employment and student workers (where permitted) is also an underutilized, economical resource to support the skilled workforce, particularly during peak periods.
When work falls off redundancy in the field is immediate. In a union firm engaging and letting go of field labor is almost routine so it self-corrects. Open shop employees trained at the firm’s expense are harder to part with. Foremen, superintendents, and project managers are another story because we need these highly skilled, loyal employees so planning for market declines is critical. Most foremen and superintendent have come up through the ranks having been trades people before moving up to foremen then superintendent and, to a much lesser extent, to project manager. The element of flexible overhead referred to as “temporary regression” is when work slows foremen go back to working with the tools, superintendents go back to being foremen or working with the tools and project managers with trade experience have the same opportunity. I am asked “what if they refuse” and my answer is: “They have announced their lack of loyalty so let them go”. There is little to be gained negotiating with people whose job you were trying to save.
If work slows for an equipment intensive organization such as generals, concrete or masonry contractors, etc., equipment is idled but the ongoing costs of ownership continues. This element of flexible overhead “equipment cost controls” precludes the ownership or long-term leasing of any piece of equipment that does not work 65% of each year (unless highly specialized and not available to rent). Short-term rental-and-return each time it is needed is cheaper than owning equipment not in use 65% of the time (do the math). When you get control of overhead, the need to maintain volume no longer drives the business and enables you go after only risk balanced work within the organization’s core competencies. The most profitable alternative in a downturn.
Next week: US Economic and Construction Market update.
Eighteenth Crisis - Era Message to Contractors: Embracing and Implementing "Flexible Overhead"
The successful contractor of the future will modify their business model to manage overhead costs in order to profit during the inevitable market downturns like we are experiencing now. As backlog falls off and aggressive competition for the lesser amount of work drives profits down, many firms will experience a reduction in volume and profit. Despite resistance many will eventually be forced to reduce overhead personnel.
The motivation to cover this subject now is that it takes some time to understand and to decide to alter the way you manage overhead, and to be prepared to introduce it. Overhead is neither bad nor good. It is neutral, a necessary cost of doing business and should be as aggressively managed as production costs. However, in the construction industry overhead costs vary dramatically from one company to another to the extent that there is no accepted standard. In some cases, it is a loosely structured expense. Overhead is a control function but in some companies, it has expanded to comfort where, for example, standard office facilities and company cars can get the job done but luxury offices and cars can get it done in greater comfort. I am not assessing, just illustrating. Overhead should be scrupulously managed, re-evaluated annually, and the determinant should be necessary versus unnecessary.
When the declining market eventually recovers, and it will as they always have, overhead will have to be put back in place to deal with increasing sales. That may be some time yet but between now and then is the time to learn about, evaluate and implement the flexible overhead concept. Many firms will have laid off people, but to be sure the best of the best employees will still be there. Most say, “all my people are great or I wouldn’t have them”, but the reality is that organizations mirror the population. Some managers perform well, some very well and some great. No one lays off their best performers so the least of the well will be gone and the others will be doing fine, but as more work comes in they will need help. Your choice is to put the same positions back in place or to maintain your existing core high-performance team and supplement them using flexible overhead principles. The added overhead will require no long-term commitment and you can reduce it within a week. Every time your work falls off, short-term or long, you will be glad you did. Coming out of a downturn is the easiest time to initiate flexible overhead because it requires no displacement of core personnel. Just the addition of non-permanent employees and resources.
As an example, let’s look at one department of a self-performing general contractor doing $40 million a year. (The principles are the same for a firms doing less than $5 million or more than $100 million.) In the accounting department the CFO had four assistants with separate responsibilities i.e., accounts payable, accounts receivable, payroll, general ledger, etc. Work slowed to the point that one had to be laid off. With minimal cross training the remaining three took over. In the subsequent recovery with more work coming in the three needed help. The choice was to reemploy the same person or skill set or to reconsider the entire accounting department process. All skilled employees spend some of their time doing nonskilled work such as copying, filing, running errands, etc. Instead of re-dividing the skilled activities to four people a part time clerk was hired (or you can use a temp agency) to assist the three with the nonskilled portions of their work which expands their time for the skilled activities. This new position was engaged with a written understanding that it was temporary as-needed employment and that hours worked may be reduced or increased or the position terminated with one (or more) days’ notice. I can hear the objections already and my response is: this is being done all over the country and it works. Just try it. They didn’t need a skilled bookkeeper to make copies or run errands. If growth eventually requires this position to become full time, it may be appropriate to make it a permanent position and use part time temporary help to continue the process. Operational planning should concentrate on needs and positions not employees.
Using the same guidelines, you can re-engineer the workflow of every department: marketing, administration, the shop, the yard, etc., and most controversial of all, estimating. Everyone draws the line at estimating protesting, “it is far too complex, the lifeblood of the company, an extremely skilled position”, etc. However, estimators spend hours a week making copies, filing, looking up products, sending out drawings and specifications, chasing down vendors and subcontractors and the list goes on. Ask any estimator if they could use a gofer, a messenger, or a runner to lessen their workload, increase their output and improve their productivity--all of which tends to enhance their accuracy. The overall company-wide business objective should be to maintain and support the highly skilled core people in good markets and bad.
The same process is use on the production side of the business. There are as many ways to organize and manage field operations as there are companies so no single example is illustrative. Once flexible overhead guiding principles are applied in one area of an organization managers come to understand how it works and begin to apply it in other areas in unique ways that best suit their organization. Flexible overhead is a state of mind as much as it is a process. Managers begin to analyze workflows identifying the skilled activities required to accomplish the throughput and the unskilled activities necessary to assist, support, and facilitate the skilled core team. Almost every position in a construction organization can be augmented by having less-skilled people supporting the skilled core employees. It is economical and, once you learn how to use it, more efficient. Of greater importance it is temporary, able to be shed in less than a week, and the employment of your core team is secure. (And they know it.)
Another huge benefit of embracing flexible overhead is that it enables you to profit from unexpected growth opportunities because the skill set used to reduce overhead quickly also shows you how to engage temporary resources on short notice. If the right project comes along when you are already busy, you will have the skill set and experience to temporarily expand the capacity of your core group with additional temporary support that can be disbanded when no longer needed. Next week we will cover implementing flexible overhead in the shop, yard, and field.
Next week: Implementing Flexible Overhead continued.
Seventeenth Crisis - Era Message to Contractors: The Concept of "Flexible Overhead"
The US economy has always been and continues to be cyclical, therefore the construction market as an integral part of the economy will continue to be cyclical. When the construction market is growing the industry prospers, however, when the market declines, the industry suffers reductions in profits and exposure to loss. The reason is that growth requires additional overhead expenses in the form of personnel and resources which are brought on as permanent fixed costs. When the market declines it is extremely difficult to reduce fixed overhead because you cannot eliminate half a person or half a truck. The current construction business model of permanent fixed overhead is the cause of the industry’s boom and bust cycle. This raises the question: If a firm earns a certain percentage of profit putting X amount of work in place in a year, shouldn’t it earn the same percentage of profit the following year when it puts in place, perhaps 15% less work? Most don’t.
Construction enterprises make more money in good markets than they make or lose in downturns and because the length of growth periods have been longer than the downturns, most come out ahead. This has been going on so long it is generally accepted as a cost of doing business. However, the cyclical nature of the business is one of the reasons the construction industry has the second-highest failure rate in the nation. The business model must be modified to a process that allows construction organizations to prosper in both good markets and bad. It makes no sense that a growing company that has been profitable at eight, then nine, then $10 million in sales would automatically lose money if it is forced back to nine or eight million dollars by a decline in the market.
If the company made money growing to $10 million, is it forever barred from profiting if it is forced to downsize? No, but to be profitable after reduced sales of 10% or 20% they would have to immediately reduce overhead costs by a similar amount. Most say: “Impossible! It can’t be done” and they are correct if overhead remains the same. Whether they recognize it or not, if a construction enterprise is forced to reduced sales they are also “forced” (if they choose to make a profit) to reduce overhead expenses accordingly. I say “choose” because this is a management decision, and they have a choice, but reducing overhead is painstaking. Flexible overhead is a process that allows the reduction of overhead costs without the stress of laying off core key people and incurring the cost of disposing of idled resources, both of which will be needed in the future when the market recovers.
Planning on continuous growth cannot work in a cyclical market. The successful construction enterprise of the future will be organized to go up and down in sales to cope with cycles and other market conditions, and never feel compelled to chase inappropriate work just to maintain volume. The contractor of the future will be profitable in good markets and bad and the drive for size will be substituted with a drive for prosperity. The Flexible Overhead concept is a method of managing overhead that enables you to reduce it by 15% to 25% in a week or less. The process allows you to do that without disrupting your organization or losing core key people. The 15% to 25% range is dependent on individual circumstances and choice. Most organizations start the process small to be comfortable that it works and then increase towards the upper limit. Flexible overhead can be introduced during a growth market or at the end of a declining market where it may actually be easier if a firm has been forced to lay off personnel (as many will before this crisis is over). Implementation requires minimal effort and the benefits are immediate, such as being able to profit in good markets or bad, and experiencing the satisfaction of never wasting hard-earned profits from good years to pay for surplus overhead you don’t need in bad years.
It is natural and understandable to resist voluntarily giving up hard-earned growth. When I ask a contractor audience to select one project from a prior year that they wish they never had, most pick a job that lost money. They are wishing for smaller volume and more profit which suggests that downsizing is an appropriate choice. The marketplace is unpredictable, affected by so many variables that it is difficult to accurately forecast even a few years out or to predict the next down cycle. While a growing enterprise cannot be sure of a favorable market in the future it does need to add overhead to expand. That risk can be controlled by putting on overhead that can effortlessly be removed if the market turns down. With a portion of your overhead being adjustable, you are no longer compelled to maintain sales at any cost but can fall back if necessary and concentrate on profit.
Companies using flexible overhead manage their profit not their volume. They can also manage sudden increases in volume of 25% or more because they are able to adjust overhead resources up or down quickly, temporarily and economically faster than the average firm can secure permanent resources. This practice is a departure from the norm but is clearly the profile of the successful contractor of the future.
The research has been completed, measurements made, and the reality tested. Flexible overhead is no-cost or low-cost insurance against profit shrinkage and losses by being able to shed overhead instantly in a market cycle downturn, It also enables you to turn off overhead costs for a few weeks or months for short-term eventualities that slow the work. Such as: When a major project is delayed, when an exceptional number of bids are missed in a row, or when for any reason work falls off. Continually profiting in good times and bad offers a whole new appreciation for the construction business. The only downside is we won’t be able to complain as much about what a tough business this is. Details on how to implement flexible overhead next week.
Next week: Embracing Flexible Overhead.
Sixteenth Crisis - Era Message to Contractors: Preparing for the Next Construction Market Cycle Published July 1, 2020
It is almost impossible to run a business when the world economies are crashing around us for reasons so unique that there is no precedence. Our country and our industry have gone through 16 weeks of extraordinary uncertainty about the economy and about what might happen next. The suddenness of the crisis, stay-at-home orders, project interruptions, postponements, and cancellations seemingly at random created such confusion that how or when to react was inexplicable. With new and sometimes conflicting information daily from Washington and the media the only choice for many seemed to be to wait and see what develops.
This far along, with no end in sight, and the strong possibility that new work to fill backlogs will drop off before things get better; most construction professionals can see that a market downturn is inevitable. How deep and how long may still be uncertain, but I think we can agree that it has already been long enough that we need to make some decisions—we need to do something. Those that have been through a downturn before know that one of the first things that happens is aggressive competition sets in as firms resist downsizing and with just about everyone trying to capture more work in a declining market, profits suffer.
There are only two choices in a downturn. Fighting to capture enough work to maintain sales by any means possible is by far the most popular choice but presents the most risk. The less popular choice of downsizing the business to cooperate with (rather than fight) a declining market has far less risk but is more painful. Downsizing means reducing the cost of doing business (cutting overhead) which includes laying off people because, as we all know, overhead expenses for a construction enterprise are made up of plus or minus 90% employee related costs. Voluntarily cutting back the size of a firm is difficult, even distressing, which is why it is such an unpopular choice.
The most popular choice, chasing work while profits are spiraling down exposes an organization to serious risks. The difference is that in a growth market there are more profits from the other projects to help cover the lose from the occasional bad job. In a declining market diminished profits may not be enough to cover a losing project and a losing project is an increased possibility because of the aggressive pricing trying to capture the much-needed work. Even during a growing market construction is a low-profit business with the ever-present possibility of a losing project in both good and bad markets. This exposure is compounded when, motivated by the need for work, a firm decides to go after work in unfamiliar territory and/or work of a slightly different type or size than the organization is experienced with which increases project risk exponentially. There is no statistical data to calculate the likelihood of a losing project during a declining market. However, the construction industry has the second highest business failure rate in the country and the fact that the failure rate always increases significantly during downturns suggests a correlation.
Research confirms that one of the reasons the failure rate goes up in a declining market is that if a construction enterprise waits too long before reducing overhead they weaken their financial condition which makes them vulnerable if the downturn drags on and hinders their financial ability to fully participate when the market rebounds. Many have said, “If I am forced to reduce overhead at some point(s) during a downturn I might as well have cut it sooner”. It is disappointing to have spent a lot of money holding onto people only to have to let them go anyway. Many have tried to keep people busy by traveling far and wide taking work outside the organization’s experience and core-capabilities but that often magnified underperformance and in too many cases resulted in losses. During many years of turn-around work I often heard “What choice did I have?” or “I had to keep my people busy.”, or “No one can make money during a downturn”. For those determined to maintain sales or to reduce sales as little as possible in a declining market these statements are true, and I fully understand and admire the determination to retain your employees.
It is human nature to resist giving up hard-earned growth gained at great effort. The problem is the risk and cost, and it does not pass the logic test. Consider the following: If you asked a contractor why don’t you increase your sales by say 10% or 20% during a favorable market most would explain that “You can only grow as fast as the market grows. If the market is not expanding at 10% or 20% that amount of growth would be extremely difficult and to attempt it I would have to drop my prices, find additional resources, and have to secure them and pay for them”. With this in mind it should also follow that in an unfavorable market severe adjustments in pricing will be forced into the marketplace and idled excess people and resources will need to be paid for or discontinued. Everyone seems to agree that growth requires an increase in overhead, but they do not seem to agree that the reciprocal is true. The reciprocal is that negative growth (a reduction in sales) requires a reduction in overhead.
A review of prior messages will demonstrate that the research information, data, and facts keep coming back to the same conclusions and formulas:
- A growing construction market reduces competition
- A declining market increases competition
- A growing market fosters increases in profits
- Declining market always causes decreases in profits
- In a growing market human and other resources become scarce
- In a declining market underutilized human and other resources have a continuing cost
- A consistent growing market becomes a “sellers’ market” and the selling price of construction goes up
- A declining market quickly becomes a “buyers’ market” and the selling price of construction goes down
- The US economy has been cyclical for as long as anyone can remember
- The US construction market follows and lags the economy
- The construction market has been cyclical since at least WW II
- The construction market will continue to be cyclical.
These truths combined with the fact that the construction industry has the second highest failure rate in the country demonstrate that the current construction business model of permanent fixed overhead is inappropriate and illogical. It does not, cannot, and will not support consistent profitability in a cyclical market. There is a solution, Flexible Overhead. Developed in 2014 this progressive concept will be described next week.
Fifteenth Crisis - Era Message to Contractors: Market Brief—Recommended Defenses
Market Brief: The construction market is unchanged in that recovery continues to be pushed out farther with each new event as the expected pandemic reactions begin a domino effect impacting other areas of the economy. (This is a change for those expecting a short V-shaped recovery.) Initially the depth of a construction market downturn is of less concern than the length because a modest loss incurred during a short-term recovery is worth the cost of remaining fully staffed in order to take immediate advantage of a rapid rebound. It is difficult to project when this construction market might get anywhere near pre-crisis levels but certainly not this year and possibly much longer. Stimulus funding and increased federal spending on infrastructure will help but not enough for a full recovery. The only thing that will turn this tide is a successful vaccine becoming available. Absent a vaccine, an effective cure for Covid-19 would help.
Construction Firm Defenses: I wish the three years of research on how to profit during a construction market downturn had discovered a litany of defenses to choose from. It did not. What it did do was to isolate and define the one viable defense/solution that works. The research substantiated that if the pre-downturn cost of doing business (overhead) is X dollars, to generate a profit producing less than pre-downturn sales required that the overhead costs must be equivalently less than X dollars. How much less is not a mystery. If sales drop 10% or 20%, overhead must drop proportionally 10% or 20%. If not, when fewer projects are contributing to overhead, profits have to help fund the overhead reducing overall profit which, depending on the depth and length of the downturn, can lead to losses or worse.
Each project performs differently but most rely on average profit percentage to calculate markup on future projects. We do the same with overhead expenses spreading the estimated cost over future projects by applying it as a percent of sales. The difference is that overhead is an actual cost, and profit, being what is left over after all incurred costs are accounted for, is a variable. A modest reduction in profit has limited impact but in the extreme there is an absolute limit when actual costs on a given project exceed what we are paid. Any project loss including missing contributions to overhead must be made up for from the other projects. In a declining market with fewer projects the short-fall must then be paid from the remaining projects reducing company-wide profitability.
In the early months of a market downturn the work on hand continues to be profitable because it was priced and captured during pre-downturn competitive conditions presumably with reasonable markups for the anticipated overhead contributions and profit. The research in question discovered that for the average construction enterprise there was almost no noticeable financial impact for the first one to three months of a downturn as the backlog of work diminished slowly. This can lead to a false sense of security until the shrinking market increases competitive pressure causing sales to fall off and profits to diminish while overhead costs remain. Because profit percentage is considerably less than the needed overhead contribution, noticeable reduction in profits typically occur within the first six months of a decline in sales. With fewer projects contributing, profit is quickly consumed by continuing overhead costs unless overhead expenses were reduced early on, which very few firms did in prior recessions preferring to wait and see what would happen.
In some cases, sales were attempted to be maintained by sacrificing markup in an effort to overcome competitive pressure and capture more work. This defense made matters worse because the greater amount of work had to be performed precluding timely reductions in overhead. Work taken with little or no profit margin should have been expected to break even at best. Most who took this route incurred critical reductions in liquidity, in many cases dangerous losses, and in some cases business failure.
In the eight major downturns since WWII aggressive competition drove down profit margins as expected for the duration of the market decline. However, the research uncovered an unexpected circumstance in that aggressive competition continued to hold down margins during the market recovery. When the declines in sales bottomed out and began to recover, the aggressive competition fueled by a determination to resist downsizing was succeeded by a determination to make up lost ground and return to prior sales volumes. This restrained margins until the markets got close to or achieved pre-downturn size. This research breakthrough helped to explain why market downturns in the construction industry are so destructive.
Margins in many industries begin to recover as their market recovers, and they continue to rebound as their market strengthens. For example, when retail sales decline their margins suffer but as sales rebound margins rebound. Margins in the construction industry do not recover until close to or achieved pre-downturn market size is achieved. This increases the length of time firms endure reduced income by double or more. In other words, in a construction downturn margins suffer during both the market decline and recovery which means we need to redefine “margin recovery” and separate it from “market recovery”. A recovering construction market begins after the decline bottoms out and continues until the market returns to pre-downturn size. “Margin recovery” begins when the market approaches or achieves pre-downturn size. Understanding the huge difference between market and margin recovery is critical in planning for and operating a construction business during a market downturn. This information is crucial in that the construction market is cyclical at roughly ten-year intervals.
This reality is why I so strongly recommend reducing overhead as soon as it is recognized that a market decline will last six months or more. What needs to be understood is that anticipating a six-month market decline means that you can anticipate plus or minus twelve months of aggressive competition reducing margins and increasing risk. If one or two months or more into a market decline you realize it will likely last six months or longer, it is time for some serious defensive action. While you may be able to afford to maintain overhead until or beyond the six-month benchmark, the question is, should you? It is generous to employ people for the extra months, but the cost to a firm entering twelve months or more of reduced income or worse magnifies the firm’s risk. It also impacts the remaining employees and affects the prime responsibility of top management which is to protect the company. Many firms have maintained full employment during market downturns for six months or longer, often taking cheap work to keep busy. In doing so they were eventually forced to lay off more people than would have been necessary after running their equity and working capital into the ground. They also minimized their financial capability to fund their expansion when the market did recover.
While emotions are certainly affected, this is a business decision. Caring for all of our employees is a loyalty exceeded by our responsibility to protect the company to the benefit of the remaining, re-employed, and future employees.
Fourteenth Crisis - Era Message to Contractors: Construction Market Downturn's Impact on Profitability
Most industries prosper during growth and many also profit when sales decline. Logic would suggest that if a business makes $X profit while operating at full capacity it would make 80% or 90% of $X profit when operating at 80% or 90% of capacity which is exactly what happens in most industries. The construction industry is a unique exception in that its profitability is connected to and dependent on growth. When sales decline in construction, profits suffer almost immediately. Contrast this with most other industries. Manufacturing is a good example.
If a manufacturer’s market drops off 10% and production is reduced by the same amount, total profit diminishes by 10% but profit as a percent of sales remains roughly the same. In some cases the profit percentage increases during a production decline because efficiencies improve with a more manageable manufacturing pace. When these companies produce 90% of product capacity they enjoy 90% of the profit they had been earning. Fixed costs continue but are usually budgeted to average annual production needs which takes into account periodic or seasonal fluctuations in sales. These types of industries profit at variable outputs and their profit as a percent of sales is a constant. Production rates are not tied to fluctuations in sales because manufacturers warehouse excess production during a sales decline which is then available for peak sales periods. Profit is, for all practical purposes, a constant and production rates do not need to be adjusted to market conditions.
Compare this with the construction industry starting with the reality that net profit margins for general contractors and construction managers at plus or minus 2% are considerably less than manufacturing profits. Fixed overhead costs for these contractors at an average of 4% to 6% or twice to three times their average profits leaves little room for error. Trade contractors have a little higher profit margin and overhead costs, but the ratios are similar. In a construction firm if any job underperforms, the other projects have to contribute to overhead and possibly other costs on that project reducing company-wide profitability. In a downturn, when there is a reduction in sales fewer projects contribute to annual fixed overhead costs which immediately and often substantially reduces company-wide profits. Construction industry overhead costs are commonly referred to as a percent of sales, but they are for most firms a permanent fixed cost with a minimum, if any, ability to be reduced on short notice.
In construction, when there is less work available, competition increases overnight reducing the selling price because the same number of contractors are trying to maintain sales with less work available. For this reason, every construction enterprise becomes vulnerable in a market downturn. The cause is threefold: With overhead a fixed cost made up of plus or minus 90% highly trained and highly valued employees, it is difficult to cut on short notice. It is close to impossible to increase profitability in the production of work on hand. And you can’t add additional profits to the pricing of new work when everyone else is lowering their prices trying to capture the fewer available projects. If a market declines, margins move quickly in the wrong direction.
If this circumstance were to be subjected to a “logic test” by persons totally unfamiliar with the construction industry they might ask:
-if the overall construction market at, for example, $1 trillion was profitable before a downturn
-if some years prior to that it was profitable at $900 billion
-if years prior to that it was profitable at $800 billion
-Why, when the trillion-dollar construction market retreats to $900 or $800 billion where it had been profitable in years past, is it not profitable again?
The answer is aggressive competition. The construction process is unique in that competition is a primary driver of the selling price of construction services. Competition is dramatically affected by the amount of work available which is what drives the selling price of construction. Profitability is dependent on the amount of work available. In a growth market there is work available to satisfy contractor’s appetites for the volume of work they want. When that occurs the quantity of work a firm can go after is restricted only by their available resources of labor, equipment, etc. In a strong growth market when the “want and need” for work is satisfied, competition loosens up and the number of contractors pursuing each project drops precipitously. With a lessor number of bidders, who do not really need the additional work, it becomes a seller’s market and prices inflate significantly. Construction profits accelerate.
In a declining market the reverse occurs. The number of bidders goes up, the need of each bidder for the work increases which amplifies competition and very rapidly drives down the selling price of construction as it shifts to a buyer’s market. In theory, if the construction market declined 10% and every contractor was satisfied with 10% less work conducting themselves accordingly, the percent of profit would remain unchanged allowing each to enjoy 90% of the profit they were earning prior to the downturn. Competition would be balanced easing pressure on pricing. However, what has occurred in the past has been a reluctance to downsize generating aggressive competition as each firm attempts to maintain sales in a shrinking market. This (to use an old fashion term) causes a “price war” that no one wins and the selling price of construction plummets.
History will repeat itself if this happens during the current downturn, and there is little reason to think it will not. The US economy is cyclical so about every 10 years the construction market will cycle down. If this pattern of losses and business failures is to be avoided in the future, the construction industry will need to embrace the concept and process of Flexible Overhead.
Thirteenth Crisis - Era Message to Contractors: The Dynamics and Patterns of a Construction Market Downturn
Finally: some light at the end of the tunnel. The US economy may have bottomed out and unemployment may have leveled, even improving some. I say “may have” because the Labor Department Jobs Report is subject to revision, and there were 15% fewer responses than pre-crisis. Accepting the report as is, there are still 21 million workers on unemployment so questions remain: How many jobs will the economy support? Will consumer spending recover anytime soon? When will small businesses rebound and will all of them survive? The economic news this week is spread from predicting a modest to slow rate of recovery with few, if any, expecting recovery this year.
Length of Recovery: The construction market lags the US economy. In spite of this certainty you may have seen a few articles in industry publications suggesting that “construction can ‘lead’ the economy into recovery”. However, they were politicians and industry people trying to promote federal funding for infrastructure projects. Even accepting the wishful thinking, most see there will be less construction put in place in 2020 than in 2019. The question is how much less? Forty seven percent (47%) of the construction jobs lost this far have returned, but that is still only halfway back. There is also little backlog coming forward as projects continue to be canceled for lack of funding and designing of future work withdrawn for lack of need. Obviously there will be a lot of work completed during the market decline. Just not enough to satisfy appetites after the growth experienced between 2016 and 2019. It is not in our nature to settle for less--downsizing to the amount of work available.
Profitability: Whenever there is less work margins suffer because the selling price of construction goes down as the industry shifts into a “buyer’s market”. Losses become more common, and some businesses eventually fail. No type of construction was spared in prior downturns because contractors with limited experience in other types of projects or with working in different geographic areas went after work they were not familiar with. Many were successful in capturing that work because they were aided in their pricing by a lack of experience or limited local knowledge. In the current circumstances there will likely be a reasonable amount of infrastructure and heavy construction work available that will attract companies burdened with a shortage of building projects. When the market shrinks, competition increases and the selling price deteriorates for every type of work as construction companies fight for work anywhere, any type (almost at any price).
The “Compression” Dynamic: [Schleifer’s Dictionary of Business English] Compression: the domino effect of the downward pressure applied to construction pricing by large contractors during market contractions.] What happens in a downturn is larger construction companies desperate to keep their people busy, aggressively go after smaller projects than they normally would. This takes work away from other firms forcing them to go after smaller projects than they normally would and so on through mid-size firms and finally down to small firms. With their greater capitalization big contractors are able to use aggressive pricing to take smaller jobs and/or expand geographically by moving into markets they do not normally compete in. The lowest level in this avalanche, the smallest contractors, have nowhere to turn and some are driven out of business.
Defense: Contractors need to understand this dynamic which happens every downturn and should therefore be expected. Compression highlights the reality that cutting the cost of doing business and downsizing is the only defense during a declining market. The only option is to cut overhead proportionally to the amount of the market decline enabling you to produce a lessor amount of work at a profit. If there is less work available, and a firm attempts to maintain their sales volume they will have to take the work off their competitors who are trying to do the same thing. Compression causes industry-wide losses which is part of the reason that construction has the second highest business failure rate in the country. A failure rate that always accelerates during declining market cycles. This has been happening for decades and has not been recognized because it was an unknown and unidentified dynamic. Now that we know about it we can deal with it.
Market Cycles: As an industry we need to stop believing that it is automatic, almost acceptable, to lose money during a market decline. This happens so regularly to those who refuse to downsize and cooperate with a declining market that we have begun to think it is inevitable. It is not inevitable unless contractors persist in fighting declining markets rather than cooperating with them. We have got to stop thinking that we control the market. The construction market is independent of the construction industry and cannot be influenced by contractors. The construction market is a product of the US economy and results from the needs of parties outside of the construction industry for things to be built and the ability and willingness to pay for it. This is the business environment we work in so it is critical that we learn to prepare for and manage through the inevitable market cycles.
Reality: Market cycles and compression are very real and dangerous realities. Those who don’t understand these dynamics and patterns will not recognize them when they occur and will not be prepared to react appropriately. You cannot fight the avalanche once it begins. The only way to fight compression is to continually lower your prices as larger competitors force their way into your market which causes losses you should not incur and may not be able to afford. What you can do is refuse to take work at a loss which means downsizing to cooperate with a declining market. All of us know to get out of the way of an avalanche because defying a landslide is a deadly choice. The only thing certain about the current market downturn and compression is that there will be others. Let’s hope they are at least 10 years apart which is the average interval between construction market downturns since WWII.
Twelfth Crisis - Era Message to Contractors: The Potential and Timing of Recovery
The US economy will recover as will the construction market. They always have. That was true during the 2009-2012 recession but it didn’t prevent nation-wide losses in the construction industry. Knowing that the construction market will rebound is not much help in planning for or managing through it. What IS NEEDED is to know how long it will last because there is a big difference in the impact of a 4-month and a 14-month downturn. How to plan for it and what actions to take would certainly be different.
During the deep and lengthy 2009-2012 construction market downturn, I consulted with a number of construction firms that were struggling with reduced sales and having serious financial difficulty. Every contractor I was involved with said the same thing in one form or another, “If I only knew the market was going to get so bad I could have done something about it” or “I would have done things differently”. During a meeting with one contractor, I said, “You were at one of the seminars where I explained that the data collected in an extensive research project and the business models developed clearly indicated the construction industry was entering a deep and lengthy market decline”. Without hesitation he looked me straight in the eye and said, “I didn’t believe it”. Granted there is no guarantee that research projections are 100% accurate just like there is no guarantee that any of us will be here tomorrow, but we still plan our day.
As construction professionals we have no choice but to gather all the data and information we can, make objective evaluations, and develop short and long-term strategies and plans for our businesses. We need to collect information continually and adjust our plans accordingly. Key to this process is objectivity, and to maintain objective it is critical to keep emotions out of the process. What I have observed is that trust in data and information is often influenced by feelings and emotions—to the extent that it is not so much not believing the information as it is NOT WANTING to believe what we don’t want to see happen.
It is 12 weeks since the pandemic has put the economies of the world on hold which simultaneously suspended some construction projects, delayed others, and caused cancellations. Obviously, none of us were prepared because this had never happened before. In short order it became apparent that the entire world was affected and the selected defense against the virus was to stay away from each other, effectively shutting down major portions of the economies of every country in the world. Also, because this never happened before, we had little choice but to listen to those in authority and the “V shaped” recovery was coined. This provided short-lived comfort until it became apparent that this was not a short-term event.
In week 2 of this weekly message series it was stated that the 90-day timeframe, popularized in the news, was off the table because the construction market would not likely return to pre-crisis size this year. The 4th message explained that few construction firms could sustain their existing overhead if the downturn lasted more than six months. The 5th and 6th messages reported no end-in-sight and the 7th suggested that confidence in stimulus funding fixing the construction market was overly optimistic given the long-term outlook described in the message. Week 8 warned of the cost and impact on productivity of the newly required work-site protocols and weeks 9, 10, and 11, presented ongoing developments that continued to push the recovery farther out.
Why do I keep repeating this? Because all the major downturns since WWII started the same way. They were supposed to be short until there weren’t. Good news sells, optimism is the preferred attitude, and there are some short-term benefits to looking on the bright side. In the first year of the 2009-2012 construction market disaster I had a widely published article outlining the economic fundamentals that indicated we were facing a deep and lengthy construction market decline. Several construction associations advised that they could not send this kind of negative information to their membership. One called and asked “if I could lighten it up a little”.
To assist readers in deciding for themselves how much longer this construction market decline will last, here is a sampling of the continuing ripple effect and latest developments affecting the economic disturbance we are experiencing.
- 30% of unemployed in US don’t think their jobs will be there
- Mortgage delinquency rate doubled in one month
- Travel demand essentially zero according the President of United Airline
- American Airline plans to cut 30% of its staff
- 90% of the museums on the planet closed, 13% may never open
- Hertz the largest car rental co. bankrupt--20,000 out of work
- Major League baseball teams may each lose as much as $100 mil this year
- Universities nationwide concerned that enrolment may drop as much as 20%
- Consumer spending cut by half
Construction Related Developments:
- 30% of construction firms surveyed furloughed or terminated employees
- All states but SD suffered a decline in construction employment
- NY state construction workforce is down by 40%
- CA with no statewide shutdown, dropped by 15%
- Orlando Airport is considering reducing the scope of it’d $4.2 bil project
- A $1bil FL resort project and a $420 mil halted
- Disney cuts $900 mil from construction budget
- Convention Centers nationwide delaying or canceling projects
- State DOTs furloughing and laying off, stopped planning construction projects
The US economy and the construction market will recover. Some contractors will not. Research indicates that the only defense is using the information available to you to estimate how long you believe this downturn will last and develop a plan for how your firm will get from here to there. Prudence suggest you include a cushion in case it goes longer. My calculations indicate that the construction market will not return to 2019 volume in 2021.
Eleventh Crisis - Era Message to Contractors: The Ripple Effect of this Economic Disruption
Sending employees home from work, limiting the size of business and social gatherings and wearing protective masks has a lot of people wondering about life in the future. What will education and school be like? Will future graduates see the world anywhere near the way we do? Coronavirus has slammed the world economy forcing entire countries to close their borders, impacting US industrial supply chains and global economic activity that fuel economies across the globe. The pandemic has brought the travel, hospitality, entertainment, oil, auto, commercial real estate and sports industries to their knees. There are still people talking about a rapid recovery or the new optimistic term “V-shaped rebound” at the same time as others debate whether or not to open grammar schools, high schools or colleges to face-to-face learning in the Fall or places of worship to more than a mask-armored few. Restaurants are opening, but only for those brave enough to make their way to the location pushing through those refusing to wear masks or to participate in social-distancing, and then dine in a space where everyone has to remove their masks to eat.
This is what is already happening and, in turn, causing a ripple that may have a long tail slowing commercial activities that are now indirectly being impacted by the pandemic:
- Employees of parking facilities are out of work
- Auto mechanics and dealers have little to do
- Uber and Lyft drivers find hardly anyone needing a ride
- Many health care workers not directly involved with infectious diseases or emergencies are out of work
- Retail establishments are opening to few people able to or willing to spend
- Rail, bus and taxi services have almost no one to transport
- Many will not let people into their homes to provide services
- Cars and tires are not selling because fewer people are adding any mileage to their vehicles
- Just to mention a few. The list goes on and on.
Now begins the initial efforts of getting back to work. Getting the economy moving again. However, some of the lost jobs are not needed, mainly because those out of work can’t spend enough to keep establishments open, and many of those fearing being out of work feel constrained. Potential consumer spending fits into two categories: those who have little to spend and those who can spend but with so much uncertainty refuse to or limit spending.
Considering all of this, it is not much of a leap to suggest that it may take some time for this economic recovery to gain much traction; and there is little to encourage optimism that, when it does, it will just sprint back to health. Municipalities and states are destined to go deeper into the hole until spending increases enough to generate the tax dollars they need to crawl out of the red. Industry relies on consumers and businesses to purchase its goods and services and will continue to suffer losses until spending rebounds. It is reasonable to say that small and mid-size businesses, a big part of the economic engine that drives the economy, will profit little during this laborious and protracted recovery effort. It appears that the newly minted phrase “V-shaped rebound” was overly optimistic leaving us with a slow or, at best, a moderately paced recovery. The goal we are looking for is savings accounts beginning to grow, restaurants full again and airports occupied. In the meantime, the construction market will continue to decline, finally level out, and eventually begin to recover. It will follow the US economy which may have trouble regaining its vitality and endurance. Backlog for 2021 is evaporating as we speak, and our design partners are not pushing out a lot of work for 2021 and beyond. AIA reporting that April architect billings and inquiries were at record lows says it all.
It has never happened before, and I cannot conceive of a circumstance where the construction market would “lead” the economy instead of lagging it. Therefore, the construction market will follow this slow to moderate recovery parade wherever it goes. How deep? My hope is that the construction market decline will not be worse that the 2009-2012 recession, but that may be optimistic. Prudence suggests that you make your best estimate as to how deep you believe it will go and downsize your operation to cooperate with a market that is heading in the wrong direction. How long? At this point it really doesn’t matter because it will clearly be longer than the six-month threshold described in the fourth weekly crisis message to contractors. Six months is a limit after which very few construction enterprises can afford to carry excess overhead for much longer.
There are options: (1) Wait and see. (2) Make easy to moderate cuts in your cost of doing business, like cutting any nonessential costs you can find and laying off anyone not aggressively carrying their weight. You can then make additional cuts when needed. Or (3) Do the exercise recommended in the tenth crisis-era message utilizing whatever information you have, estimate the average of the best and worst-case scenarios for your business in your particular market and make the cuts all at once--cooperating with the projected market, and operating at lower volume but at a PROFIT.
What about stimulus funding and the possibility of stimulus funding for the construction industry? Current stimulus funding may be keeping food on the table but it is certainly not fueling an economic recovery. You will need to make your own decision about the potential for a stimulus rescue of the construction industry but please understand that is another “wait-and-see” proposition. If it is anything like the federal construction industry stimulus program during the 2009-2012 recession there will be a lot of talk about “shovel-ready projects” and perhaps some funding--too little-too late. Wondering when Congress may get around to construction stimulus or get around to funding our huge infrastructure needs, and then when that will generate some new work might be an interesting exercise, but it is not a reasonable strategy. The research-verified six-month limit excludes this as a viable option and the only way to grab this straw is to wait and see. Time is not on our side.
Tenth Crisis - Era Message to Contractors: The Construction Market—Recovery, Timing, Profit
If you did the exercise recommended last week in the ninth Crisis-era Message and determined to your own satisfaction that the US economy and the construction market will rebound in six months or less from its start, which would be on or about September 15, 2020, there is little need to read further. If you determined the US economy or the construction market will recover after that date, consider the following:
For the US economy to begin to recover it needs to stop getting worse. (“recovered” for our purposes means to be at least approaching 2019 levels. The construction market will follow the US economy recovery but historically lags it by 12 to 18 months. Because so many are convinced about this economic decline, that “this one is different”, you might want to predict a lag of say 6 to 12 months. In this “best-case” scenario the construction market would be healthy again as early as March 15, 2021. According to research into the eight major construction market downturns since WWII, that would be an extremely low probability, but let’s work with that optimism for a while. What are the things that could improve or upset this projection?
First, you need to speculate, estimate, or make an educated guess about several important questions that will affect your business planning for this disruption:
- When will the US economy recover and will it rebound to where it was?
- When will the construction market recover and will it rebound to where it was?
- Will aggressive competition drive profits down as it has in all past construction market downturns since WWII?
- If so, will that cause construction business failures?
- Will some construction enterprises reorganize in order to profit with reduced sales?
- Is there going to be a new normal?
It will be helpful to evaluate or measure the likelihood of certain things happening that will affect our businesses: (Scoring: 1 = lowest likelihood, 5 = highest likelihood)
- The US economy bounces back almost immediately and the construction market recovery only lags 6 months. [Likelihood 1 to 5 ___ ]
- The US economy recovers but, because of changes in consumer and public spending it, does not approach the 2019 levels for the foreseeable future. [Likelihood 1 to 5 ___ ]
- Resistance to capital spending because of a caution to conserve cash holds the construction market back from approaching 2019 levels for the foreseeable future. [Likelihood 1 to 5 ___ ]
- Aggressive competition depresses profits during the construction market decline (as it always has in the past). [Likelihood 1 to 5 ___ ]
- Aggressive competition also depresses profits during construction market recovery (as it always has in the past). [Likelihood 1 to 5 ___ ]
Draw your own conclusions about the impact of your scores on your business. The future of the industry’s recovery that you plan for your business can be as rosy as you believe it is likely to be. The problem is, when optimistic projection don’t materialize, it can be disastrous. When projections you plan for turn out better than expected, it may still be problematic, but at least it’s not a disaster. My approach for planning around a market decline is to take an average between the best-case and worst-case projected scenarios and then predict about 10% to 15% towards worst case. Why favor worst case? Because when the optimistic projection does not occur it is a disaster, so I want to error on the lessor penalty—on the less risk side.
Construction professionals have no choice but to make an educated guess about future economic developments because reacting to this disruption of the construction industry is critical to future success. (Unless you agree with those that believe that business-as-usual will get us through this.) Time is not on our side and for some construction firms it is almost too late to react because their balance sheet is already affected. Firms that were struggling financially (for whatever reason) going into this crisis will likely have difficulty getting through it. Another exposure that will compound this problem is that stopping and restarting a construction project is not without costs and new Covid-19 job-site protocols will have costs that were not anticipated in the original estimate. If you expect to be compensated for either or both costs you are not alone. Most of what I am hearing is the same. I wish I was as confident as some but my experience does not justify much support.
I will not go into a lengthy discussion of claims other than to advise caution on planning or accounting for the anticipated additional compensation. The expectation is a “claim” and my experience with the tens of thousands of claims I am familiar with is that some claimants will receive all, some nothing and some a portion that averages roughly 50%. And all of these are reduced by the amount of legal, consulting and other associated costs of claims. These prior claim results all added up to an average settlement of 50% on the high side to a negative number on the low side. I record pending claims at zero, conservative construction professionals book them at 25%, optimistic construction professionals book them at 50% and gamblers at 100%—ignoring the cost of claims. I am not saying you will not get lucky. I am saying don’t contaminate your accounting records with luck. As to when claims convert to cash, you already know—if not, ask any experienced construction CFO. I did not mention the “merits” of a claim because I have not seen merit to have much effect on claim settlements, particularly long after the event in question. Some claims that I thought were a slam dunk lost and some I was sure had no merit at all won. My experience suggest that a flip of a coin is as good as any other method of predicting the resolution of a construction claim. Obviously, you can adjust this to your own experience. For more on the cost of claims see ENR article “When to Avoid Costly Conflicts” by Tom Schleifer and Bob Rubin go to letstalkbusiness.net and click on “Articles.”
The industry profit margins and typical cash reserves are too thin to fund maintaining overhead during a market decline much longer than six months. If your margins are well above industry average, your cash reserves are strong, and you are willing to expend them, you can “wait and see” a little longer. I do not recommend it because business in not a game of chance. Protecting the value of the company is the primarily obligation of top management.
Ninth Crisis-Era message to Contractors: The Construction Market—Bracing for Long-Term Disruption
Published May 13, 2020
Two things are required to support the construction market: The need for something to be built and the ability and willingness to pay for it. A decline in the US economy slows expansion in the private sector which reduces the “need” for new construction. In the public sector the “need” for construction such as infrastructure continues through an economic decline, but reductions in taxes and fees stall the funding of public construction.
When the economy slows, funding and borrowing capacity in the private sector suffer from reduced sales and profits. Funding sources that remain available go unused by a reluctance to spend and caution to conserve cash. One of the first things to be cut is capital spending, which results in the loss of construction funding.
The construction market lags the US economy. The “lag” occurs because of the 12 to 18-months it takes to design, fund and build a project. When the US economy slows down, the projects that are under construction usually get completed, (not all in this crisis) but the design and funding of future projects are interrupted. This means that as the current work in progress is completed over 12 to 18 months, it is not being replaced in the same proportion creating a “lag” as construction put in place declines. When the US economy recovers, the design phase is stimulated again as are the funding sources, but it takes 12 to 18 months (lag) for these projects to be designed and funded before they progress into the construction phase.
This brief description of the dynamics of the construction market confirms that construction will not rebound before the US economy, which is a condition precedent for construction to even “begin” to recover. It will then take time for the construction market to fully recover, which will be when it returns to its prior size and prior profitability. History tells us that until that happens aggressive competition will suppress profits so we can anticipate slim margins during both decline and recovery. Margins return when each enterprise’s appetite to regain their pre-crisis size is satisfied so competition can lighten up.
Construction Professionals need to approximate how long it will take for the US economy to rebound and how long after that for the construction market to recover. A logical first step in that process would be to evaluate where we stand today. I suggest we list what we know about the factors impacting the US economy so that you can assess for yourself what the timing might be and how that might affect your business:
US Economy Related Information:
- 33 million people on unemployment
- Unknown how many furloughed or on leave
- Weakness in GDP projected to be worst since 1930s
- Lifting of social restrictions in stages
- Some states extended restriction through May
- Vaccine in unknown future date
- States and municipalities suffering lost taxes and fees
- Private industry suffering lost sales and profits
- Capital spending will be affected for some time—conserving cash
- Uncertainty about return of consumer spending—When? How strong?
- Energy industry operating at half capacity
- Impact of stimulus funding unknown
Construction Industry Related Information:
- Construction workforce down 975.000 in a month, steepest drop since 1930s
- Industry jobless rate 16.6%
- Reductions in construction employment expected through May
- ENR reports a survey: 35% projects delayed, 14% canceled
- Same report--projects in design 41% delayed, 15% canceled
- New job site protocols will cost and will impact productivity
- Financing for some projects delayed with uncertainty in bond market
- Energy industry has cut spending 30%
- Some states already canceled 2020 transportation budgets
- Serious concerns over potential material shortages
I have been asked if there is any good economic news out there. Yes, but not nearly enough to sway the overwhelming national trends. Readers can add their information to these lists, and we will continue the discussion next week. To evaluate this information, you might want to place next to each item on the first list above the shortest time you think that issue might correct itself or be corrected. Then worst-case scenario, the longest it might take. I usually use the average of the two as the “likely” timing for discussion or decision-making purposes. As each item will have an independent score, you can use them separately or calculate another average to decide for yourself approximately when you think the US economy might recover. Using the same process, consider when and what the impact of each of the items on the second list might have on your business. If this seems like too much work, I will offer some projections next week.
Next week: When and where the construction market is heading.
Eighth Crisis-Era Message to Contractors: New Worksite Protocols: The Impact
Published May 4, 2020
Construction is either continuing or about to restart depending on your location, which is the good news. The other news is that the new COVID-19 safety requirements now apply. They vary by location, are continuing to evolve and are not necessarily fully understood by those who will enforce them. Other than a concern about the need for some clarifications, you will get no argument here about the need. Our industry is obviously in uncharted territory and is in no position to judge whether the requirement will be effective, and it goes without saying that we will comply. There is no need to get into the details here as the requirement vary considerably and contractors are already scrutinizing those that apply to their projects as they are issued. My guess is that how strictly they will be applied will vary, and that the consequences for not strictly adhering to them will also vary. This is how each new OSHA safety regulation was received and reacted to over the years so it will work itself out eventually.
Many of the guidelines issued require “strict” compliance, which may mean different things to different people and other guidelines caution that more stringent requirements may be added later. Most say that if there is any conflict between applicable regulations, the stricter will apply and, in some jurisdictions, noncompliance is grounds for shutting the job down and/or revoking the building permit. Others have fines attached and at least one encourages the public to report construction noncompliance and suggests there may even be a reward. Another exposure we face is the reporting of real or imagined noncompliance by disgruntled employees. What is yet to be determined is the part that the unions might play in all this. So far a few local unions have lobbied for shutting down construction in their work area and some contractors report as much as 20% absenteeism on active projects.
Planning and executing the new requirements may be a little complicated, but it is something that construction professionals are capable of doing and absorbing. The much bigger issues are: what will it cost, who is going to pay for it and who is liable if the measures are ineffective? Contractors may claim that they did not cause this, and project owners will be able to say that they did not either. Contractors may claim that this is a changed condition while owners may assert that the contract says the contractor will comply with all codes and regulations. There is little I can add other than to say it will be fertile ground for disputes and lawyers. The caution here is to manage and minimize costs as if it were your own money, because it may be. And keep meticulous cost records whether or not you expect to go to claim.
What is of concern are the liability issues that may arise. A review of multiple federal, state and municipal guidelines indicates a liberal use of open ended and all-inclusive words such as: any, all and every. Some guidelines place responsibility on contractors for not just their own compliance but, in some cases, for the compliance of others. There are clauses that suggest the contractor is responsible for the compliance of subcontractors, sub-subcontractors, suppliers, other trades and visitors; including the behavior of employees off site and off the clock – like “prohibiting” car-pooling. The problem we face is that responsibility is closely related to legal liability.
Of further concern is the question of who is responsible if an employee becomes infected on or off the job? Who is responsible if the employee infection forces everyone on the project to be quarantined? Would the employer be liable for the lost wages of the infected person? Would the employer be responsible for the lost wages of all who are quarantined, and would that include people employed by others? Is anyone liable for lost wages of people who are not sick, but cannot work because someone else is infected? Obviously, there are more questions than answers, but the solutions for these questions, if they arise, could generate considerable legal costs, administrative time and perhaps settlement costs.
Now that we can or are about to restart construction, we need to carefully pre-plan exactly how we will manage the costs and the impact on productivity of the new work protocols. Clearly these restrictions on our job sites will affect profits. Prudence demands that we estimate the cost as accurately as possible and adjust the anticipated profit on our accounting records. When revenues are interrupted, business activity is disrupted, but when profits are impeded your business is exposed. Measure the impact now while there is time to react to it. Don’t wait until it occurs and don’t let the surrounding market drama distract you from taking a dispassionate look at your capital and borrowing power and determine how much of it you might be going to need if the market decline lasts very long.
Next week I will address defensive actions indicated by a long-term decline in the construction market.
Seventh Crisis-Era Message to Contractors: The Long-Term Outlook
Published April 29, 2020
The “Wait-and-See” contingency is convinced it is too early to predict the effect of this crisis on their businesses. I expect the optimism out of Washington, DC, and some in the news media are feeding this opinion. The construction industry has already been negatively impacted by the global crisis and the construction market downturn is following the same pattern as the prior eight downturns since WWII. What is being questioned is: Will the US economy and the construction market rebound quickly and completely? I join with my readers in wishing it would. However, as a researcher I am compelled to consider the data and to study the past to project the future. Those waiting are convinced that “this time it is different” and I agree that the cause is different, but that does not change the effect. The current construction market is closely following the models developed during research of the prior downturns.
The construction market is deteriorating, the pace is worrisome, and the bottom is not in sight. Obviously, the rebound can’t start until the market stops declining. Hardly anyone believes the US economy will get better in May or June and data for July will not be available until mid-August. Therefore, the “wait and see” group will be six months into the downturn before they find out if the US economy will begin to recover any time soon. The speculation is when the economy will bottom out, not when it will rebound. Some experts are talking about this fall or winter and some are saying 2021. Pick the time frame you feel is appropriate and determine if you can hold out that long. Using your prediction for the beginning of recovery, when will most people be back to work, and will they be spending like they used to? Will the construction market immediately rebound when US economy levels out, or does it have to get back to it’s prior size before there will be enough work to go around?
Trying to determine when the US economy may recover is complicated by uncertainties beyond our borders. Health is a fundamental determinant of economic growth and sick nations around the world are handicapped in terms of production, consumption and aggregate growth. The less-developed countries of the world with poor health care systems and services, not backstopped by advanced healthcare infrastructure, will delay global recovery. The ability and willingness of developed nations to assist poor countries in this new-normal world will impact global recovery which, in turn, affects US economic recovery. Global economic growth is the driver of worldwide demand for commodities, but the global economy is shut down. Our trading partners cannot afford our goods and services and are having difficulty producing and transporting imports that we need. There are already reports of delays and shortages.
On top of this, the worldwide economic crisis has effectively collapsed the global oil market. This sent oil prices to unprecedented levels which, in turn, is causing the energy sector to be a drag on the US economy. Consumers normally benefit from lower energy prices, but not this time because both flying and driving are practically at a standstill. Consumers plus business investments make up the bulk of growth in the US economy and both have been negatively affected by energy prices. Demand for oil is nonexistent. It cannot return until global growth picks up which includes air travel and jet fuel demand. These, however, are dependent on social restrictions being lifted. When that happens, we face the potential for changes in consumer behavior. Some experts are speculating that oil demands may not reach their previous peak for years. To prevent a wave of bankruptcies in the US energy sector we may see a government rescue of at-risk energy producers. Unfortunately, this might push oil prices even lower as it perpetuates the oversupply.
There is no known policy fix for this virus induced economic catastrophe and it will take a long time for US companies to repair their balance sheets. Some firms will not survive and there is the possibility that unemployment may reach a post-war record high before it corrects.
On the positive side the US consumer balance sheets were strong leading up to the crisis, personal savings were high and consumer debt, as a percentage of disposable income, was historically low. The federal government is pumping billions of stimulus dollars into the economy with various programs. Because we have never been here before it is impossible to predict the impact, but it should lessen the destruction and, hopefully, shorten the pain. There is speculation that the stimulus may exceed a trillion dollars (5% of GDP) and more if this continues to drag on. I don’t think that stimulus funding is going to prevent a recession, but it should slow the decline.
Next week I will address the productivity and profit implications of new work protocols and restrictions on construction sites being required by states and municipalities.
Sixth Crisis-Era Message to Contractors: Impact of Back-to-Work Restrictions
Published April 22, 2020
The problem with the back-to-work restrictions that construction organizations will face when we can finally get back to work is that we do not know what they will be. There are and may be additional OSHA and federal guidelines, but it looks like each state will make final determinations about how to follow those guidelines or to add to or modify them. As the “guidelines” evolve into 50 different state regulations we may face often changing, confusing, and difficult to initiate and administer protocols and procedures. This is compounded by the potential undefined liabilities associated with the question of who is responsible if someone on-site comes down with the virus? If the remainder of the workforce, including those working for others, are quarantined, is the employer liable for lost wages and benefits? Undetermined.
We may not yet know how our construction site activity will work under new “back-to-work” restrictions, but we can be certain it will impact productivity, schedule, and profitability. While we may all agree that some work with restrictions is better than no work, we need to be deciding now how we will put the new work requirements into place. There is little argument that the amount of effort put into pre-planning the work is directly proportional to our success and profitability in the field. I suggest that it is prudent to get a head start on implementing the new, but yet unclear, requirements so you can hit the ground running as soon as restriction are lifted.
Two of the guidelines that will most likely be included in one form or another, and that will clearly impact how our trades-people are accustomed to working, are social distancing and periodic, or possibly continuous, cleaning and sanitizing tools, equipment and who knows what else. Just acquiring and providing work-site access to sanitizer and other protective supplies and gear has a lead time and should be considered now. Where, who and how much, are a few issues that can be considered in advance in that they will be our responsibility soon enough.
It probably goes without saying that new requirements will add costs and will impact productivity. Pre-planning will be required to maximize efficiency in initiating the new requirements and accomplishing the work while complying with them. “On time on budget” may be a challenge and there will be little time to debate who should pay for any or all of this. As the requirement will affect profitability, it may be appropriate to estimate the cost of that impact and adjust projected profits, per project, depending on anticipated outcomes. I can hear the complaints already, so it may be appropriate to be reminded that our credit grantors judge us as much on our skill at meeting profit objectives as on the amount of the objectives. A measure of our own proficiency is our ability to make projections and to then meet or exceed those projections. Part of that process is the timely adjustment of projections as they become impacted by failure to perform or by influences outside of our control.
There are several steps to managing the new requirements you may want to consider:
- Determine what you will do to comply with the requirements on each project as some jobs may need to be treated differently than others.
- Decide how compliance with the requirements will be managed, measured, recorded and assured.
- Resolve who on site will be responsible for compliance.
- Will there be ramifications for an individual worker’s non-compliance?
- Will both compliance and non-compliance be recorded and by whom?
Again, I sense screams about “overkill”. It is here we need to consider the unknowns about who might be liable if, despite compliance with the regulations, someone gets sick or worse. It may be unknown, but what we do know is that what gets measured gets done, and that compliance without documentation is sometimes alleged as uncertain compliance or even non-compliance. There will be legal issues. It’s part of doing business, and compliance is not the same as documented compliance.
This crisis has already and will continue to impact our industry. This is totally outside of our control. What we can control is our reaction to it and how we will manage our internal protocols, processes and procedures in response to it. We are still in charge of our businesses and, therefore, responsible for the outcomes in both good years and bad—in both normal and unusual circumstances. If you think you can get through this crisis without a decrease in profit, or just a modest decrease, great. However, if you even sense the possibility of more than a modest decrease in profit or the slightest potential for loss, you know that you have to take action now. It is too late after the loss has occurred. It is almost impossible and always painful trying to overcome loss after it has happened. The primary objective is the prevention of loss, which is not necessarily less painful, but a much better outcome.
During early stages of the last two construction market downturns I was often accused of being a pessimist and doomsayer. This construction market downturn is following the market models developed from research of the eight major downturns since WW II. What I am hearing this time is “this one is different”. The cause of the US economic decline may be different, but the effect on the construction market is the same. It is not as if people do not believe the data. It is that they do not want to believe the data and saying “this one’s different” reinforces hope and delays action until the “wait and see” instinct is satisfied. Those who know me know that I wish I were wrong.
Next week I will address the long-term impact of this crisis on the construction market. The one- and two-year outlook is not encouraging.
Fifth Crisis-Era Message to Contractors: Pace of Recovery-Impact on Construction
Published April 16, 2020
It is becoming clear that the pandemic will not end suddenly, nor will the US economy rebound rapidly. It’s beginning to sound like a drawn-out affair with experts speculating about where, when and how to lift social and commercial restrictions. They all seem to agree that it will not be like “flipping a switch” which sounds like the current “turned off economy” will just become less turned off—more like a dimmer than a switch. Socially moving slowly from severe restrictions to less severe restrictions may feel good, but for most businesses moving from not enough customers to a few more customers is still not enough customers. Most commercial enterprises prosper at near-full to full capacity, but how many can profit with just “a few more customers.” For most businesses this crisis will be over when they have most or all of their customers back—think restaurants, airlines, sports venues, stores, anyplace people gather. Then the economy can recover.
All of this is too much to digest at once, and we construction professionals can’t solve a global pandemic so let’s concentrate on what we CAN do—protect our companies. Construction professionals have no choice but to forecast their individual markets in order to plan their reaction to the current and potential disruption. We already know that construction follows and lags the US economy so let’s build a logic stream. Consumer spending drives the US economy which stimulates capital spending which drives the construction market. That gives us a place to begin. Ask yourself how long you think it will take to put 20 plus million people back to work? When will sports venues open? How soon will people feel comfortable going to restaurants, traveling or simply back into society? That’s when consumer spending will begin to increase. The next milestone is when consumer spending rebounds to prior levels, which is essential to full recovery. As the economy recovers, capital spending should increase with it; however, losses and the amount of debt accumulated during the slowdown will likely impact the pace of increases in capital spending.
- Therefore, you need to estimate when you think social restrictions will be reduced, marking the start of the US economic recovery.
- Then the additional length of time for ALL social restrictions to be lifted which should mark the point where consumer spending may return to prior levels.
- Adding these lengths together and factoring in your estimate of the impact of debt and prior losses incurred should yield an approximation of the regeneration of capital spending.
- Guessing how many more months it will take for capital spending to rebound to prior levels should give you a pretty good supposition of when the construction market across the country will return to 2019 levels.
We are now being told that the lifting of social restrictions will be partial and staged. At this point we don’t need an accurate estimate of when the construction market will be fully recovered to make decisions. Partial relief has not started. Staged relief implies more delay so just getting to full consumer spending is at least months away and then we wait for capital spending to catch up. The big question remains: when will the construction market rebound to 2019 values? - which history tell us is when profits will rebound.
There is evidence that projects continue to be delayed and cancelled while the talk of a rapid rebound persists to worsen. When (and if) delayed projects are released, bringing them back to life will not happen overnight. At that point we will also need new work to maintain backlog. Unfortunately, design firms are beginning to report delays and cancellations of some of their work in progress which may be a developing problem. Add to this the reality that cities, counties and states continue to suffer a dramatic reduction in tax revenue at the same time as private industry is incurring serious losses from reduced sales. If there is any disruption in new work coming into the market, recovery will be delayed. Please understand that I hope I am wrong.
There are few ways a construction enterprise can cope with this declining market, but “wait and see” is not one of them. Facts: The construction market has been disrupted. Clearly it will rebound, but when and at what pace? Each construction industry professional must decide that for themselves. Those with the responsibility to protect an affected enterprise must determine how long they can afford their present overhead. Can you outlast this developing market downturn, or do you need to conform to it in order to profit from the work you do have?
Fourth Crisis-Era Message to Contractors: Time Is Not On Our Side,
Published April 10, 2020
Last week in this crisis message series I said time is not on our side. Three weeks back I said that prudence suggests a reduction in overhead sooner rather than later. Unfortunately, since then we’ve seen nothing but more bad news; social restrictions extended through May 1, warned to expect more virus deaths and continued spread until at least mid-April, ten million unemployed. No need to go on, other than repeating that the construction market follows and lags the US economy—this time it lagged by days not months. With so many unknowns, time has run out. This while many of us are still wondering how should I even think about this—what is the process I should go through to figure this out--what are the principles I should use—can I even identify the problem, let alone evaluate, quantity and analyze it? What we do know is that the construction market has already been affected and, while we can’t solve the global problems, we can react to the impact on our businesses. Senior managers and owners of construction enterprises, expecting a reduction in volume, need to determine now how long they can afford to carry their full overhead. These enterprises include contractors, subcontractors, architects, engineers, suppliers, service companies and those in the supply chain to these organizations.
The next step should be to decide for yourselves how long your individual construction market will likely be impacted. There are some fundamentals you may want to consider in making informed decisions. We are bombarded with news that this disaster will get worse before it gets better so even the beginning of the US economic recovery is unknown. What do we know? Consumer and business spending are the economic engines that fuel the economy. When recovery finally begins, a lot of consumers may have limited money to spend, while at the same time lingering fear may cause others to hold on to what cash they have. Restrained consumer spending impacts business spending and some industries like hotels, restaurants, travel and others may be slow to recover. There is little evidence that the rate of economic recovery will be robust.
In the meantime, cities, counties and states will have suffered extreme reductions in tax revenues; and private industry will have experienced severe losses from lack of activity, which may cause these buyers of construction services to reduce capital spending to conserve cash. This would slow total economic recovery, defined as when Gross Domestic Product returns to pre-crisis value. All of this may impact the restarting of delayed construction projects and much-needed new projects to replenish backlog, a prerequisite to achieve a full recovery of the construction market.
With the above in mind (and anything you can add to it), you have little choice but to speculate on when the economic recovery will begin; and will the initial rebound be instant or anemic? Another question is, when will total recovery occur? Fortunately, we don’t need to know that to make the critical initial decisions. The reason being, historically US economic downturns that fully recovered in less than six months had relatively little impact on the construction industry. I am reasonably comfortable guessing that few construction professionals watching the news expect full US economic recovery within six months so construction will clearly be impacted. A construction market recovery normally follows and lags the US economy by at least 12 months, which suggests that full construction market recovery may be well after full US economic recovery.
Prudent senior managers and owners of construction enterprises will decide for themselves and their companies if they can afford their full overhead for six months or more if their sales fall off. Most have already incurred six weeks of full or almost full overhead, so time is not on our side. The worst case is trying to absorb overhead for months and then finding the downturn will last longer.
If there is an economic ripple affect, how long is anyone’s guess. The limited optimism I am seeing in the news is described as resulting from anticipated “pent up demand”. My concern with that is that economics tells us that consumer and commercial transactions are stimulated by a demand, AND the ability or willingness to pay for it. Pent up demand notwithstanding, when social restrictions are lifted the economy may continue to suffer from both constrained ability and restrained willingness to spend on the part of consumers, businesses and cities, counties and states. If so, the economic “ripple” effect may have a long tail.
I have talked with a number of business people who insist that we need to “wait and see.” While I respect their opinion, I don’t think time is on our side. I am dealing with a lot of unknowns, analyzing new information as it comes out and trying to define cause and effect so that we can better project the impact on our businesses. You are on the front line and your feedback would be of great value in this effort. Please share your evaluation of these issues and let me know what you are seeing and doing in these uncertain times.
Third Crisis-Era Message to Contractors: Why a Measured Response and When?
Published April 10, 2020
We are all in this together and doing our part to stem the spread of the virus. Most fear that this is not a pause but a tsunami. Which it is, in that the effects will be felt well beyond health issues, and for a long time after they are under control. It is difficult to plan a business response when we are contemplating what it will take to solve the bigger problem affecting the entire human race. In fact, most contractors are convinced that they have to wait and see where all this is going before they can even consider the impact on their business. My concern is that time is not on our side and that when we finally realize how this will unfold, we may discover that the solution for our company is long overdue. As with so much in life, timing can be critical
When we develop business plans in “normal” times we project into the future which, of course, is unknown, but we have no choice. We plan to our “planning horizon” which includes our belief in what the future holds and our level of confidence in that belief (the odds). We use what we know, search for additional information and strategize accordingly. In the current circumstances there are plenty of unknows, but also enough data trends to project far enough into the future with reasonable accuracy to formulate what to do now with considerable confidence. This is not the time for emotional or knee-jerk reactions. We all want to be good citizens and good people and most feel responsible to employ as many people as possible during this crisis and I applaud those feelings. What I am recommending is that you make certain in advance that your company can afford to do that and for how long.
We can expect some relief from restrictions when there is evidence that the incidence curve is heading down and with any luck the stock market should respond favorably. The question for us is: When will the construction market rebound from delayed and canceled projects, and will new capital spending be available to fund new projects? This will depend on the US economy rebounding which can’t happen overnight. The first project cancelations were in mid-March, which for our purposes can be considered the beginning of the crisis impact on our industry. We can define a total rebound as when the annual rate of construction put in place meets or exceeds the rate it was before this started.
As an exercise let’s explore when you, the reader, think total rebound might occur. I will express possibilities while you adjust your calculations to your own beliefs. Most restrictions have already been extended through April. When the virus incidence cure rate starts heading down, restrictions will be reduced. Take your best guess when that will happen. Let’s be optimistic and say mid-May. However even after that milestone, there will still be tens of thousands of people sick, others testing positive, and virus concerns will still be in the news; so everyone will not be racing back to work. Some work will resume, but total economic recovery is unlikely. Based on length of continuing illness and even with a reduced rate of virus spread, it is probably safe to say that total construction rebound will not happen for quite a few months after the incidence curve starts down. After that it will take some time for remobilization, so my guess is that the most optimistic possibility for full production is out six months at a minimum.
In the meantime, public entities will have suffered extreme reductions in tax revenues, and private industry will have experienced severe losses from lack of activity which will undoubtedly result in conservation of cash, impacting the restart of delayed projects and potentially more cancellations.
Absent full recovery, the deficiency will obviously be shared unevenly among construction enterprises based on backlog, cancellations, delays, etc. The prudent contractor should decide now for themselves if they can afford their full overhead if their sales fall off for four, six, eight months or more. The worst case is trying to absorb it for months and then finding it will last longer.
Second Crisis-Era Message to Contractors: Immediate Measured Response
Published April 9, 2020
How Long? In my first “Crisis-era Message I said: “How long this will last is exactly what we need to know in order to formulate a response.” We have choices when facing the unknown: do nothing or make estimates based on informed approximations. The responses I am receiving suggest most contractors intend to wait and see—justified by the unknown. (Default to inaction) Nothing on the news suggests anything is getting better so my prior recommendation to plan for 90 days should be considered a minimum. If the virus incidence curve reduces, restrictions will be moderated; but will construction rebound immediately? The economic impact will extend far beyond any reduction in new virus cases. Can we measure the economic impact on construction?
Our industry follows the US economy which is suffering its way towards a recession at best and depression at worst. If the economy rebounds, how fast will construction rebound? Most of the construction in-progress will be completed, but pressure to conserve cash will cause some projects to remain postponed or cancelled. New projects already designed and funded normally go forward during an economic downturn, which is why construction has been a lag industry. However, the pressure to conserve cash may continue because the economic losses during this downturn, in theory, will need to be recovered before capital spending can rebound. Public entities will have suffered extreme reductions in tax revenues and private industry will have experienced severe losses from lack of activity. These economic engines were cash-rich going into this crisis but will not be so coming out of it. This means a greater reliance on debt to fund future construction which is far less attractive.
The pace of construction recovery may rely in part on stimulus funding to business and industry, which is uncertain and usually has to be repaid in some form. This combined with a likely reduction in business and industry’s appetite for debt, will impact the construction industry’s rate of recovery. The outlook: The beginning of a construction recovery will be measured in months and so the 90-day window is off the table. A construction revenue return to pre-crisis levels will not likely occur this year for lack of funding. We are left with limited choices: cut overhead immediately and continue to cut to the extent of any reduction in revenue; or wait to see what develops and cut overhead later after months of losses. Another important question is, will a slow recovery result in the destruction of profits from the pricing reductions we saw during the 2008-2012 downturn? This was caused by a determination to maintain a full share of a diminishing market.
I fully understand the reluctance to cut overhead which means people, particularly within weeks of suffering through a severe long-term labor shortage. Will you get the people back? Unknown. Depends in some measure on how you treated them while employed. How will you execute backlog? Some backlog is likely to evaporate, and incurring losses doesn’t make completing work any easier. At times like this the fun goes out of being the boss. You are left with making your own informed approximation. Consider the shortest and the longest time that you believe a construction recovery can and will occur. I suggest taking the average of those lengths of time and deciding if the enterprise you are accountable for can and should incur those losses while keeping in mind the responsibility of Protecting the Value of the Business.
A Crisis-Era Message to Contractors
Published March 25, 2020
We’ve never been here before, the new normal, so we need to take a unique and longer-term view about how to react. A health crisis turned immediately into an economic crisis and we can’t know how long it will last, which is exactly what we need to know in order to formulate a response. To react appropriately we need to know if we are experiencing a nation-wide (world-wide) economic pause or a full-blown recession. If we knew for certain it would be a recession, which, of course, we don’t know at this time, I would consider drastic cuts in overhead. If a pause, I would recommend less drastic cuts in overhead. Both require the same reaction and differ in degree only. Therefore, the obvious reaction must be to reduce overhead now, directly proportional to any reduction in revenue you are, or will be, experiencing. If down 15%, cut overhead 15%.
We do know that a pause is occurring, hopefully months not years, and if too long could lead to a recession. Time will tell, but we need to react now so we are left with probabilities or, as some would say, best guess. My hope is that the current intervention will slow the spread of the virus which will be reflected in lowering the incidence curve we all see on TV. That will stimulate the stock market because the market looks to the future and never looks back. There are a lot of measures of the economy, but movement in the market is instantly available to everyone and is a primary driver of commercial and consumer activity. Experts are telling us the virus curve will come down, but that it will not be seen for weeks at a minimum. If so, it will take time for the market to react and additional time for businesses and consumers to react.
The information I am analyzing suggests that the above has a better than even chance of unfolding, but that it will be 45 to 90 days before we see a positive economic reaction. What this suggests is that a recovery from any project delays, funding issues or new capital projects released is at least two months out and very possibly three or more. Our inclination is to avoid overhead cuts as long as possible, but there are serious costs associated with that. Prudence suggests we plan for a minimum of three months, probably longer so delay is not advised. I do not take it lightly, and as difficult as it is, cutting overhead now is the only defense available under these unprecedented circumstances.
This may be an appropriate time to be reminded that the primary obligation of boards of directors, business owners and top management is to Protect the Value of the Business. This is a balance sheet issue.
Note: Additional information on how to cut overhead can be found on letstalkbusiness.net. Click on “Manual” and go to Managing Overhead in the table of contents.
Thomas C. Schleifer, Ph.D. is a “turn around” expert in rescuing companies from financial distress. With more than 45 years of contracting and consulting experience, he advises contractors on organization, structure, and strategic planning. He was Founder and President of the largest international consultancy firm serving the contract surety industry. He was a project manager and vice president of a construction company. He is author of Managing the Profitable Construction Business, Construction Contractor’s Survival Guide, and Glossary of Suretyship and Related Terms. He has a B.S. and M.S. degree in construction management (CM) from East Carolina University, and a Ph.D. also in CM from Herlot-Watt University, Scotland. He was the first Eminent Scholar of the Del E. Webb School of Construction, Arizona State University in 1993. He can be reached at firstname.lastname@example.org.