New Zealand’s construction industry has suffered high rates of business failure and liquidation recently, with businesses of all sizes, operating across all sectors of the industry, being affected over the last few years.
People looking to build can be excused for proceeding with caution – the prospect of building in today’s climate can be daunting. However, understanding and recognizing the factors behind these business failures and taking proactive steps to work with a stable construction business can help you protect your investment and have a smooth construction experience.
In this article, we’ll explore why there are such high failure rates in construction businesses, especially in the current financial climate, and what to look out for to ensure your next building project does not fall victim to one of them.
Why do construction businesses fail?
Underpricing and cost blowouts due to small project margins
The cheapest quote isn’t always the one you should go ahead with. The industry is notorious for its low profit margins. This lack of financial flexibility, combined with often tight project timelines, puts an enormous strain on companies, making them extremely vulnerable to unforeseen project issues. Contractors often come unstuck when they can’t accurately price risk or incorporate a sufficient, sustainable profit margin into their projects. In extreme cases, they might submit very low bids intended to secure the work, but then try to increase margins to acceptable levels through variations or by pressuring subcontractors, which can compromise quality.
When a project runs over budget, the financial strain can quickly become unmanageable. This can lead to delays, disputes, and companies going out of business. Contractors who underprice projects often hope to make up for the low bid through variations and additional work, but this strategy is fraught with risk and increasingly untenable in a competitive market.
Warranty claims
If a construction company is not diligent in its work, defects and faults can arise after the project is completed. Addressing these issues can be costly and time-consuming, eating into the company's profits and cash reserves. Issues always come up from time to time, so you want a company that is in it for the long term. If not priced properly, there will be less goodwill to come back and fix what they are legally obliged to. Choosing a company committed to long-term relationships ensures they will address any warranty claims with care and responsibility.
Impact of inflation, market fluctuations, and fixed price contracts
The construction sector is highly susceptible to inflation and market fluctuations. During periods of high inflation, the cost of raw materials and labor can increase dramatically, but these costs cannot be passed on to the client if the contract is fixed. This mismatch can quickly erode profit margins.
Fixed price contracts are a double-edged sword. They provide you as the client with certainty but place contractors at significant risk. However, risk for them can mean risk for you. Fixed price contracts mean that while the cost of labor and materials continues to rise during a construction boom, the agreed-upon price remains the same. This creates a significant financial burden on contractors, who bear the brunt of it. This tension can lead to disputes, project delays, and financial losses for construction companies.
In the current inflationary environment, you should be aware that a 'fixed price' doesn't mean there isn't conditions in the small print that allow for extra costs to be passed on. There can be significant clauses added around what are provisional sums, price escalations, or exclusions, there may still be cost blowouts and opportunities for variations to be charged. Both parties need to understand what the risks are and what the contractor is doing to try and mitigate them. Because it’s tricky to predict how much a build will cost, these contracts can put your entire project budget at risk.
Growing too quickly
It’s important to be cautious of construction companies that are growing too quickly. Rapid growth can be as dangerous as stagnation. When a business takes on more projects than it can handle, it becomes overextended, increasing the risk of going under. Problems often arise when a company tries to grow too fast without having the necessary resources, manpower, and ability to manage that growth. Expanding into new geographic areas or taking on larger projects without proper planning can lead to logistical challenges, quality issues, and financial strain. A company that grows incrementally and methodically is more likely to have tested and proven processes in place, ensuring a more sustainable approach to business expansion.
What should you look out for before employing a construction company?
To safeguard your building project, you need to be vigilant and proactive. Here are six things you can do before signing on the dotted line with a construction company for your next project.
Do your due diligence
Look into the company’s past customer feedback to gauge their reliability and quality of work. Investigating their relationships with suppliers and subcontractors can provide insights into their operational stability and reliability. Researching the company’s history and the profiles of its directors can help you understand their track record. Look for any patterns of financial instability or legal disputes, as these can be red flags.
Considerations on liquidity issues and cash flow management
Understanding the company's financial health is critical. Investigate their liquidity and cash flow management practices. Large deposits upfront and unrealistic timeframes can be a red flag. It's important to understand the payment terms and that payments are staged to tie in with project milestones. This will ensure the contractor remains financially stable and incentivised to complete the work on time. You could also ask subcontractors and other suppliers if they’re paid on time by this business. Delayed payments can indicate cash flow problems and can lead to delays in your project as well.
Significance of having in-house teams vs. reliance on subcontractors
Companies with in-house teams offer greater control over quality and timelines. This can mean more predictable costs and outcomes, as the company directly manages its workforce. You can benefit from a streamlined communication process, reducing the chances of delays. In-house teams are particularly beneficial for projects requiring consistent quality and specialised skills. There can be the efficiencies of repetition where in-house staff are very efficient and skilled in particular fields.
Companies with more done in house – or vertically integrated, can often bring cost efficiencies as there is less ‘margin on margin’. But there is an overhead competent to manage this inhouse works
Firms that rely heavily on subcontractors may be able to offer more competitive pricing due to lower overhead costs. However, this can introduce variability in work quality and potential coordination challenges. Heavy reliance on subcontractors can result in less accountability and higher risks of project delays. The financial risk here lies in the potential for unforeseen expenses if subcontractors do not meet the project standards or timelines. Generally, if a company has some core competencies in-house which allow them to bring value, they may bring in contractors for specialized areas or more local contractors.
Evaluating their capacity
Research and careful planning are crucial when entering new markets or types of construction to ensure the company is not overextending itself. Rapid company growth can sometimes indicate that processes have not been tested and proven. Carefully evaluate a company’s capacity before committing to a project. Look for signs that they are expanding methodically and have the necessary infrastructure in place to support their growth. Incremental growth, rather than a sudden leap from small projects to multimillion-dollar ventures, shows a more sustainable approach.
Review contracts thoroughly
Contracts are the backbone of any construction project. Ensure that they are clear, comprehensive, and legally binding. Seek legal advice to review contracts to ensure your interests are protected. Clear contractual terms help prevent misunderstandings and disputes during the project, providing a safeguard against potential conflicts. Understand how contracts can be administered. Have someone on your side who understands construction on bigger projects to ensure your interests are protected and to help navigate any complexities.
Industry context and financial stability
Consider the broader industry context and the company's financial stability. Mispricing and inadequate contingency planning can lead to significant challenges. Be cautious of so called ‘fully fixed price' contracts, especially during market downturns and inflationary periods. Look for a company or contract structure that shows where the budget risks lie, and how these will be mitigated as early as possible in the project – rather than just being a variation at the end. Come to an agreement with the contractor so that they are not passing all the risk of blowouts onto you – but are also not overextending and putting themselves at risk.
By understanding these factors and taking proactive steps to assess and select your construction company, you can significantly reduce the risks associated with your building project. Careful planning, thorough research, and a cautious approach can help ensure a successful and smooth construction experience.
