New analysis from the Australian Constructors Association (ACA) shows that building firms are entering administration at more than twice the rate of other industries. In the year to March 2023, builders failed at a rate of 619 per 100,000 firms. The rate for the rest of economy was 270.
This reflects some deeply troubling financial conditions in the construction industry. Data from credit rating agency Equifax shows building sector profit margins have fallen from around 3 per cent to below 1 per cent. Liquidity has collapsed from 15 per cent to below 5 per cent. Most concerningly, over half of all large builders are now carrying current liabilities in excess of current assets—a technical definition of insolvency.
How did one of Australia’s most important industries become so dysfunctional?
It is not enough to point to the competitiveness of the market. Many industries are fiercely competitive, yet margins are often healthy and insolvencies contained. Professional services firms, for example, such as engineers, enjoy pre-tax profit margins four times as high as builders, while suffering one-fifth the rate of insolvencies.
Something else is going on.
I put it to you that the construction industry underperforms because it is a textbook example of market failure.
Nobel prizes have been won for describing the conditions of efficient markets. The basic lesson is simple: markets work well when the buyer knows exactly what they want, and the seller knows exactly how much it costs to produce.
Whatever market that describes, it is not construction.
Here’s the problem. The accepted practice in any commercial transaction is to specify everything that needs to be done as much as possible upfront, and then put a hard price on it. It’s called a fixed price contract and it works well when you’re buying a fleet of cars, an office lease or IT equipment.
When applied to products with highly uncertain costs—say, a building—the model fails. It fails because it transfers all that uncertainty onto the seller. In construction, this amounts to an inordinate burden of risk around ground conditions, design details, weather, and third-party interfaces. When those risks are realised, they are funded out of profits.
Extrapolate that pattern of total risk transfer across time and you get a deeply unstable industry characterised by systemically weak financials, a myopic short term focus, litigiousness and adversarial ‘sharp practices.’ Welcome to construction – the lawyer’s playground.
At this point you might be asking, why do builders continue to accept these terms?
The answer is because building is normally a buyer’s market. In a buyer’s market, suppliers feel compelled to accept the terms because they need the revenues – they need to ‘feed the beast.’ As one seasoned builder put it to me recently: “There’s always somebody stupid enough to do something desperate, or desperate enough to do something stupid.”
Every so often, however, building becomes a seller’s market. That is the world we are in right now. Under these conditions, contractors have the market power to manage their own exposure by simply refusing to participate in a fixed price regime. Clients find themselves struggling to secure a builder for even the most feasible and well-financed projects. As one developer asked me recently, “where have all the builders gone?”.
They haven’t gone anywhere. They’re just waiting for a more attractive risk proposition. Here’s what that looks like.
First, involve the contractor in the design process at the earliest opportunity. This provides for the fullest assessment of the project’s risk profile and, by extension, the most accurate cost estimate. It also allows the contractor to provide constructability and value engineering input to improve the efficiency of your product.
Second, do not set a formal cost at the start. Instead, commission contractors on a fee-for-service basis to jointly develop the design with the consultant. This allows the contractor to quantify as much risk as possible and develop a genuine fixed price for the project. A separate delivery contract can then be let on more conventional terms.
Third, consider taking it one step further and incentivising collaborative outperformance. Contract the builder and consultant to work jointly with the client to develop the design and set a target cost. Then implement a ‘painshare/gainshare’ regime whereby any difference between the target and actual cost is shared among the parties.
We can leave it to the lawyers to fill in the details. These are the fundamental ingredients of a mature and effective building contract that promotes win-win outcomes. Most importantly of all, it will get your project built.