Hugh Rice is a senior vice president for FMI Corporation, management con¬ sultants to the construction industry. He specializes in providing in-house con¬ sulting services in the areas of mergers and acquisitions, joint ventures, stock valuations, and business continuity and management succession. FMl’s offices are located in Raleigh, North Carolina; Denver, Colorado; Tampa, Florida; and Minneapolis, Minnesota. Hugh can he reached in Denver at (303) 377-4740. Earlier in this decade, FMI Corporation documented those underlying trends that would impact the direction and profitability of the construction industry during the ensuing 10 to 15 years. With the end of 1995, we offer this revised and expanded list of major issues driving the industry. Understand¬ ing and anticipating changes in the industry are the keys to long-term prof¬ itability and survival for the individual firm. Dramatic Reduction in Litigation The flow of the construction process leads to natural differences of opinion among the various building team partici¬ pants. The traditional design/bid/build delivery process accentuated these dif¬ ferences into full-fledged legal and eco¬ nomic warfare in the 1970s and 1980s. Claims, change orders, back charges, and similar evidence of disputes domi¬ nated large segments of the industry. As Partnering, a creation of the Army Corps of Engineers, has been a tremendous success. is the case with most movements within the construction industry, the owners (the customers of the contractor) decided that a change was needed. Partnering, a creation of the Army Corps of Engi¬ neers, has been a tremendous success. Disputes have been avoided, productivi¬ ty has increased, and some measure of civility is returning to the construction industry. Those who believe partnering is a fad are going to be surprised. It is here to stay and will be enhanced by combining it with Total Quality Man¬ agement (TQM) and safety precautions to create a project team committed to a smooth-running, highly productive, acci¬ dent-free workplace. Partnering events will be replaced by a continuous improvement process lasting for the life of the project. The other phenomenon that is a prod¬ uct of project disputes and will con¬ tribute to their decline is the discovery of the design/build project delivery method. By whatever definition, deliver¬ ing a constructed facility from a single source of responsibility is an idea whose time has come. The insurance and surety industries, as well as governmental bod¬ ies that purchase construction services, are behind the curve and will have to catch up. In the future we will see much less glorification of the “change order artist.” The prequalification process will, over time, eliminate from the bidding process those firms whose practice is to file claims and litigate with every owner. A business strategy that worked well until now — bid cheap and make up the dif¬ ference with claims — will increasingly be less successful. The second half of the 1990s should see a “peace dividend” accrue to the construction industry in the form of lower legal fees, more produc¬ tive projects, and less management time devoted to nonproductive activities. R&D: A Major Expenditure Research and development will become a major expenditure item in the U.S. construction industry in the 1990s and beyond. Up to this point, research and development has not been discussed very much by construction executives; most has been accomplished at the uni¬ versity and governmental levels. Very few U.S. engineering and construction companies, even the largest ones, have done significant research aimed at improving the construction process. Foreign pressure is beginning to show the U.S. construction industry that it 6 Interface must innovate and expend funds on basic research or become technological¬ ly obsolete. Depending on whose statis¬ tics you believe, Japan, for instance, expends somewhere between 4 and 40 times as much on basic research and development in the construction industry as does the U.S. Technology is coming to the construction industry — finally. Labor costs and scheduled reductions of over 50 percent are deemed possible. There is a movement in the U.S. in this direction. The formation of organiza¬ tions such as the Construction Industry Institute is aimed at fostering creativity, research, and innovation. Other organi¬ zations like the Corps of Engineers are beginning to encourage and fund research to improve the technological aspects of the construction process. Since it is the marketplace that dic¬ tates major changes within the industry, research and development will become an issue in the U.S. market only if it is viewed as a way to enhance profitabili¬ ty. This will occur as it becomes more and more obvious that the way to make significant productivity improvement is to find a better way to skin a cat. Com¬ panies that expend funds to find new methods, techniques, types of material, and equipment — as well as those firms that take advantage of the technological advancements of others — will realize the greatest profit increases. Enhanced Productivity: A Key to Success Leading from this research and development, enhanced productivity will become the key to success. Being the low-cost producer has always been the ultimate prerequisite to long- term suc¬ cess as a contractor. This is going to be even more true as the buyer’s level of sophistication increases and the contrac¬ tor’s ability to differentiate himself from competitors becomes more difficult. Productivity improvements represent the single largest opportunity for cost reduction and, therefore, enhanced com¬ petitiveness and profitability. Statistics show that, of the labor dollars expended yearly on any given construction pro¬ ject, roughly 30 percent is wasted. Fig¬ uring out ways to reduce that 30 percent by even a few percentage points can have a significant impact on a firm’s profitability. The TQM process will have its great¬ est impact when it infiltrates the individ¬ ual project level. Job-site TQM com¬ bined with partnering and an integrated safety program could make a dramatic improvement in productivity. Productivity in the U.S. construction industry declined approximately 20 per¬ cent during the past 20 years and is expected to continue that downward trend for the foreseeable future. Those companies that embrace technology and exercise innovation and creativity in project design and execution will have a significant advantage over those which continue with past practices. Training Will Accelerate The amount of money and time spent on training at all levels of the construc¬ tion industry will grow at double-digit rates for the next five to ten years. Sev¬ eral forces are converging to create this need. First, the so-called “baby bust” dur¬ ing the period of 1965 to 1976 has led to a reduction in the number of new entrants into the work force during the 1990s. Second, the construction industry has an image problem that makes it unattractive as a career choice for young newcomers. Third, the skill levels of those people who are attracted to the construction industry are below those needed to meet the minimum require¬ ments for skilled labor. Fourth, the retirement of thousands of long-time craftsmen is creating a need for 200,000 new construction workers each year. The consequence of these factors is a serious shortage of qualified construc¬ tion workers in the 1990s in many parts of the country. Several efforts are being mounted to develop and fund craft train¬ ing on a massive level. The successful firms will be those that attract the best people, train them to required skill lev¬ els, and structure pay and benefit pro¬ grams to retain them. The quality and effectiveness of a firm’s training pro¬ gram will dictate its long-term success. Labor Shortage Will Be Temporary Nature has a way of self-correcting imbalances. The same is true of the cur¬ rent skilled labor shortage. While the shortage is very real and could last for up to ten years, there are already forces in place that will mitigate the problem. First, the attention currently being focused on the issues will lead to better recruiting, image enhancement, and improved training and retention of workers. Second, capital (e.g.. equip¬ ment, technology) will be substituted for labor, leading to productivity improve¬ ments and a reduced need for personnel. Third, large-scale immigration will con¬ tinue to supply the U.S. with entry- level workers whose only option will be some type of manual labor. Fourth, the second baby boom (1977 to 1994) yielded 72 million births (versus 76 million in the original one) which will repopulate the work force after the turn of the century. Fifth, dramatic technological innovation will finally come to construction, reduc¬ ing the need for large numbers of new construction workers. Some forecasters assert that these forces could lead to large-scale structural unemployment within 20 to 30 years. Industry Consolidation to Continue Consolidation in the construction industry is an ongoing and inexorable process. Over the long term, there will be fewer and larger companies dominat¬ ing the industry. The reasons are fairly obvious. Financial strength and capacity will increasingly become a requirement for participating in large, complex pro¬ jects. Design/build and privatization projects require financial stability. Although markets are currently quite soft, the surety and banking industries are getting more sophisticated in their underwriting process and will tend to support those firms best able to meet financial obligations. Firms with access to capital are using it to acquire market share or buy other firms. The overall level of competition and sophistication in the industry contin¬ ues to improve. Those companies that are marginal in their ability to process April 1996 7 Total as a Percentage of Domestic Nonresidential Construction work and manage their business are going to be casualties. As the charts in figures 1 and 2 show, the large compa¬ nies (top-rated 80), as measured by the ENR 400 (Engineering News- Record), have steadily increased their share of the nonresidential U.S. market over the last 25 years. This will lead to a two-tiered market. At the upper end will be large, sophisticated regional or national firms that are well capitalized and well man¬ aged and that focus on projects requiring financial strength and technological sophistication. On the other end of the scale will be the small, local so-called “niche contractors” who have significant expertise in a particular area or relation¬ ships that allow them to be competitive with larger companies. This consolida¬ tion will be positive for those companies that survive. Right-Sizing: A Response to Change There are two aspects to the phenom¬ enon of downsizing, or right-sizing. First, the restructuring process going on in American industry as a whole has resulted in the outsourcing of many ser- Figure 1. ENR 400 Domestic Volume. It is now recognized that the initial cost of a project is not a true measure of the total life-cycle cost. vices, particularly engineering, construc¬ tion, and maintenance. This trend is cre¬ ating business opportunities for the astute construction firm to form strategic alliances with owners, replacing those services that were formerly done in¬ house. Second, there is a general realization that the domestic U.S. construction mar¬ ket is a mature industry. There are spe¬ cific segments of periodic growth, but overall the industry has been virtually stagnant for the past 25 years (see Fig¬ ure 3). While the market has been flat, the competition, as measured by the sheer numbers of contractors, has been increasing. This overcapacity is causing many firms to decide that “less is more.” Right- sizing is a natural response to the market situation described above. Expect to see more and more firms enhance their profitability through well executed efforts to become small. Decline of the Competitive Bid System Awarding the construction contract to the lowest responsible bidder has been the procurement method of choice in the U.S. for decades. It is a legal require¬ ment for most government contracts and is held out as the best system for maxi¬ mizing the efficient use of taxpayer dol¬ lars and for minimizing graft and cor¬ ruption in the contracting process. However, the competitive bid system is being challenged for two reasons. First, the modem tendency toward dis¬ putes and litigation is accentuated by the design/bid/build process. Second, it is now recognized that the initial cost of a project is not a true measure of the total 8 Interface ENR 400 ENR Top 80 Domestic Construction □ — life-cycle cost. The trend away from emphasis on initial cost only is illustrat¬ ed by the totally privatized road mainte¬ nance program in British Columbia as well as the recent Wisconsin Depart¬ ment of Transportation experiment to have asphalt paving contractors guaran¬ tee their work for five years. Strategic alliances are being formed among contractors and between contrac¬ tors and engineers to offer services to the owner on a negotiated and/or design/build basis instead of via the low-bid system. Enlightened owners will increasingly realize that intelligent purchasing of construction services from prequalified contractors can provide a low-cost, high-quality, faster project. The contractor who responds to that need will be rewarded with higher prof¬ its. Privatization Will Be a Reality With the ongoing pressure to reduce the cost and scope of government, the process of privatizing the funding and operation of traditionally public services is unavoidable. Much of the rest of the Figure 2. Top ENR 80 vs. Total ENR world has embraced this idea more aggressively than has the U.S. Mexico, for instance, has built over 2,000 kilo¬ meters of privately funded highways in recent years — while the U.S. can boast of only a few dozen miles. However, creative contractors, engi¬ neers, and developers recognize an opportunity to secure projects at a com¬ petitive advantage and will continue to push this concept. If the underlying demand exists for a public project, the financing can ultimately be found. The political and regulatory keys will be established to allow privatization to become a reality, although it will be a slow and painful process. Specialization Will Increase In the 1990s and beyond, specializa¬ tion in the industry will continue to grow at an ever- increasing rate. The day of being all things to all people as a contractor is over. The question is going to be “What are you good at?” A large firm may be capable in several areas, but it will have to identify those capabil¬ ities and organize the business around specialized areas. The reasons for this are very clear. First, from a marketing standpoint, it is much easier to sell services if the com¬ pany is highly focused in its mission and its skills. Second, as earlier mentioned, the opportunity to enhance productivity dramatically improves if the company provides only a few services. Doing the same thing over and over again allows one to become very proficient. This specialization will apply to large and small firms alike. Large firms will be specialized through division of func¬ tional areas. Once again, this particular trend will have the effect of enhancing the profits of those people who respond to it. Diversification: A Universal Movement While creating specialties, construc¬ tion firms must be careful to avoid over concentration within a specific market. Contractors have realized that product and service diversification is necessary to survive in a rapidly changing world. April 1996 9 Nonresidential Total Construction Companies Figure 3. Nonresidential construction. Contractors are moving into the engineering arena, while engineers are developing construction management capabilities. Contractors are moving into the engi¬ neering arena, while engineers are developing construction management capabilities. Large general contractors recognize the need to be in all three basic industry segments: industrial, commercial, and heavy civil. All types of firms are increasingly diversifying geographically. Creating multiple spe¬ cialties is a very effective means of diversification. Sales Is Everyone’s Job Contractors must realize finally that sales and marketing are the key to long¬ term success. The customer will contin¬ ue to drive the contractor’s strategy and behavior. All activities of the firm are marketing — not just those activities that have traditionally been called “mar¬ keting.” Most companies will discover what a few already know: superior cus¬ tomer service is critical to success, even for public works contractors. More con¬ struction companies will provide formal training in client relationship skills for superintendents, foremen, and craft workers. Foreign Investment to Continue The foreign investment that has been pervasive in the U.S. construction indus¬ try for the last 15 years is going to con¬ tinue. It will obviously ebb and flow as conditions in the world change and vari¬ ous markets fall in and out of favor, but the long-term trend is clearly in the direction of a global industry. Some of the key underlying forces that will cause this trend to continue include: 1) a gen¬ erally positive view of the U.S. con¬ struction economy over the next 10 to 15 years from outside our borders, 2) a Today, out of the largest 100 contracting firms in the U.S., 19 are either totally or partially foreign owned. The number in 1980 was two. need for all large international firms to have a presence in one of the largest construction markets in the world, and 3) ease of entry into the marketplace and the unrestricted flows of capital it allows. Today, out of the largest 100 con¬ tracting firms in the U.S., 19 are either totally or partially foreign owned. The number in 1980 was two. This phenom¬ enon is not just related to the contractor market; the construction materials mar¬ ket has been significantly consolidated via foreign investment. Approximately 10 Interface 70 percent of the U.S. cement capacity is currently owned by non-U. S. inter¬ ests. The aggregate/ready-mix/asphalt markets have large foreign players con¬ tinuously making offers and purchasing U.S. companies. The effect of all this is once again positive. These companies are generally well capitalized, they are in business to make a profit, and they will enhance the competitiveness and long-term profitability of the industry. Employee Ownership Will Spread Another movement in the industry that should proliferate over the next 10 to 15 years is employee ownership. The advantages are numerous but much maligned. It is a well recognized fact that increased motivation among employees comes from having a piece of the action and the sense that they are more than just employees. Employee ownership creates an entrepreneurial atmosphere inside the company. This is crucial in terms of retaining and moti¬ vating people. Often there is an entre¬ preneur at the helm, but the people who work for him or her see themselves as hired hands. Creating the opportunity for people to be entrepreneurs within their company is very possible through ownership, proper organization, and incentives. Capital needs have also changed. The Contractors are realizing that the risk/reward relationship in this industry is totally out of kilter. days of becoming a contractor with $5,000 and a pick-up truck have long since past. Now it is $50,000 and a flatbed, or $250,000 and a fleet of trucks. The ability of one person to mar¬ shal such resources, especially buying out an existing firm, is limited. Pulling together the kind of capital needed to purchase a company of any magnitude or to get one started is going to require multiple participants. Consequently, more companies will be owned by a group of key employees than by a single person. More contractors will realize that the number of very successful employee- owned firms is no accident. Profit vs. Volume The next ten years will see a dramat¬ ic shift in focus from volume to profits. Contractors are realizing that the risk/reward relationship in this industry is totally out of kilter. For an industry with one of the highest bankruptcy rates to have one of the lowest levels of aver¬ age return on equity is inappropriate. Although there seems to be no short¬ term solution to the supply/demand imbalance, more and more firms are for¬ saking the holy grail of volume for a consistent bottom line. Although surety credit is currently in oversupply, avail¬ able bonding credit will not continue to be the measure of how large a firm should be. More firms are sizing their business based on their available organi¬ zational resources rather than solely on how big a credit line they can extract from their bank and surety. With such razor-thin profits, the margin for error in construction is very small. More con¬ tractors are going to manage their busi¬ ness for survival; when the inevitable problem comes, they will have an ade¬ quate financial base to avoid bankrupt¬ cy- In the future, many companies choos¬ ing to do less volume will, in fact, gen¬ erate more profits than their competitors who continue to press recklessly on the volume accelerator at all costs. These are some of the major trends impacting the construction industry for the rest of the decade and well into the 21st Century. Even though some of these trends and changes will create dis¬ locations, conscientious companies that anticipate the future will survive and prosper. Executive Package Advertisers RCI wishes to acknowledge and thank participants in its executive marketing package. These companies have reaffirmed their commitment to the profession of roof consulting and have made possible the monthly publication of Interface. Allied Signal, Inc. Butler Roof Systems Carlisle SynTec Systems Firestone Building Products GAF Materials Corporation Insta-Foam Products JPS Elastomerics Corp. Olympic Fasteners Roof Accessories Company, Inc. Siplast Soprema Roofing and Waterproofing U-Flow Roof Drain Systems April 1996 11
