Construction Insolvencies are no Mystery 7

Wednesday, February 26th, 2014
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Last month, Federal Small Business Commissioner Mark Brennan released a report prepared for the Federal Small Business minister [the Hon Bruce Billson MP] that reviewed the circumstances surrounding the collapse of Urban Contractors, a Canberra based landscaping and earthworks firm which went into administration last October, leaving around 180 subcontractors out of pocket following a dispute with head contractor Lend Lease regarding the new ASIC building in Canberra on which it held the Major Works subcontract.

This is the latest in a flurry of government interest in construction related insolvency at both state and federal levels. For some years, ASIC has been releasing reports on the sector’s growing prevalence in insolvency statistics. In NSW, the government commissioned the Collins Inquiry into the same issue. In some states, Small Business Commissioners have witnessed dramatic increases in calls from contractors seeking help with issues surrounding non-payment.

These inquiries and reports all try to get to the bottom of what is causing this great problem. From where I sit, however, it is actually quite straightforward. Rather than any single event or mistake, insolvencies are merely the end point in a series of events. Here is a view of component parts that lead to insolvency from the unfortunate view of one who sees them up close.

  1. It all starts at the top when the head contractor bidding for the work feels compelled to offer the lowest price possible. The price has nothing to do with the actual cost of completing the work. It is already a loss. The contractor is desperate to get the work in order to pay off the losses from the last job. At this point, the project is already headed for disaster. But the head contractor will pass on all the possible risks associated with additional costs to its subcontractors and recover any loss through back charges; that will also mean keeping the retentions.
  2. The head contractor then seeks tenders from a host of subcontractors who do exactly the same thing: under-price the work just to provide them with cash flow. This leaves no margin for error. One thing goes wrong and the subcontractor will sustain a big loss.
  3. The head contractor then awards tenders to its subcontractors by hitting them up to drop the price even more. In desperation, they agree. The subcontractors are now exposed to a far greater loss than the head contractor. They figure they can make up some cash flow on the inevitable variations.
  4. The subcontractors have not read the contract properly and so do not realise the level of risk the contract is demanding of them. They also do not follow the procedures related to approval for variations, extensions of time and liquidated damages. All these will kill any profit they may still have.
  5. Neither the head contractor nor their subcontractors have properly specified the work and discover that there is a whopping chunk of work not allowed for in the price. A war of liability ensues over who bears the unexpected cost.
  6. The head contractor sees the coming losses and so passes on the costs to the subcontractors via back charges. The subcontractors who are already on a loss maker, lose even more. Often, the monthly payment from the head contractor does not even account for half their costs.
  7. The head contractor starts to feel the pain of being held to a contract price that did not cover the cost of the project, and so finds itself battling both the client and its subcontractors over cash flow and payments. The head contractor’s client is demanding more work than was in its scope and is not getting an approved variation for it. The head contractor will direct the subcontractors to do the work without any agreement from the client to pay for it.
  8. Disputes arise from the unpaid variations. The head contractor cannot pay for it because it needs the money for other projects, and so argues for more back charges.
  9. The subcontractors are now almost without cash flow at all. Some find their contract requires them to carry the risk of latent conditions that result in extra costs; others discover their scope was worded in such a way as to include a lot of work they did not budget for.
  10. Subcontractors start to go under. The work slows. The client starts to hit the head contractor up for Liquidated Damages and withholds that amount from its payments. The head contractor has now transitioned from taking on a loss-making project to being insolvent. As it withholds payments on its subcontractors even longer, some go under, until the head contractor goes under.

This may be a compartmentalised view, but most insolvencies feature a number of the aspects outline above. The overarching dynamic here is straightforward: pressure to win contracts leads to under-pricing of work. Most contractors allow only a five per cent gross profit margin on their work. That is too low and unsustainable. From there, pressure builds on all parties to seek back-charges, pull money out to cover past losses and argue variations wherever possible.

Understanding the causes of insolvency is much like what we learned in second grade maths.

You can’t construct a $3 million building for $2 million.

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  1. Gordon Taylor

    A good narrative of how trouble is passed along in the industry. The driver behind it all is that the industry is inherently cyclical and contractors make the error at times of believing that survival equals having to take advantage of someone else at the bottom of the cycle. This is shortsighted and creates more financial pain over a longer period of time. The alternative is to take the pain in the short term and reduce the size of the business, which is usually less overall pain. In my view the government should take the money they would spend on the enquiry and invest in infrastructure!

  2. Robert Kaplan

    Thank you Mr Anthony Igra. A very good article. I am feeling a lot of frustration of what is going on in the market place. I am a residential builder in Brisbane and specialise in renovating existing buildings. I have been involved in this industry for over two decades and have seen a lot of changes as fas as regulatory, customer and building practices.
    As a builder I pride myself on my work and people who know me or have used my services see that they get value for money and sometimes more then they hoped or paid for. I treat my clients' houses as if they were my own and if I wouldn't be happy with that why should they, so my standards are high.
    Recently I had been asked by the beauru of statistics to fill out a form a four page questioner in relation to a building project i was undertaking. It was pretty personal. It had the clients name address, contract date, amount on the contract. The work that was to be performed and the size of it. The information which as required was" if there was any variation in the contract price or was the client/owner physically going to make improvements themselves as far as plastering painting and the value"etc. Then had to submit this by the due date or get a penalty of $170.00 per day. If you ask me what I think about this, the building industry has a lot of soul searching to do as well as the government. The government has shifted a lot of liability on the small builders. These include responsibility for others actions (work place health and safety) environment , Taxation who is a contractor or an employee and the list goes on. There are too many conditions imposed for someone just trying to make a honest living. My business at the moment is experiencing a lot of financial pain. People are just getting prices and sitting on their hands. My main customers are down sizing so the work has slowed. I now need to carter more for two different customers. Generation X and Y. Generation X does their homework, know what they want but spend the money when they have it or a capable to service. They are very particular with the building products and the cosmetics of the works.
    Generation Y looks for price and as long as it looks 100% it doesn't have to be approach. They want everything yesterday and its good if you can add a bit more in for the same price.
    The last two months I have been quoting a lot with not much success. I am being undercut sometimes by a few thousand. Recently my engineer said to me while we were outside the clients house "Robert do you know what your problem is? you do five star work but the market at the moment only wants to pay for three star. Don't buy the best material, or put so much of yourself into the job for quality." My response to that was "I will advertise that I only do five star work and if you want any less don't bother calling me".
    I think the plumbing trade is smart, plumbers are united. Their prices are set and they don't cut each others throats. The most under looked and underpaid trade in the building game is carpentry which is the back bone the main element holding the structure for other trades to be able to come in and do their work. This trade is happy to undercut and do work for silly prices. Now builders have a six and a half year liability with work. Plumbers don't. Plumbers actually are under the builders umbrella but are paid more then the builder/carpenters.

    So to sum everything up, I think homeowners who want to build should look for small builders who give them realistic prices not the cheapest and for builders who do one job at a time and not juggle others as well.
    This will ensure that the money set aside for the house works is allocated for that and not other jobs. The attention to detail and time on site will also be beneficial to the homeowner. Builders will be forced to give a more realistic quote as they will need to allocate more time for the client.

    I hope I have showed a different dimension to what is going on.

  3. Tony

    Anthony, I couldn't agree more. Having been involved in a number of recent projects with head contractors and felt the pain – it's dead right! One of the things that really annoys me is having to sign Statutory Declarations imposed by head contractors just to get payment. You put your signature to a piece of paper saying you have paid all your own contractors and suppliers. I guarantee we're not the only ones lying signing it but you can't help it – you have to sign it in the hope you might get paid within a month after your invoice is due and keep calling the creditors to let them know you are still in business! We have moved our focus away from builders because with the situation the way it is, it just doe not pay!

  4. John Stevenson

    Excellent article, very informative and 'spot on' Anthony.
    Thank you.

  5. Darryn Millard

    Anthony, it feels like you were writing the
    My story, that is exactly what happened to me & my company of 10years.
    I find your advise & expertise invaluable
    & be forever grateful.
    I have started again & all my clients have
    Come back & now i know what not to do.
    Painfull experiences can be a great teacher
    For all other contractors out there
    Be proud to deliver your service at the best price & dont fall victum to the thort of
    having a major profile job & drop the price.
    Be proud to protect yourself from dishonest building contractors.

  6. Brett Bates

    An interesting analysis with many generic descriptors – most being accurate to some degree – of the performance of a typical building construction project. The problem being that the Lend Lease project for a federal government building was used. Here's the facts with Australia's tier 1 builder. They don't need to 'win' projects by engineering a low tender bid. In most cases they invited or at least are select tenders. Secondly. When the government is the client the project budget and the administration of the contract are focused on one thing. That 'thing' is that there will be No messy disputes because A: the government would probably lose and B: the project must be viewed as being successfully delivered. LL don't hire dummies. The government and its myriad agencies abound with them. There are probably other reasons the subbie went broke in this instance. It isn't in the interests of the builder to send their subcontractors broke. Any builder who sets out with this as a primary business objective will eventually fail themselves.

  7. Richard Hooker

    The Federal & State governments are the main reason the backbone of the construction industry 'trade subcontractors' lose out & suffer financial hardship.
    There is one common theme when head contractors go broke, they always owe the tax man big dollars, & they have not met their statutory tax obligations for many months & sometimes years, yet the governments remain silent.
    My solution is simple, anybody should be able to log on to the ATO/OSR portal & enter the ABN of the head contractor, & the ATO/OSR should advise either yes or no if the head contractor & ALL of their associated companies tax affairs are up to date, especially PAYG & Payroll Tax. Then the subbie can make an informed decision as to the risk of signing a contract or even continuing with further work. Imagine how quickly the ATO/OSR would collect the tax owed, because the head contractor would need to keep their tax affairs up to date. Clients could then feel comfortable signing up a head contractor & most importantly subbies will feel confident the head contractor is financially stable. Ultimately head contractors will less likely buy a job, knowing they can't use the tax component as their buffer.