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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.