Why contractors can't help suicidal bidding when the workload turns down

The most concerning issue now facing construction as it dives deeper into recession is that of firms taking on work at less than cost.

This is not sustainable business behaviour.

More than falling workloads, falling prices defined the chaos that ravaged the industry during the recession of the 1990s.

Worryingly, there are the first signs that sub-economic bidding may define the shape of the recession ahead and in the previous blog I looked at some numbers that show the impact on cash coming into the industry of falling prices.

But if the business behaviour of bidding below cost is so destructive it rather begs one big question:

Can main contractors, as the primary "work brokers" for the industry, break free from the spiral of downward pricing that leads to suicidal bidding either within their own ranks or within the ranks of the numerous firms within the supply chain?

The answer I suspect is no.

Firstly it is worth noting that it is natural, and in most cases proper, for prices to fall when demand falls. But there is a point at which price falls cease to be a healthy mechanism for weeding out weak firms and where panic takes hold and good and bad firms alike are crushed in the stampede to win work.

The notion that price wars are always good for consumers and clients is rather naive. Few can argue that the mess left of construction after the recessionary effects of the early 1990s was in the interests of the nation, the clients or the construction firms themselves.

Those who might praise the workings of the unfettered free market would have to answer the question of why it was that both the Conservative Party through engaging Sir Michael Latham and the Labour Party though Sir John Egan found it necessary to examine in detail the contractual workings of the construction industry.

Both saw great merit in a more cooperative approach to constructing. Partnering became the buzzword. But the sceptics, I was not one, argued it would not survive a recession.

I remain convinced that much of the good work which permeated the industry will survive. But on the main case made by the sceptics, that contractors and indeed clients would return to type and turn aggressively on their supply chains in a crisis, I find myself increasingly prepared to accept I was wrong.

So why can't contractors refrain from the habit of suicidal bidding?

Below are some thoughts

But before bowling into the debate there are a few qualifications I think are necessary.

Firstly, I admit freely that these thoughts are a hotchpotch and far from a comprehensive sweep of the factors influencing contractor behaviour in regard to pricing in a shrinking market. And secondly, I am sure my academic friends will not hesitate to chide me for the cavalier introduction of theory in which I am rather ill schooled. But journalists are gunslingers not marksmen. The allusion to theory is there to spark thought rather than to suggest rigour in the argument.

For all that, hopefully there is sufficient in the broad argument that contractors cannot but fall into a painful price war that leads to suicidal bidding when downturn strikes given the current industry and regulatory structures.

Anyway, to the thoughts:

On the face of it contractors face the "Prisoner's dilemma", the classic game theory problem.

In expressing the dilemma facing UK contractors in terms of the game we get something like:

Contractors cannot discuss prices, but they know if they all take a "cooperative" stance and refuse to bid below cost then the industry remains competitive, but without being suicidal. If workloads are shrinking it probably means they each share the pain of reduced turnover, but at least the work they do win remains profitable or at cost. Their vanity may be damaged, but their sanity remains intact.

But if some break rank, those that hold firm win no work and go out of business.

So, as the theory suggests, they go for the option where they can best control the level of risk and which offers the least-worst option. This means they all take to bidding below cost.

This creates a downward spiral where the exit point is collapse of firms who can no longer sustain the cost, whether they are the best firms to be doing the work or not.

Life of course is not that simple, but the problem illustrates the inevitable outcome of the contractor's dilemma.

There is of course other theory that may help us to gain an insight into the systemic failings that lead to "suicidal bidding". Let's look at the issue of moral hazard, the notion that people behave differently if they are exposed to risk.

What struck me when I looked at the graph below (which appeared also in the previous blog) was how much more elastic prices appeared to be in response to changes in demand in the 1990s recession compared with earlier recessions.

Here we have to be a bit careful because the graph only considers new work as I have excluded repair maintenance and improvement work, which in the worst period of the 1990s recession appears to have taken a big beating.

We are at the mercy of the data, their quality and the adjustments and assumptions made by statisticians, but the data do suggest that prices for RMI work are significantly less elastic than those in new work.

There seems little doubt that there is some "leakage" between the two sectors of construction that in the 1990s would have expressed itself as downward pressure on prices in the new work sector - certainly with the materials and labour supply being largely common to both.

But for now let's put that nicety to one side.

What on the face of it seems pertinent to me is that in the years ahead of the 1990s recession, the structure of the industry changed. Subcontracting increased, which helped to "derisk" the process for main contractors.

It is hard not to suspect that this fragmentation of the industry allowed main contractors, as the primary negotiators on the price paid by client and ultimately the price for the job and hence the cash into the industry as a whole, to take on work at lower and lower prices in the knowledge that "the squeeze" could be passed down the line.

In a more vertically integrated process, where the contractor directly employs more of the workforce and undertakes directly more of the work, there is less scope for passing these cuts in costs down the line and far more of the risk on costs would lie with the contractor. This would, one might reasonably assume, make main contractors more reticent to take risks in pricing.

The notion of moral hazard would certainly seem to support this view, given it seems reasonable to assume contractors did feel more insulated from the full force of the risk taken when bidding for work.

A third factor that should be considered is the problem which jargon might describe as an "organisational disconnect" between those that bid for work and those that deliver it. This "disconnect" may be physical or over time.

Those bidding for work are incentivised to win work. When the market gets tougher they will be inclined to move out of their comfort zone or face the wrath of their bosses. They duly deliver contract awards, but they are inherently laden with greater risk.

Those who have to deliver the work are obliged to deliver it at a profit, even if it is profit is not inherent within the contract as originally drawn up, at least not if you factor in sensible contingencies for risks. But the poor chaps (hard and brutal though some may be) managing the project cannot with impunity complain to their masters that "it won't work".

Their career progress relies on them delivering profit come hell or high water, and the former is too often the result.

The squeeze is put on the suppliers. The "fat" in the project is stripped out. The result all too often is that the project becomes inherently more risky, with levels of site supervision reduced and corners cut.

Here I think it worth putting in a quote I have lifted from a 2003 document written by Steven McCabe of the University of Central England. It is a quote he dates to the early 1990s made by a site manager.

"Everyone says we are an industry in crisis. The thing is, I've worked in this business for twenty years and it's never been any different. Sure, we have difficulties from time-to-time. But my view is that with a good bunch of lads [he was referring to subcontractors who, he explained, tended to work together on a regular basis] you can sort most things out. What annoys me, though, are the 'suits' from head office who tell you to cut costs by screwing the very people who produce the goods."

Organisational disconnects can also happen over time, with people moving on. Projects after all can take a couple of more years to deliver and the effects of a "cock up" can take even longer to unwind, by which time the person who put together the bid may well have found work elsewhere.

Indeed managers, even senior managers, may become complicit in this process. They will know that the full consequences of a bad bid today may take many years to come to light and perhaps may never do so, given a fair breeze, a change in the economy or a takeover.

There are echoes here, perhaps, of the debate on the effects of the bonus structure operating in the financial services sector.

I recall an interview with Rick Willmott of Willmott Dixon where he addressed this very point. He argued that one of the benefits of reduced staff turnover was that people were more likely to live with the risks they took and so they were inclined to be more considered in taking them.

But the critical point here is that those taking risk and those living with the consequences are seldom the same. This comes back to the moral hazard argument. It would suggest that the system as structured becomes more risky when under strain.

I have heard it said that growth is built into the DNA of contractors. This is not unreasonable.

Pure contracting is cash generative and can be run on negative capital employed. I hear finance directors reaching for their phones here ready to tell me I am talking rubbish. But the aggregated figures for contracting businesses do tend to support the view. A quick totting up of the trade debtors and trade creditors within the contracting industry, which I do from time to time, provides a clue as to who is holding on to cash. The answer which normally comes from this exercise is larger contractors.

The more work you win, the more you grow, the more cash you generate. It's appealing, particularly when cash is said to be king.

For those that are publicly listed, there may be further incentive to win work at all cost in a bid to meet the expectations of shareholders and the City. The City is blamed (rightly or wrongly) for creating short-termism, demanding results today. This does suggest, if the charge is valid, that it will be tougher for quoted firms to resist the urge to take on cut-price work. After all the potential losses inherent in today's order books will not be realised for a few years hence.

But for contractors to be able to squeeze the supply chain they need to be confident that the supply chain can be squeezed. Broadly speaking the supply chain splits into materials suppliers and subcontractors/specialists.

The specialists and subcontractors are subject to most of the forces above. They do however have a big disadvantage in that they have less opportunity to squeeze beneath them. And they are probably more aware of the risks, being in the main smaller organisations with, in theory, fewer "disconnects" between the bidding process and the delivery.

This group is populated by many smaller firms who are less savvy and less well resourced, so are prone to find themselves in deep water and panicking more easily than others. This leads to some very poor long-term decision making as bosses - many with their entire personal wealth on the line - take desperate risks in a bid to survive.

It would be wrong to ignore also the reduction in the price paid for construction work in the 1990s that derived from non-payment of what was fairly owed to subcontractors and suppliers. Inevitably it is extremely tricky to assess how much non-payment contributed to the overall reduction in output costs per unit of output volume, perhaps very little, but it will have been a factor.

From my experience as a journalist covering the "subbie-bashing" beat in the early 1990s, it appeared commonplace for contractors to "renegotiate" price post completion or in some cases to give the subcontractor the "F.O. and sue us then" valediction. Not the industry's finest hour.

The situation with materials suppliers is more interesting. Here the notions of marginal pricing play a role. Materials suppliers are significantly more capital intensive than others in the construction sector. This means that the marginal cost of servicing a contract falls far short of the full cost, which would include servicing the capital invested.

Under stress materials prices can fall rapidly to the marginal cost of production. So contractors are able to squeeze costs here fairly readily, below the costs prevailing in a normal market.

But this is not sustainable. It could be argued that the industry is merely deferring inflation. The bigger concern is the long-term damage to the capital infrastructure and the preparedness of business to invest in the sector.

Considering all the above it seems to me that when volumes drop sharply chasing prices down is the natural response for the clients, the main contractors and the specialists, sub-contractors and suppliers within the industry. There are few if any breaks to control this process.

And increasingly it would seem that the partnering and framework arrangements that were designed to offer some safeguard against the negative excesses and unwanted side effects of free-for-all competition are being abandoned.

If we are seeing the collapse of the structures built over the past 15 years to discourage the worst excesses of contractual misbehaviour within construction, surely it behoves those with a long-term interest in the industry to look for mechanisms that will avoid an ugly repeat of the early 1990s.