Why is the industry making such a meal of its bread and butter?

Amid profit warnings and problem ‘legacy’ projects, contractors such as Balfour Beatty are struggling to turn profit predictions into cash. Elaine Knutt speaks to accountants and industry experts to ask why experienced firms are getting it wrong.

Realising a profit on a construction contract isn’t easy, of course. But for today’s highly-evolved contractors, it’s hardly an unrealistic goal either. In 2014, they’re benefitting from several decades of introspective reports and improvement agendas; collaboration, risk-management and supply chain management should by now be fully inscribed in their DNA; and Enterprise Resource Planning software – or even BIM – ought to be giving them all-round visibility of the financial picture at any time.

But an epidemic of problems in predicting profits is exactly what we’re seeing in the industry today, with Balfour Beatty’s embarrassing sequence of five profit warnings the most public symptom of a malaise affecting several Tier 1 contractors. Morgan Sindall is the latest to issue a profit warning after a string of problem projects, ISG and Sir Robert McAlpine have recently reported losses on their construction operations, and Royal BAM Group acknowledged that a UK civils job had contributed to its losses. In May, Willmott Dixon also said that profit before tax was down 20% in 2013 due to completed projects “that did not deliver the margins we had expected”.

The difficulties in delivering contractors’ core skill set have possibly contributed to a wave of senior personnel changes. For instance, Vinci Construction acquired a new chief executive but lost three members of the old guard, and Sir Robert McAlpine suddenly lost one of its main board directors. 

Meanwhile, a recent KPMG study of contractors’ financial health provides the background context: net cash balances are close to half of 2010 levels, and net operating margins have fallen from 2.8% in 2010 to an average of just 1.2%.

It will all be some comfort to Balfour Beatty, as it prepares to regroup under the leadership of incoming chief executive Leo Quinn. But its recent performance is still troubling: with the most recent £75m profit warning, it conceded a £30m profit overstatement from 25 “legacy” M&E projects run by Balfour Beatty Engineering Services; £20m from major London projects, £15m from under-performing business units in the south west and Wales, and £10m gone astray from a “handful” of projects in the major infrastructure business.

In the transcript of a grilling from City analysts, Balfour Beatty directors acknowledged that projects and delivery units already identified in previous profit warnings accounted for around £50m of the £75m shortfall, suggesting that their problems had worsened over the summer, while new problems not previously on the radar contributed £25m. Another detail that emerged was that the “vast majority” of the adjustments were under £3m, suggesting a high number of repeated errors, rather than a small number of major calamities.

Asked to explain the reasons behind the write-downs, Nick Pollard, chief executive of Construction Services UK, said: “They relate to operational issues in the field, a shortage of key resources or that under tender, a proposition that was originally conceived was ill-balanced or ill-judged in some way and is therefore at the end of those projects has given us problems.” However, for the full story, Balfour Beatty, its investors and the wider industry will have to wait until KPMG concludes a full review of Construction Services UK contracts. 

Of course, there are no prizes for identifying a key underlying dimension: the fact that the industry has turned the corner from recession only to collide head-first with rising labour, material and subcontractor costs. And while Balfour Beatty and others are today probably only taking on work on negotiated two-stage tenders, they still have “legacy” projects under construction that were bid as single stage design and build – with all the attendant design and cost risks.

As contracts and management consultant Trevor Drury, of Morecraft Drury, says: “It’s difficult to be specific on what has gone wrong. It’s probably a whole host of problems. But the underlying reason is the effects of the economic upturn in projects that were bid during the recession. Eventually it will work its way through but until then lots of contractors could find they have problems.” Certainly, Balfour Beatty argues that it’s in a short-term squeeze that should ease when the problem contracts reach handover – in the majority of cases, that’s in 2014.

But Balfour Beatty has also hit problems delivering a £45m Welsh PFI student accommodation project that was negotiated in early 2013. At that time, there was still uncertainty about the recovery, but input prices were already on the rise, and the Construction Products Association and RICS were both forecasting a rise in output. So if it’s not all about “legacy” contracts, what other factors could have led Balfour Beatty to misjudge operational matters and the resulting profits? And what are the lessons for other contractors?

CM has sought opinions from accountants and business advisers, insiders from major contractors and the sub-contractor community. And the picture they paint is of major contractors struggling to manage the ever-changing dynamics of the construction sector, where a paper profit at tender stage can have disappeared by the time sub-contract procurement is completed, or a design issue at the start can wipe it out your margin. But this is the industry’s bread and butter – shouldn’t we be doing it better?

Multiple management tiers

Ask contracts consultant Jason Farnell of CR Management why Balfour Beatty and others are struggling, and he points to contractors’ multiple tiers of management, and individuals’ difficulties in distinguishing what really matters from the daily round of fire-fighting. “You get layers of management with no clear idea of what the job involves, or how they’re supposed to police the Cost Value Reconciliations (CVRs) produced by site surveyors. People are paralysed by the reporting, but not doing anything about the integrity of the reports,” he says. “I personally came out of contracting because I was producing more and more reports, and not doing anything to change the next cycle of reports.”

Likewise, contracts consultant Trevor Drury believes the monthly or quarterly CVRs are often being produced with less skill nowadays, with an over-reliance on software and lack of experienced nous. “When I used to be a contracts surveyor, I used to spend a week a month on the CVR to advise the board on where the liabilities lay. You’re always trying to work through the fact to get to the fiction. There’s the risk of just trusting the spreadsheets – you’re trying to identify the rogue numbers, what doesn’t look right. But as soon as it’s in a spreadsheet it has credibility,” he says. 

Farnell also believes that Balfour Beatty and other contractors often need to work harder at enforcing common systems of governance and control. “On profit-taking guidelines, most companies have their internal processes and governance systems, but there’s often a gap between that and site reporting practices. The people on site do what they always have done, they operate the systems of the contractor they started with – it’s a training issue.”

For Balfour Beatty, whose regional construction business is actually a complex blend of relatively recent acquisitions, that’s a key issue. It acquired Bristol-based Cowlin in 2007, Dean & Dyball in 2008, and Birse in 2006, as well as parts of Rok in 2010. As Farnell suggests, look below the surface at Balfour Beatty, and you might find some managers are still adhering to Birse procedures on valuations, perhaps a Cowlin heritage on withholding notices or Rok’s attitude to contingencies.  

Accountants specialising in the sector acknowledge that many contractors struggle with accurate profit taking. “It’s probably the biggest issue for us in any construction audit. Clearly, there’s an element of crystal ball gazing. A project might run for three years but you need to assess the final outcome in year one,” says Andy Monteith, head of construction at Baker Tilly. On Balfour Beatty, he also points to possible failures of project governance: “Was there management override of any controls? That’s a risk in any business where judgements are required. ”

Or could inadequate early-warning systems on design risk be part of contractors’ current problems? John Munro, an experienced design manager who has worked at Tier 1 contractors including Balfour Beatty, ISG, and William Verry, argues that most majors are still structured around the two poles of “operations” and “commercial” and their parallel reporting lines. That division, he argues, creates a corresponding stress on programme and budget in the monthly management reports – to the detriment of design issues.

Then there is the industry’s issues with supply chain management and payment. Rob Simmons, director of Dorset-based Tier 2-3 contractor FenSec, points to the main contractors’ payment problems in managing cash flow as a source of knock-on site issues. He says he is still asked to accept work on 60 or 120 day terms – suspecting that the Tier 1 is actually negotiating 30 or 60 days with their client, then awarding themselves the margin. “There is a shortage of cash everywhere, and now it’s percolating down to the main contractors. But the contractors that do manage to enforce those [longer] terms will find that the subcontractor might then struggle to pay for supplies and staff.”

There is nothing really new or shocking here, just as there is unlikely to be any major shocks in KPMG’s review. Instead, the profit-taking problems at Balfour Beatty, and beyond, go to the challenge of an ever-shifting economic landscape; of implementing control procedures consistently and effectively; and last – but not least – running site operations efficiently.

It’s tempting to conclude that construction is inherently so complex that such problems are just a fact of life. But instead, let’s give the last word to someone who has a fresh perspective on the industry after a 30-year break, and whose job it will be to cut through that complexity to restore profitability. As incoming chief executive Leo Quinn said in his letter to 40,000 Balfour Beatty staff: “Our business is not complicated. It starts with the customer: nothing happens without an order. We bid work, build work and bill work. What could be more straightforward?”