Ian Heptinstall
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Want to make 14% profit margin?  Own a construction company

It is common knowledge that construction is not a very profitable industry to be in.  But is this actually the case?  I’m not so sure…

Last year I analysed the financial accounts of 13 British, Australian and New Zealand construction companies, with an average revenue of nearly £4 billion/year.  One in four made more than 20% profit, and they averaged 13.9%, even though one of the 13 reported significant losses.  If we ignore the loss-maker, the others 12 averaged over 17%.

12 of them are involved in general construction, with one who works mainly in oil and gas.  And no, don’t check your diary, it isn’t the 1st of April.  Nor did we have to search very far to find this data.

So how can this be, because ‘everyone knows’ that contractors make hardly any profit, have to survive on wafer thin margins, and where 5% profit is seen as an aggressive stretch target?

Return-on-Sales = vanity

The frequently mentioned wafer-thin profit margin of the industry is return on sales (ROS) – profit divided by turnover.  And our 13 companies averaged 3.3% on this measure, supporting the general idea that the industry makes very little money.

However, the use of ROS is extremely misleading, when you are considering profitability.  The implication is that companies have the right to keep a certain percentage of everything that goes through the tills.  Whilst in some business sectors there may be some logic to this, I don’t see why construction companies should do so.  The turnover of contractors is basically the cost of the project being built.  Why is it felt that if the building happens to have expensive finishes and components, that the company building it should make more profit on that job?  The contractor’s overheads don’t change just because you specify stainless steel pipe rather than carbon steel, or you lay a carpet costing $100/m2 compared to one costing $10/m2.

Business investors know that a better measure of a business performance is what return is made compared to the money invested and ‘tied-up’ in running the company.  And construction companies do not usually have to invest much money to start up the business and to keep it running.

Return on Equity = Sanity

On this basis our 13 companies averaged 13.9% profit , measured as return on equity (ROE) – profit divided by the shareholders equity on the balance sheet.  Equity is basically the money the shareholders put into the company, plus the cumulative retained profits.  It is also called the ‘net worth’, what would be left over if the company was liquidated.

So not such a bad business after all – tie up $1 million and make $139,000 profit a year.  Better than keeping it in a savings account.  The fact that your client gives you $10  million of their money to spend is irrelevant.

Website Investopedia, in an article called “ROA And ROE Give Clear Picture Of Corporate Health“, suggested professional investors would see 15% ROE and 5% ROA as a reasonable return.  Our construction industry sample of 12 companies – if you exclude loss-making Balfour Beatty – was slightly better than these benchmarks over the two years studied.

Another profitability ratio to check out is return on capital employed (ROCE), which adds debt to the shareholders’ funds used in calculating ROE.  Investopedia suggests this should be at least 2x the cost of borrowing, which for our sample it was – with an average ROCE of 11%.

But what is your “Best Asset”?

We also looked at another measure, one that is not well known, but that we think is a much better indicator of the value-added by construction companies than ROS, ROE or ROCE.

Its relevance can be seen if you think about what it is clients are really buying from the major contractors.  Most of a contractor’s turnover passes straight through their bank account, being spent with suppliers and subcontractors.  In our surveyed companies we estimate that about 85% of the revenue is spent with the supply chain.  This spend is almost coincidental to what the contractor does, and on many projects the contractor doesn’t even influence what is specified and bought, this being the domain of the client and their design consultant.  If the designer chooses an HVAC system that has a high capital cost but very low operating costs, in order to reduce life-cycle costs, or minimise a building’s carbon footprint, why should the contractor make a higher return – especially if it costs no more to install?

What you really buy from a contractor is the ability of the people who work there.  Their ability to design, manage, and install projects.  Whilst some contractors will have a distinctive technology or supply chain, in general, all other aspects of the project are the same.  They buy from the same suppliers and subcontractors as each other.

Their “assets”, in the non-accounting sense, are their staff.  “Our people are our biggest asset” might be a cliché, but what happens if you turn the cliché into hard numbers?  This is what we did with the construction companies that we analysed.

When I compared their profitability with the amount of money they spent on employees each year, this showed that on average they made a return on “investment in employees” (ROIE) of 13.9%. Again not a bad return on this financial commitment.

So here’s how our 12 contractors looked on the three different profitability measures

ROIE – Return on Investment on Employees

ROIE also makes a great management accounting measure to support decision making.  What holds back many construction organisations is not capital, or even sales, it is the people they have who can deliver.  Their strategic constraint is in their people, and taking too much work is one of the largest strategic risks in a service organisation.  Yes some resources can be bought in on a project-by-project basis at relatively low risk, but not all.  The project and contract managers play a key role, as do engineers and supervisors whose capability is known and trusted, and the senior managers who oversee projects and approve key stages.  If they are overloaded, or supplemented by people you have never worked with before, risk increases.

And in construction, it only takes one or two projects to go wrong, out of the hundreds that are completed each year, and the company’s profit becomes a substantial loss.  In a complete business improvement programme, we would be more precise about which resources we used in this analysis, but all employees is a good enough basis for a high-level overview.

Return on Investment in Employees (ROIE) is not a new idea.  In 1990 my friend Robert Bolton did a project on this with Land Rover as part of his MBA, where Return-on-Human-Resources was used to help the business choose between different internal projects.  He demonstrated that the most profitable projects were not what everyone thought they were.  Robert built on Bleake’s work published in the McKinsey Quarterly of Spring 1989, and on Goldratt’s measure of T/CU (Gross Margin per unit of business constraint), both of which support better day-day managerial decisions than ROS or ROCE.

 

ROIE is not the only way in which the distortions inherent in ROS can be overcome, but it is an easy way to make a start.

If you are a contractor, do you use this measure, and if not why not?

If you are a client, you now know what to do when a contractor says that they are not making enough money to take your project – make sure they are talking about ROIE rather than ROS!

 

Summary of the data I used:

About the Author Ian

Ian is a consultant who helps clients to improve the performance of their capital projects and programmes. Before becoming an independent consultant, his experience included 15 years working as a project manager on capex projects, 10 years in procurement, including being chief procurement officer for a large construction company, and 10 years management consulting with niche consultancies in supply chain and procurement.

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