Making a Profit in Construction

Making a Profit in Construction

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South Africa is readying itself for an infrastructure development boom. On 24 October 2012 the Business Day newspaper reported that at an infrastructure investment conference in Johannesburg, President Zuma had announced that the government was drafting legislation to enable infrastructure development, as well as trying to find funding methods for 18 strategic infrastructure projects.

These projects are estimated to be worth R4 trillion over 15 years.

The huge prospects for companies at all levels of the construction industry that this represents are clear. But whenever huge opportunities like these present themselves to business, they bring with them several dangers.

There are some common mistakes to be avoided by small construction firms when pursuing big projects.

Single project focus

Firstly, many small construction companies spend all their time and energy on bidding for and servicing large projects. This is understandable – on paper the figures attached to these projects look extremely tempting.

However, this single focus leads companies to becoming simply project-based operations, making them highly susceptible to a feast-or-famine situation. When their single big project is finished, many such companies do not have a pool of smaller projects that will sustain them until the next big opportunity arrives.

 

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The single project focus must be avoided by dedicating time to look for new opportunities continually, even when at work on a large project.

Lack of diversity in offerings

A report published in August 2011 by two members of the University of Cape Town’s Department of Construction Economics and Management, Dr Abimbola Windapo and Prof Keith Cattell, indicates that “the ability of a company to grow, improve turnover and gain greater market share is linked to its ability to diversify its services and products.”

Most of the successful companies that were surveyed were “active in at least three types of product/service markets – most commonly in civil engineering contracting, general building contracting, property development and housing development.”

In other words, to ensure the sustainability of their operation, a construction firm should focus not only on having a number of projects at hand, but also on diversifying the range of products and services they offer.

Unclear profitability

Often the profits attached to these projects are not as high as the contractors expected them to be. This is due to a number of factors, chief among which is a lack of experience and understanding in project costing. This leads to the expected profits gradually being eaten away by unplanned-for expenses. The net effect is that profits on big projects are often nominal, if not ultimately negative.

The lower than expected profits are a major cause for concern in the industry. A 2011 report on financial support options published by the Construction Industry Development Board (cidb) states that, between 2007 and 2009, the reason that more than 1 400 construction enterprises failed is “the current lack of profitability in contracting: a measurement of profitability established within the industry has indicated a continual decrease in this regard over the long term.”

Overextending working capital

This is a catch-22 situation that many construction companies find themselves in when they are handling projects. To increase their turnover and improve their cidb ratings, thereby making themselves eligible to bid for even larger projects, these companies overextend themselves in the projects that they take on.

Having taken on projects too big for their own resources to cope with, they find themselves both without the working capital they need to continue with the project, as well as continually having to subcontract various aspects of their projects to other companies – which reduces profits even further.

The lack of working capital and access to finance is a major constraint on contractors at all levels of the industry. In their report, Windapo and Cattell found that the leaders of the successful firms interviewed were unanimous in “acknowledging that the specific strategy responsible for their company’s development, growth and success, was their decision to develop a strong financial base for the company.”

Developing a strong financial base – which is often described as a company having cash reserves of between one and a half and two times its monthly turnover – is not an easy feat, particularly given the low profit margins in the industry. It is made even more of a challenge in the South African context by the extreme delays in payment that are often encountered when projects are undertaken for public sector clients.

Financing mechanisms

To build a strong construction sector, the development of financing mechanisms that take into account the specific needs of upwardly migrating contractors must be promoted. In its 2011 report on financial modelling options, the cidb found that there are “limited options available from banks or other lending institutions to cover [contractors’] large working capital requirements, especially in the absence of sufficient collateral.

The various banks in South Africa have developed and implemented a project finance model but it has not been implemented successfully.”

An aspect of financing that may assist lenders to overcome their reluctance, and which is described as “not fully understood, recognised and exploited” and “a missed opportunity for many companies” in the same cidb publication, is enterprise development.

Enterprise development in the construction sector

Enterprise development programmes offer an opportunity for emerging black-owned construction firms to build their capacity, which will enable them to bid for larger projects, as well as improve their profitability.

The cidb report on financial modelling options lists several benefits of enterprise development programmes for emerging black-owned firms, including recognition by both banks and large construction companies for sub-contracting purposes.

Furthermore, enterprise development is a focused intervention designed to grow emerging businesses with measurable results, which encourages large corporations to support these programmes for the various rating credits they can obtain.

Case study

The impact that an appropriate enterprise development programme can have on an emerging construction firm is dramatic. Among several construction firms in Raizcorp’s ARIZE comprehensive enterprise development programme is Turnkey Group, owned by Khomotso Choma.

Prior to the recession, Ms Choma built Turnkey Group into a recognised name in construction, with a turnover of about R21 million. But then the recession hit. The company struggled to get paid for the work they had done, their suppliers were demanding payment and threatening legal action and a severe cash-flow crisis was looming. Turnover spiralled down to R7 million and the company faced a bleak future.

At that juncture, Ms Choma applied to join the ARIZE comprehensive enterprise development programme run at the BECSA Business Support Centre in eMalahleni. The learning and guidance provided by the programme enabled Turnkey Group rapidly to implement the processes and structures required to turn the company around.

Moreover, the company was able to create a strong platform for future growth in terms of capacity for new work and job creation.

Within a year of Turnkey Group being accepted into the programme, the company’s turnover grew by 114% and they won the Govan Mbeki Housing Award for the Best Informal Settlement Project of the Year 2012.

Conclusion

The cidb’s Business Conditions Survey for the third quarter of 2012 reflects none of the optimism that one would expect in light of the President’s announcement at the infrastructure investment conference. It states that; “Respondents are generally pessimistic about current and expected business conditions, building activity and employment levels are low and profitability is under pressure.” The reason generally given is “inadequate access to credit.”

The imminent infrastructure boom and the opening that this presents for contractors to diversify their offerings, as well as the possibility of using enterprise development programmes to increase capacity and develop business skills, present great opportunity for contractors to lay firm foundations for their companies’ future growth with an entrepreneurial approach.

Allon Raiz
Allon Raiz is the CEO of Raizcorp, the only privately-owned small business ‘prosperator’ in Allon Raiz is the CEO of Raizcorp. In 2008, Raiz was selected as a Young Global Leader by the World Economic Forum, and in 2011 he was appointed for the first time as a member of the Global Agenda Council on Fostering Entrepreneurship. Following a series of entrepreneurship master classes delivered at Oxford University in April 2014, Raiz has been recognised as the Entrepreneur-in-Residence at the University of Oxford’s Saïd Business School. Follow Allon on Twitter.