Why ‘dysfunctional’ contracting model is pushing Australian companies to brink

Image: p a w e l via AdobeStock - stock.adobe.com

A group representing construction contractors in Australia has called for fundamental changes to the business model in the sector, amid razor-thin profit margins and elevated rates of business failures.

In a new report entitled No Risk, No Reward, the Australian Constructors Association (ACA) has warned that building companies are entering administration at more than twice the rate of other industries.

Meanwhile, average profit margins have fallen from 3% to 1% and liquidity has dropped from 15% to 5%.

More than half of all large builders in the country are carrying current liabilities in excess of current assets, according credit rating agency Equifax. That suggests that those businesses are technically insolvent.

The ACA has put the blame for the situation at the door of fixed price contracts. “This model does not work well for transactions with high uncertainty – say, a building project,” the report said.

“It fails because the fixed price contract transfers all the uncertainty in cost and design onto the seller. When those risks are realised, they are funded out of profits.”

Australian contractors’ concerns around the fixed-price contracting model echo those among their counterparts in other international markets.

In June, Construction Europe reported on how fixed-price arrangements appeared to be falling out of fashion amid a decreasing appetite for risk on the part of contractors. Risk, already difficult to predict, has become even more so since events like the Covid-19 pandemic and the Ukraine war.

“The model of total risk transfer has produced a deeply unstable industry – systemically weak financials, a myopic focus on the short-term and an adversarial culture. A lawyer’s playground,” the report said.

“Builders are in constant survival mode, struggling to eke out a margin. Clients are in a constant battle to maintain feasibilities in the face of recurring disputes and variations. In the worst case, the builder collapses and the client is forced to retender and incomplete project, wiping out its profits.”

Alongside the burden of “unquantifiable risk”, contractors face being “locked-in” to contracts because it so costly to exit a transaction once a contract is signed.

Three principles for success

Labelling the current situation a “bad outcome for everyone”, the ACA advocated a change to the business model in construction and a move to adopting construction contracts that proved to be a “win-win” for all parties.

It set out three ‘principles for success’. They are:

1) Early contractor involvement: The report advocated involving contractors from the outset, regardless of the contract form. That would allow for the fullest assessment of a project’s risk file and the most accurate cost estimate, the report said. Contractors would also then be able to provide constructability and value engineering input to consultants and clients.

2) No formal cost at the start: The report discouraged clients from asking contractors to provide a guaranteed fixed price at the outset, instead recommending that they commission them on a fee-for-service basis to develop the design with a consultant. This would allow contractors to quantify as much risk as possible, it argued.

3) Incentivise collaborative out-performance: The report recommended using the design and planning phase to develop a ‘target cost’ as the design matures. That paves the way for a contract to implement a ‘painshare/gainshare’ regime where any difference between the target cost and the actual cost is shared among parties working on the contract, with the aim of enhancing collaboration.

Recommendations for contract models

The ACA said that such principles were already “becoming routine” on civil infrastructure projects both overseas and in Australia.

It also acknowledged that some forward-thinking vertical building clients including the New South Wales Department of Health and the Department of Defence were starting to adopt “more mature” procurement practices.

And it particularly recommended two forms of procurement:

1) Two-stage competitive early contractor involvement (ECI) framework: A model which sees the builder contracted to participate in the planning and design phase separately to the delivery contract. Once the design is settled and an accurate price determined, a separate contract for delivery can be let to the same or different contractor. The ACA said: “[Two-stage ECI] has been repeatedly shown to outperform traditional fixed-price delivery models by facilitating a high level of interaction and collaboration between contractor and client.

2) The ‘managing contractor’ model: Under this model a contractor is competitively selected to collaboratively manage the full lifecycle of the project with the client. The contractor usually only charges management and advisory fees and subcontracts design and construction functions to third parties.

ACA CEO Jon Davies said, “No contract can account for all the unexpected events that will complicate a building project as it unfolds, but it can incorporate mechanisms to encourage the client and contractor to resolve them fairly and reasonably.”

“Changing current practices will create the conditions for improved productivity and a healthier industry.”