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The art of bouncing back - resilient contracting in difficult markets

Published: 28 Sep 2015 Average Rating: 5 / 5 Print
 
This article appeared in Contracting Excellence magazine on 28 Sep 2015 view edition
 

Author: By Joanne Simpson, Director of Corvative Pty Ltd., Perth, Western Australia

If you think your business cannot survive tough times, author Joanne Simpson has a different view. She explains the risks and challenges then unpacks a new toolbox containing things you need to do differently to thrive even when unexpected events occur. Her experience and research proves that resilient contracting is easier than you might think.

Volatility is tough during times of economic decline. Not every business providing contracting services will survive it, and some will fail catastrophically.1 But some, paradoxically, will thrive. What makes some contractors resilient and others fail?

Faced with deep cuts in revenue, resource companies seek to cut their operating costs. For organizations that depend on that business, this means both reduced volumes and pressure to cut rates.

A volatile environment will challenge even the most resilient firm. And few industries have experienced the same pressures that the resources industry has been facing recently. Commodity prices have fallen dramatically in the last two years and are not expected to recover in the short term.

The purpose of this article is to argue that resilience is the “X-factor” that makes survivors different.2 But the rules for resilience are not that complex. Applying the rules makes it more likely a contractor will both survive and thrive.

The dark side is fragility

Resilience is an organizational characteristic. We can define organizational resilience as the ability to respond to both expected and unexpected threats, to perform reliably in the face of volatility, to adapt and take advantage of extreme unforeseen circumstances. The dark side of resilience is fragility. Fragility is a consequence of over-reliance on, or over-adaptation to, a limited set of environmental conditions (e.g. a sustained period of high commodity prices).2

A principal trying to decide which contractors will be around for the long-term, and a contractor trying to be that long-term provider, can both benefit from thinking about resilience and fragility, the two opposing sides of the survival coin.

Contractors put themselves at risk

Research shows that external economic conditions are not usually the main reason for contractor failure.3 Rarely will one factor alone make a contractor fragile. Contractors make themselves fragile when their willingness to take risks is greater than their ability to predict and understand them or their capacity to absorb the consequences if market conditions change. Contractors can also put themselves at risk if their patterns of thinking, organizational structures and attitudes to uncertainty are too rigid to enable them to react quickly to a changing environment.4

The risk-seeking behavior of some contractors is much like that of a gambler who continues to place risky bets without the spare cash to cover them. Or a homebuyer who borrows to the limit of his debt-servicing capacity when interest rates are low, trusting that rates will not go up, or that personal circumstances will not change.

A delicate balancing act

Patterns of fragility and resilience can emerge in any part of a contractor's business. A contractor's organizational capacity in terms of which services, people and equipment the firm can supply at a given moment, is a major factor in determining which markets it can enter and which clients it can service. One would imagine that the more resources a contractor can muster, the more capable the firm will become to win work. A contractor faces a delicate balancing act between having access to resources and paying for resources that are unproductive. Having too many people, too much capital equipment, and too many fixed costs means that the contractor will be carrying too much overhead in a falling market. But not having the capacity available means a contractor will not be able to respond to short-term opportunities. And in a rising market, a contractor may have to pay a premium to access resources on a short-term basis.

Trading flexibility for certainty?

Contractors tend to adopt a mixed model where some people and equipment are part of the firm's permanent resource, but others are leased or hired in on short notice as required. The contractor trades flexibility for certainty, exchanging the risk of exposure to demand volatility for an exposure to supply volatility.

But although outsourcing a big part of its workforce makes the contractor less exposed to shifts in demand, outsourcing can also weaken the firm's adaptive capacity and make it fragile. Investment in staff, their engagement, involvement and empowerment, and the institutionalization of their knowledge are all factors contributing to adaptive capacity and thus resilience.5

Contractors can balance their risk by entering into employment arrangements with long-term personnel that keep them on retainer, allow them to work on a part-time basis or take extended leave when work is limited, but include a commitment for them to be available if work returns. Alternatively, they can enter into long-term agreements with contingent workforce and equipment providers, who then take on the risk of supplying a variable demand in return for a fee. The contractor is able to transfer the demand risk but will then generally retain most of the quality risk.

Spotting early warning signs vital

If a contractor's control systems are not responsive, problems and crises will not be visible until a contractor is deep into them. One factor in resilience is the capacity of a contractor's systems to amplify “weak signals” -- the subtle indicators of impending disruption. For instance, if your long-term client stops returning phone calls you may have an emerging problem.

Contractors need to have enough commercial buffers to cope with frequent changes and failures. They need to understand their risk appetite and their capacity to accept risk. They need to have a deep understanding of their capacity to rebound in the face of repeated shocks and losses, and to consider these questions:

  • Can they survive winning only one in ten bids?
  • Can they ride out a year of no revenue?
  • If they lose their profit entirely on half the jobs they take, can they still give their shareholders an adequate return?
  • Would they have to go into debt to maintain their dividend policy?
  • How far can they pursue a dispute or a claim before they have to give up?

Spread the risk

Resilient contractors are conservative about their working capital needs. The tendency of many firms in a rising market is to either return funds to shareholders or spend spare cash on growth and acquisition. In a volatile market, the resilient contractor will retain above-average returns, rather than paying them out. Then, in a falling market, the contractor has ample cash reserves to cover its overhead and take advantage of discounted acquisition opportunities.

Resilient contractors maintain some diversity in their activities, so that one single outlier event does not prevent them from doing any income-producing work.6 They also seek to spread their client base by both industry and geography, so that a downturn in one industry or region does not necessarily affect all of their clients.

Balancing the cost of bidding

Construction contracting is a highly competitive market, especially in hard economic times. The cost of bidding for work is a significant proportion of a contractor's operating costs. Anything a contractor can do to both reduce the cost of bidding and the probability of success creates a competitive advantage. A contractor needs to balance inexpensive but low-probability bidding strategies against costly but high-probability strategies. A resilient contractor will not only adapt its bidding strategies to the environment, it will consciously seek to reframe the environment to make alternative strategies viable.

Whichever strategy a contractor selects, it is still in a position of asymmetric information. The principal will always know more about the job than the contractor. The contractor's challenge is to maximize its knowledge of the job at minimum cost to investigate. How effectively the contractor can judge what the principal requires will influence how accurately they price and scope the work.

The contractor also needs to consider the terms and conditions required by the principal. Whatever indemnities, warranties and limits to liability the principal requires, the contractor has to be confident that they will be able to afford or offset the consequences if any of those indemnities or liabilities are triggered. And further, the contractor needs good intelligence on aggregate exposure across its entire portfolio, both from a likelihood and consequence perspective.

Understanding risk trade-offs

Fragile contractors either undervalue their exposure, underestimate the likelihood of a triggering event, or consciously under-insure to save cost. Resilient contractors make conscious decisions about the trade-offs between the consequences of accepting risks and the costs of offsetting.

Prior to commencing work, a resilient contractor:

  • has efficient methods for investigating and estimating site costs, including escalation;
  • can judge the quality and completeness of the information provided by the principal;
  • understands the likely risks and their likelihood of occuring;
  • has buffer in their margin for unforeseen events.

But even the most perfect pre-award preparation may not prevent failures in execution. For instance, it is not uncommon in falling markets for clients to reduce scope, defer, or even cancel projects, even well into execution. The resilient contractor will ensure that it is well-protected contractually from the costs of suspension or premature termination, and that it can promptly and cleanly unwind.

What's inside the resilient contractors' toolbox?

No one factor makes a contractor resilient. Resilience emerges when a contractor has a toolbox of strategies that enable them to respond to an extreme event or a generally hostile environment.

Resilient contractors, being qualitatively different from their peers, do the following:

  • Maintain core expertise in-house, but adopt a range of measures to manage short-term demand volatility.
  • Grow cautiously, and within their capacity to manage the most extreme failure scenarios on that growth path.
  • Eschew rapid growth in favor of trusted relationships with their clients.
  • Adopt appropriate bidding strategies for their bidding environment.
  • Concentrate on developing strategic and unique expertise in niche markets.
  • Carve out islands of stability through long-term relationships with preferred clients.
  • Operate on the lowest possible overheads and with a flexible organization structure that can grow and shrink with demand.
  • Look after their people and maintain a network of past and potential employees and affiliates.
  • Actively monitor the environment for opportunities and risks.
  • Remain well within their potential capacity to service debt.
  • Maintain excess cash reserves.
  • Protect themselves contractually from unreasonable risks and abrupt shifts in demand by their clients.

END NOTES

  1. Gary D. Holt (2013) Construction Business Failure: Conceptual Synthesis of Causal Agents, Construction Innovation, Vol. 13 Iss: 1, pp.50 – 76.
  2. Taleb, Nassim Nicholas, Anti-fragile: How to Live in a World We Don't Understand, Vol. 3. Allen Lane, 2012.
  3. Rice, Hugh and Arthur Heimbach, Why Contractors Fail: A Causal Analysis of Large Contractor Bankruptcies,FMI Quarterly, 2007 Issue 2- see more at: http://www.fmiquarterly.com/2007/04/why-contractors-fail-a-causal-analysis-of-large-contractor-bankruptcies/#sthash.KjizevWz.dpuf (free registration required).
  4. Allen, Kathleen Change Leaders: Creating Resilience in Uncertain Times (2012) 2012 Leader to Leader 13 http://doi.wiley.com/10.1002/ltl.20004
  5. Lee, Amy V, John Vargo and Erica Seville, Developing a Tool to Measure and Compare Organizations' Resilience (2013) 14 Natural hazards review 29 http://resorgs.org.nz/images/stories/pdfs/journal/developing_a_tool_to_measure.pdf
  6. Wedawatta G and B Ingirige, Coping with Extreme Weather: Strategies of Construction SMEs , International Conference on Construction in a Changing World (2014)

ABOUT THE AUTHOR

Joanne Simpson is Director of Corvative Pty Ltd, a contract and commercial services consultancy based in Perth, Western Australia. She has 20+ years of procurement, contracts and commercial experience in major studies, projects and operations in the resources industry. She holds Masters Degrees in Business Administration from the University of Western Australia and in Construction Law from the University of Melbourne in Australia.

 

 
 
 

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