Construction Firms Take Fixed Prices on Work They Have Not Started
A contractor bids a price for a project lasting years, then absorbs whatever the costs turn out to be. The industry combines thin margins with substantial risk transfer.
The Bid Problem
A contractor bids a price for work that may take three years, based on estimates of labour, materials, subcontractor costs, and productivity.
If costs come in above the estimate, the contractor absorbs it. If the design changes, the client is meant to pay through a variation, and whether they agree is frequently disputed.
The winning bid on a competitive tender is frequently the one that made the most optimistic assumptions. That is a selection mechanism working against the industry.
This is sometimes called the winner curse. In an auction where bidders estimate an uncertain cost, the lowest bid tends to belong to whoever underestimated most, which means winning the work and losing money on it.
Thin Margins
Net margins in construction commonly sit in the low single digits. On a large project, a modest percentage cost overrun eliminates the entire profit and can produce a substantial loss.
The industry therefore has very little tolerance for estimation error, on projects that are by nature difficult to estimate.
| Contract type | Risk to contractor |
|---|---|
| Fixed price, lump sum | Full cost overrun exposure |
| Cost plus fee | Limited |
| Guaranteed maximum price | Overruns above the cap |
| Design and build | Design risk added to cost risk |
The Working Capital Trap
Contractors typically incur costs before being paid. Work is performed, applications for payment are submitted, and payment arrives after certification, frequently with a portion retained until completion.
That retention can be held for a long period after the work is done. Meanwhile subcontractors and suppliers require payment.
The consequence is that growth consumes cash. A contractor winning more work needs more working capital to fund it, and rapid growth is a common precursor to failure in the sector for exactly this reason.
Where the Accounting Judgement Lives
Revenue on long contracts is recognised over time as work progresses, commonly measured by costs incurred as a proportion of total estimated costs.
That method depends on the estimate of total costs, which management makes. Understating expected total costs increases the percentage complete and therefore the revenue and profit recognised now.
Where a contract is expected to make a loss, the entire loss must be recognised immediately rather than spread. The timing of that recognition depends on when management concludes the loss is probable.
This is why large contractor failures are frequently preceded by a sequence of contract write downs. The problems existed for a long time and the recognition arrived late.
The Subcontractor Chain
Main contractors subcontract most of the physical work, which distributes both capability and risk down a chain.
Payment flows down the same chain, so a delay at the top propagates. Subcontractor insolvency then propagates back up, since the main contractor must find a replacement mid project at short notice and at whatever price is available.
The fragility of the chain is a structural feature and it is why contractor failures cause disproportionate disruption.
What Distinguishes the Survivors
Selectivity in bidding, meaning a willingness to lose tenders rather than win bad ones. Preference for contract structures that share risk. Strong claims and variations management, since recovering legitimate additional costs is a core competency. And a balance sheet capable of absorbing one bad project.
Growth in revenue is not a positive indicator in this sector on its own. It frequently means the company is winning work others declined.
The Bottom Line
Construction takes fixed prices on multi year work with thin margins and pays costs before receiving payment, so growth consumes cash and estimation error destroys profit. Revenue recognition depends on management estimates of total cost, which is why failures follow a pattern of late write downs. Winning more work is as often a warning as a success.