Importance of Construction Industry

The construction industry is one of the biggest industries in the world. The contribution of this industry towards the global GDP revolves around one-tenth of the total amount. It is also a potential employment generator and provides work to almost 7% of the total employed workforce in the whole world (Watch, 2010). et al. (2010) states that the construction industry is one of the most dynamic moderators of the overall economy in a country (Isik et al., 2010). The extent of this industry has become so vast that the energy, in the form of electricity or fuel, consumed by it hovers around two-fifth of the total energy consumed all over the globe. The resources that are utilised in the construction sector are also staggeringly high and itself consumes 50% of the total world resources. The construction industry has become a basis for judging the performance of the economic condition of a country (Raman et al., 2008). The construction industry plays an important role in enhancing the economic performance and the national welfare of a country by transforming various resources to construct economic and social facilities (Bashir, 2000). It contributes an average of 5%–9% of the gross domestic product (GDP) of developing countries (Abu Bakar, 2002).

According to Edmonds (1979), planners and politicians look to the construction industry to provide the basis for sustained economic growth. Between 50 and 60 percent of most countries’ capital formation is in construction: houses, hospitals, schools, power stations, roads, railways, dams, ports and so on. After agriculture, construction is the largest economic sector in developing countries (Edmonds, 1979). In terms of globalisation, Raftery et al. (1998) review recent developments in the construction industry in several Asian countries and identify three trends:

a)     Larger private sector participation in infrastructure projects

b)     Increasing vertical integration in the packaging of construction projects

c)     Increased foreign participation in domestic construction

They attribute these trends to:

“the globalisation and deregulation of markets necessitated by fiscal technological and managerial constraints.” (Raftery et al., 1998:729)

According to Ofori (2000), these trends have helped polarise the financial and technical superiority of the developed countries and the corresponding inferiority of the developing countries and, in the long term, this gap could be filled through technology transfer. The construction industries of the developing countries will have to bring technology, finance and management knowhow. A possible approach is through joint ventures with developed countries’ construction companies (Ofori, 2000).

Business Failures

However, in terms of business survival, the construction industry has constantly experienced a relatively high proportion of business failure compared to other industries (Yin, 2006), which is around 12% (Ab Halim et al., 2011). Another study by Strischek and Mclntyre (2008) also highlighted a huge number of business failures in the U.S. construction industry. The number of contractors for the period of 2004-2006 dropped from 850,029 in 2004 to only 649,602 in 2006, which is a decrease of almost 24 percent. These numbers cover various types of construction works including buildings (non-single-family), heavy/highways, industrial buildings/warehouses, hotels/motels and multifamily home construction, and specialty trade contractors. Construction companies have a higher failure rate than other types of companies (Ab Halim et al., 2010). As mentioned by Langford et al. (1993) and Edum-Fotwee et al. (1996), the state of the British construction industry is not much different from that of the U.S. The failure rate in the British construction industry shows it always experienced a relatively high proportion compared with the rest of the British economy.

According to the Surety Information Office (SIO), construction is a huge enterprise, and even capable and well-established contractors can ultimately fail. According to data by SIO, out of the 1,155,245 contractors operating in 2006 in the U.S., only 919,848 were still in business in 2008 a 20.37% failure rate. Despite a rigorous prequalification process and best judgment about the qualifications of the contractor, sometimes the contractor’s default is unavoidable. However, when a contractor fails on a bonded project, it is the surety company that remedies the default (Surety-Information-Office, 2010).

As the financial markets experienced a meltdown in the fall of 2008, the average stock price dropped by about 50%, which wiped out trillions of dollars of savings. Housing construction virtually ceased, and home prices plunged by about 20% nationwide and by as much as 50% in some parts of the country, wiping out trillions more of savings. Millions of homeowners found that their mortgages exceeded the value of their homes, and defaults and foreclosures followed. This led to huge losses by banks and other lenders, which in turn led to bankruptcies, restructuring, and massive layoffs (Brigham and Houston, 2009).

Challenges and Remedies

In other industries, strategy has become a central theme in strategic management literature (Milosevic and Srivannaboon, 2006). Unfortunately in construction, it has shown indications of slow adaptability to change (Yee and Cheah, 2006). The study of more than 500 US construction firms showed that the industry is struggling with the need to move from a project-based behaviour toward a behaviour that emphasises the customer and the firm as the key (Chinowsky, 2001). This struggle caused over 10,000 failures a year in the US construction industry. As acknowledged, these failures are generally caused by internal and external strategic factors (Alaghbari et al., 2007, Wang et al., 2004, Arditi et al., 2000) and their implication of business perceptions which affected their strategic behaviours and strategic performances (Dincer et al., 2006, Dansoh, 2005, Arditi and Kale, 2002, Arditi and Gunhan, 2005, Cheah and Garvin, 2004, Price, 2003, Price and Newson, 2003, Seadan et al., 2003, Cano and Cruz, 2002, Chinowsky and Meredith, 2000, Chinowsky and Byrd, 2001, Huemer and Ostergren, 2000, Kuprenas et al., 2000, Ngowi and Rwelamila, 1999, Venegas and Alarcon, 1997, Warszawski, 1996, Paek and Kim, 1993, Prince, 1992, Betts et al., 1991, Betts and Ofori, 1992, Winch, 1989). Beaver et al. (2005), extending the original 1966 work of Beaver (1966) identify cash flow ratios as the best classifier between failing and surviving companies. This view is supported by Fadel (1977), and Peterson (2005) who demonstrate cash flow ratios’ ability to predict future returns.

The findings of Yin (2006) strongly support the previous findings of Hwee et al. (2002) regarding the crucial role of cash flow management in the construction industry. Cash flow is the most important factor influencing profitability when a construction project is in progress. For many years, the construction industry has considerably suffered a higher bankruptcy rate than other industries. One of the major causes of bankruptcy is inadequate cash resources. The penalties for failure to deliver are quite harsh, and the way contracts are written is very much on the client’s side (Broomhall, 2010a). According to Ab Halim et al. (2011), financial problems faced by the contractors are also caused by the low profit margin from the project. Through the open tender system, contractors always have to produce quality work at the cheapest price.

According to Broomhall (2010b), in order to achieve competitive advantage you need to go to survey the market, invite bids from different contractors and suppliers, and you need to negotiate with developers at the stage of tender or before tender. Definitely companies need to be on the ground and registered there, rather than bidding from satellite offices. Apart from this, there are challenges that arise from tough contract conditions as well. Contractors and consultants highlight not only that bond and penalty requirements are demanding, but that more often than not, they will be in the client’s favour. The other difficulty encountered by some contractors in Middle East to date, has been a problem with payments. Evidently, contractors are not the only ones to encounter difficulties. Developers too, have their own set of problems (Broomhall, 2010b). To profit financially, contractors must now press Clients to show more flexibility in its contracting model and share more of the risk of fluctuating prices between clients and contractors (Andrew, 2009).

‘The biggest risks of working in Middle East appear to be commercial in nature. Many clients prefer performance bonds that are difficult to obtain after the financial crisis’, said Kohn Pedersen Fox (KPF)'s principal Anthony Mosellie (Broomhall, 2010a). Another study by Enshassi et al. (2006) shows that dependency on bank loans and payment of high interest (i.e. cost of capital) is one of the main factor behind the failure of contracting firms. As suggested by Edum-Fotwe (1996), construction firms must undertake regular performance evaluation to ensure the adoption of timely and appropriate strategies to sustain their businesses. Kangari (1992) suggests that understanding the causes and symptoms of business failure would help identify early warnings of an impending financial crisis. Cannon et al. (1991) emphasise that the financial aspect, particularly the financial ratio, often presents a signal to a company’s business (Edum-Fotwe et al., 1996).

Analysing the financial information can help provide answers to justify the financial health of companies. Furthermore, the study of Peterson (2005) suggests the use of industry average and range as a comparative point for ratio analysis to obtain an accurate picture of a company’s financial health. Subsequently, he employs seventeen financial ratios to evaluate financial performance for construction companies.

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