Clark Ellis, Principal

Continuum Advisory Group Trade Contractor Pricing Will Rise in the Next Two
Quarters: Find Out Why and What Can Be Done
The business of construction trade contracting is unique. While it is one of the
most closely aligned businesses to macroeconomic conditions, it also features
some characteristics that are not just unique, but downright counter-intuitive…
unless you understand the industry structure in which they operate.

COUNTER-INTUITIVE FACT: TRADE CONTRACTOR MARGINS IMPROVE PRIOR TO MARKET

RECOVERY

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Electrical Paving HVAC Utilities Drywall Painting Foundations

Chart 1: Contractor Pre-Tax Return on Sales Recession Periods Are Shaded Red
Mitch Cohen Source: Risk Management Associates, Philadelphia, PA Annual Statement Studies 1985-2008
Principal, Denver
MCohen@ContinuumAG.com As Chart 1 illustrates, a broad index of trade contractor margins begins to
303.470.7886
recover slightly after recessionary periods end and on the very front end of the
construction recovery. It is also important to point out that the opposite is even
John Doherty more true: trade margins begin dropping well in advance of recessionary
Principal, Chicago
JDoherty@ContinuumAG.com periods.
312.953.6334
There are at least two relevant questions for homebuilders to ask at this point.

Clark Ellis 1. Why does this counter-intuitive fact exist?

Principal, Raleigh 2. What should I do about it now?
CEllis@ContinuumAG.com
919.345.0873
The answer to the first question can be found in the industry structure analysis
of then Harvard professor Michael Porter, “Porter’s Five Forces”1. In the
Continuum Advisory Group residential building industry, the power of suppliers (in this discussion, trade
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Cary, NC 27519
1
www.ContinuumAG.com “The Five Competitive Forces That Shape Strategy”, Michael E. Porter

3.2.2011
contractors) is constantly undermined by the exceptionally low barriers to entry
for competitors. This problem is more pronounced in some trade categories:
plumbing and electrical, for example,
require a higher degree of training
and in some cases licensing so …these new companies
therefore are a bit more protected.
However, they are also subject to the
fact that the main requirements to
typically bid low. While they
be in business as a trade contractor
are some knowledge of the particular don’t win every bid, their
trade and a minimum of tools and
equipment. low bids begin to drag
Therefore, as the market expands down pricing in the market.
and trade contractors become more
in demand, they are able to price
their services higher, just as classic macroeconomic theories of supply and
demand would suggest. However, if the market expansion continues for an
extended period of time or the market growth rate is particularly high, new
entrants (i.e. new competitors) are attracted to the market. As these participants
enter the market, they create downward pressure on pricing because they begin
bidding on the same projects that the incumbent firms were targeting. This is the
first general factor that exerts downward pressure on contractor margins.

The new competitors come from two general sources: former employees of the
incumbent firms and entrants from outside the local geographic area. Because of
their lack of experience either in running their own business or with the local
construction economy, and their need to develop revenue sources to feed their
new venture, these new companies typically bid low. While they don’t win every
bid, their low bids begin to drag down pricing in the market.

The second general factor that pulls down margins and overall profitability
measures for trade contractors comes from the cost and productivity side. As
one of the typical sources for new competitors is former employees of the
incumbent firm who decide to go out on their own, this causes a shortage of
intelligent – typically managerial or at least supervisory – labor. Any trade
contractor who has been successful will tell you that the most basic unit of
capacity for a profitable contractor is either the project manager or
superintendent. Lacking enough competent, productive and trustworthy
managers and supervisors, the labor productivity of the incumbent’s business
starts to slip, further exacerbating the margin fade.
In addition to the managerial and supervisory gap, an overall skilled and
unskilled labor gap will appear in the market during particularly rapid and/or
long periods of market expansion. These two talent gaps continue to increase
the contractor’s costs. Labor productivity slips as the market wage increases, call
backs increase as quality suffers and construction defect risk increases. So at the
top of the market, or frequently while the market is still expanding, the
established incumbent trade contracting firms begin to experience significant
margin and accompanying profit fade.

At the bottom of the market, “Economic Darwinism” has run its course and the
majority of the new market entrants have exited the market in one way or
another. The firms who entered from different geographies refocus on their core
markets, if they are still solvent, and the local start-up firms go out of business in
large numbers and high percentages.

Therefore, even at the bottom of

a very bad market contraction, There is no better time than the
the trade contractors who have
the capital base, experience and present for builders to evaluate
management talent to survive
will begin to see fewer
and select the best trades to work
competitors bidding on the
smaller number of available
with going forward and to
projects. At the same time, the establish rules of engagement
managerial, supervisory and
general labor shortages reverse that will promote total cost
and the contractor is once again
relying on his most experienced control, on-schedule performance,
and highest quality staff to
execute work. In short, the high quality and good safety.
downward pressure on bid prices
and the upward pressure on
input costs tend to reverse, causing the trade contractor’s margins to brighten
instead of fade.

The answer to the second question, “what should I do about it now?” requires
each individual builder to examine its core philosophy on how it works with its
trades. However, our leadership team’s 50 plus years combined experience
provides some general insights that can be valuable no matter the builder’s
preferred sourcing strategy.
 Identify your best trade contractors: Have your purchasing, construction

1 and warranty teams spend two hours per week for the next month
discussing the performance characteristics of the trades in your key
areas, Structural, Mechanical/Electrical/Plumbing (MEP) and Finish, to
identify companies that would be worthy partners going forward. While it
is possible to be extremely structured and detailed in this assessment,
the key categories to evaluate should be: total cost (bid price plus
variance purchase orders plus warranty), schedule performance, safety
performance and quality.

Determine the maximum volume that each key contractor is comfortable

2 managing and establish whether they are interested in growing in the

future. This can help determine how many contractors will be needed in
each key trade to handle the unit volume as the division expands in the
future. Also, if a contractor is not willing or able to scale its business to
support the builder’s growth, the builder may have to take its business
elsewhere.

Establish material quantities and unit pricing for each trade – this is best

3 done by the builder or by engaging a neutral third party so that the trade
and builder have confidence in the numbers and process. This step is
critical to ongoing cost management that is driven by transparency and
objective data.

Agree upon the data source that will drive changes in unit pricing (for

4 example, the Random Lengths Database is a source for lumber unit

pricing). Moving forward, this will both limit trade cost inflation and
provide confidence from both the trade and the builder that the right
costs are in place.

Establish a forum for ongoing continuous improvement dialogue and

5 processes. Include your key trades, purchasing, construction and

warranty staff in the process. Any action items or initiatives that result
should be directly tied to impacting one or more of the key categories
from above (total cost, schedule performance, safety performance or
quality).

The underlying purpose in all of the above activities is to leverage the current
environment, where fewer but more stable trade contractors are operating in
the market. These contractors will be able to bring expertise to your projects
that can help move your performance indicators across all key categories.
Builders who identify the right trades to work with and establish the baseline
activities described above will see much less inflation in trade costs as the
market expands.

In the recovery and next expansionary period of the market, most experts agree
that house prices will not appreciate at the same rate as they did during the
2000-2006 expansion. During this time, rapidly rising house prices outpaced
significant trade cost increases, obscuring the fact that most high volume
production builders did not have the right relationships, processes or measures
necessary for basic cost management.

2
Chart 2: Projected Housing Starts Through 2013

Chart 2, which illustrates the latest forecast from John Burns Real Estate
Consulting, the premier residential real estate market analyst firm, indicates that
the recovery and expansionary period is likely to be gradual. A gradual expansion
is likely to create less opportunity for new entrants into the trade contracting
business, thereby removing one source of top-line inflation control for the
builders.

In the next two quarters, builders are likely to see trade contractor pricing
bottom out and begin to rise due to the supply factors illustrated above. There is
no better time than the present for builders to evaluate and select the best
trades to work with going forward and to establish rules of engagement that will
promote total cost control, on-schedule performance, high quality and good
safety. Builders who choose to wait or who choose to do nothing will be subject
to higher trade cost-inflation over the next several years and will be at a
competitive disadvantage vis-à-vis their competitors who proactively engage in
the process described above.

2
“US Housing Forecast: Data Cutoff Date December 1, 2010. John Burns Real Estate Consulting,
www.realestateconsulting.com.