Why are contractors in the construction industry vulnerable to insolvencies?

The latest monthly figures from The Insolvency Service show that construction firms accounted for 17% of all insolvencies in September 2023 with 332 construction companies becoming insolvent. BCIS addresses the question ‘Why are contractors in the construction industry vulnerable to insolvencies?’.

In the year to September 2023, the total number of construction firms becoming insolvent was 4,287. This was an increase of 8.3% on the 3,958 insolvencies recorded in the year to September 2022, and a 33.2% increase on the 3,218 in 2019. And it’s not just the smaller contractors. With Buckingham Group, citing ‘extreme inflation’ for its closure – and more recently, Westridge Construction, it appears that firms with a turnover of £700m and £64m, respectively, aren’t immune either.

Historically, construction has often been vulnerable to insolvencies. But what’s behind the steep increases in insolvencies in most recent years?

Extreme inflation

From the pandemic and subsequent lockdowns to the war in Ukraine, a series of unforeseen events have seen inflation rocket to extremely high levels across the globe. And, although it’s rises in the Consumer Price Index (CPI) that tend to hit the headlines, BCIS data shows that inflation has had an even more adverse impact on the construction industry, with some materials experiencing levels of price volatility not seen in a generation.

In July 2021, for example, annual growth in the BCIS steel for reinforcement index (Price Adjustment Formulae Indices Series 4 – Civil Engineering and related Specialist Engineering) peaked at 91.8%. Although price increases have cooled for most construction materials, many remain historically high, with structural steel still higher than pre-pandemic levels. This pressure, coupled with the rise in labour and plant costs, has made it increasingly difficult for construction companies to operate profitably.

High interest rates

The finance contractors rely on has become much more expensive over the past year, as the Bank of England rate rises pass through to lending. According to EY Parthenon’s latest profit warnings (3^rd Quarter) report, they saw ‘rising interest rates take over as the main driver of warnings’, with ‘credit-related warnings hitting their highest level since 2008.’

Aside from construction companies feeling the impact on their own profit margins, it has adversely affected sectors that rely on credit availability. One of the sectors where this is most evident is the housing market, which ‘triggered a fifth of all warnings in 3Q2023 – ‘this included housebuilders but also the wider housing value chain, from construction contractors and suppliers to estate agents and mortgage providers’. Although some businesses and consumers have been shielded from the impact of rising base rates by locked in low interest rates, this can’t continue indefinitely.

In addition, high interest rates create an environment that discourages potential investors or lenders from providing financial support to struggling firms, that could help them recover from financial distress.

Labour as the new cost driver

A report by Currie & Brown – published in June this year – claims an additional 225,000 construction workers will be needed by 2027 to meet demand, a shortfall that is contributing to the current rise in labour costs.

Decreases in new work output, particularly in private housing, have helped to lessen the impact of this shortfall, but labour has become the more significant cost driver for construction.  This growth isn’t forecast to rise above 8.3% annual growth in 1Q2024.

While recent data from ONS has shown construction pay has been increasing, on average, by less than other sectors in recent months, there has been a determined effort by workers seeking inflation-matching rises.

Among the industry wage awards settled in the summer, the Building and Allied Trades Joint Industrial Council agreed an 8% increase for builders, while the Construction Industry Joint Council agreed 7.6% rises for building and civils operatives. There have been similar rises, and more planned for the new year, among mechanical and electrical (M&E) trades. The latest data from the Hays/BCIS Site Wage Cost Indices suggests agency placements in skilled building and M&E roles have also seen higher growth in pay, no doubt in part because of the knock-on effect of the publicised wage awards for salaried workers.

What does this mean for firms at risk of insolvency? Labour increases tend to squeeze profit margins – firms with salaried staff have the additional expense, regardless of whether they win work or make any profit, while firms who use contract labour will need to pay wages commensurate with inflation.

Exposure to the contract cycle

All the contractors in the supply chain rely heavily on finance and are very sensitive to cash flow disruption. This is because they must pay for materials, labour, and sub-contractors well in advance of payment from their client (ultimate client or contractor). This requires accurate financial planning; a delicate balance that can easily be upset by late payments and fluctuating resource costs.

In addition to this, weakening and uncertainty in demand can be compounded by high finance and political U-turns that make projects unviable or lead to them being cancelled. Typically, contractors in the UK operate at thin profit margins with tight cash flow so they’re especially vulnerable to late payments, a common challenge for contractors in the UK. There have been repeat initiatives and legislation trying to tackle late payment, but it continues to be a problem.

Historically, financially distressed contractors will go to great lengths to keep the conveyor belt of cash moving and, in this economic environment, they must resist the temptation to ‘buy work.’ As tendering becomes increasingly competitive, some contractors may also feel obliged to agree to fixed price contracts, without securing fixed prices from their sub-contractors and suppliers.

However, where contracts do not have an inflation adjustment clause, for example, applying the BCIS Price Adjustment Formulae Indices (PAFI), it means they have no legal facility to adjust contract sums. This leaves contractors in a particularly vulnerable position if they’re asked to bear the brunt of the rise in labour, materials and subcontractor prices. If the contract extends over a substantial period, any hope of a profit margin could easily be wiped out.

Large and tier-one contractors are also at risk on fixed price contracts, although there has been a move towards more collaborative approaches, to try to avoid the damaging impact of subcontractor and supplier failure.

Most of EY Parthenon’s latest quarterly profit warnings came from what they describe as ‘the squeezed middle of subcontractors and suppliers, where the impact of cost and labour headwinds have been compounded by the sharp slowdown in the housing market.’

Conclusion

There are some glimmers of hope amidst the news relating to the high number of insolvencies. Buckingham’s new administrators were able to save its rail division, while ISG and Mace have taken on staff from the Mechanical and Engineering firm, Michael J Lonsdale, that collapsed recently.

But the continuing high numbers of insolvencies in our industry is a huge concern. A reduction in contractors leads to reduced construction capacity, potentially less competition and upward pressure on tender costs. This is a particular issue for sectors and subsectors requiring specialist skills, such as M&E, where we may see an increase in demand – especially if the government implements a strategy for decarbonising technologies and retrofits.

Also of concern is the possibility that some contractors will be tempted to under-bid and/or enter into fixed-price contracts that don’t include fluctuation clauses. This will only add to the existing pressures they face, such as late payments, due to the contract cycle. It’s more vital than ever that contractors in the sector continue to focus on running their operations as efficiently as possible, while also mitigating risk for their business and sub-contractors through contracts that contain fluctuation clauses.