As you watch the commentary about the Australian Residential Construction Industry, you may wonder, "How did it get to this point?".

It's quite simple, and I'll explain it to you.

Builders do not generally come out and declare they are in financial trouble. If they did, this would become a self-fulfilling statement.

Until they can no longer hide the truth, they will paint a rosy picture and keep taking consumers money.

A construction company's CEO saying "we are financially sound" then saying in the same press release, "we are focusing on getting deposits through our sales team" seems extremely cavalier to me.

In order to fund the ongoing costs of a construction company, a sales deposit is hardly sufficient, especially if the company has 400+ staff and has 4000 buildings under construction.

5% of the contract value is the maximum sales deposit a company can be paid to carry out the preliminary service agreement scope of works.

A deposit claim is generally split into two parts within the deposit stage. A first run claim involves producing the following outputs: drafting, variations, documenting plan change requests/markups, a soil test and contour survey be produced for the site.

Upon signing the contract, the builder receives the balance of the deposit claim, this is after the plans are redrafted, the costing and colour selections have been completed.

In order to get consumers to build with them, builders market the $5000 as almost risk free to the consumers. It is unlikely you will cancel your deposit (ask for a refund) and go elsewhere once you have paid your deposit. They know that commitment/planning fallacy & sunk cost bias weighs heavily on your decision making so taking a deposit from you, even a small one, is a strategic move to ensure you don't go to another builder.

This is why builders always have "specials" that are time limited - a very traditional marketing hook that has been used for hundreds of years (because it works) - time or quantity limited are the only two types of specials.

For the building company, the deposit money is not a cash cow. They need to pay building certifiers, engineers, surveyors, draftsman, estimators, administrative staff (to carry out colour selections), contract administrators (or admin staff), schedulers (to place orders with suppliers), supervisors to organise and book in work to be done on your site, and all of this is paid from the deposit money.

After the deposit is paid, the builder will need to do all the administrative and site work up until the slab stage payment claim in order to be paid again - that is, get to the base stage progress claim.

All this work is funded from the builders general float (available cash flow) as the deposit money is well and truly spent before work commences on site.

This is the interesting point, until the slab goes down and the builder can get into the next contract stage claim - the base stage claim, the builder is paying everything from their available cash on hand.

Because of the way this 5% deposit is received over time by the builder they simply have more outgoings over this time span than the 5% will float.

I say all of this to counter the claim that raising sales deposits will improve the financial position of a large builder with significant overheads, it will not.

The builder still needs to pay its running costs (staff costs) even if it seems that no major work is funded onsite (the people organising the work inside the office still need to be paid). The builder also needs to pay its suppliers for work that is under construction.

For a builder, there is a tight rope walk in cash flow management between managing supplier payments from your available cash versus getting progress claims through the front door from your clients.

If the progress claim rate drops significantly, yet the supplier claims increase, or supply payment terms are reduced from 30 to 14 days for example, then it is easy for any builder to become insolvent. They no longer have a cash flow offset facility because the suppliers dont want to be left holding the bag.

You can read more about progress claims here (opens the QBCC guide for home-owners).

You can read about contractors attempting to claim increased payments here (opens the QBCC website).

According to my perspective, two things have led the industry being where it is today

  1. Outsourcing and just-in-time supply chain management, the supply side of the industry does this to reduce its operational costs (burden) by not having to hold stock until it is really needed (reducing capital costs, storage and labour & admin costs).
  2. The lack of innovation by builders: a lack of process innovation (office systems/skill/output based) and material and construction system & process innovation (site based). Why change a product made of the same material for 100 years builders say? What could go wrong with that in a supply crunch?

There are only two ways I can see builders navigating the supply chain and material cost crunch issue they now face.

Firstly, a rise and fall clause is inserted into the contract, which is not standard in domestic residential building contracts (RBC).

Furthermore, most RBCs are fixed price agreements with contract administration required to manage variations and cost escalation that occur after contract signing. These are not difficult to manage, but time consuming and the contract administrator must know how the contract works in order to administer the changes properly.

Secondly, in my opinion, the only way to address material and labour price increases is to use provisional sums and prime cost allowances in their contracts.

In the case of provisional sums, the builder must "guesstimate" and be within 10% of the actual sum at the time of contract preparation. This is where the term "reasonably foreseeable" becomes significant and important (more on this in another post).

For a few reasons, builders traditionally did not use either of these contract options.

Firstly, it increases the building company's administrative burden. In reality, you really need qualified contract managers managing contracts, not just random admins (trained to follow a process), who know what and how these clauses do/mean and how they work.

I have worked in companies that have only one or two qualified contract administrators, plus a bunch of lower-paid administrative staff who handle the bulk of the contract administration work.

Secondly, most building companies pay the least amount you can to have someone follow "the process" in the admin department. This means you should be operationally fine (until you aren't); until an actual understanding of the contract and what changes mean become critical to survival.

I call these admin employees "the minimum viable employee" (or MVE), they are great to keep your overheads down but not great if anything out of the norm happens - like a supply chain meltdown and converging housing stimulus plus shortages.

The builders problem in using minimum viable employees is that in the current market, the money made that is available to cash flow your operations is reliant on having competent contract administrators (not MVE's).

Third, If the builder does not have a well-structured process for managing contracts, and keep their ego in check so they don't overextend themselves (take more deposits than their float can manage), they could lose money quickly.

Fourth, many builders are carpenters, (or more recent years) come from marketing backgrounds, who moved up to business without learning how to manage legal, administrative and financial issues - often entrusting this responsibility to a partner or someone else.

Many of the people in critical roles within building companies are not builders, rarely if ever go onto a site, nor do they care about anything other than P&L.

Fifth, there are a lot of builders who know what "money in/money out" means, but they really do not understand the amount of money they need to cash flow a slowdown in progress claims versus the requirements fund their outgoings over time inclusive or sporadic progress claim receipts.

These builders are simply used to new money coming in the door to keep the operation humming. Its almost like a construction ponzi scheme - once new money stops coming in (paying for work in progress), so to does the operation grind to a halt and the entire chain collapses.

Employees with a solid understanding of contract administration, the effects of contract clauses, and the timeliness and process of managing contracts are essential. In most builders' admin departments, there aren't enough people with this level of understanding, they're simply not “construction” qualified or experienced. They have zero site experience or zero contract administration training. They just do not know or understand the effects of their action or inaction especially when this is critical to the companies survival.

According to critical chain theory, "no chain is stronger than its weakest link, and similarly, every system must have a constraint (reference) that limits its output."

As building companies race to reduce overheads and increase profits, I mean pay the minimum viable employee to get the job done (to maximise shareholder, owner returns) building companies have failed to invest in building, training, and making sure that anyone who touches a contract understands fully what it means and how it works for the builder and for the client.

Builders must invest in their staff and up-skill those individuals who want to learn more about how to do their jobs better, rather than send them to industry "flash" events.

A ripple in the supply chain means a compounding and critical impact on the builders process, as we have seen. Builders seem to "do what they do" and stick to the formula, unaware of the changing environment or unwilling to change for the future.

Builders wait until the problem is front in centre. In my opinion, there is zero pro-activeness or progressiveness shown by any of the major project builders. They are dinosaurs ripe for disruption and extinction.

In their busyness, builders have failed to recognise that their lack of process and material innovation in their organisation has left them at the mercy of the same supply chain as their competitors.

All of these builders use mostly the same materials, use the same supply chain, and use the same labor force.

The construction industry has caught a cold due to a ripple in this interconnected supply chain.

I am somewhat happy that the industry is having to grapple with the situation they are in.I am not happy about the pain the customers have and will continue to go through as builders try and claim post contract variation "rise in costs" claims against them (utter bullshit because it was reasonably foreseeable at the time of contract preparation), however i am hoping that the pain the builders are going through may be stimulus for change in the way they do things both operationally and from a material/design perspective.

Since these builders are in the construction business, they are in a better position to mitigate the risk than the customer, who is a layman. It is reprehensible for them to demand a variation for an increase in material and labour costs after completion.

Because of their ignorance and lack of financial planning and contract administration, they over commit, doing more than they are capable of. It seems that there is almost zero introspection or mea culpa by builders, rather they are doing what they always do, blame everyone else but themselves.

It would be nice if they didn't just stick their heads in the sand (including the industry associations, "read lobby groups") and claim they were victims of circumstances. It would be great if they actually looked at ways of mitigating this for the future - be proactive rather than reactive, as they seem to have been.

In order to secure customers, builders have spent too much time on dog and pony shows, marketing bullshit. Some of those marketing dollars should have been spent on innovation and staff training instead.

Perhaps if every building company was forced to pay an innovation tax (and not pass this onto their customers like they did with the brick levy) - and the innovation tax was actually spent on innovation - then things might change.

If these companies spent less on their marketing budget and put that into using better quality materials, hiring qualified staff, training and upskiling existing staff, and investing in research and product development, then perhaps they can get out of the shit they got into.

The biggest problem as I see it, is builders arrogance and short-sightedness - they will all simply retort to this position saying "the customer just won't pay for it".

Hence the cycle we are are in and why it can most certainly repeat it self in the future. At what point does the industry change? The answer is when it is forced to (7-star energy ratings for example).

Regulation is the only way to change the building industry unfortunately, as builders will not self regulate (they are just too greedy, too arrogant or too stupid).

The construction industry associations are full of the same builders that created this mess, so they are only looking to maintain the status quo. They don't "rock the boat" with their members because they want their membership fees to keep coming in.

When the government tries to change (even if somewhat misguided), all we hear from the associations is how this will “hurt” their members and make consumers pay more (exactly the same as what the builders say when change is mentioned).

The race to the bottom is paved with good intentions and casualties. In this case the causality is the consumer.

There is another way that things can change, the state governments can go into partnership with suitable building companies and architects to design and build planned estates.

Cut the developers out of the process (who drip feed the market with land supply to maintain pricing). The government just has to be mindful that if they string along the builders progress claims (no cashflow), nothing will change and they still end up with failed companies and less output (houses).

Maybe its time to take the supply away from private building companies and elevate the constraint up to state governments. If we have a supply problem, as we do, and the builders are unreliable and poorly managed then mitigate the bottlneck by elevating this constraint and manage around it.

I do hope that the building companies change out of fear that what they are currently going through will repeat itself in the future unless they make a change.

Maybe they should spend some money on material and process innovation and build a new path away from their competitors.

Alternatively, builders can stay in the same loop and keep experiencing a self induced long COVID!