The Construction Productivity Paradox

The productivity of the UK construction sector has been rising up the political agenda.  Reports by the World Economic Forum (WEF) ¹, McKinsey ², the Infrastructure Client Group and the Institution of Civil Engineers ³ have all highlighted that over the last twenty years productivity in construction has barely changed whilst productivity in manufacturing has improved by around 80%.  If the UK construction sector could achieve the levels of productivity seen in manufacturing, there would be a lot more money to invest in hospitals, schools, roads and railways.

The construction sector isn’t short of advice on how to improve productivity.  The WEF proposes six key areas for change, McKinsey suggests seven areas for action and, in its Construction Sector Deal, the Government lists yet more actions to support improvement.  The recommendations include familiar themes like greater use of offsite construction, digital technologies and developing advanced manufacturing methods for construction.  These innovations have been available for some time and are not widely used in construction.  Perhaps we should ask why the industry is reluctant to invest in improving its productivity.  And we could begin by understanding what we mean by construction productivity.

“Simply put, productivity is the ability to get more economic output from any given level of inputs.  Or, even more straightforwardly, the ability to make more stuff with the same number of workers.”

Duncan Weldon, Two Hundred Years of Muddling Through – Little Brown 2021

Productivity is the value added by a business divided by the amount of labour employed in producing its products and services and is typically expressed as £/person employed or £/hour worked.  The value added is the wages paid to the workers plus the business’s gross operating profit ⁴.  The Office for National Statistics (ONS) calculates the productivity of the UK construction sector by aggregating the value added and the labour employed for all of the companies in the sector.

The ONS defines the construction sector as all activities within sections 41 to 43 (excluding 41.1) of the UK Standard Industrial Classification of Economic Activities 2007.  This includes the construction of buildings and civil engineering works and some trades such as plastering and scaffolding.  It does not include consultancy services, computer systems or many manufactured items like precast concrete or transport equipment.  Whilst most of these items are recorded as inputs to the construction sector, they are not directly included in the value added by the sector.

Construction productivity is a measure of the value added per unit of labour for thousands of building and civil engineering contractors and specialist sub-contractors from the very largest national contractors right down to the smallest local building firms.  It is an interesting economic statistic, but it is of little help in understanding how construction companies add value and in measuring the effects of specific initiatives to improve productivity.  That requires us to investigate the productivity of individual businesses and, in particular, the large general contractors that have such influence over project delivery in the UK.

For an individual business, productivity is defined as:

A company’s gross profit is its revenues minus its cost of sales and is shown in the consolidated income statement that most large contractors publish in the financial statements in their accounts.  A metric that investors often use when comparing the performance of different companies is the gross profit margin or gross profit expressed as a percentage of turnover.  It reflects the company’s business model and is seen as a measure of how well it controls its cost of sales or how efficiently it uses labour and materials in its production process.    

Data from the accounts of quoted UK contractors suggests that their gross profit margins are typically in the range 5-10%.  In comparison, many leading manufacturers have gross profit margins in the range 10-40%.  Before the Covid pandemic, Boeing Inc’s financial reports showed a gross margin of 19.6% and Apple Inc a margin of 38.3%.  This difference reflects the different business models in contracting and manufacturing.

Most contractors obtain their projects through competitive tendering and then sub-contract up to 80% of their value.  This means that the prices they charge for their projects and their costs of sales are largely determined by competition in the market, leaving few opportunities to improve their performance by investing in better people, new technologies or better processes.  This approach also limits contractors’ opportunities to collaborate with their suppliers in reducing the costs of their inputs.  If a supplier has been through arduous tendering and negotiations to win a sub-contract, they are unlikely to share information or collaborate in reducing their prices.

It is possible for contractors to improve their productivity without reverting to the 1970s business model when they owned their plant, employed most of the labour on site and controlled the production process.  It requires careful thought and some simple analysis based on the definition of productivity set out above.  It is tempting for firms to just go ahead and implement some of the recommendations in the many reports on construction productivity.  But, without careful thought and analysis, they risk wasting their efforts and possibly, reducing their productivity even further.      

An obvious strategy for improving productivity would be for a contractor to produce better projects without increasing costs and then persuade their customers to pay higher prices for them.  Analysis shows that if a company could increase its prices by 5% without increasing its staff numbers or the costs of its sub-contracts, its productivity would improve by more than 30%.  The challenge for the company would be to develop demonstrably better projects than its competitors and then persuade its customers to pay higher prices.  This would require radical changes in current approaches to procuring projects that are unlikely in the medium term.

An alternative strategy would be to reduce the cost of sales by improving efficiency in the company’s supply chain.  The contractor could collaborate with its suppliers and invest in its supply chain to reduce costs, sharing the benefits with the suppliers.  If it was able to reduce the costs of its sub-contracts by 10% and share this 50:50 with its suppliers, its cost of sales would reduce by 5% and analysis shows that productivity would increase by nearly 30%.  Unfortunately, the improvement could be short lived, as other contractors would adopt the new approach, and competitive tendering would pass the cost reductions on to customers in lower prices.

The most promising strategy for improving productivity could be to reduce the time it takes to deliver projects.  If a contractor was able to deliver its projects in half the time without increasing its staff and with continuity of work, it could effectively double its revenues.  Allowing for the fact that the cost of its sub-contracts would also double, it would still deliver the same gross profits, and analysis suggests that its productivity would more than double.  A 50% reduction in time would require a radically different approach to planning and managing the project from detailed engineering through the manufacture of components to assembly on site.  But the benefits would more than justify the investment.

It is in all our interests for construction to improve its productivity, but the industry is not going to achieve this by randomly implementing the initiatives set out in the many reports on the subject.  We should begin by creating market conditions that encourage improvements in productivity, which means helping customers define value in their projects and creating procurement practices that reward the delivery of value.  The construction industry could then start the painful process of adjusting its business models and integrating supply chains to reward every participant for the contribution they make to the value delivered to the customer.

In time, these arrangements would lead the construction industry to focus on productivity as a priority and measure productivity consistently across projects.  It would also encourage contractors and suppliers to work together, investing in new technologies and practices that would continuously improve productivity.  As the economist Sir John Kay put it in an article in the Financial Times:

“modern humans – uniquely – are productive because they engage in cooperative activity.”

John Kay, FT Weekend 28/29 July 2018

References

1.     Shaping the Future of Construction – Future Scenarios and Implications for the Industry.  World Economic Forum, March 2018.

2.     Reinventing Construction: A Route to Higher Productivity.  McKinsey Global Institute, February 2017.

3.     From Transactions to Enterprises, A New Approach to Delivering High Performing Infrastructure.  Institution of Civil Engineers and the Infrastructure Client Group, March 2017.

4.     The Value of Everything, Making and Taking in the Global Economy.  Mariana Mazzucato, Allan Lane 2018