The poor productivity and performance of the construction and building sector is a major global issue because construction-related spending is approximately US$10 trillion ($13.9t) per annum, equivalent to 13 per cent of world GDP.
These inefficiencies have been highlighted in New Zealand by the disappointing performance of our building-related companies, particularly Fletcher Building.
A recent study by the McKinsey Global Institute, Reinventing Construction: A Route to Higher Productivity, concluded that "construction appears to be stuck in a time warp. In the United States since 1945, productivity in manufacturing, retail and agriculture has grown by as much as 1500 per cent; productivity in construction has barely increased at all". New Zealanders are fully aware of this low productivity issue.
How many major domestic construction projects have been completed on time and within budget? How many families have had their new home or kitchen renovation finished on time and within the original estimates?
The Economist, dated August 19, highlighted the fact that Berlin Brandenburg Airport was due to open in 2012 at a cost of US$1.8 billion ($2.5b) but media reports now indicate that its opening date will be mid-2019 at a total cost of more than US$10.0b.
An industry expert was quoted as saying, "more than 90 per cent of the world's infrastructure projects are either late or over-budget", with the new Apple head office in Silicon Valley opening two years late at a cost of US$5b instead of the original budget of US$3b.
The Productivity Commission has highlighted a similar situation in New Zealand. Its 2012 report on housing affordability noted that "industry productivity is flat-lining, and this is reflected in growing building costs and evidence of poor building quality.
"During the recent housing boom building costs increased above the general rate of inflation, and residential buildings costs are higher than in Australia".
The poor performance of the domestic construction and building industry has been reinforced by the liquidators' first report on the failed Bagley & Blake Construction. The company, which was established by Nick Bagley in Auckland seven years ago, specialised in contract carpentry as well as civil and concrete works.
The liquidators' report noted that the company failed "because cash flow was insufficient to meet day to day operations" and the "company was undercapitalised for rapid growth experienced in recent years".
Why is the construction and building sector so unproductive and why do so many companies suffer large losses or go bust, even in boom conditions?
The Economist believes the sector has two major problems. First, the industry has become less capital-intensive, with workers replacing machinery. This is partly because immigrants are willing to work for low wages but it is also due to the volatility of the sector, which discourages capital investment. The Economist notes, "Capital-heavy approaches to construction bring high fixed costs that are difficult to cut in downturns. Workers, in contrast, can be fired".
Second, the industry is populated by a multitude of small companies that are undercapitalised and inefficient. Mergers and consolidations are sparse because "building codes differ not just between countries but within them, which makes it harder to reap the benefits of scale.
"The customised nature of most projects further limits the usual advantages of size. Because the designs of most projects differ, contractors have to start from scratch for each one".
The United States has 730,000 building outfits, with an average of 10 employees each, while Europe has 3.3 million building companies with an average of just four workers each.
How many families have had their new home or kitchen renovation finished on time and within the original estimates?
SHARE THIS QUOTE:
McKinsey notes that "construction has suffered for decades from remarkably poor productivity relative to other sectors" with labour productivity growth averaging "only 1 per cent per annum over the past two decades (and was flat in most advanced countries)", compared with growth of 2.8 per cent for the total world economy and 3.6 per cent for manufacturing.
However, there is a big difference between the productivity of the large construction companies - mainly involved in infrastructure, civil contracts and large-scale building projects - and companies involved in small projects, particularly standalone houses and residential renovations. This is because the latter rely on trade subcontractors, which can have particularly low productivity.
McKinsey also notes that the productivity of large construction companies is adversely affected if they are heavily reliant on trade subcontractors. This has been a contributing factor to Fletcher Building's problems.
The consultancy group identifies 10 root causes for the sector's low productivity.
The following six probably apply to Fletcher Building and other New Zealand companies:
• Increasing project and site complexities
• Extensive regulation, land fragmentation and the cyclical nature of public investment
• Inadequate design processes and investment
• Poor project management and execution basics
• Insufficiently skilled labour at frontline and supervisory levels
• Industry underinvestment in digitalisation, innovation and capital
In other words, our construction companies have become hopelessly stretched during boom conditions because of inadequate investment in the aforementioned areas. The situation is exacerbated when they win contracts on a low-price, fixed-price basis.
McKinsey identifies seven specific initiatives that would improve productivity, including greater use of digital technology, improved on-site execution, improved procurement and supply-chain management and a reskilling of the workforce.
The consultancy firm believes that annual global construction-related activity will increase from US$10t at present to US$14t by 2025 and the sector would increase its annual added value by US$1.6t if its labour productivity caught up with other sectors.
Meanwhile, the 329-page Productivity Commission report into housing affordability identified poor building productivity as a major contributor to New Zealand's high house prices.
It identified the following industry problems: projects exceed their original budgets; there is a failure to meet agreed timeframes; work is non-compliant or defective; and there is poor design and layout.
In addition, the industry has a reliance on lower-quality materials which have a shorter lifespan and require higher levels of maintenance.
It stated that "the New Zealand building industry is dominated by small firms and has been characterised as a 'cottage industry'".
The commission's recommendations, which were published in March 2012, were similar to McKinsey's recommendations, which were published five years later. These included: innovative approaches to supply chain management and procurement; reskilling the workforce; and greater use of prefabrication and modular components.
Five years later, big $300m-plus projects, individual houses and kitchen renovations are still not completed on time and within the original budget. New Zealanders reluctantly accept these inefficiencies because property values continue to rise and there is a widely held view that overpriced kitchen renovations will be fully captured in the value of the house.
This is one of the reasons why inflation, in this case house price inflation, masks and facilitates major industry inefficiencies.
The media coverage of Fletcher Building's construction problems could have a silver lining because it has focused attention on an inefficient sector, which is a significant drag on the overall productivity of the New Zealand economy.
Fletcher Building has two choices: it can either batten down the hatches and reduce its construction activities or be a major industry change leader.
It could achieve the latter by investing heavily in the sector, through technology, upskilling its work force, improving its procurement procedures and other initiatives.
Improved industry productivity would have material benefits in several areas, including the Labour Party's proposed KiwiBuild programme.
Labour is proposing to build 100,000 affordable homes over a 10-year period, with 50 per cent of these in Auckland. Improved productivity would probably allow Labour to build 115,000 homes, instead of 100,000, for the same amount of money.
This would have a material impact on the country's productivity and housing affordability.
• Brian Gaynor is an executive director of Milford Asset Management which holds shares in Fletcher Building on behalf of clients.