Much like kids on a road trip with their parents, we have all been asking, “When are we going to get there?”. Well kids, we have arrived, and we are finally starting to see higher gross profit margins in the construction industry.
Each year our agency studies several financial measures of our customer base, which is over 300 contractors throughout California, and one area we have been watching closely is gross profit margins. From 2014-2016, we were seeing revenues and backlogs steadily increase, but gross profit margins remained stagnant with almost no growth. The rise in revenues still lead to more bottom-line profitability, because our contractors were doing more revenue with the same amount of overhead. However, gross profit margins were not budging.
2017 finally proved to be the breakout year for gross profit margins. With our customers having full backlogs and limited labor in the market to expand revenues with, it seems contractors came to a crossroads where they could afford to bid jobs with a little higher margin. As a result, we saw the average gross profit margin for our customers increase by 2.5% in 2017, which is almost a 10% increase over 2016.
Coming into 2018, we have seen a dramatic shift in the bidding landscape with many bids only having one to three bidders. Many of these bids have spreads between them, which I believe is in large part due to contractors still adjusting to the changing competitive landscape. Let’s face it, we were all traumatized from the Great Recession and years of limited work in the marketplace. Those memories don’t fade quickly, so it’s easy for the priority to be maintaining a full backlog to keep the machine going and our employees working.
The reduction in the number of bidders can easily be explained when we look at the backlogs of our customers. On average, our contractors now have almost 9 months of backlog from a low of roughly 3 months during the bottom of the recession putting contractors in the position to be more patient and strategic in picking the right opportunities versus the desperation and aggressiveness that was so common several years ago.
In addition, the tight labor market in construction isn’t going away any time soon. One contractor even told me they could double their backlog tomorrow if they had the people to do the work. The fact is, it is going to take time to attract people back to the industry or train new blood, which forces contractors to be more selective in the projects they take on.
Taking all these market dynamics into account, we foresee gross profit margins continuing to increase in 2018 and encourage our customers take full advantage. Avoid getting stuck with low margin or high-risk projects that take your attention away from fully capitalizing on the lucrative opportunities out there today.
As backlogs continue to grow, bonding capacity is becoming more and more important. We track the amount of bonding capacity that our customers use, and that usage has doubled in the past 5 years. For some contractors this may mean that not only will labor be a constraint but so will bonding capacity. Ultimately, this could reduce competition and raise profit margins even more.
I would encourage contractors to talk with their surety agents now to formulate a plan to increase bonding capacity. While in some circumstances bond capacity can be increased overnight, it can take planning and preparation. As I often say, the last thing a contractor wants in a market with high margins is to miss on a lucrative opportunity, because they couldn’t get a bond. So follow the Boy Scout mantra and “Always be prepared.”