The business cycle

Abstract

The economy follows a Business Cycle which has four stages; expansion, prosperity, contraction and recession. The global economy is currently in a recession stage following a crash in the US Housing Market which resulted in a credit shortage in Financial Institutions on a global scale. This has impacted all industries, including construction, where consumers have lost confidence and decreased investments.

The Construction Industry has seen a fall in private sector investment leading to a reduction in the number of projects available for tender and construction with an increase in competition from other Contractors. Projects already in the design and construction phases, for example Wembley ARK Academy, have also been impacted by the recession and have been required to look into alternative strategies.

The global recession has impacted the construction supply chain on all levels – Client, Main Contractor, Subcontractors and Suppliers. A reduction in funding for projects has lead to a decrease in the amount of work available and an increase in the amount of competition for these projects. The cutting of profit margins and low prices being quoted for projects is causing many Clients and Main Contractors to be price-driven rather than focussing on the long-term aspects of a buildings life-cycle and an efficient Supply Chain Management System.

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Introduction

Based on the Brief given, this Vocational Practice Analysis will analyse if the recent down-turn in the Economic Climate has impacted the Construction Industry Supply Chain, by investigating the different levels of the supply chain – Subcontractors, the Main Contractor and the Client. The purpose of this investigation is to establish if the behaviour and strategic direction of construction projects, organisations and external factors have been influenced by the changing climate.

The report is structured by investigating the background theory, setting the context of the Construction Project, introducing the theory of strategically managing the Supply Chain and analysing the impact of the down-turn on the project and the project’s Supply Chain.

The economic theory will look at the recent economic downturn including defining a Recession, the causes and the effect it is having on the Construction Industry.

The following section will introduce a Construction project, Wembley ARK Academy which is a £32m new-build school for Willmott Dixon Construction Ltd.

A Supply Chain, often related to Supplier/Customer relationship and management, will be explained in regards to its use and benefits to Clients, Main Contractor’s, Subcontractors and Suppliers. This section will also describe Willmott Dixon’s Supply Chain Management System and strategy.

Once the context has been set in the above section, the report will analyse the impact on the different levels of strategy, Project Level, Willmott Dixon Divisional, the Subcontractors’ and the Clients’ strategy to minimise the impact on their organisation. A number of different methods have been used to gather the information for this analysis, including interviews, industry data and questionnaires.

Finally the theory and analysis is pulled together in the Conclusion which aims to outline the overall impact and relevant organisations’ strategic responses that has affected the Construction Project.

Recession

Economic Cycle

The economy tends to follow a long-term business cycle[1]. A business cycle looks at the fluctuations in economic activity over a period of time and is measured using the Real Gross Domestic Product (GDP). GDP is the value of the country’s economic output and can be calculated in three ways:[2]

Output method – The total value of production of all goods and services.

Expenditure method – this measure focuses on expenditure through consumption, investment, government spending and net exports.

Income method – this is measured looks at the total income in the country through employee salaries and wages, company profits and rental income.

The economic cycle was first identified in 1860 by a French Economist, Clement Juglar, who believed the cycle was eight to eleven years long[3]. The Juglar cycle, also known as the Business Cycle[4], states that the recovery stage includes increases in external factors such as consumer confidence, productivity, prices and aggregate demand and the cycle is usually between seven and eleven years in total.

The cycle is thought to have four stages[5]. These are:

• Expansion – of the economy, often following a recession
• Prosperity/Recovery – the wealth and comfort within this
• Contraction/Crisis – phase where the economy slows down and begins to decline
• Recession – general economic decline

Economists are split in their views regarding the business cycle and many believe it is not a cycle but economic fluctuations[6]. One of these different views is the Keynesian economics view that fluctuations in aggregate demand are seen as the business cycle. Although Keynesian models do not directly link with business cycles, models such as the accelerator and multiplier models do have results which are similar to cycles[7].

External influences, which include unemployment, technology, and natural crisis, also have significant impact on the Business Cycle. One key factor on the Cycle is the government and their’ Fiscal and Monetary Policies, which are used to stabilise the economy and decrease the excesses of the business cycle which therefore level out the economy and the cycle. These policies include:

• Interest Rates – reducing rates encourages spending whilst increase in rates encourages savings.
• Taxes – reducing taxes can increase personal wealth and promote spending, but in turn Government spending would reduce or National Debt would increase.
• Government spending – producing more work and employment but funding for this would be required
• Supply of money – the mount of money available to an economy has an affect on inflation and price levels.

Recession

The most commonly used definition of a Recession is “two down quarters of GDP”[8]. Gross Domestic However this common definition is often challenged[9] as it does not consider all economic change variables, such as consumer spending and confidence and unemployment levels. In the United States, The National Bureau of Economic Research (NBER) is responsible for declaring a recession with the general definition of “a significant decline in economic activity spread across the country, lasting more than a few months, normally visible in real GDP growth, real personal income, employment (non-farm payrolls), industrial production, and whole-retail sales.”[10]

One factor that is consistent in the varying definition is that a Recession is a period of time in which the economic activity within the Business Cycle slows down. This slow down often results in a rise in unemployment and a decline in output and investment levels, which could include a fall in household income, business profit, investment spending and inflation. If a recession lasts longer than three to four years, or if the GDP is down by 10%, this can be referred to as an Economic Depression[11].

A recession, and it’s subsequent “recovery” phase can be modelled in one of four “Shapes”, which are modelled in fig 1. The shapes of the graphs are formed from the speed of fall into the recession and the time period it takes to recover again.

V-shaped Model

Recovery period is approximately the same duration as the Recession Period;

U-shaped Model

a more gradual decline and recovery than the V Shaped model;

L-shaped Model

the decline is very drastic followed by a long sustained period of low/stagnated growth;

“W”-shaped Model

Sometimes called a double-dip recession[12], starts to recover before the economy drops back into recession again.

Recent Economic Recession

Cause

In late 2007, the ‘housing bubble’ which had been created by re-selling of the securities had collapsed which resulted in the securities tied into the US Real Estate to significantly reduce in value. This impacted organisations and financial institutions globally as many suffered large losses and bankruptcy, which instigated a credit shortage in the US banking system.[13] Another term that has been used for this credit shortfall is the “Credit Crunch” Recession.

During the early 1990s, the traditional lending markets began to saturate, financial institutions began to increase their appetite for risk and began lending to the Subprime market which is defined as lending to consumers in the highest risk category. Traditionally, subprime borrowers have a higher than normal defect rate on repayments.[14]

The underlying issue was linked to a loss in confidence, as the securities had been packaged and sold to a financial institution, then re-packaged and re-sold and the market had lost the ability to track the sub-prime debt. The term “Toxic assets” were created to denote securities that included sub-prime loans[15]. As a result of the threat to increased risk of these Toxic Assets, Financial Institutions began to loose confidence and stopped purchasing securities which in turn decreased credit availability to banks, organisations and individuals. The global stock market was impacted as investor confidence was also drastically damaged due to the inability to track the toxic assets and those organisations that would be impacted by them.

Implications

Due to the global nature of the Financial institutions, the impact of the withdrawal of credit was felt globally, which resulted in a drop in international trade, rising unemployment and housing price declines[16]. Banks began to assess each application for credit more thoroughly and made credit availability a lot more difficult. This in turn resulted in financial institutions, such as Fanny Mae and Lehmann Brothers “folding” and, in the UK Government bailout for Northern Rock and Royal Bank of Scotland (RBS).

The availability of credit created a spiralling effect and default rates on mortgages began to increase and unemployment began to rise as business loans were withdrawn. As house prices decreased then a number of assets began to fall into negative equity, where the value of the asset fell below the debt level, which added extra pressure to the financial institutions as they were at risk of none recovering of the debt.

Impact on Construction Industry

The UK Construction Industry was worth over £123 billion in 2008, which equates to approximately 6% of national GDP, made up Infrastructure, Housing and Commercial projects funded by both public and private investments.[17]

The recession has hit both public and private funding within the Construction Industry, which has resulted in many projects that were going through the planning phase being deemed as high risk and funding being either removed or suspended.[18] As a result of the credit shortage and decrease in general economic confidence, House prices decreased and the private commercial sector was also more hesitant to invest in construction projects with both sectors opting for the rental market and postponing capital investment. The Housing sector has suffered the most, followed by Commercial and Civil Engineering.[19] The restriction of credit for the Commercial sectors has made many organisations reassess their growth strategies.

In Supply and Demand terms, this resulted in fewer projects being commissioned (Supply) and therefore there is a rise in competition from other Main Contractors (Demand), resulting in a severe drop in profit margins to try to secure these projects.

Private sector work has decreased as many have struggled to obtain funding, however, Public sector has also struggled, but due to Fiscal Policies, the supply of credit has remained available for the construction industry with the Government slogan being “spend our way out of recession”[20]. The continued investment by the Government into sectors such as education has helped the industry with the availability of construction projects. Unfortunately, the Government has created a huge rise in National Debt (see Section 6) which will have to be recovered in the near future.

The recession has also had a large impact on the Construction Industry’s workforce with a number of contractors and subcontractors needing to reduce their employee numbers or enter into administration due to the reduction in demand for work. This has led to many skilled labour being unemployed, leaving the industry and skilled foreign labour leaving the country. This will have an effect on the industry’s recovery as once the economy starts to recover a large amount of the skill base would have been lost and therefore knowledge would not be available and money would need to be spent on re-training again.

Previous Recession

In autumn 1988, the United Kingdom suffered a recession which originated in the housing sector. In early 1988 average earnings were rising at a faster pace than retails prices which meant that the majority of people felt well-off financially, but at the same time house prices were increasing even faster than average earnings. With a combination of rising average earnings and the housing market looking appealing as an investment the demand for housing was high.

In March 1988 the Government made its Budget announcement of a Taxation change which restricted the tax relief available to house owners. The policy change was postponed until August 1988 which resulted in a huge influx of people wanting to buy a house so they could benefit from the existing tax relief[21]. This outcome of this was that house prices accelerated which also triggered an increase in interest rates from 7.5% in May 1988 to 15% in October 1989[22] which was unsustainable. Once the new housing taxation relief policy was implemented in August 1988 house sales decreased by such a large amount that the housing market collapsed. House prices decreased which left many house-owners in negative equity, and interest rates were high which made mortgage and debt payments more difficult to pay. House builders were left with land which was over-valued which they could not sell as its value had decreased and there were not buyers willing to buy in this time of economic recession.

This resulted in an economic recession hitting all sectors. Employment fell from 1.8m in 1990 down to 1.4m in 1993 in construction[23]. The Construction Housing sector fell drastically from 1988 followed by the Construction Commercial sector in 1990. The Commercial sector lagged behind due to the nature of the projects are large and therefore projects which were taking place when the recession hit kept construction companies going during their duration. Then in 1990 when these large projects were complete there were fewer large commercial projects available for tender and any which were there had increased competition. Repair and maintenance made losses between 1990 and 1993 and infra-structure struggled, but this was not as much as the other sectors, primarily supplemented by the Channel Tunnel construction which was taking place which large amounts of investments by the privatised and energy industries[24]. It wasn’t until mid 1994 that orders began to increase and the construction industry began to recover.

Project

Project Description

The Wembley ARK Academy project, commenced in June 2009, includes the demolition of existing houses and pavilion and the construction of a new Academy. The ARK Academy will provide educational facilities for approximately 1600 pupils including infant, junior and secondary school ages. The £32million project will also include the construction of a new sports hall and external sports facilities which can be used by the general public out of school hours. The buildings are predominantly structural steel frames with precast concrete slabs and some timber elements.

The Client, London Borough of Brent (LBoB), is part of the Government’s national Building Schools for the Future (BSF) initiative. LBoB’s BSF programme looks to regenerate the LBoB by providing improved school facilities to areas in-need and areas of growth. Through the engagement of the local communities, the LBoB are working towards improving learning to young people and raising standards in areas of disadvantage.[25] This programme is managed by Partnerships for Schools (PfS) which was created by the Department for Children, Schools and Families (DCSF). PfS are an organisation that is in charge of managing and delivering the Government’s capital investment programmes into schools. The BSF’s “Academies Programme” is a part of the Government’s capital investment programme in which its aim is to invest £45billion on rebuilding and renewing almost all Secondary schools in England over a 15 year period.[26] In 2000, the original target was set at 200 new Academies to be opened, or in construction, by 2010, but the target was increased to 400 Academies due to its success. [27]

The Main Contractor, Willmott Dixon Construction Ltd, is a part of the Willmott Dixon Group. Willmott Dixon Group is one of the UK’s largest privately owned companies employing over 3,000 people specialising in construction, housing, maintenance, repair and investment. The Group reported a turnover of £838m in 2008 and are expecting this to reach £930m in 2009[28]. The Construction divisions carry out capital investment projects in the following sectors:

• Commercial;
• Law and order;
• Health;
• Hotels;
• Low carbon;
• Leisure and fitness;
• PPP/PFI;
• Education.

Within the Education sector works includes primary, secondary, higher and further education and academies and are members of a number of Academy Frameworks.

ARK Academy’s objective, in partnership with LBoB and PfS, is to deliver an all-ability school, which is free to all students. Each party are independent which therefore allows the Academy the flexibility to choose their own curriculum and staffing. The PfS assists with the design and construction of the school which helps to support LBoB and the Academy.

The land in which the Academy is being built is freehold owned by London Underground Ltd, who have agreed to lease this land to the LBoB, who in turn are responsible for the development and the associated cost of the ARK Academy Project.

The Wembley ARK Academy is made up of two separate buildings with a large amount of external works for sports grounds.

Procurement

The tender for the Wembley Ark Academy project was procured via the National Academies Framework, which consists of six Main Contractors, known as Panel Members, who are invited to bid for each and every Academy being constructed throughout the duration of the Framework Agreement. At the end of the framework the panel members are reassessed based on the tendering and delivery history and are either re-appointed or a position is opened up to other Contractors.

The procurement process begins by the Panel Members being notified of a tender opportunity for a specific Academy contract (Wembley Ark in this instance) where an initial expression of interest is sought required form the panel members. This is followed by a project briefing session (“Bidder’s Day”) which is in advance of the ‘Project Invitation to Tender’ (PITT) being issued.

The PITT consisted of answering between twelve and seventeen questions covering topics such as team selection and risk management, and must be returned in a specified timeframe. In this instance the duration was two weeks, which resulted in Four Panel Members being selected to progress to the next stage of the procurement process, the PITT interview. The Evaluation Process, which looks at the PITT documentation and feedback from the interview, down select the candidates to the final two. The two remaining Panel members were given a fourteen (14) week period to enter a more detailed design competition, which develops the design of the Academy, from RIBA Stage B through to stage D, and up to the point in which a planning application can be made. The planning application can only be submitted at this stage as the statutory period is fourteen weeks and is a pre-requisite of obtaining Financial Close. At this point the preferred bidder is then selected.

In this instance the preferred bidder, Willmott Dixon, were given a further sixteen (16) weeks to progress the design from RIBA Stage D to stages E / F. Upon completion of this phase, the contractor is able to commence work on-site upon obtaining Financial Close.

One of the main advantages of being a Panel Member on the PfS Academy’s Framework for a Contractor is that they have a higher chance of getting future Academy projects is the limited competition, as it is only Contractors that are within this framework that can tender for Academy jobs.

Contract

The form of contract being used on the Wembley Ark Academy is a Lump-Sum Bespoke “Design & Build” Contract for PfS Academy Framework. The type of contract used is dictated by the source of funding (PfS) and the Client does not have an opportunity to change this under the scheme.

A “Design and Build” contract differs from other types of contracts as it does not require a Quantity Surveyor to be appointed by the Client but instead there must be an Employer’s Agent who acts on the Employer’s behalf. A document called the “Employer’s Requirements” is basis of the contract, where the document specifies the Contractor’s delivery criteria. As part of the Partnerships for Schools (PfS) there is an “Authority’s Requirements” document, which is the same as the “Employer’s Requirements” document, and contains all of the requirements set out by PfS and London Borough of Brent which are specific to this project. These include the lease agreement with London Underground Ltd, progress reporting (including progress photos), working hours, traffic arrangements and a large number of other items. For example, the site is located adjacent to Wembley Park Underground Line and Station and also has a bus lane running past the entrance to the main site access route. Conditions have been included in the contract in regards to the location of the site as care must be taken to keep the bus lane clear at all times and the roads must be kept clean at the access point into and out of site. Also, the land where this Academy will be built is owned by London Underground Ltd. Therefore, London Borough of Brent have a lease agreement in place between the two parties in regards to the lease of this land.

A “Design and Build” contract usually transfers all risks to the Main Contractor and away from the Client as the Contractor is responsible for both the design and construction phases. This can be appealing to a Client dependant on the specifics of the project, and is often a preferred route if the Client is looking for a prompt completion date, a good quality finish is required and/or if risk and price certainty is important.[29] A “Design and Build” contract is advantageous to the Main Contractor as they are involved at a much earlier stage and can work with the Architect and typically results in the design and construction phases overlapping which reduces the overall project length and risk exposure.

There are key milestone dates which are linked to the start date of the academic school year which must provide necessary teaching facilities. If these dates are not met the Liquidated and Ascertained Damages (LADs) included in this contract are to cover for the cost of temporary provision of school facilities. This penalty is not a fixed LAD amount per week or a percentage of total contract value, which are typical in most contracts, but is whatever is seen as a reasonable penalty in regards to temporary school facilities. For example, if the first phase, the Primary School, is late then Willmott Dixon, the Main Contractor, would need to either provide a temporary accommodation or make available another area of the building if this is complete.

Payments to Willmott Dixon from the client are made against pre-agreed payment milestones that would have been decided upon and agreed within the Contract. Valuations are carried out on a monthly basis by the Contract Administrator and the Project Surveyor for Willmott Dixon (see section 3.1.4 for the Project Organisational Structure). These valuation dates are agreed from the commencement of the project. The Sub-contractor payments would be backed-off onto these valuation dates. The valuation meeting allows the Contract Administrator to go through the valuation, derived from the Project Surveyor’s estimates, and come to an agreement on the value. The Contract Administrator is working on behalf of the Client, London Borough of Brent, and therefore aims to keep the valuation figures low as this will be the amount that London Borough of Brent then pays to Willmott Dixon for that months work.

There are many advantages and disadvantages to Willmott Dixon, the Contractor, in using a “Design and Build” Contract:

Disadvantage – The main disadvantage is that the risk is transferred from the Client to the Main Contractor. In this instance, Willmott Dixon are responsible for both design and build phases of the project which are based on the “Authority Requirements” document details the high level specifications and it is down to Willmott Dixon to determine, during the design phase, how they are going to provide them. If there are any un-foreseen issues, off-specs or mandatory change requests then the responsibility is with Willmott Dixon’s and they must therefore manage these risks and the associated additional costs.

Advantage – The main advantage to the Main Contractor when using a “Design and Build” contract is that they get to choose the Design Team that allows the contractor to appoint the Architect, Structural Engineers, Landscape Consultants and the rest of the Design Team as they are responsible for the design. Therefore, Willmott Dixon can pick organisations that they have built a good working relationship. This relationship is important as there must be a level of trust between them as Willmott Dixon holds all the risk and so they need to ensure they have a team supporting them and one that they know they can work with to provide the best final product to the Client.

Another benefit on this project is that as Willmott Dixon have worked on other Academy buildings and, although the design is different, the projects often have similar characteristics. Generally this can simplify the process for Willmott Dixon during the design phase and when looking to appoint Subcontractor for the project. For this same reason this is also a benefit to the Subcontractors on the Supply Chain (see Section 4) as the policy favours subcontractors who have worked on similar schemes in the past.

Project Economics and Cost Management

Wembley Ark Academy is based on a Lump-sum form of contract, which means that the project value has already been agreed between the Client and Willmott Dixon. On the basis that Willmott Dixon deliver all of the requirements set in the “Authority’s Requirements” Document and provide a building which is “fit-for-purpose” then this agreed amount will be paid to them.

The agreed Project value is £32million and it has been split into payment milestones. The entire project has been divided into phases and these phases must be handed over on certain dates. The project is to be handed over in the following phases:

The first and second phases are to be completed by September 2010 ready for the start of the new academic year and therefore it is vital that these dates are met as school facilities need to be available for the students.

The payment milestones are linked with the above phases and it is against these milestones that the monthly valuations are valued against with the Contract Administrator.

An advantage of this form of contract, on the Wembley Ark Academy project, is that as it is based on a lump-sum this gives cost certainty to Willmott Dixon, which also allows for more accurate budgeting by the Project Surveyor.

The cost to deliver the project was divided into construction packages which include the procurement budget and ultimately make up the cost of construction of the Academy Building. The packages are also used to monitor progress status and used to track the costs in the total Project Cost Plan. The Project Surveyor would cost each package from information in the quotations received during the tender stage, and knowledge from historic information of similar projects. As Willmott Dixon have completed a number of Academy project in similar stature to the Wembley Ark project, then the process of creating these cost packages was simplified and should, in theory, prove to be more accurate as there was more knowledge available.

The above Cost Plan is used throughout the procurement stages of the project by the Surveyors and provides a target figure which is used during the procurement of different Subcontract packages.

The Project Costs are monitored and managed throughout duration of the project by the use of a Cost Value Comparison (CVC) Report, which outlines the budgeted, target and the actual costs, and it is updated on a regular monthly basis. The purpose of the Report is for the Surveyors to control and manage expenditure on Subcontractors, Suppliers and Preliminary costs. Later in the Delivery phase, the CVC is used in conjunction with Cost to Complete (CtC) Report which is also completed on a monthly basis at the same time as the CVC document. The CtC lists each Subcontractor, Supplier and Preliminary and breaks down forecasted costs into months for the remaining duration of the project. This CtC tends to analyze each element in more detail so that a final cost can be reported more accurately to the Divisional Management Team.

Using a “Design and Build” contract allows the Main Contractor to look into different Value Engineering opportunities, by looking into improving the value of goods and/or services. To achieve this either the function needs to be improved at the same cost or the cost of the product or service is decreased but still providing the same function. This means that materials, products or systems can be revised from the original specification but must provide the same quality and function, or even better, at a lower cost.[30]

Management Roles and Structure

One of the key advantages of a “Design and Build” contract is that it puts the Main Contractor at the centre of the organisational structure (outlined in Section 3.1.2). Below is the Management Structure for the Wembley Ark Academy project:

Client

The London Borough of Brent, as the “Client” (also referred to as the “Employer”), has control over the overall project deliverables through the “Authority Requirements” Document, which includes the project’s detailed requirements (see Section 3.1.2). As stated previously in Section 3.1, the London Borough of Brent’s Building Schools for the Future programme is managed and controlled by Partnerships for Schools (PfS) who are in charge of delivering the Government’s capital investment programmes. Therefore, PfS are the organisation that oversee the entire programme and London Borough of Brent therefore manage the Academy programme within their region, which includes the Wembley Ark Academy project, and makes the payments to the Main Contractor. The “Day to