The Economics of Construction

Agenda Publishing

Contents

GETTING TO GRIPS WITH CONSTRUCTION INDUSTRY STATISTICS: CONSTRUCTION INDUSTRY OR CONSTRUCTION SECTOR?

Construction can be seen as an industry concerned with the production of the built environment. As an industry, its inputs cover a large variety of skills and materials. Its output covers many different types of products and services. As a sector of the economy, it includes the assembly of buildings and structures on site, the production of materials and building components and, indeed, the whole supply chain. This includes architects, surveyors, civil and structural engineers, plant and tool hire, construction product manufacturers and distribution. The construction sector is treated as one sector but, in fact, it covers a wide variety of work across many different areas. Construction output covers everything from the building of housing, commercial and industrial properties, education and health facilities to the building of vital infrastructure for water, energy, roads, rail, telecommunications and ports.

Whatever an individual or collection of individuals may wish or need to do in the economy or society, they will require construction to have taken place first to be able to do it. People need houses to live in, schools and universities to undertake learning, clinics and hospitals to make or keep us physically fit and comfortable, and offices to work in and shops to buy goods in. Even if we work from home and shop online then we still need the internet infrastructure to have been built. In addition, we need roads to drive on, rail infrastructure for trains to travel on, clean water for drinking and bathing, electricity and gas to power heating and lighting. As the built environment has grown over many years, the current buildings and infrastructure have developed over time, and, as a consequence, the repair, maintenance and improvement of existing buildings and infrastructure is also vital.

To measure the scale of investment in construction as part of the whole economy, the United Kingdom National Accounts, also known as The Blue Book (see Office for National Statistics 2017), contains a chapter entitled "Gross Fixed Capital Formation" (GFCF), which presents the total invested by the economy in plant and equipment and buildings and structures. This investment is essential if the country is to survive and remain competitive, in much the same way as companies need to invest in machinery in order to survive.

Fixed capital is the value of assets that usually last longer than one year and are usually used to aid production. The concept of capital formation describes the production of the means of production. The term "gross fixed capital" is used to indicate that the plant and machinery and buildings are measured at brand new values before any depreciation has been deducted.

In terms of the whole economy, investment in the built environment, which includes buildings and structures, such as infrastructure, is a vital component of the United Kingdom's fixed investment. Fixed investment is defined as long-term investment in plant and machinery, transport equipment, information technology, buildings and structures as well as major improvements to existing buildings and structures. The built environment accounts for over a half of all GFCF each year. Figure 1.1 shows that, in 2016, 52.8 per cent of all UK GFCF was in the built environment. The importance of this is that fixed investment enables increases in the productive capacity and productivity of the whole economy, by facilitating the production and movement of goods, capital, services and people.

Data covering construction

To understand a sector of the economy, you need to be able to measure it. The construction sector is certainly no exception to this. No one set of data fully explains the construction industry. However, there are three key types of official data that cover the construction sector, and each set provides a piece of the puzzle.

The first set of data is provided by the UK government's Department for Business, Energy and Industrial Strategy (BEIS) and includes all firms registered to pay value added tax (VAT), combined with an estimate of very small firms that are below the VAT threshold and so do not have to pay VAT.

The benefit of this data is that it allows us to look at the basic structure of the industry. The majority of the focus tends to be on the largest firms within the construction sector. Clearly, though, the sector is dominated by small and medium-sized enterprises (SMEs), defined as firms employing fewer than 250 employees. According to the BEIS, in Figure 1.2, as much as 75 per cent of the £272 billion turnover in the construction sector in 2016 occurred within the SMEs, with 25 per cent of turnover in construction accounted for by the largest firms, which are defined as those employing 250 employees or more.

Figure 1.3 shows that the difference between large and small construction firms is even greater. Of the 2.3 million people employed in construction in 2016, 86.4 per cent were employed by SMEs, while large contractors employed only the remaining 13.6 per cent of the total construction workforce.

Furthermore, the percentage of SMEs within construction amounted to 99.9 per cent of all firms in Figure 1.4. However, a key point to note is that the largest 0.1 per cent of firms still account for 25 per cent of the total turnover of the construction industry.

The BEIS business population estimates are useful at a general level. However, they suffer from two key issues. First, the definition of construction covers only the number of firms and employment of the contractors – those firms that operate on the construction site itself. Yet this is only one part of the whole construction supply chain, as construction is a very complex sector. Defining construction as only including contractors on site ignores the contribution of the supply chain of all the building components and materials and the design and civil and structural engineering inputs and other specialists.

Construction is a process involving architects and professionals, contractors, merchants and distributors, plant and tool hire, in addition to minerals and products manufacturers. All but the contracting element of this process is neglected in the BEIS statistics. As a result, the BEIS statistics are likely to underestimate the value of the construction sector to the UK economy.

The supply chains that supply the goods needed for on-site construction include the product manufacturers, builders' merchants and distributors, plant and tool hire. Product manufacturers produce all the materials and products that go into the construction of a facility, and can be split into two broad categories: heavyside products and lightside products. Heavyside products include, but are not limited to, sand, bricks, concrete, asphalt, steel and glass, and tend to be used on the exterior of a building. Conversely, lightside products, which include lighting, heating and ventilation, air-conditioning and electrics, tend to be used in the interior of buildings. Builders' merchants and distributors act as wholesalers and retailers of building materials and products. Tool and plant hire firms exist to provide additional capacity for heavy machinery or tools that are needed on site to complete the project but are not currently owned by the contractor or subcontractor, which may be vital given that the bespoke nature of construction, with every end product in each project being different, means that different sets of inputs may be needed across projects. Directly owning machinery and tools for activity across all areas of construction would mean considerable periods of unproductive inactivity whenever there is little work in certain sectors. It therefore makes economic sense to hire plant and machinery only when required.

In addition, even within the contracting side, there may be many layers or tiers of contractors depending upon the size of the project. For example, Figure 1.5 illustrates that, even on a small project, with only one SME contractor involved, parts of the supply chain may be hidden, including when the contractor purchases materials and products from builders' merchants and distributors and hires additional machinery and tools when needed.

However, on large projects, as in Figure 1.6, there may be more than one major contractor, operating as a joint venture, as a result of the high degree of risk and the large scale of production involved. As they are usually multi-million-pound projects, and even multi-billion-pound projects, only the largest contractors have the size to take on the risk involved. The major contractors subcontract work out to those with skills in specific areas: specialist contractors and civil engineering firms. As with machinery and tools, direct employment of those with specialist skills would mean significant periods of unproductive inactivity when these skills were not needed. Subcontracting out specialist skills and activities ensures that the major contractors do not suffer the burden of unproductive cost when there is a period of inactivity. At the same time, it frees up the specialist firms to find work with other main contractors, which is an efficient way of using the resources of construction firms by making it possible to have continuity of work instead of periods of idleness. Subcontracting also explains why the construction industry contains a large number of small firms, which are taken on with other subcontractors to carry out large projects. In essence, the main contractors effectively undertake the role of winning projects and managing them.

In addition, for some construction products used in large quantities, the main contractor may purchase products directly from manufacturers in order to take advantage of economies of scale or savings of size. Economies of scale exist where the purchaser can obtain a product at a lower price by purchasing large quantities because buying in bulk reduces the cost per unit.

The Office for National Statistics (ONS) provides two other key sets of data that cover the UK construction sector. The first set of data is designed to help in calculating the total value of the output of all the industries in the economy as a whole. After steel is produced in the steel industry it is passed to the construction industry to be assembled as the steel frames of buildings. Similarly, glass is manufactured in the glass industry to become the windows as part of constructed buildings. If all the inputs to the construction industry were counted as part of the industries they come from, they would be counted twice if they were included in the value of construction output. Construction output is, therefore, only the value added to the materials and components by the contractors and subcontractors on site. Therefore, annual construction data measures only gross value added (GVA). Construction output, or construction gross value added, measures only the selling price of output minus the cost of materials, which, when taking all firms in the construction industry together, is what it provides to the UK economy after subtracting the inputs that go into construction from other industries, including designers and engineers. It is, effectively, the turnover minus the total amount spent on goods and contracted-out services. Using this method avoids double counting. Double counting would mean, for example, counting the work of subcontractors twice: once as a subcontractor, and twice when the same work was included in the value of the main contractor's sales.

Table 1.1 illustrates the GVA in UK construction during 2015, which was £119.2 billion. Sixty six per cent of this GVA was provided by building contractors, which included major contractors, specialist contractors, civil engineering contractors and the subcontractors in the construction trades. The importance of utilizing GVA rather than turnover is clear from Table 1.1, which shows that the GVA of contractors was £78.7 billion, while the total turnover or sales of contractors was £214.8 billion. Seventeen per cent of UK construction GVA is provided by manufacturers of construction products, with materials and products distribution providing 8 per cent of the GVA in the construction supply chain, while architects and professionals provide 5 per cent.

This ONS data on construction GVA helps us to understand that what is commonly used to measure the size of the construction industry is only the contribution of contractors and subcontractors on site and not the value of the finished buildings, including the materials and all the other inputs from architects, civil and structural engineers and other construction professionals. It tells us little about the type of work undertaken in construction. Construction is therefore not really one sector but several industries, as it covers such a wide variety of work. However, the second type of data available from the ONS covering the construction sector can give us an insight into the different areas of activity within the construction sector and how it varies over time.

This information comes from the "Monthly Business Survey (for Construction and Allied Trades)", which measures construction output from the industry in the UK. The survey samples 8,000 businesses, which include all businesses either employing over 100 people or with an annual turnover of more than £60 million. Construction output is defined as the amount chargeable to customers for building and civil engineering work done in the period, excluding taxes. However, once again, businesses are asked to exclude any subcontracted work, to avoid counting the work of subcontractors twice: once when the subcontractors record the value of their work in their statistics, but not when it might otherwise be included by the main contractors as part of the value of their output. Construction output also does not include payments made to architects or professionals from other firms. However, it would include them if they were directly employed by a contracting business registered in construction.

The ONS construction output data allows us to look at the value of construction output at current prices, which includes inflation. Current prices are the prices charged by contractors, and, over time, these prices increase because of inflation. Inflation is the steady loss in the value of money because of firms raising their prices, as the same quantity of output is sold for a higher price. If inflation is removed from the data, construction output can be measured in constant prices, showing the actual change in the quantity of construction activity.

Figure 1.7 illustrates the time series of construction output at both current and constant prices. The value of construction at constant prices helps us to assess the real change in output. The value data shows that the total value may have increased over time but it does not inform us whether the change is attributable to price increases or to increases in the real volume of construction. In Figure 1.7, between 1997 and 2007 the value of construction output more than doubled, an increase of 108 per cent. However, the volume of construction output rose by only 24 per cent. Consequently, the majority of the growth in construction value over the 1997– 2007 period was attributable to increases in price. Over the same period UK economic activity grew by 34 per cent, so UK construction did not increase as quickly as the rest of the country's economy.

One reason the construction industry did not grow when the rest of the economy expanded may have been because, every year during this period, the construction industry produced sufficient output not only to replace the existing stock of buildings and infrastructure but also to add to the building stock needed to accommodate expansion in the economy, and the increase in stock was achieved without increasing construction output by as large a percentage increase as the rest of the economy. One reason for this possibility is that buildings and infrastructure are durable. Once built they may last many decades, and annual construction output can easily exceed the amount of building work needed to maintain the current stock, a proportion of which constantly needs demolition and replacing.

During the financial crisis the value of construction output at current prices fell by 6.5 per cent between 2008 and 2009. However, after inflation has been removed from the figures, the volume of construction activity fell by 17.8 per cent between 2007 and 2009. This contrasts sharply with a 5.1 per cent fall in UK national income over the same period, evidence that the UK construction industry was three times more volatile than the UK economy overall. The volatility of construction activity is a subject we return to in a later chapter, as it greatly influences the need to cope with sharply fluctuating demand and uncertainty in the construction industry.