Underwriting Prefabrication: Is the Juice Worth the Squeeze?
On average contractors expect their prefabrication labor hours to double in the next five years, according to FMI’s 2024 Labor Productivity Study Part 2: Prefabrication. While that is a bold and exciting vision for the future of prefabrication in our industry, it will not happen without significant commitment and investment from individual contractor organizations to grow their prefabrication capabilities.
In the volatile, low-margin business of construction, big bets on the future are scary. It’s often daunting for contractors to think about major investments in prefabrication, given limited resources of capital and talent. So how do you right-size and rationalize the investment thesis? If you had to go to your board or executive leadership team to ask for approval on the investments necessary to grow prefabrication, what would your business case look like?
Looking at this through a purely objective financial lens: Is growing the percentage of work that is prefabricated accretive to earnings? Does the growth of prefabrication also need to enable additional enterprise growth for the economics to make sense?
Comparing the economics of traditional installation methods versus prefabrication-enabled installation requires the ability to analyze the two approaches at the operating profit margin level. While prefabrication may have lower direct costs and higher gross margins, it also has presumably higher operating expenses (facilities, equipment, etc.). Therefore operating profit margin is a logical economic comparison metric.
To think through how to understand the opportunities for prefabrication, let’s examine a couple high-level scenarios:
Scenario 1: There is no material difference between our operating margins on prefabricated work versus traditional methods. (See illustration below.)
| Current State | Prefab Growth Only | Company & Prefab Growth | ||||
|---|---|---|---|---|---|---|
| Traditional Methods | (Millions of $) | (Millions of $) | (Millions of $) | |||
| Revenue | $100 | $90 | $100 | |||
| Operating Profit | $5.0 | 5.0% | $4.5 | 5.0% | $5.0 | 5.0% |
| Prefabrication | ||||||
| Revenue | - | $10 | $10 | |||
| Operating Profit | - | 0.0% | $0.5 | 5.0% | $0.5 | 5.0% |
| Total | ||||||
| Revenue | $100 | $100 | $110 | |||
| Operating Profit | $5.0 | 5.0% | $5.0 | 5.0% | $5.5 | 5.0% |
Rationale for pursuing prefabrication growth at similar operating margins to traditional methods:
- Prefabrication Growth Only
- While the earnings may be the same, we presumably have more certainty in safety, schedule, quality, etc. (i.e., We are able to reduce the overall risk profile of the business. So, the risk-adjusted earnings are more attractive.)
- Enterprise Growth in Addition to Prefabrication Growth
- By increasing our prefabrication volume and/or capabilities, we are enabling enterprise growth, as our limited resources of experienced installers and field leaders are freed to take on more work, as a portion of their current work (presumably more basic, routine tasks requiring less experienced or skilled workforce) is being prefabricated by others. This allows the organization to pursue a great volume of work without having to source experienced craft and field leadership at the same rate. (This same resource capacity-enabling effect can be achieved through outsourcing of prefabrication to a third party, assuming the economics are a wash.)
- Enhanced prefabrication capabilities may also enable enterprise revenue growth by increasing your firm’s attractiveness to owners or general contractors that require their trade partners to deliver prefabricated solutions. Said differently, prefabrication capabilities can provide access to project opportunities previously unavailable.
Scenario 2: Our operating margins are materially greater on prefabricated work than traditional installation methods. (see illustration below).
| Current State | Prefab Growth Only | Company & Prefab Growth | ||||
|---|---|---|---|---|---|---|
| Traditional Methods | (Millions of $) | (Millions of $) | (Millions of $) | |||
| Revenue | $100 | $90 | $100 | |||
| Operating Profit | $5.0 | 5.0% | $4.5 | 5.0% | $5.0 | 5.0% |
| Prefabrication | ||||||
| Revenue | - | $10 | $10 | |||
| Operating Profit | - | 0.0% | $1.0 | 10.0% | $1.0 | 10.0% |
| Total | ||||||
| Revenue | $100 | $100 | $110 | |||
| Operating Profit | $5.0 | 5.0% | $5.5 | 5.5% | $6.0 | 5.5% |
If our prefab work is more profitable than our traditional installation methods, any incremental revenue we can move from traditional field installation methods to prefabrication is accretive to earnings. The rationale here is the same as scenario 1, but now we are realizing margin expansion through the incremental growth of prefabrication.
In either scenario, or permutations thereof, the objective is to be able to square the economic rationale for growing prefabrication.
If, for example, you were able to develop a thesis that prefabrication has the potential to enable the enterprise to add $1 million annually to operating profits, this would likely encourage people to pay attention to the opportunity. What is likely to follow is a series of questions related to investment needed to realize this opportunity:
- Do we have the internal controls today to truly isolate earnings between our prefabrication shop and field installation?
- What level of investment is required to grow our prefabrication capabilities to a level that can deliver these kind of results? Over what period of time?
- What is our anticipated return on investment? Over what time horizon?
- What level of confidence do we have that our current or future work will support this type of increase in our prefabrication volume?
- What shifts in our strategy, business development, estimating/preconstruction/design efforts would we need to act on to capture more of the right work that would facilitate growth in our prefabrication function?
- What are the internal, organizational hurdles we’ll have to overcome to make this work?
These are all valid questions that deserve to be answered before investing heavily behind a strategy to grow prefabrication. But the initial step of sizing the economic (profit) opportunity on the end gives an organization a jumping off point to begin having substantive conversations about how the strategy could work, and what additional diligence efforts need to be conducted before underwriting a prefabrication growth strategy.
