Industrialized Building and the Failure of Katerra

Why Modern Methods of Construction Don't Work

Offsite manufacturing, modular and prefabricated building have been transforming construction like nuclear fusion has been transforming energy: they have both been twenty years away from working at scale for the last 60 years. These ‘modern methods of construction’ have a dismal track record. The brutal economies of scale and scope in a project-based, geographically dispersed industry subject to extreme swings in demand have always bought previous periods of their growth and development to an end. 

 

While the history of prefabrication features major projects like the Great Exhibition in 1855 and more recently the Oresund Bridge in 2000, the reality is that prefabrication has only been successful in specific niche markets such as institutional buildings, or house manufacturers like the Japanese and Scandinavian firms Sekisui and Ikea. Failures like Katerra in mid-2021 and the mail order houses sold by Sears Roebuck a hundred years ago in the US are common. In the UK 2017 Industrial Strategy Construction was one of the four Sector Deals along with AI, the car industry and life sciences, with the aim to change the way buildings are created with a manufacturing hub for offsite and modular construction. By 2021 the focus had moved on, to the energy efficiency of buildings and new design standards. 

 

The up-front capital requirements of prefabrication make it a capital-intensive form of production, which brings high fixed costs in a cyclic industry characterised by demand volatility over the cycle. This means macroeconomic events often determine the success or failure of the underpinning business model and the success or the eventual failure of the investment. A batch of new US prefab housing firms failed during the GFC after 2007, for example, demonstrating the importance of the relationship between economic and business conditions and the viability of the business model for industrialised building.

 

Manufactured housing in the US also provides an insight into the institutional barriers to industrialisation in construction that exist in many countries and cities. Although the Department of Housing and Urban Development hasa national code, US cities discriminate against manufactured housing as local and county governments use a variety of land use planning devices to restrict or ban their use, and often place them in locations far from amenities such as schools, transportation, doctors and jobs. Despite these barriers, in 2021 there were 33 firms with 136 factories that produced nearly 95,000 homes. 

 

An ambitious attempt at offsite manufacturing (OSM) and industrialized building was made by Katerra, a US firm that was reinventing construction but has now gone into receivership. The manufacture of building elements and components somewhere other than the construction site has been variously called prefabrication, pre-cast and pre-assembly construction. Types of offsite construction are panelised systems erected onsite, volumetric systems that involve partial assembly of units or pods offsite, and factory built modular components or pods. The degree of OSM and preassembly varies from basic sub-assemblies to entire modules. Katerra manufactured prefabricated cross laminated timber (CLT) structures.  

 

 

Katerra

 

Katerra was a Californian start-up, founded in 2015. In 2017 it reached a $1 billion valuation, The company’s goal was complete vertical integration of design and construction, from concept sketches of a building to installing CLT panels and the bolting it together. On their projects the company wanted to be architect, offsite manufacturer and onsite contractor. This led to issues with the developers and contractors the company dealt with most of whom, it turned out, didn’t want the complete end-to-end service Katerra offered. 

 

The company started by developing software to manage an extensive supply chain for fixtures and fittings from around the world, but particularly China, and then added a US factory making roof trusses, cabinets, wall panels, and other elements. In 2016 the business model changed because architects weren’t specifying Katerra’s products. Katerra would design its own buildings and specify its own products. In 2017 it built a CLT factory that increased US output by 50 percent. The factory shut in 2019. Dissatisfied with design software that didn’t meet its needs, it developed a custom suite called Apollo. This was to be a platform for project development and delivery, well beyond the document control and communication of then available software from Oracle Aconex, Trimble Connect, Procore and SAP Connect. Apollo integrated six functions: 

1.      Report: use an address to find site information, zoning, and crime rates etc.; 

2.      Insight: design with the two building platforms; 

3.      Direct: a library of components used in the building; 

4.      Compose: for coordination between the different groups working on a project;

5.      Construct: for construction management (similar to Procore and Bluebeam):

6.      Connect: for managing the workforce on a project, with a database of subcontractors.

 

One of the company’s three founders was a property developer, and his projects provided the initial pipeline of work that made the company viable. Initially, buildings were designed by outside architects, but in 2016 the company started a design division. A second founder had a tech venture capital fund, the third and CEO did a stint at Tesla. Their ambition was to leverage new technologies to transform building by linking design and production through software, designing buildings in Revit and converting the files to a different format for machines in the factory. 

 

In 2018, after raising $865 million in venture capital led by SoftBank’s Vision Fund, Katerra acquired Michael Green Architecture, a leading advocate of CLT, and over a dozen other architects and contractors. In 2020 the business model changed again, by taking equity stakes in developments to boost demand. Katerra struggled to complete the projects. Accumulating losses and cost overruns during the Covid pandemic overwhelmed the company and in June 2021 Katerra Construction filed for Chapter 11 bankruptcy. 

 

In six years Katerra had grown to a 7,500 person company. That growth cost both money and focus, of the total US$2.2bn raised, SoftBank invested $2bn between 2018 and 2020. Without a clear focus, Katerra didn’t have a target customer base and got distracted by software and developing internet-of-things technology. The executive team was dominated by industry outsiders, but Katerra hired architects and engineers from traditional firms. Tension was inevitable. The fatal problem was execution, Katerra didn’t vertically integrate acquisitions into a company that did everything. It was fragmented and didn’t have a product platform or Apollo ready in time.   

 

With Apollo, Katerra was actually behind other companies developing platforms that manage design and construction in various ways. These platforms are at the technological frontier, a fourth industrial revolution technology for OSM with automated production of components. Other firms have developed different approaches to digital manufacturing and restructuring of firm boundaries to Katerra, integrating design and construction through development of digital platforms that provide design, component specification and manufacturing, delivery and on-site assembly. 

 

For example, in 2018 Project Frog released KitConnect, bringing together a decade of development into prefabrication and component design, and integrating BIM with DfMa and logistics. US start-ups in the wake of Katerra like Junoand Generate also don’t build factories but outsource assembly. Outfit offers homeowners a DIY renovation from its website, then orders and ships the materials and provides step-by-step instructions for completing the work (the Sears model again). Also in 2021, the IPO for PM software company Procore raised $635 at a valuation near $10bn, a record for construction tech. Rival Aconex was bought by Oracle in 2017 for $1.2bn. Platforms are in the process of becoming a basic part of construction tech. In the UK Pagabo launched a procurement platform in 2021, mainly for the public sector, using framework agreements for building work valued between £250k to £10m. Australian 2021 procurement IPO Felix had local start-ups Buildxact, SiteMate, Mastt, Portt and VenderPanel with competing platforms.  

 

 

Conclusion

 

The idea of construction as production was based on OSM, but after decades of development has yet to become a viable business model. There have been successes in manufactured housing, but often macroeconomic factors undermined their viability. Niche markets exist in institutional building, or wherever it is the most effective or efficient piece of technology available. This manufacturing-centric view of progress in construction, endorsed by numerous government and industry reports, is the end point of the development trajectory from the first to the third industrial revolutions.

 

The technological base of OSM is a mix of those from the first industrial revolution, like concrete, with second and third revolution technologies like factories and lean production. Despite all efforts this has not become a system of production because OSM does not deliver a decisive advantage over onsite production for the great majority of projects. Instead, construction has a deep, diverse and specialised value chain that resists integration because it is flexible and adapted to economic variability. Policy makers may neither like nor appreciate this brute fact, but economies of scale are the economic equivalent of gravity and OSM has not delivered. 

The constraints of OSM have outweighed the drivers and benefits. At this stage the market share of OSM remains small and niche, estimates are low single digits of total construction work in the UK, US and Australia. Success elsewhere is restricted to a few specific markets and project types. The problem is not the technology, which can be made to work, but the expected economies of scale are difficult to achieve because of a range of factors. Some of these factors are internal to construction, but others are external. In particular, macroeconomic events like financial crises or energy and commodity price changes can quickly undermine a business model. 

Norman Foster said in an interview ‘A building is only as good as its client’. With industrialized building the client is the producer, which is not necessarily a bad thing, however this has restricted its use to niche markets. How to apply the technologies of the fourth industrial revolution so they work with the economies of scale for onsite production in construction, beyond the OSM paradigm that has been followed for years without success, is the challenge

 

 

 

 

What is Construction Economics?

 Construction economics investigates issues and topics associated with the construction and maintenance of the built environment by firms, industries and projects, using economic theory, concepts and analytical tools.

 Construction economics is also concerned with the macroeconomic role of the construction industry and its relationship with associated manufacturing, professional services and materials industries. 

Construction economics applies a broad range of approaches to economic aspects of the construction firms, industry, and projects. These include industry economics, industrial organization and other management studies, financial and behavioural economics, econometric analysis and modelling, legal and institutional research, and transaction cost economics.

Topics of interest in construction economics include the roles of participants and processes, productivity and value for money, environmental performance and sustainability, the delivery process and procurement, the financing, viability and competitiveness of construction firms and projects, technological and institutional development, construction statistics and measurement, international construction, regulation, and government policies affecting the industry. 

Some of the earliest construction economics publications were on developing economies, bidding strategy, input-output data, building cycles, multinational firms, market structure, firm performance, size and scope, and the role of construction in long run economic growth. Over time organizational behaviour, transaction costs, decision making under risk and uncertainty, R&D and innovation were added. Recent work has been on issues around construction statistics and data and the measurement and performance of the construction industry and construction projects. 

Over the last five decades, contributions to construction economics have come from diverse viewpoints and places. There have been contributions from economists like Patricia Hillebrandt, Paul Strassman, Graham Ive, Stephen Gruneberg, Martin Skitmore and Goran Runeson, but also from architects, quantity surveyors, sociologists and engineers like Ducio Turin, Ranko Bon, George Ofori, Jim Meikle, Graham Winch, David Gann and Lauri Koskela. Construction economics is multi-disciplinary and uses multiple models to disentangle and analyse issues associated with the construction industry in particular and the construction of the built environment more broadly.

More Data on Australian Contractors

 Grattan Institute Transport Infrastructure Report

 

 

The Grattan Institute, a Melbourne based think tank for public policy, released an important report into procurement of Australian transport infrastructure projects. Their Megabucks for Megaprojects report has four chapters and makes 12 recommendations. The chapters contain a lot of carefully compiled and useful information, while the recommendations are all worthy and, despite their careful phrasing, make a strong case for greater client involvement in the design, documentation and management of large public sector projects. 

 

Chapter 3 of the report is ‘Competition is fundamental’, addressing the issue of the dominance of tier one contractors. The chapter collects data on projects and contractors that is not readily available, with the sources and methodology detailed in the appendices. Their key point is the increase in size of projects since 2014, as shown in Figure 3.3 below.

For the last few years the quarterly value of work done on these large transport projects has been over $5 billion. In 2020 Australian governments spent a record $120 billion on road and rail transport projects. 

The argument is that it is increasingly difficult for mid-tier contractors to win work on these very large projects, of the 11 projects above $3 billion 8 were ‘contracts involving multiple tier one firms’. These firms are ‘few and well-known’ in Australia and their Figure 3.10 shows how few, and how they consolidated their position through M&A over the last couple of decades. 

The two sources of potential competition for the three tier one contractors are domestic rivals that might scale up sufficiently or new international entrants to the Australian market. In chapter 4 the report argues strongly for breaking up large contracts to allow greater participation from domestic firms, Recommendation 10 is: State governments should develop and use a systematic approach to determining an optimal bundling of work packages for large projects, including when to disaggregate bundles that include both complex and straightforward activities. While not a new idea it is still important because public clients do not generally do this, and often do not have the resources required to manage multiple contracts. 

 

That leaves international entrants, which the report argues have been playing an important role since 2005: ‘International entrants add to local competition, and it’s very helpful to governments if there are a variety of market players willing and able to take on work. In particular, when tier one firms form a joint venture to bid on a large contract, the only source of genuine competition may be from international firms’. Their Figure 3.5 shows the distribution of contracts between new international entrants and firms that were already here in 2006. Of those firms, Bouygues won 4 contracts, Lang O’Rourke and Acciona 5 each. 

There are barriers to entry when bidding for these contracts, on top of the high bid costs. These are the lack of transparency in the weighting given to selection criteria and the emphasis on local experience. The report’s Recommendation 8: In selecting a successful bidder, governments should not weight local experience any more heavily than is justified to provide infrastructure at the lowest long-term cost. Governments should publish weightings of the criteria used to select the winning bid for a contract. The Grattan Institute is strongly opposed to ‘market-led proposals’ from contractors, and strongly in favour of open tendering. The state with the highest transparency rating is NSW, also the state with the most contracts with new international entrants. 

The report collects data on 51 projects over $1 billion in Australia since 2006. Their dataset of transport infrastructure projects includes 177 contracts worth more than $180 billion (in December 2020 dollars). That data makes this an important contribution to the debate about construction industry policy in Australia, to the limited extent that there is such a debate. A couple of decades ago this data would have been published by the Commonwealth, by the Department of Industry or similar organization, and incorporated into the procurement guides being developed by the Australian Procurement and Construction Council and related State agencies. The report concludes “these guidelines leave a great deal of room for subjectivity in the choice of contract type. Although some of the state guidelines and decision-support documents are quite detailed, none go so far as to prescribe a rigorous and systematic methodology for procurement strategy selection.”

 

This raises the awkward question of who the report is addressing. The fundamental problem is the politicization of the project selection process not the cost of delivery, Australian construction is not expensive by international standards. The recommendations address the problem obliquely by highlighting improvements in procedures and processes, all of which have merit, but not considering alternatives such as the role an independent authority could play or national coordination of procurement and other regulatory systems. In this it was something of a missed opportunity

 

 State and Federal budgets have billions in unallocated funds for projects at all levels (community sports grants, local and regional infrastructure) and for major projects the Commonwealth has Snowy Hydro, the NAIF, the Murray-Darling Basin Plan etc etc. These projects, large and small, shovel money out the door with little or no accountability and there is no evidence that politicians are interested in change at this time.  

Comparing Large and Small Construction Firms

 Output and Income for Australian construction firms 

 

Australian industry data is provided in the Australian Bureau of Statistics annual publication Australian Industry (ABS 8155), produced using a combination of the annual Economic Activity Survey and Business Activity Statement data provided by businesses to the Australian Taxation Office. The data includes all operating business entities and government owned or controlled Public Non-Financial Corporations. Australian Industry excludes the finance industry and public sector, but includes non-profits in industries like health and education and government businesses providing water, sewerage and drainage services. The selected industries included account for around two-thirds of GDP. Excluded are ANZSIC Subdivisions 62 Finance, 63 Insurance and superannuation funds, 64 Auxiliary finance and insurance services, 75 Public administration, and 76 Defence. The most recent issue is for 2018-19.

 

The analysis is based on industry value added (IVA) and industry employment. IVA is the estimate of an industry’s output and its contribution to gross domestic product (GDP), and is broadly the difference between the industry’s total income and total expenses. IVA is given in current dollars in Australian Industry. The data is presented at varying levels for industry divisions, subdivisions and classes, but unfortunately does not include the number of firms. There is, however, some firm size data. Micro firms have less than 5 employees, small firms 3-19, medium firms 20-199 and large firms more than 200 employees. 

 

Figure 1 shows large construction firms have 15% of employment, 30% of wages and salaries and 23% of output. Medium firms have 18% of employment, 27% of wages and salaries and 21% of output, and micro and small firms account for approximately 65% of employment but only 55% of output. The labour-intensive work of small firms largely explains the lack of long-run growth of productivity in construction.

 

Figure 2 shows large firms have twice the level of output and income per employee compared to small and micro firms, and medium firms nearly 50% more. There is no significant difference between micro and small firms. IVA per employee is an imperfect but useful proxy for productivity, and this shows the gap between large and medium size firms is significant. 

The relationship between firm size and IVA per employee is not surprising, large firms are typically better managed than small firms. Management is the most important determinant of the capacity and capability of construction firms, because managerial skills give a contractor greater flexibility. How firms utilise their capabilities differentiates them within a diverse, location-based production system. It is widely recognised there are differences between industries in the way that production is organized and new technology adopted, adapted and applied, but differences within industries generally get less attention. Important differences are the individual characteristics of firms such as their size, the effects of competitive dynamics, and how the adoption of new technology by one company in an industry influences the adoption of technology by other companies in that industry. For building and construction this is significant, not only because of the number of small and medium size firms, but because of the size and reach of the major firms.

 

Figures 3 and 4 show IVA and income per employee for three years respectively. The most recent 2018-19 year is representative of the industry, based on this data. Construction firms convert around a third of their income per employee into IVA per employee, however large firms have twice the income per employee. These figures identify the balance sheet effect, as firms leverage the capital on their balance sheet to maximise revenue and profits. 

Construction has a large number of small firms bidding for work in local markets with little or no control over prices. There is a diminishing number of firms that can deliver large projects in a given region or have national operations, and there are a few dozen multinational corporations in construction. Construction economics has a wide range of views on the types of markets these firms operate in and their competitive behavour. There is, however, universal agreement that construction is an industry of projects, and firms operate in markets for projects of many different types. 

 

The relationship between firm size and contract value is therefore a fundamental reality in construction, and is also the foundation of the relationship between projects and firms. A firm is a legal entity and the typical reporting period is one year. A firm’s income is the cumulative cash flow of their portfolio of projects over a year. The focus on projects and construction management in construction research obscures the role of firms as the ongoing participants in the industry. 

 

For firms in construction markets annual revenue is the aggregated income from current work, or contracts won but not completed. Construction firms and contracts range widely in duration, size and value, but the amount of work a firm can take on must be related to the capital a firm has available. This relationship between firm size and the annual value of contracts or projects undertaken is based on the assumption that construction firms seek to maximize revenue but are constrained by their working capital. In construction the contract packages reflect the complexity of work, so there is a wide range of contract sizes. Construction contracts can, therefore, be arranged based on contract size and complexity. This is a well-known and widely agreed characteristic of the industry, with the relationship first researched in the 1980s. Competing contractors’ bids were affected by the type of project and by the value range, small firms considered both contract type and size, and large firms were more successful when bidding for large contracts. Contract size and complexity are also important because the wide range of contract sizes in the construction market is the major determinant of the number of firms. In a project-based market, defined by project size and complexity, there are many standardized projects but few companies able to undertake particularly difficult projects, those large construction firms deliver large projects and/or with a high degree of complexity.

Fewer Large Contractors in Australia

Long-run Changes in the Number and Size of Firms in the Australian Construction Industry 

There have been five Construction Industry Surveys (CIS) by the Australian Bureau of Statistics (ABS), the most recent for 2011-12.  All five surveys found the construction industry is overwhelmingly made up of small firms which contribute most of the industry's output and account for almost all of the number of enterprises. Table 1 shows the breakup between contractors in Building and Engineering and the subcontractors in Construction services (which were called trades in the earlier surveys). The 2002-03 survey used different categories of businesses (not establishments) in residential, non-residential and non-building, and trade services and is not comparable with the other surveys. In 2002-03 there were 339,982 businesses of which 269,228 were trade services and 70,753 were residential, non-residential and non-building businesses.

How the size of firms is measured in the CIS has changed twice. The three surveys in 1996-97, 1988-89, and 1984-85 divided firms into three sizes: employ less than 5, employ 5-19, and employ 20 or more. The 2011-12 survey divided firms into small 0-19, medium 20-199 and large with over 200 employees. The 2002-03 survey divided firms by income and the data cannot be compared to the other surveys however, although income was used to classify firms, the 2002-03 survey produced a similar result, finding 90% of firms were small or very small. Here the 1996-97 survey and the 2011-12 survey data is presented. The breakup of firms by size is in Table 2.

In the 1996-97 survey businesses with less than five employees accounted for 94% of all businesses and over two-thirds of all employees. Less than 1% of businesses employed 20 or more. Businesses with less than five employees accounted for slightly less than half the total income and expenses, whereas businesses with employment of 20 or more accounted for almost one-third of these. The data in Table 3 is percentages, showing the importance of the 0.62% of large firms. Their 13.6% of employees earned 32.3% of salaries and wages, generated over 28% of income and nearly 25% of gross output.

The survey in 2011-12 classified firms by the number of employees into small 0-19, medium 20-199 and large with over 200. The same data for the 2011-12 survey is in Table 4. The changes between 1996 and 2012 are revealing. The total number of firms has increased marginally from 195,000 to 210,000, but the share of small firms has increased from 94% to 98% as the number of medium and large firms fell from 12,300 to less than 5,000. There was a trend with the number of medium sized firms decreasing to less than half, while slightly increasing their share of industry employment.

In 2011-12 less than 0.1% of firms were large, employing 18.6 % of the workforce, paying 32% of wages and salaries and generating 27% of industry income and 25% of output. 

 

These are remarkably similar to the 1996-97 CIS numbers, however, the 186 large firms in 2011-12 had almost the same share of employment, income and output that 1,200 firms had in 1996-97. This was a significant increase in industry concentration. In the 1996 survey the 1,200 firms employing 20 or more had a total of 66,000 employees and accounted for 13.6% of employment and 24.4% of industry output. 

 

In 2012 there were 186 firms employing 200 or more with 177,000 employees, accounting for 18.6% of employment and 25.5% of IVA. These long-run changes in industry structure can not only be the result of business failures, which are common with SMEs but less so for large firms. Instead, there has been a long wave of mergers and acquisitions reducing the number of large firms and increasing industry concentration. 

A stylized representation of construction industry firms by market type is in table 8, showing how concentrated markets can be the outcome of either firm size or specialization. Figure 5 relates market type to contract size. As a firm gets larger it takes on bigger projects and compete with fewer other firms. How construction economists sought to reconcile theoretical and conceptual models of construction firms with the messy reality of the construction industry is discussed in the next section.