Factors affecting the profitability of construction companies in Hong Kong

Abstract

This study investigates the factors that affect the profitability of construction

companies in Hong Kong. Profitability refers to income less expenses before

taxes, or net operating income, as a percentage construction business turnover (value

of construction work done). Profitability is an important indicator of a company’s

competitiveness and is also a key performance indicator of the quality a company’s

management. This study attempts to measure and explain the observed variations

in profitability across construction companies.

In this study, I have used construction company production data collected from the

Census and Statistics Department (CSD). The data set contains income and

expenses data of groups of construction companies classified according to HSIC

(Hong Kong Standard Industrial Classification) down to four-digit level over the

period 1981 to 2002. The data set was used for empirical analysis.

After controlling for depreciation of fixed assets, variation in cost of capital and

income from other businesses, our data show that profitability varies with company

size, degree of subcontracting and material content. The results suggest that as

the size of a construction company increases, profit margin declines initially.

Profit margin then increases as size increases beyond a certain size, which suggests

increasing return to scale. The scale effect, however, diminishes slowly and then

exhausted when size of the company grows beyond the optimal level, after which

the company will experience decreasing return to scale. Empirical data from Hong

Kong showed that there were only a very small number of "over-sized" construction

firms that operated beyond the optimal size. This suggests the construction

companies in Hong Kong are profit orientated and would not expand beyond the

optimal level to achieve other non-profit objectives.

In addition, I also found that both the degree of sub-contracting and the level of

material content have significant negative impact on the profitability of construction

companies in Hong Kong. The former result suggests that profit margin declines

as more works are subcontracted out. This implies that in addition to provision of

physical resources, subcontractors are also paid for their efforts in managing

resources, specialist knowledge and risk taking. The negative impact of material

content on profitability suggests that the construction material market is a very

competitive market. A construction company cannot charge a significant premium

(larger than its profit margin) for provision of construction materials as the

construction client or main contractor can also purchase the material at more or less

the same price.

The results of this study shed light on our understanding of factors that affect the

profitability of the construction contracting business, an area that serious lacks

empirical study. In addition, the results provide valuable information for the

decision makers of construction companies when tendering for construction work

and for benchmarking of the profitability performance of their companies.

Construction clients and cost consultants would also find the results useful for

construction cost budgeting and estimating.