How will your business practices change during the next 10 years?

When you think about your firm’s business practices, have you basically been doing business the same way for the last 10 years? Now, think ahead: Do you think you will be able to continue doing business the same way for the next 10 years?

When most engineering firm owners are pressed, they admit that most of the business practices their firms use are those they learned at the firms they left before starting their own businesses. When asked to speculate where those predecessor firms might have learned their business practices, most owners admit that the predecessor firms probably learned at the knee of the firms before them. If you follow this train of thinking, you will discover that—despite all the technical innovations of the modern engineering age—the business practices of design are 80 to 90 years old.

If we look at the sector in simple supply and demand terms, we may be able to detect patterns that can help plan the future of our firms. If the business practices of engineering truly haven’t changed in dogs’ years, the sector is ripe for change, either from within or from without.

Supply
The total number of design companies in the United States has been dropping since 2001 (Figure 1). We have experienced almost a 22-percent loss in firms since then. At the same time, U.S. engineering graduates, especially in construction-related disciplines, continue to decline (Figure 2). The United States produced almost 2,000 fewer civil engineering graduates in 2005 than in 1996, despite increased demand across the country. Meanwhile, although there is some debate on the validity of the numbers, India produced 350,000 engineers and China 600,000. India and China’s numbers may include associate-degree holders, as well as other disciplines not counted as engineering in the United States, but even then, the numbers are orders of magnitude greater than in the United States.

Figure 1: Total number of design firms in the United States (Source: Dun & Bradstreet)

Figure 2: U.S. engineering graduates (Source: American Association of Engineering Societies, 2005)

Engineering salaries in construction-related disciplines have stagnated for almost 10 years relative to the general economy. American Council of Engineering Companies (ACEC) members report that their average starting salary for entry-level engineers is $44,000 (ACEC Business Trends Survey, 2006). Meanwhile, Wall Street investment firms actively recruit graduate engineers with starting salaries in the mid $70s. At the spring ACEC meeting in Washington, D.C., one company principal stated publicly that 80 percent of Columbia’s graduating engineering class walked down the street and started jobs with investment firms.

The profile of engineering companies is also unique (see Figure 3). Small companies predominate—more than 75 percent have five or fewer employees. The total of the "jumbo" (more than 100 employees) and "large" (between 25 and 100 employees) categories is less than 50 percent of the total sector. This represents a fragmented sector, one where no single company or group of companies holds a controlling market share. One of the aspects of a fragmented sector is that a broad range of companies compete for the same work, and therefore suppress prices. Companies with many employees and large overhead structures compete against smaller companies with little or no overhead, making any decision to increase prices problematic.

Figure 3: Profile of U.S. Engineering Firms—Small = 5 or fewer employees; Mid-sized = 5 to 25 employees; Large = 25 to 100 employees; Jumbo = more than 100 employees (Source: Dun & Bradstreet)

Also weighing in as a factor in the supply of engineers is baby-boomer retirement. There are currently approximately 78 million baby-boomers and only about 32 million "gen-Xers" to replace them. This is a negative replacement rate of 2.5 to 1. For many owners, this replacement rate will make a normal retirement-through-succession impossible, as there will be many more sellers than buyers. As the baby-boom generation retires, many companies will experience a knowledge deficit as the experience and hands-on knowledge departs with the retirees.

Demand
Since the end of the recession in 2002, demand for construction has leapfrogged. The American Institute of Architects’ Architectural Billings Index (ABI) stated that 2006 and 2007 may be "the best two years in a row since the late 1990s," with increases of 6.2 percent in 2006 and 6.3 percent in 2007, compared with each prior year. Residential construction still remains down, but ABI predicts robust activity in health care, office buildings, and hotels. Health care and institutional activity account for more than 60 percent of the non-residential construction activity in the United States.

Infrastructure needs have been temporarily put on the back burner in the war economy, but remain as real needs to be addressed when the war eventually constricts. In 2006, the U.S. Department of Transportation (DOT) estimated that the "cost to improve" highways in the United States would be nearly $119.9 billion annually (DOT 2004 Conditions and Performance Report), and that is for highways alone, not other infrastructure needs. Meanwhile, construction costs are projected to rise 70 percent from 1993 to 2015.

Imbalance in the equation
If the supply of engineers in the United States is shrinking and the demand for services is going up, why aren’t fees going up? Because of the fragmented nature of the sector, each and every company, no matter the size, believes it is in competition with all others. With their lower overhead structure, small companies can compete successfully against large firms at a lower price point. There is also an endemic opinion in many companies that engineers shouldn’t make a lot of money. These factors combine to keep prices artificially low for the companies that compete in the sector, making engineering services a relative bargain in the construction enterprise.

Also adding into this imbalance is the increase in offshore engineering companies that provide U.S. firms with opportunities to outsource plan and specification preparation. Since many of these offshore companies use Indian and Chinese labor, their rates are one-sixth the rates that U.S. companies charge. U.S. companies that outsource labor in preparing plans and specifications are using the price advantage to hold prices at a low level, rather than increasing along with U.S. labor rates.

Predicting the future
If we stand back from our companies for a minute and look at them with a long view toward their five-year future, what can we predict? The following seem absolutely certain:

• fewer bodies to do the work;
• increased demand for services; and
• fewer companies competing for the work (but larger ones).

The following are not certain, but probable:

• outsourcing will increase in response to labor shortage; and
• alternate delivery methods will increase.

Planning for the future
As a company plans its future, it will have to take into account the above pressures. Companies will be faced with choosing between equally unpleasant options: turning down work because they are short-handed, or taking on work with the risk of failing on delivery. Since production of new engineers takes 10 years—five years of college and five years before sitting for the professional engineer exam—even legislative help on the education side will not help this shortage.

One of the best tools engineering companies can use to plan their futures is scenario planning. While usually a "big company" tool, it can be used successfully by companies of any size. Scenario planning essentially charts out expected future states and then looks at the probability and risk associated with each future state. For example, what would happen to your company if you had 33 percent fewer employees against the same demand for services? What would happen if your residential market dropped off entirely? What would happen if your top three clients went out of business?

Collecting the data and projections on future states can be both entertaining and harrowing, but the most difficult part is in assigning probabilities to these future states. It is best to have a wide variety of input to the process to increase the validity of the outcome. Once you have decided on a "most probable" future, then break down the tactics necessary to get your company there.

The next 10 years will most definitely not be the same as the last 10 for engineering companies. Too many forces are at work simultaneously to allow the sector to muddle along unchanged. The engineering companies that will survive into the next 10 years are those that envision their role in the changed state of labor and construction, and adapt fluidly to that new role.

Robert VanArsdall is senior business management consultant in the Design Professional Group of the XL Insurance companies. Through its Design Professional Group, XL Insurance offers professional liability insurance programs for architects and engineers. More information about XL Insurance and its products, including the new XL Insurance Contract Guide for Design Professionals: A Risk Management Handbook for Architects and Engineers, is available at www.xldp.com.