December 15, 2017 by David Bowcott
The primary defense against margin erosion is the project contingency. Construction is not a predictable business, and the project contingency is that all encompassing pool of capital dedicated to each project, which provides much needed funding when the unexpected happens. The contingency is not profit margin while the project is at risk, rather it is a cushion of capital to protect the project margin. Any good contractor, from the prime contractor to the lowest-tier subcontractors, use project contingencies. However, the criteria that separates good contractors from great contractors relates to the methodology they use to arrive at the ideal contingency. Those that use a consistent and disciplined method when building out project contingency create options that allow them to win projects ahead of those that throw all risk into a contingency bucket with minimal effort or discipline.
Any good contractor, from the prime contractor to the lowest-tier subcontractors, use project contingencies.
Before we get into the techniques used to arrive at a disciplined contingency build out methodology, let’s do a quick recap of the capital sources that are used to fund the unexpected:
Insurance and Performance Security – Required by contract or purchased by choice, insurance and performance security cover a multitude of unexpected events including property damage, third-party property damage or bodily injury, design and professional failures, environmental events, and contractor/supply chain failure. Such insurances are dedicated to the project, or can be in the form of the practice policies carried by the prime design firm, the prime contractor and its respective supply chain. Of note, there is an over-supply of insurance capital, and that means risks not traditionally thought of as insurable can now be insured.
Funds of Others – Some unexpected events are the result of other project stakeholder’s actions (or responsibilities others have via contract), as a result they are responsible to provide necessary funds to recover from the unexpected event.
Contingency – The funds in excess of your project margin that are used to deal with the unexpected. Sometimes these funds are used and not recovered, but sometimes they are used to bridge finance until other funds are recovered (insurance, funds recovered from other parties). The projects overall contingency is made up of all contingencies carried by all parties to the project.
Profit Margin – When recovery can’t come from sources referenced above, you are left with eroding the project’s expected margin in order to correct for an unexpected event.
Balance Sheet – When the above sources are not an option, it is ultimately your balance sheet that will bear the costs of correcting the unexpected event.
A foundation of disciplined contingency build out is capturing as much data around contingencies used in previous projects. What caused the contingency to be eroded in the past and to what degree? In order to accomplish this you need to have a very strong data strategy. Quite simply, when things go wrong on your project, and there are resultant unexpected costs, does your firm have a consistent and disciplined approach to capture and aggregate this vital data? Is the data set robust enough so your firm can sort through the data easily and apply it to various projects you bid on throughout the year? Are you using consistent risk event categories in order to make the data aggregation efforts easier and more effective? Key data variables like asset type, geography, and project delivery model could provide your firm with comprehensive insights when setting future project contingencies. If you don’t have a well thought out, 100-per-cent consistent methodology, you need to make the investment to develop one. Additionally, whenever possible, use the data of others to add to your repository.
Once your firm has a best-in-class contingency build out strategy, you will be able to arrive more accurately at your project contingency. Further you will be able to more creatively, and efficiently manage contingencies. For instance, if you clearly break out the various risk events that are captured within the contingency, you will see if there are less expensive options to finance those risk events. As an example, if you have a very high level of confidence as to how much of your contingency is related to weather events, you can now perform a cost-benefit analysis on the potential of buying weather insurance. There are several new risk finance options in the market and if you accurately break out your project contingency, you will create efficiencies in your bidding process that could mean the difference between winning and losing the project.