Monday, June 25, 2012
On LinkedIn, an engineering student, Lina Maria Arroyave Gutierrez, posted a questionnaire about whether construction was risky. I wanted to expand upon that post in terms of discussion of not just the risks but also how those risks are managed. Construction like many other commodities has a number of inherent risks because of the nature of the work. It also has many of the risks that are common with other types of procurement. One differentiator between construction and other commodities is in the potential magnitudes of the risk. A second differentiator is while the purchase of goods has many laws such as the UCC that apply, construction is a service and those laws do not apply. Management of the risk with construction is done in a number of ways and throughout all stages of the work.
The most common methods of managing risk starts with location / site analysis. In location and site analysis you would be considering a number of factors that Lina Maria listed such as:
•Advance site review and analysis (preventative risk management) :
•Permits and government approval required
•Potential for War and civil disorder
•History of Labor problems / Strikes
•History of Corruption & Bribes
•Availability of resources and materials
•Opinion of neighboring community
•Safety (personal, property)
•Potential conflicts due to differences in Culture (Language, religion)
•Local laws and requirements
•Environmental / Conservation Restrictions
•Inconsistent/different site conditions
•Poor accessibility, site surrounding conditions
One you have determined that the location and site are acceptable for your needs the next step in the process is to determination of conceptual requirements as part of preventative risk management. This may be done as part of what is called the “programming” phase of the design where the designer will meet with the customer to determine the specific needs of the customer for size, functionality, capability, use, capacity, flexibility and future growth or expansion. Some customers may totally know what is needed and will tell the designers that while others need to work with the designer to go through the thought and review process to determine what’s required. This identifies the general scope of what’s needed. The better you are at determining these requirements, the fewer changes there may be to the overall scope of the work.
The next step is the prequalification of the architect, engineers and consultants that will be used to design the project, and possible review and manage the performance. This is another preventative risk management tool. Pre-qualification includes interviews, reference checks, financial checks, prior customer feedback. For specific projects that would be similar to yours it may also include verifying that individual members of the proposed team have the required experience, as they will frequently be different than the team that delivered the prior successful project. As a buyer the last thing you want is for someone to be learning at your expense either as billable hours or in errors made that need to be corrected. Having design standards that establish the quality of what you want designed and the types of materials that you want to be used is a good way to manage against the cost of over-design as you are limiting what the designer may use for the design.
The contract with the architect or engineer will allow the Owner to manage certain costs and transfer certain risks to the designer. This is done through a solid description of the services they need to provide and their standard of performance in performing those services. For example to transfer the risk of errors or omissions in the design to the designer normally is done through three things. First is the establishment of the designer as an expert, which requires the highest standard of care. A disclaimer of any buyer knowledge of the subject is second, so it is clear that the buyer is relying upon the supplier for performance. The third may be to require Errors and Omissions Insurance policies for errors or omissions to the design of the work.
The next step in managing the cost and risk is the management and review of the design during the design process to ensure that the design meets the customer’s business requirements and any design standards provided. As some design contracts fees are based upon the cost of construction it’s important to avoid the design in of materials that add no additional value, only cost. To avoid assuming design risk, the Buyer or owner may make suggestions that the designer has the right to accept or reject. If the buyer was to direct the supplier to manage the design in a specific way, that direction could absolve the designer from liability if that direction was the cause for the error or omission. So part of a buyer’s managing its risk is the management of its own people.
The next step in managing risk and cost is the prequalification of the contractors, subcontractors and equipment suppliers that will be used in performing the work. This is done for preventative risk management to ensure that the supplier or contractor has the skills, experience, capacity, equipment and personnel to perform the work. Pre-qualification includes interviews with the contractors, reference checks with other customers, financial checks of the supplier, prior customer feedback, etc. Depending what is discovered you either may determine the supplier or contractor is not qualified to perform the work or that you may need additional terms and requirements in the contract to manage against risks you identified.
In construction procurement there are a number of different contracting strategies that may be used and each contract strategy has different inherent risks that may need to be managed in the contract terms. Different strategies also require different levels of management and different skills sets of the individuals involved. The contracting strategy will also have a potential impact on the work schedule so there will be a trade-off between the desire to have the work completed quickly versus the different costs and risks associated with each contracting strategy. For example, having a complete design for bid or proposals is probably the least risky, but it also takes the longest time for the work to commence. Approaches that allow the commencement of some of the work earlier have risks that need to be managed.
The next step is analysis of potential risks with specific contractor or subcontractor selection. Not all potential contractors are equal in terms of size, financial stability, capabilities, management tools and personnel capabilities. As such with each potential supplier you need to determine what changes, terms or other commitments are needed to ensure the specific contractor performs. There are four basic approaches to manage the risk of performance. Those tools are:
1.Relationship building with the Contractor,
2.Structural management (such as requirement meetings and reviews) and management escalation rights.
3.Formal management under the contract (such contract notices).
4.Financial (such as liquidated damages).
As part of managing cost and risk you need to manage the contractual transfer of certain risks to the contractor. This is done by
1.Establish responsibilities and tasks to be performed.
2.Establish “standards of commitment” for each task.
3.Include contractual remedies for non-performance (For example include liquidated damages).
4.Require indemnifications for certain third party claims that are caused by the Contractor or their sub-contractors
5.Require insurances from contractor for all possible perils.
6.Include contract terms that transfer other risks.
7.Include requirements for contractor to establish and manage both quality and safety programs.
Do not direct the contractor on how to do either as that could make you responsible if they follow your instructions and there is a problem.
Another key in managing cost and risk is to ensure the contract is written in a manner where it will be enforceable. For example this would include making sure the party that signs the contract has the authority, making sure the entity you are dealing with can be held accountable and has the necessary assets to stand behind the commitments they make.
Perform on-going management and review of the work as part of managing quality, compliance to the drawings and specifications, performance and management of risks. If needed, include financial protections against certain risks such as financial guarantees, or bonds for payment and performance of the work.
You may use of specialists and consultants both in advance (such as site surveys, boring samples etc.) and during construction for testing, management of quality and compliance with the specifications and drawings as part of testing and acceptance or the work.
Establishment an owner representative or project office on site for management of change, claims and frequent reviews of progress and performance by all parties involved helps manage performance and reduces potential claims for delays and problems can be acted upon promptly.
Contractual Risks that may arise may be broken down into two categories:
1)Those that you can perceive in advance and address in your contract and
2)Those that are not contemplated and may need to be addressed during the contract term.
Examples of some of these risks cited by Lina Maria along with some of the ways they may be managed are listed below:
a) Change in government. A change in government if perceived in advance can have certain risks be managed in the contract such as rights to terminate the contract if project was government funded and funding is cut. Potential economic policy changes where work performed after that date may be subject to adjustments based upon changes in inflation.
b) Changes in mandatory labor rates would normally allow for claims to be made by the supplier for work performed after the change in rates.
c) Changes in currency exchange rates may be managed a number of ways in the contract for items that will be required to be imported as part of the work or could be managed by advance purchase or hedging
d) Change in customer requirements are normally addressed through the changes provision
e) A change in customer’s need for the work may be addressed by rights to terminate the agreement without cause or issue a change order to significantly reduce the scope of the work
f) Obsolescence is normally dealt with via changes to the project scope.
g) Use of new materials or technological advances are managed by changes to the scope of the work.
h) Technical complexity is managed in part by pre-qualification and selection or qualified designers and contractors.
i) Safety risks are managed by transferring the risk to the contractor and requirement that they manage programs and also carry insurances.
j) Natural Disasters are managed in contracts by both “force majeure” provisions that excuse performance and insurances against such perils. For a contractor their loss revenue during the period may be managed by Business Interruption Insurance policies.
k) Weather conditions (wind, temp, rain, etc.) Normal weather conditions are a risk that the contractor assumes although they may make claims for additional time and cost for excessively bad weather conditions versus historically normal conditions.
l) Changes in requirements are managed via change order or variation provisions
m) Funding issues and payment delays are usually managed by payment requirements, interest on late payment and the ability to file liens against the work and the contractor’s ability to stop work and claim breach of contract for late payment. They may also be managed by third party payment guarantees.
The following risks listed by Lina Maria are normally managed by assignment of trained, skilled team members of all parties involved in the project and may be enforced by approval rights over all project personnel.
•Lack of coordination
•Poor and incomplete drawings
•Lack of standards
•Documents not issued on time
•Delays in subcontractor works
•Poor project/plan schedule
•Low productivity/ Incompetence/quality
•Organizational stability/change in staff
•PM team responsibilities ill defined
•Incompetence and lack of skills
Construction Procurement is no different from many of the standard contract risks that exist in supplier relationships, of which many of those you seek to manage through your contract terms. Every procurement activity can have the following risks:
1.Performance risks with contract deliverables, quality, schedules, on-time delivery
2.Risks from third party claims
3.Risks of supplier claims
4.Contract enforcement risks
5.Risks in defining and getting what you want.
6.Risks with change to the product, the relationship, your demand, the circumstances.
7.Risks in pricing and payment
8. Risks in long term support
9. Availability and continuity of supply risks
10.Legal risks associated with the product or service complying with laws
11.Risks with defective products or services and warranty redemption, warranty support
12.Risks with delivery performance and the need for flexibility
13.Risks dealt with in the various types of insurance coverage.
14.Risks with the import / export
15.Risks with the supplier performance or interruptions to performance
16.Risks in recovery should something go wrong
Within each of the above general categories there are a number of different risks that may be involved. For example, to manage enforceability risks requires that the contract be written in a manner to ensure that all the terms are clear and enforceable. Problems with contract terms can negate the transfer of risk or costs and they can impact the ability to recover costs and damages for a breach or even being able to claim a breach.
Common risk management techniques for any procurement also apply to construction. Those are:
1. Clarify all requirements in advance
2. Pre-qualify and use qualified, stable suppliers.
3. Select a contracting strategy you can best manage with the people and skills you have.
4. Use the contract terms to transfer risks and responsibility to manage performance to the party that is most capable of managing those.
5. Train internal personnel to manage risk and performance
6. Manage financial risks with bonds, insurances, warranties and guarantees.