It has been almost three years since the onset of the COVID-19 supply chain crisis. Since then, we have seen rising inflation, knock-on rising interest rates and labor supply shortfalls.
But the impact of inflation, rising interest rates and labor shortages on the financial health of the construction economy isn’t immediate. The financial impact on subcontractors, suppliers and prime contractors is often felt two to four years after these metrics turn for the worse. When we look at the beginning of inflation rises and interest rate rises, we see it has been approximately two-and-a-half years for inflation and one-and-a-half years for interest rates. Labor shortages in construction has been a growing problem over the past 10 years and worsened with the onset of COVID-19. We are now entering that critical window where financial weakness caused by a worsening of these metrics is beginning to have an impact on the financial results of the construction economy. Bottom line, all construction stakeholders need to exercise heightened operational vigilance to minimize the impact of these “company crushers” on their organization.
Top 5 Operational Risk Controls for a Weakening Construction Economy
So what does “heightened operational vigilance” mean? Well, your organization has operational procedures, which are likely a combination of written procedures and procedures housed within your enterprise/project management platforms. Some of these procedures might need to be tightened and adherence to these tightened practices emphasized to staff. The following represent five operational practice areas all construction stakeholders should be constantly reviewing to ensure they remain best in class:
1. Go or No-Go Practice
This practice focuses on your organization’s ability to vet the risk of taking on or carrying out a specific project. In this process you assess the risks associated with the project and compare those risks to the project’s opportunities. Some of the component parts of this procedure include:
The use of a formal risk assessment methodology, including a risk matrix.
A review of the project scope, market sector, geographic location and other key metrics to ensure it aligns with your business plan and, more importantly, your experience and skillset with delivering the project.
The establishment of a dedicated “go or no-go” team which includes senior leaders of the organization.
Sign-off procedures that validate senior management has vetted and either approved or rejected moving forward with the project.
2. Prequalification
Does your organization have a formal prequalification process to ensure the construction stakeholder partners you are working with have the financial, business and safety measures in place to carry out this project successfully? All stakeholders should be prequalified, including those that are letting the contract to your company and the subcontractors who will carry out the work, including design firms.
3. Award Practices
Once you have prequalified the firms you are going to enter into contracts with, you need to ensure that these firms have clarity of their contractual responsibilities, have accounted for all the appropriate components in their pricing and adhere to the requirements of the contract post-award. Within this category of operational practices, you would have procedures for bid leveling (e.g., ensuring a subcontractor’s price includes the proper scope of work), clarity on contractual obligations and assurance that all necessary documentation is provided before the contract execution begins (i.e., properly signed contract, licensing, insurance, surety bonds, subcontractor default insurance, etc.). With labor issues contributing to a number of risks on a construction project, it’s critical that your pre-award vetting process includes an assessment of both the quantity and quality of the labor forces needed to complete the scope of work as stated on the master schedule. This can also include a past performance review, a work-in-process compared to annual revenue comparison and in-person meetings with key stakeholders to really vet whether they can deliver on their obligations.
4. Performance Security
Is your organization asking for the appropriate amount of performance security from the organizations you are transferring project responsibilities to? Are you asking for surety bonds or letters of credit? Is the amount requested sufficient? Do you have a subcontractor default insurance program in place? Are you utilizing financial tools like holdback properly within your contracts? These and many other performance security tools can be utilized to reduce your financial exposure to contractual failure.
5. Quality Assurance/Quality Control
Does your organization have a formal QA/QC team that ensures the work has not only been done but also has been done properly? Does that team have authority to stop work when they have identified defective workmanship? Does every project get a dedicated QA/QC manual to ensure all project stakeholders recognize what needs to be delivered for the project? Are your project teams conducting first work-in-place inspections for all new definable features of work, or at least the most critical ones? These and other QA/QC procedures will ensure you are not paying for work that hasn’t been done or hasn’t been done properly.
The above represent only five categories of operational risk control. Your organization should ensure you not only have these procedures (and others) in place but that they’re also best in class. Diligence around your operational risk control practices at this precarious time in the economy will be well worth the effort, both for your profitability and your corporate brand. The next two to four years should see growing weakness in the construction economy, but you have the opportunity now to act.
Questions? Contact:
David Bowcott
Managing Director, Construction and Infrastructure Group, NFP
100 King Street, Suite 5140 | Toronto, Ontario M5X 1E1
Cell: 416.566.5973 | david.bowcott@nfp.com
River Steenson
Senior Vice President, Subcontractor Default Insurance Leader, NFP
1068 9th St. | West Linn, OR 97068
Cell: 503.939.7249 | river.steenson@nfp.com