Helpful Practices for Risk Management in Construction

Follow these construction risk management tips when buying construction projects in a down economy.

In the current economic conditions, many development project owners are looking for bargains, and there are bargains to be had. Whatever the politicians may say, contractors know the construction industry is still in a slump. The slump has translated into a lingering-maybe even malingering-drive toward the cheapest price. If you are bidding on a project, be prepared to compete with two or three times as many bidders as in better times. Even if you are in a negotiated price situation-congratulations!-the pressure remains to keep prices, fees, general conditions and any other cost elements as low as possible. This pressure has resulted in many contractors and subcontractors bidding work at ridiculously low or even negative margins.

It is one thing to pursue a particular project or opportunity as a “loss leader.” But you do not need an MBA to understand that this is not a sustainable business model. Yet many contractors seem oblivious to the long-term consequences of taking projects at a loss. Each instance of a below-cost price is a train wreck in the making, as the laws of economics are a force to reckon with. Some contractors and some projects will survive the situation, but more than a few will find themselves in an ugly mess.

There are no easy answers, unless you have no employees, low overhead and enough money in a savings account to cover the costs for a year or so. What about everyone else? You’ll need proven strategies to survive this climate and the self-discipline to implement the techniques.

Stay Away From Unfamiliar Market Sectors

A tight market with hardscrabble pricing is the sort of opportunity that should come with alarm bells. This is not the time to enter unfamiliar territory, when the ability to plan and price contingency is non-existent. Too many contractors decide to do just that, and many of them will not survive the experience. By the same token, stay away from subcontractors whose job experience is unrelated to the pending project. Even those with flawless reputations may suffer, and if a major subcontractor is struggling, the entire project will suffer, too. In addition, any contractor desperate enough will go to great lengths to conceal its problems until those problems have blossomed and grown so large that the entire project is affected. Stick to known markets and look for subcontractors who are doing the same.

“Making It Up Later” Is Not a Proven Strategy

In a good economy, contractors may deliberately pursue pricing below market on some aspects of a project, with the intent of finding savings in other aspects of the project in order to make up the cost deficit. But that strategy does not work when every single aspect of a project, and every single line item on the estimate, has been pared to the bone from a cost perspective. Resist the urge to believe that there are opportunities in the buy-out or in purchasing that will enable you to find the magic savings. In other words, be honest with yourself.

There is No Free Lunch

Pricing that is too good to be true is, indeed, probably too good to be true. Whether you are submitting a hard bid or assembling a guaranteed maximum price, resist the temptation to take a super-low price from a subcontractor whose pedigree you can not determine. 

Advise your own customer, whether project owner or prime contractor, that some low prices are too risky to accept (think: contractors whose inability to perform could derail the entire project). Push back on any customer who is applying too much pressure to accept prices that are too low from contractors who are too close to the edge. 

Enforce Construction Risk Management Discipline

Now is the time to pay even more attention to insurance certificates, verification of available funds, surety bond opportunities, corporate guarantees or any one of the other risk management tools available no matter where your company is in the project line-up. Ask questions up the chain about where the money is coming from and do not accept vague answers.

Ask questions down the chain about each contractor’s ability to bring a viable workforce to the project and obtain materials and equipment. Ask questions about whether money is flowing all the way down the “food chain” of subcontractors and vendors. And in each instance where you have not yet signed a contract or a subcontract, negotiate hard for contract clauses that obligate the other party to respond to these inquiries and allow you to suspend work if you are not paid on time or allow you to pay lower tiers directly if need be. 

Good risk management is not limited to pushing risk downward onto others. Now is the time to follow all those risk management rules or practices that were put in place in a better economy, even if they have been ignored for a while. 

Watch for Warning Signs

If a payment is late, do not beat around the bush. Ask why it happened, ask what could have been done differently to avoid a late payment, ask what steps will be taken in the future to prevent a recurrence, and then follow up. If you hear that vendors and lower-tier subs are not being paid, confront the upper-tier sub to find out why and insist on direct communication with lower tiers in order to minimize the likelihood that project funds will be diverted from them.

Require Surety Bonds

When project budgets are being pared, adding in the cost of surety bond premiums may seem unnecessary. But remember that requiring performance and payment bonds from a contractor brings two benefits. First, established sureties are more careful nowadays in writing bonds, and financially shaky contractors should be flushed out of the process as a result. 

Secondly, a surety bond provides security for either performance or payment, depending on the type of bond at issue.

The answers are not very hard, although implementing those answers will most certainly be difficult. But that is what it will take to get through a very tight construction market. You do not want to be part of the train wreck.

Construction Business Owner, October 2010