Keep Your Eye on the Ball
Thomas C Schleifer, Ph.D.
We are at the beginning of what might be a rocky economic 2023. With the short-term future so uncertain it is critical to avoid running out of money while navigating this inflation fueled (post- pandemic/Russian invasion of the Ukraine) economy. The worst mistake we can make is to be smug. “I didn’t get COVID – the supply chain seems to be loosening up – Russia didn’t ‘conquer’ the Ukraine – everybody seems to be coming back to work – even inflation has smaller teeth than we thought.”
If you are thinking any of these things, you are not alone. My mind is full of the same optimistic whisperings and there are reports of plenty of work in the pipeline. This worries me, however, because as soon as we start to resurrect the optimism generic to us contractors (only an optimist would become a contractor) we take our eye off the risk ball. We begin to minimize the dangers and start seeing opportunities. In other words, accurate risk assessment may go out the window.
Risk Assessment
Risk exists in any commercial transaction, but the construction industry is particularly vulnerable to risk. Construction risk is sometimes poorly defined and often misunderstood. The responsibility for various project risks can be ambiguous. In our industry, designers avoid risk, owners prefer to pass it along, and contractors absorb it.
I’m not saying successful contractors are not risk takers. The very nature of our business is to embrace the risks inherent in a contractual business transaction that bets we can profitably complete a fixed-price, complex, regulated, high value building project over an extended period of time utilizing partners we do not directly control. Only a born optimist would even consider such a risky transaction. Contractors are risk takers. Successful contractors, however, are careful risk assessors. They do not take their eye off the ball.
Risk Factors
Today’s construction risk environment is dramatically different than it was in the past, and risk factors are mutating just enough to be almost unrecognizable. My research into contractor failure highlights the following ubiquitous risk factors native to contracting:
- Growth – Most of us contractors are addicted to growth. However, research reveals when a construction company expands in size, it requires careful management decisions to reduce the risks inherent in change.
- Partnership Risk – Each subcontractor and supplier are critical to a project’s success, so it only takes one disruption in the entire process to intensify project risk.
- Capital Position – We have been discussing this risk in the first three blogs this year. Secured equipment loans, unsecured working capital credit, and surety credit for payment, and performance bonds are vital to the construction concern. Every year a considerable number of construction companies exit the business because they run out of credit.
- Shortage of Skilled Labor – This risk factor has been growing steadily for the past 20 years and is getting worse with the pandemic and the current political bias against immigration.
- Commodity Pricing – Project owners have for some time been thinking of custom construction services as a commodity. This, in turn, encourages owners to be less discriminate about contractor selection and to think of price as the single key differentiator putting contractor profit margins in jeopardy.
- Contract Terms – As construction has become more litigious with buyers (owners) shifting risk to contractors, the need for legal expertise before contract execution has become as important to successful outcomes as proper engineering.
- Innovation – Advancements in field and office technology are competitive differentiators and will be even more so in 2023, driven by the worsening labor shortage. However, all change is risky, and innovation-related risks must be identified upfront to make informed innovation decisions.
Managing Risk
Risk in construction cannot be fully eliminated, but it can be mitigated. However, risks cannot be mitigated until they are identified, measured, and thoroughly understood. The three key risk management steps for, contractors, owners, sureties, bankers, and designers consist of:
- Recognizing and identifying specific risks in advance.
- Assessing and quantifying their importance and exposure.
- Mitigating and managing their impact and cost.
Investment Business Example
In the context of finance and investing, risk management is focused on assessing, monitoring, and mitigating operational risk, credit risk, and market risk throughout the day-to-day activities of the firm. One of the most common techniques in finance and investing is the assessment of Value-at-Risk (VaR), which makes use of historical information and probability theory to analyze the likelihood and magnitude of losses that could occur during credit events or market turmoil.
Just Think About It
Professional risk management is as applicable to construction as it is to investing. The moment before a contractor signs a multi-million-dollar performance contract is an “investment threshold” or “credit event”. I submit that signing such a contract not having identified, assessed, and executed proper risk mitigation is nothing short of reckless and irresponsible. It is time for our industry to recognize job, contract, and market risk as real threats to our company’s survival and take professional measures (like investment companies do) to recognize and manage risk.
More on this topic next week
For a deeper look into the Value-at-Risk, read more here: VaR
For a broader view into risk management read more here: RISK MANAGEMENT
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Please circulate this widely. It will benefit your constituents. This research is continuous and includes new information weekly as it becomes available. Thank you
