Sector - Finance & Legislation
Creative Ideas for Mitigating Unpredictable Costs
It will come as no surprise to anyone in the construction industry that we have a real issue with unpredictable costs, especially in this current time of supply chain and labour disruptions. Our own research at the Southern Construction Framework talks about a forecasted average 6% increase by Q2 2022, and up to 10% nationally as reported by our NACF colleagues. Meetings with our contractors, consultants and clients can leave us collectively scratching our heads. But equally there have been some great ideas that have come out of these conversations or have sparked more creative thinking around how we address and mitigate the fundamental problem of whether a project, which could be years in the making, is still affordable.
But it isn’t all bad news there are some great innovations coming from this. Here are some ideas below, which won’t necessarily always be relevant to all, but could be useful nuggets to take away and adapt.
*Also, a word to the wise… while indices (e.g. BCIS) are an important means of measuring and predicting change, they are ultimately estimates and in such a volatile and unpredictable market, can quickly become outdated. So, while they can offer some insight, always consider the wider context.
Early involvement of a complete and integrated team
For new projects, bring on board your consultants and a contractor from as early as possible. Consider both as part of your team. Share the outputs you want and the budget you have and work through the solutions together. This approach allows you to take advantage of offsite prefabrication (locking in prices sooner). Pick a procurement route that embeds that ethos on day one. Use the expertise of the integrated project team to ensure cost information is kept up to date – as mentioned above, third party indices can be falsely reassuring, an early integrated supply chain can give real-time advice and provide a far more accurate picture of what is achievable within the budget.
The important thing is to stay open minded and welcome the expertise and opinions of all.
Mitigating currency fluctuation
It is very difficult currently to get the supply chain to take any risks on currency exchange fluctuations, because understandably, they are uncertain of what is going to happen in the future and need to protect their business. If you ask a contractor to take a risk, understand that they will need to build in contingency and take a risk averse approach (particularly in the current market).
Some of the bigger and longer standing construction trades have been accustomed to being exposed to currency fluctuations and are therefore more able to adapt to change. These suppliers haven’t worried so much about currency fluctuations or have tried and tested ways that they turn to in order to deal with it. For example, an installer of air conditioning units may know that it is going to have to spend a lot of Euros, so will likely have a pot of Euros within the business to make sure it can always buy at preferential rates. The reason currency fluctuations are such an issue right now is because members of the supply chain that wouldn’t usually be exposed to these changes (or at least the fluctuations would not be so significant) are much more risk averse.
My first piece of advice, which from my client days in construction project management I would have found somewhat to difficult advice to accept, is to get closer to the finance team and as early as possible in the project. A great example of how this can work well is with a higher education client that already charges some of its students in Euros so is already taking a risk around currency fluctuation as an institution. On this basis, we supported the client to review its standard practice of converting all currency received from students and keep income in Euros. With this, an agreement was reached to enter a contract sum split between Sterling and Euros. Fixed as two currencies meant that the risk premium associated with currency exchange was mitigated, at a fraction of the proposed risk cost.
That might not be an option to all clients, but you can also consider taking out insurance on currency fluctuations (or supporting your contractor to do so).
Involve the finance operation in this decision making – it’s to the benefit of all!
The earlier the purchasing, the better
Early purchasing is nothing new, but perhaps has never been more important. By planning in advance and working hand-in-hand with suppliers throughout with open and transparent dialogue, it is possible to engender a more collaborative culture. Multiple heads are always better than one in coming up with solutions.
This is especially useful if you don’t have a constrained site and you are able to purchase and store materials early and onsite. Just-in-time delivery is not as reliable as it once was so this helps mitigate not just against cost risks but programme to.
Even if storage on site is not available, early orders can allow suppliers to in turn place orders with their own suppliers to lock in material and third tier contract prices.
Successfully using Contractor Design Portions (CDPs)
CDP can get a bad reputation for many reasons associated with the contractor coined ‘Design and Dump’ approach. Whilst I would not advocate this approach wholesale there is a way of looking at CDP that could help particularly around materials costs and be considered by contractors.
In short, using CDPs can be a clever way of getting through some of the price fluctuations. We return to the example above. Consider an M&E designer installing an air conditioning unit for a project. They are going to be the people buying it, so by doing the CDP they are able to pick the right components that are currently available with a fixed price on the market. They can build the design around what’s available, rather than relying on the less specialist knowledge of the contractor design team. In a two-stage open book procurement process, those sub-contractors are incentivised to find the best priced materials as competitive tension still remains!
Another re-emergence, this time in construction contracts is the X1 clause. X1 has not been seen much in the industry in the last 10 years as prices have been relatively stable (I personally have never seen this clause used on any project I have supported), but it is now becoming much more popular. The principal is that it links certain packages of work to various indices, so rather than asking a contractor to price a risk for price fluctuations, they peg the price of a particular item to an indice. If a price goes up a contractor benefits and if the price goes down they don’t. Quite often they include a float or some tolerance, so that it is only when the fluctuations are extreme in either direction that there’s a benefit (or not) to the client or contractor.
Switching to NEC Option C is also worthy of consideration at the moment, which is a different form of contract. Option A is usually the most commonly used but is a fixed-price contract. Option C is ‘pain gain’. So, there is a target price for the main contractor and if they come in less than that, there is a share of that gain and if they come in over, there is a share of the pain.
For both options you do need to consider whether a switch to this form of contract is compliant with your procurement route. Many single supplier or direct award frameworks are not able to change their contracts in this way. However, multi supplier arrangements (where a Mini Competition is used), don’t have to specify a single form of contract (or contract terms) so it can be open to change. It goes without saying you need to check your organisation’s risk appetite, whilst there are definitely some benefits to this approach, it does mean you are shouldering some of the risk yourselves.
By Kingsley Clarke, Operations Lead at Southern Construction Framework
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