Keeping Project Costs Under Control in the Development Phase
However, the major impact on the construction phase is the cost of the labor. Large coal-fired projects use a lot of labor during the installation phase and unfortunately, there is a shortage of skilled labor which is driving up this labor cost. When initially planning the work, even before the engineering phase begins, more and more owners are turning to this issue of labor shortages. They are recognizing that project timing may need to be shifted to avoid other projects in the area that might be planned for the same time frame. They are also recognizing that the project design may need to be altered to reduce the dependency on massive labor, e.g. more shop assembled components may be required.
Owners are looking to contractors that can “guarantee” an available supply of skilled labor to build their projects. Unfortunately, by shifting this risk squarely upon the shoulders of the contractor, many contractors are left out. But those contractors that are accepting this responsibility are looking north and south of the border. Some are even talking about sourcing from overseas. Obviously, there is the issue of visas and training to overcome.
Another issue that is becoming more and more onerous is construction cost overruns. Contractors are claiming against (and suing) owners for unanticipated cost overruns. Usually, the causes are not clear cut. The claims and lawsuits frequently drag on for years with the final resolution being a lose-lose for all parties. To overcome some of this, a few owners and large general contractors now engage lower level contractors early in the project. At times, they pay for the subcontractor’s efforts to assist in design/constructability reviews as well as cost estimating.
When contractors are pushed to accept firm price construction contracts, a typical tactic is for the contractor to add contingency monies to his price to cover the eventualities of cost overruns or liquidated damages assessment. However, one owner negotiated a novel approach — the contractor disclosed the contingency he planned to add and the owner then set this money aside, in an escrow fund, to be used only in the event the contractor really needed it. Obviously, there were certain conditions imposed on both parties, but it kept the contract price closer to what a “clean” project would have cost yet it gave the contractor the comfort that there was a cushion in the event things went awry.
All of the discussions to this point have been aimed at mitigating project costs that usually occur before the site work begins. However, there is still much more preplanning that can be done in the project development phase which can have a significant impact on the site activities. The following are some typical examples, with actual cost reduction opportunities based on the $1.2 billion coal-fired project outlined at the beginning of this paper:
Let’s start with one of this industry’s most compelling and costly issues — safety. Many believe that the shortage of skilled manpower is the main culprit in the spiraling cost of power plant construction; they believe that to attract qualified labor will only require a larger purse, a larger payroll and a few more skilled individuals. It’s just not that simple. Today, and even before today, a large piece of project cost is unseen, unseen because it’s been buried in the element of the cost of safety; safety, and the insurance costs it has exacted. The costs of safety are, and will continue to be, a significant component of all of the previous, current and future power generation projects.
Just a quick arithmetical review of a typical power generation installation contractor will bear this out. Assume a contractor with $300 million in annual revenues (the kind of contractor who might take on the $360 million dollar construction portion of this $1.2 billion coal-fired power plant project). He’ll have a 7+ OSHA recordable rate averaging $25,000 of medical costs per incident. By adding in the indirect costs, this can go up to more than $35,000 per incident, or around $3 million per year. That’s one percent of this contractor’s revenues – or over $3 million built into the cost of the $360 million example.
So, many owners and general contractors decide early in the project development phase to only work with contractors who can demonstrate a history of safe projects. Cutting a few million dollars here and there add up quickly.
What is quality? One thing for sure, it’s never an accident. Rather, it’s the result of an intelligent effort. It is an attitude and it impacts cost. Without quality management, construction defects and their costs of correction become part of the cost spiral.
For example, not properly controlling the welding work of the boiler or piping could lead to major problems – problems that may require costly weld cut-outs, re-welding and re-stress relieving, or sometimes problems that won’t manifest themselves until years after the welders have gone away.
There is a cost associated with this lack of control. Literature is full of examples where poor quality results in costly remediation. There are statistics which suggest that twenty percent of a contractor’s gross sales are needed to cover the cost of poor quality. That’s the equivalent of one day out of every five days worked! Put another way, it’s $78 million out of the $360 million construction costs we’re discussing. Yet most contractors believe it’s only five percent of their gross sales. And even if it really were only five percent, that’s still a whopping amount of money. Based on our example in this paper, that’s equal to $18,000,000.
So what are some steps being taken to reduce this? Owners are starting to insist that each job, no matter its size, be executed within a formal quality management process. They are requiring that contractors interested in working on these large projects have programs with formal plans spelling out how quality will be achieved and feedback loops that delve into the causes of problems resulting in a prevention of their recurrence.
Historically, site purchasing can also equate to twenty percent or more of the total site costs. With numbers reaching this magnitude, site purchasing is an area that can be proactively managed.
There are many different ways to approach site purchasing and each one has its own plusses and minuses. For example, some large companies use their size to gain discounts due to corporate quantity purchasing. Local companies use their community presence to solicit expediency for critical support, and companies with a purchaser alliance partnership use it to leverage price with a promise of future business opportunities.
Most company procedures today still require the typical vendor selection process to follow a “three quotes and select the lowest bidder” scenario. Since this is exactly what often drives the relationship to be adversarial, some contractors now are using an alternate approach. They use the bidding process only for identifying and pre-qualifying suppliers. Then, they select one supplier and work with this supplier to maximize value creation for both parties, as opposed to reducing costs through squeezing margins.
Let’s assume for the example in this paper that the site purchases all of the small tools and consumables. This generally comprises around fifteen percent of the site budget, in this case almost $54 million. If one could reduce this cost by 15 percent, there’d be another $8,000,000 to save. Some larger contractors are starting to see this kind of savings and are aligning themselves with suppliers to be used on a multitude of projects.
Small Tools, Consumables, and Heavy Equipment
In addition to the $54 million dollars of small tools and consumables that comprise a $360 million construction project, there’s also an equal amount frequently associated with the heavy equipment costs. Unfortunately, many contractors and owners do not pay attention to this cost the way they pay attention to the labor element of the construction work. However, this is a combined $108 million that when well managed, can be ripe for significant savings. One owner found a 10 percent savings just by including a management person with the responsibility to cull out duplicate items, wasted down time and idle cranes. In this example, that can add up to almost $11 million in cost avoidance.
Over the past two decades, not much heavy equipment has been manufactured. With the onslaught of new infrastructure projects, worldwide, there is now a dearth of heavy equipment. Couple that with the age of the equipment that is available, and throw in the shortage of equipment manufacturing facilities, and suddenly there is another serious cost impact to building new power plants.
Several larger owners have taken novel approaches to resolve this. Some have actually entered into purchase agreements for large equipment, even before the engineering was very far along on the project. Their idea was to have this equipment available when needed, and then sell it upon completion of the work. Others have pre-paid vendors of this equipment to have the equipment available when needed, at the risk that if the project does not go forward, they lose the payment, a financial risk they were willing to accept.
If all of the above ideas could be implemented, the construction cost of the project could be controlled, or reduced by over $40 million just by planning to do what a few owners and contractors are now doing. However this requires an increase in one element of the project — the supervision. And it invokes the question, “Where do we get this skilled supervision? It’s not in the budget!” That is a very realistic question.
One answer lies in partnering. Partnering between labor and management, and partnering between contractor and owner can reap many benefits. The immediate benefit is the sharing of duties which will reduce the need for supervisors. Partnering will also lead to a lessening of oversight functions, further reducing the need for duplicate supervisors. So finding some of the “extra” supervision needed for cost-effective management lies in reducing duplicate tasks by partnering. This results in reducing the need for some of the supervision, but it must be planned very early in the project — it requires buy-in at the highest management levels.
Another partnering arrangement is to partner between the owners/contractors and third party suppliers. Putting together business arrangements between the partner group and construction equipment, or the construction tools and consumables suppliers is one such arrangement. By bringing the supplier into the construction management team, another level of site supervision can be reduced — the purchasing function. For those who worry about the “fox watching the henhouse,” periodic audits can always be arranged through independent third parties. This is also becoming more common. But again, it requires preplanning.
After looking at ways to more effectively manage the site organization, there’s also the importance of understanding what’s happening around the periphery. What about the parallel projects and their demand on the same resources required by your job? How can this be shared and coordinated, within the power industry and beyond. Can coopetition, contractors that are normally competitors cooperating and sharing ideas, processes and resources on the same project be a solution? Can sharing resources between competing job sites be a consideration?
Today’s owners and contractors are not only looking at the E, the P and the C segments of their EPC work. They are also re-thinking how to tie them all together by re-thinking their risk sharing arrangements. They are implementing different contracting arrangements. There are new phrases to describe some of this these days, phrases such as “modified EPC,” “financeable EPC,” “multicontract EPC,” “open book EPC” and more. Turnkey and lump sum contracting is now a rarity.
Owners are sometimes purchasing materials and equipment directly. They are sometimes arranging the currency or commodity hedges themselves. They are dealing directly with unions, where unions will be involved, long before a contractor has been selected. They sometimes arrange for the supply of small tools and consumables during the construction phase for all contractors. And sometimes, they have even provided some of the heavy equipment themselves, for use by their contractors.
By having inserted themselves into the EPC process very early in the project preplanning phase, owners are often in the best position to assume more risk, thereby also avoiding cost increases due to contingencies normally added by those bidding for the work at a later stage of the project. This is being done by more and more owners. Some are even staffing up to handle these increased responsibilities.
Because of the spiraling increase of the cost of many of the larger projects, lenders, PUCs and others are looking for assurances that cost predictions will hold true. This article has provided a flavor of how some owners and contractors are doing things a bit differently, early in the project development phase, to help keep these predictions in check.
Source: By Peter G. Hessler - Part #2
To the previous article, Part #1, click here.