Risk Management in Construction Projects - Case Study Example

Risk Management I. AACE Dictionary 1. Risk Assessment The first thing to observe about "rational expectations" is that financial risk analysis is conducted, by agencies responsible for credit ratings. Thus, as an example, Standard & Poor's Credit Week affirms several issues on the grounds that "The ratings reflect the sound economic base of the service area, strong historical and projected financial performance, and the strong cash position of the electric system. The St. John's River Power Park project remains on schedule with commercial operation dates of April 1987 and October 1988 for units 1 and 2. . . ." A less favourable report lowered ratings because, As of June 30, [1986,] Gulf States had about $3.2 billion of debt and preferred securities outstanding. Continued absence of rate relief and the prospect of an additional rate cut in Louisiana due to disallowance of Southern Co. contract capacity requirements will result in further deterioration in measures of creditor protection. The highly political regulatory environments in both Louisiana and Texas and a severely depressed service territory substantially heighten bondholder risk. These assessments are supported by analysis of cash flow models and the exploration of what-ifs. Thus, if a utility is interested in a target bond rating, or if a regulatory body is concerned with the supply of capital to agencies under its supervision, prefiguring the implications of various local and regional developments seems advisable. 2. Risk Analysis Financial risk analysis shares a great deal with risk analysis as practiced in engineering or natural hazards policy. Expert opinion can be polled for anticipated ranges for risk factors and the values most likely to be realized. Using estimates of the range and distribution of a risk factor, financial risk analysis considers the performance of investments and the balance sheet of an enterprise. Financial risk analysis may contribute to (1) project selection, (2) the selection of financing options relevant to a given project, and (3) perspectives concerning company risk, based on an examination of cash flows. One basic motivation is to identify or develop risk management plans for investors or a utility organization to cope with uncertainty concerning future market conditions. Two issues arise at the outset of discussion of financial risk analysis. These relate to: (1) the relation between financial risk analysis and financial market processes, and (2) the rationale for quantifying the analysis. 3. Risk Mitigation In other respects, scepticism seems warranted by recent events in financial markets Thus, the entrapment of major investment figures in a web of insider trading and a pattern of collapse and bailout vis-à-vis a number of lending institutions do not seem to vindicate the invariable "rationality" of financial markets. Some means of checking expectations vis-à-vis various investments, especially ex ante their final selection, seem advisable. The Japanese may be setting the standard today in their aggressive utilization of modern computing capabilities and extensive cost databases, as the following description in an article by Kurazo Yokoyama from ABI Inform, a computer database, suggests, Actual cost data on about 10,000 buildings constructed by 40-50 firms in Japan over the period 1975-1984 were analyzed. . . . The construction cost of a standard building design with the usual functions is calculated, which is called the median cost. Then, special feature factors are selected from the tables of various building conditions. The proposed method allows an easy calculation of the cost . . . necessary to simply imagine the building. . . . The workability and accuracy of the technique have been approved by applying it to over 270 cases in the past three years. Annual Transactions of the American Association of Cost Engineers (AACE) (Morgantown, W.V.: AACE, 1988). 4. Risk Control How can the likelihood of construction cost overruns be evaluated? Range estimation is a major approach to this question, as noted in the cost engineering literature. See, for example, Michael W. Curran, "Range Estimating: Reasoning with Risk," Annual Transactions of the AACE ( Morgantown, W.V.: AACE, 1988), n.3.1-n.3.9; R. W. Hayes, J. G. Perry, P. A. Thompson , and G. Willmer, Risk Management in Engineering Construction ( Morgantown, W.V.; Thomas Telford Ltd., 1986); Karlos A. Artto, "Approaches in Construction Project Cost Risk," Annual Transactions of the AACE ( Morgantown, W.V.: AACE, 1988), B-4, B.5.1-B.5.4; and Krishan S. Mathur, "Risk Analysis in Capital Cost Estimating," Cost Engineering 31 ( August 1989): 9-16. This method is supported by historical cost data or reliance on judgmental factors when a database of comparable facilities does not exist. Range estimation operates with cost summaries of major items in a construction project, estimates of their range of variability, and other information, where available, about the likely distribution of component costs. The term "range estimation" derives from first approximations that operate with lower and upper bound estimates of component costs. Additional information usually shrinks the estimated variance of total costs, reducing estimates of contingency funds needed to cover changes in the total cost at a given confidence level or a given percentage of the time. In this sense, range estimation provides a yardstick for measuring the adequacy of contingency funds and the value of information about the variability of component costs. II. Fellows, R 1. Risk Identification Risk has its origins both within and outside a given organizational environment. For example, many of the risks you face lie outside your control because they arise outside your realm of operations. Government regulations fall into this category. Companies that produce hazardous substances, for instance, chemical companies, are always concerned that government will change environmental laws in such a way that it becomes difficult to produce their products cost-effectively. Other examples of external sources of risk include the actions of competitors (for example, they have just introduced a new product that makes one of your product lines obsolete), demographic trends (for example, the aging of the population reduces demand for your youth-oriented products), or acts of nature (for example, a sustained drought causes a dramatic drop in the output of agricultural products). 2. Risk Quantification In Fellows, R; there are two significant problems with quantification in risk analysis. First, there may not be adequate data to support efforts for quantification. And second, many people in the work world suffer from innumeracy: owing to their inadequate knowledge of mathematics and measurement, they are incapable of conducting quantitative analyses or interpreting the results of such analyses. Each problem will be discussed briefly in turn. To quantify something, you must have data, which need to be collected in some fashion. If you are dealing with events that you seldom encounter (such as terrorist bombings of buildings), you do not have the basis for collecting enough valid and reliable data to create a usable database. 3. Risk Allocation Conducting risk assessments is not cost free. It requires the allocation of qualified resources to study current processes within the organization and the environment external to the enterprise, identify possible risk events, examine their possible impacts, and suggest strategies to handle them. If resources are not available to conduct effective risk analyses, then their value will be limited. 4. Risk Response Risk identification enables you to determine what good and bad things you might encounter when undertaking an effort to do something. Risk impact analysis, both qualitative and quantitative, provides insights into the consequences of the occurrence of the identified good and bad things. Now it is appropriate to ask: What can be done to deal with the identified risk events? The process of addressing this question is called risk response planning. III. Flanagan, Roger 1. Risk Identification The concept of risk is measured by the distribution of the returns or revenues from an investment. This is called a risk profile and is a probability distribution. Thus, analysis might portray as a risk profile of rates of return from a particular investment. Probabilities are marked on the vertical axis. The horizontal axis lists rates of return that may be achieved under the varying conditions encompassed in the analysis. One major consideration is usually the variation or dispersion of this risk profile around its mean or expected rate of return. Risk adverse individuals prefer tighter distributions around the mean, even, perhaps, at the cost of a slightly lower expected value. Other decision makers may favour investments offering more dispersed returns, using the rationale that they might achieve very high rates of return. The idea is to present information as full and complete as possible on the distribution of returns from a prospective investment to inform choices about whether to go ahead with construction, whether to adopt modifications in project configuration and financing, or the like. 2. Risk Classification The problem with classification at the level of utility projects, however, is the potential size of electric power and water investments. At the level of project or financing selection, there may be no recourse except the comparison of risk profiles. The significant impact, particularly among certain classes of investors, occasioned by the default of WPPSS also illustrates the dangers of complacency concerning single projects or single company’s vis-à-vis the national bond market. Another notion is that, if a project can be financed, its market valuation summarizes all relevant information about its prospects. At best, therefore, financial risk analysis "begs the market," and, at worst, its findings might deter investors who otherwise would be pleased to place their money down. 3. Risk Analysis Modern portfolio analysis contributes an intriguing twist to financial risk analysis. The capital asset pricing theory and similar approaches focus on the co variation of an investment's returns with the payback from a portfolio of investments representative of the market as a whole. 6 The interrelation of company risk, market risk, systematic risk, and unsystematic risk largely displaces individual investment risk profiles in deciding how to buy stocks. One implication is that risk management can be achieved through suitable diversification. 4. Risk Response Risk response planning is concerned with how best to handle risk events that can arise. Its goal is to go beyond abstract analysis and to prepare people for action. If an untoward event arises and a plan has been developed to deal with it, handling it becomes a matter of implementing the plan. Having plans in place has advantages. First, it enables the people affected by a risk event to respond to it quickly, thereby minimizing damage that the risk event can cause. If you are prepared to put out a fire on your stovetop, you can arrest it before it grows into a conflagration. You can deal with it immediately. IV. Perry & Hayes 1. Risk Identification Construction is an unusually risky endeavour, and work site dangers form only part of the risk. Employers who risk capital in construction face considerable financial risks. As we have seen, construction is highly volatile. Responding exponentially to the business cycle, the demand for construction services booms and collapses unpredictably. Demand flits about from place to place as regional business cycles differ, and as jobs start up and shut down in any one locale. Demand can even fluctuate within a locale between various sectors of construction. How construction organizes itself to face, avert, minimize, or shift these risks varies considerably across countries. However, one common response to the risks faced by capital in construction is the use of subcontracting systems to share and shift risk. 2. Risk Analysis Typically, construction activity is divided into four broad sectors - residential housing, commercial buildings, industrial facilities, and infrastructure construction (roads, dams, pipelines, power and communication transmission lines, etc.). This last sector is called “civil engineering” in the European context and “heavy-and-highway construction” in North American terminology. Each of these sectors of construction activity follows its own somewhat distinct business and seasonal cycles. Regional and sectoral differences in an already volatile seasonal and cyclical business present a moving and difficult target of opportunity for profit. Techniques for risk analysis have been theoretically established for a number of years, but their practical application on construction projects has been limited (. Capitalists run the real risk of idling their fixed capital investments by missing the next target of opportunity in the ever-shifting structure of construction demand. All capitalist construction industries in all countries have devised strategies to limit exposure to the risks of idle capital when the demand for particular construction services in local areas collapses. While strategies vary considerably from country to country, they all share one common characteristic. As most construction firms are small with relatively little capital and relatively few employees compared to other goods-producing industries, there is limited capital put at risk in the face of unusual turbulence and uncertainty. 3. Risk Response In any planning to treat risks, attention should focus on these two dimensions. First, risk response plans should be developed to lessen or eliminate the likelihood of untoward events arising. For example, if you want to reduce the risk of being murdered, don't travel in high crime areas. Second, risk response plans should be developed to lessen the impact of risk events. For example, if you don't want to miss your favourite TV shows during a power blackout, you can purchase a battery operated tabletop television. Customized production creates risks. There is the risk customers will not buy what they actually want or need. There is the risk that, what customers buy will deteriorate unexpectedly. The burden and responsibility for these risks is shared and shifted among the various entities that conceive, design, purchase, and construct the customized products of the construction industry. V. BS 8444: 1996 1. Risk Identification Risk is present in all human activity; it can be health and safety related (involving, for example, both immediate and long-term health effects of exposure to toxic chemicals), economic (resulting in, for example, destruction of equipment and lost production due to fires, explosions or other accidents) or affect the environment (BS 8444-3:1996; pp. 2). In the early 1990s fixed price contracts, whereby the builder bears the risk of cost overruns, became the norm. Prior to this, builders were able to pass on additional project costs to clients through time extension and price variation clauses in contracts. Under fixed price contracts, cost increases due to factors beyond the control of the builder (such as design problems) are borne by the client, while site-specific cost increases are borne by the builder. Costs flowing from factors beyond the control of both parties are shared between the parties. The implications of this risk sharing for the management of labour are important. 2. Risk Estimation Risk shifting and risk reduction provide a second reason for extending the subcontracting system. Competitive subcontracting does not increase specialization; rather it introduces competition on the job site among similar subcontractors. The articulation of subcontracting down to individual workers is usually designed to evade regulations protecting wage workers rather than designed to extend specialization. These competing reasons for articulating subcontracting may work against each other. For instance, the cost-cutting goals of competitive subcontracting and independent individual subcontractors may heighten the risks general contractors face in attempting to meet construction deadlines and quality standards, because they come to rely on low-skilled workers. 3. Risk Evaluation It is the process in which judgements are made on the tolerability of the risk on the basis of risk analysis and taking into account factors such as socio-economic and environmental aspects. Construction is an unusually risky endeavour, and work site dangers form only part of the risk. Employers who risk capital in construction face considerable financial risks. As we have seen, construction is highly volatile. Responding exponentially to the business cycle, the demand for construction services booms and collapses unpredictably. Demand flits about from place to place as regional business cycles differ, and as jobs start up and shut down in any one locale. Demand can even fluctuate within a locale between various sectors of construction. How construction organizes itself to face, avert, minimize, or shift these risks varies considerably across countries. However, one common response to the risks faced by capital in construction is the use of subcontracting systems to share and shift risk. 4. Risk Response Subcontracting is a method for managing risk, but it also can be a method of labour control and a way to cut labour costs on construction work sites. In manufacturing, there have been two widely used methods for managing labour costs. The first is extending the detailed division of labour into ever more finely defined tasks that require fewer skills to perform and are more easily monitored because of their simplicity. The second method is tying workers to an assembly line where a worker's job is defined by a carefully laid-out progression of tasks that are typically mechanically interconnected. 5. Risk Monitoring The speed of work is roughly determined by the speed at which the assembly line is run. While construction work is not amenable to assembly line production, highly articulated subcontracting systems can serve to introduce and extend specialization within the division of labour on the construction site. This is the case in cooperative subcontracting. However, this is not always the purpose or result of subcontracting. VI. PRAM 1. Risk Analysis This stage of the process is generally split into two 'sub-stages'; a qualitative analysis 'substage' that focuses on identification and subjective assessment of risks and a quantitative analysis 'sub-stage' that focuses on an objective assessment of the risks (PRAM, pp 3). Some construction managers hold a financial stake in the building project. These "at-risk" CMs then have an additional incentive for the cost savings that can be found in any construction investment. There are also hybrid CM structures that cross between at-risk construction management and fee-based operations. Then there is total quality management (TQM). This innovative management tool has fit well with cost-conscious firms responding to competitive pressures of the late-twentieth-century worldwide economy. As described by Mills (1996, pp. 114-22), quality management requires a commitment at all levels of the firm. Only through a strict adherence to a measured degree of quality in design, delivery, and installation can construction companies cut costs and schedule time. TQM has clear benefits in that it sets extremely low tolerance levels for errors at all phases of the project. Combining many of the aspects of construction management and value engineering, the practice has been increasingly used on large-scale projects. Yet typical of the slow historical pace of construction industry change, construction firms have been reluctant to follow the leads of other industrial sectors (Engineering News-Record, May 15, 1995, p. 24). Such programs are often expensive to maintain and may never prove cost-effective for small generals and subs. The search for a successful management style is one that has troubled all industries since the time that Adam Smith first noticed the advantages to the division of labour. Just as a firm loses its competitive edge when its management methods become commonplace, so too are some construction companies looking to augment even TQM. Quinn Mills suggests the creation of a system of goals, empowerment, and measurement, or, as he terms it, "GEM" (1996, p. 127). In this method, middle-level supervisors are given leeway to reach targeted project results without the traditional top-down management control. 2. Risk Management Risk Management can involve: ✧ identifying preventive measures to avoid a risk or to reduce its effect ✧ establishing contingency plans to deal with risks if they should occur ✧ initiating further investigations to reduce uncertainty through better information ✧ considering risk transfer to insurers ✧ considering risk allocation in contracts ✧ setting contingencies in cost estimates, float in programmes and tolerances or 'space' in performance specifications. (PRAM. pp 4) The industry has maintained an important role in the economy throughout this period and appears to be relatively efficient and cost competitive (Penning-Rowsell, et al 1985). It has been characterized as highly volatile, with employment levels expanding and contracting dramatically over short time periods. Foremost among the changes in the industry has been the growth of small subcontractors. The shift to subcontracting has influenced a number of other industry trends. In particular, it has been associated with an increase in the number of self-employed workers, declining training, and the continuance of occupational health and safety risk-taking in the industry. The growing number of smaller firms has been facilitated by weak barriers to entry into the industry. Such firms do not have to be licensed to operate, nor do they need capital reserves to enter the industry. In a product market distinguished by competitive bidding and cost cutting, small builders provide an outlet for larger firms to reduce labour costs and to minimize financial risk. Resources Artto Karlos A. "Approaches in Construction Project Cost Risk." Annual Transactions of the American Association of Cost Engineers (AACE). Morgantown, W.V.: AACE, 1988, B-4, B.5.1-B.5.4. BS 8444-3:1996 B-4, B.5.1-B.5.4; and Krishan S. Mathur, "Risk Analysis in Capital Cost Estimating," Cost Engineering 31 ( August 1989): 9-16. Critall, J. (1997) “Industrial relations risk in the construction industry: a contractual perspective, ” in T. Bramble, B. Harley, R. Hall, and G. Whitehouse (eds), Current Research in Industrial Relations: Proceedings of the 11th AIRAANZ Conference, Brisbane: Association of Industrial Relations Academics of Australia and New Zealand, 432-38. Hayes R. W., J. G. Perry, P. A. Thompson, and G. Willmer. Risk Management in Engineering Construction. Morgantown, W.V.: Thomas Telford Ltd., 1986. Mills, Quinn. 1996. Staying Afloat in the Construction Industry. Washington, DC: BNI Publications. Perry, J. G.; Risk and its management in construction projects. Proc. InstnC io. Engrs, Part 1, 1985,78, Jun.,4 99-521. Penning-Rowsell, E.C., Parker, D.J., Crease, D.J. and Mattison, C.R. 1983 Flood warning dissemination: an evaluation of some currant practices in the Severn Trent Water Authority Area , Flood Hazard Research Centre, Middlesex Polytechnic, Enfield Penning-Rowsell, E.C., Parker, D.J. and Harding, D.M. 1985 Floods and drainage: British policies for hazard reduction, agricultural improvement and wetland conservation, Allen and Unwin, Hemel Hempstead Simon P, D Hillson and K Newland, PRAM - Project Risk Analysis and Management (PRAM) Guide. APM 1997. Yokoyama Kurazo. Annual Transactions of the American Association of Cost Engineers (AACE). Morgantown, W.V.: AACE, 1988. Read More