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Managing Risks in Construction: Strategic Adaptation

Russian commercial construction industry presents unique challenges due to the inherent uncertainties that long characterized this market. One way to cope with these uncertainties is strategic adaptation to the changing circumstances for both internal and external project environments. This article examines trends and conditions of the Russian commercial construction market, and how some organizations are trying to cope with them to remain profitable and competitive in the face of dynamic market risks.

MANAGING RISKS IN CONSTRUCTION: STRATEGIC ADAPTATION

B. Kagan Ceylan, AmCham News Russia, Volume 15, No.82,  June 2008

As the Russian commercial construction market continues to grow, providing increasingly attractive opportunities, it also continues to present unique challenges due to the inherent uncertainties that long have characterized this market. Rapid growth has caused continuous and rapid change in costs, creating market uncertainties and increased risk. In order to gain and sustain a competitive position, companies have to cope with such dynamics, as well as other types of uncertainties, such as those arising from insufficient knowledge of local regulations, a complex culture and communication difficulties.

One way to cope with the uncertainties that construction projects face is strategic adaptation to the changing circumstances for both internal and external project environments. This article examines trends and conditions of the commercial construction market, and how some organizations are trying to cope with them to remain profitable and competitive in the face of the dynamic risks. The observations and conclusions mainly refer to the commercial construction market in Moscow, but we expect a similar pattern in other cities as their commercial construction markets develop.

General Contractors Industry Segment

Various dynamics have made commercial construction project more difficult to manage in recent years due to the increased scale of such projects. One important change has been in the organizational structure of large commercial projects. Because increase in the scale commercial projects often brings about additional layers of oversight and control, such as those of international financing institutions or international consultants, coordination and communication become more challenging. The technological requirements of these projects are also relatively new and difficult to meet sometimes. For example, high rise commercial buildings are often designed with high strength concrete. However, the number of suppliers that can produce this type of concrete is relatively limited in Moscow and delivery of such concrete requires special arrangements. Also, the increases in the cost of labor and expert professionals due to the shortage of qualified workforce further strain the project budgets.

Another important dimension of change in the commercial construction market is the unpredictable increases in prices for material. According to Russian Construction Review (Issue No.6(41), March 2008), average inflation in building materials has seen a rise from 11.9% in February 2007, to 16.5% in February 2008.


While inflation for cost for building materials presents significant challenges for the contractors, when the price fluctuations are observed in major construction materials, the impact on market unit prices is even more pronounced.
 



Risks

Such increases can cause significant losses for a general contractor unless they are managed with improved project control systems. “In the current commercial construction market, where profit margins typically range between 10% to 20%, you can easily lose your profit; even lose money, over long project durations because of the unexpected price increases” says Argun Koculu, former project manager of two high-rise buildings in Moscow City and now managing his own firm. “We had to monitor the increases in material prices, besides other cost elements, with a competent, dedicated team within the contractor organization and resolve them with the owner continuously until the very end of the works.” The traditional project delivery method based on lump-sum contracts (the preferred delivery method for most owners), worsens the situation. Such contracts are often vaguely worded about the procedure and criteria to be used when cost changes are encountered by the contractor, resulting in endless disputes between the contractor and the owner. Koculu adds that in one project resolving their claims with the owner for construction material price increases took lengthy discussions but they eventually managed to resolve them because their contract had clearly specified how price increases in major construction materials would be handled. However, in the second project constructed with a lump sum contract containing broader description on how to handle material price increases, the disagreement with the client remains to be resolved.

Management Solutions

A number of risk management methods have been available in the U.S. construction market, such as hedging practices (observed in the 1970s against rising steel prices), or locking in favorable prices from suppliers with advance agreements. However, the current Russian construction market lacks sufficient infrastructure and existing market practices for these solutions. The risks due to dynamic uncertainties in the input prices are magnified with the increased scale of projects in the Russian market.

In the absence of well established risk management tools, general contractors try to develop the necessary internal control and governance systems in their project teams. Such internal control systems vary from (1) increased frequency in checking for major variations in material quantities and unit prices, in order to identify possible deviations from the project performance targets; to (2) more proactive claim management systems and applying increasingly tighter cost control systems to improve their internal efficiency. While such internal project control systems are well established in some large international contractors, midsize international contractors, who now undertake much larger projects and have become major players, usually lack such systems and rush to establish them. The average project size for many of these contractors typically varied in the range of $20 million to $60 million in the 1990s in a relatively stable market. Now that the size of a large commercial construction project can easily reach several times of those in the 1990s in a much more dynamic market, the risks, as well as the profit potentials, are also amplified. Organizational structure and governance are usually not ready immediately for such an increase in scale and they seek outside assistance through consulting firms or attempt to build them in-house in order to cope with the increased challenges and associated risks.  

Another means to strategically manage the risks for both internal and external construction project environments, is to eliminate the very uncertainties that may lead to those risks and transform the construction project into a commodity. In a survey conducted among six international contractors operating in Russia between 2002 and 2004, one respondent explained how this works. For internal risk management they rely on:

- a large available labor and equipment pool they can mobilize throughout the project;                    

- well established internal operating procedures; and

- a project team that that has been working together and is well coordinated in functions.        

Risks external to the project are minimized by:

- working with the same designers;

- using complete design documentation; and

- cultivating relationships with the bodies that oversee the project.

Finally, using standard design criteria and construction processes repeatedly used in previous similar projects results in a commodity like facility, rather than a one-time process with unique features, as is the case in most construction projects. Companies utilizing these methods find it possible to complete projects under budget and ahead of schedule, still rare in the Russian construction market.  

Consulting Firms and the Current Dynamic Construction Market

Another industry segment that has been significantly impacted by the recent rapid changes in the commercial construction market is consultancy services. With the increasing number of newcomers entering this industry segment, differentiating services that can respond to the changing market requirements is more important than ever.

Research and experience suggest that uncertainties that cannot be identified or forecasted can only be managed reactively with adaptive systems and managers. Therefore, designing effective project control systems that can be adapted to the local conditions and used to successfully manage dynamic uncertainties is an important but difficult part of management in many foreign construction companies. However, despite their obvious necessity, most general contractors and developers typically lack the know-how and focus on transforming their internal control systems to meet the needs of changing requirements of the market, as well as their projects. By contrast, consulting firms that specialize in such adaptive project control systems, with the necessary know-how and experience with the local conditions, are well positioned to meet these needs and are expected to play an increasingly important role as the market continues to expand.

The need for adaptive project control systems is further driven by the increasing amount of funds provided by international financial institutions, which typically require transparency in project control systems in addition to adaptability in order to maintain full understanding and control of the investment expenses throughout the development process. Our experience in providing construction advisory services for internationally financed projects shows that effective project cost control, that can cope with the often chaotic project environments, is among the highest priority of international lenders and is of obvious importance for the developer and the contractor for measuring project performance.

 

 

 

Figure 1. Inflation in building materials in Russia from July 2006 to July 2007 (source: Russian Construction Review, Issue No.6(41), March 2008)
Figure 2. Concrete price trend from June 2005 to December 2007
Figure 3. Steel price trend from December 2005 to December 2007

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