The definition of “Risk” is the chance of loss, and in construction this can apply to many areas. I’m going to focus on financial loss on a single projection or financial loss to the company as a whole.
When discussing a “chance of loss”, we are really talking about probabilities. The probabilities or “odds” in gambling are well defined such as the odds in favor of a casino in blackjack average about 0.5%. These can be calculated statistically given the large sample size and control over the variables involved. Therefore, these odds are widely accepted and understood (although often ignored for the sake of fun or by addiction).
The difficulty in calculating the same probabilities of risk in business, and construction in particular, is there are too many variables that are constantly changing. Therefore, the discussion of risk becomes more abstract. The only way therefore to manage the risk effectively is to determine what factors have contributed to losses in construction and mitigate the existence of those factors.
The surety industry is a great source of information for these risk factors, because no other industry has observed more contractors as intimately in terms of their operations and financials. That being the case, let me outline some of the biggest risk factors observed in the surety industry and the best practices in managing the risk.
The difficulty in calculating the same probabilities of risk in business, and construction in particular, is there are too many variables that are constantly changing. Therefore, the discussion of risk becomes more abstract. The only way therefore to manage the risk effectively is to determine what factors have contributed to losses in construction and mitigate the existence of those factors.
The surety industry is a great source of information for these risk factors, because no other industry has observed more contractors as intimately in terms of their operations and financials. That being the case, let me outline some of the biggest risk factors observed in the surety industry and the best practices in managing the risk.
Being Undercapitalized
There is an old saying that contractors don’t go broke from not knowing how to perform the work, they go broke due to running out of cash. Disputes and bad jobs are inevitable in construction, so one of the ways to mitigate the risk is having enough capital. Over the decades, surety companies have established best practices for the amount of working capital (current assets minus current liabilities) that contractors should have relative to the backlog they carry. There are different ratios for general contractors, engineering contractors, and trade contractors. If you aren’t clear about how to calculate working capital and how much you should have, talk with your surety agent. It is a simple and powerful way to maintain a financially healthy company.
The next four factors all have the same risk in common – trying something new for the first time. Anytime someone takes on something new, there is by definition risk of the unknown. To manage that risk, one simply has to walk before they run, and I’ll describe the best practice next to each.
The next four factors all have the same risk in common – trying something new for the first time. Anytime someone takes on something new, there is by definition risk of the unknown. To manage that risk, one simply has to walk before they run, and I’ll describe the best practice next to each.
Increase in Job Size
Sureties define the best practice as increasing job size by 1.5 to 2 times your largest successfully completed project. This means if you’ve completed a $2 million job profitably, consider a job that is $3-4 million as a next step.
New Type of Work
Start with one job and start small. If you’ve completed $5 million jobs of your normal scope, try a $1 million job in the new scope. Ask yourself if you can afford to lose 20% on the job, because that is a very possible outcome.
Work Out of Your Normal Geographic Area
Similar to the new type of work, start small and with a single job where you can afford to lose money in a worst-case scenario.
Conclusion
As one of my contractors says, “We’re in the risk management business, not the construction business.”, and I hope this gives you a few more tools to manage your risk.
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