Though risk has become a trendy word in every line of business, truly it is a necessary consideration in construction. Construction deals, capital costs, and project success depend on proper identification, elimination, allocation, and mitigation of risk. In fact, construction is one of the riskiest types of business for two primary reasons: First, each new project is unlike the previous project. Second, each project requires very close coordination and collaboration between a large number of diverse people and different companies under unpredictable conditions in order to achieve cost, schedule, and construction goals.This article provides a concise overview ofrisks in construction projects.
What is Construction Risk?
Despite the common but incorrectnotion that risk management equals insurance, risk is much broader. Risk refers to an uncertain event whose occurrence or non-occurrence will have a negative or positive impact on the project. Risks are categorized as knowns , known unknown s , or unknown unknowns . This section provides a brief overview of general categories of risk with an example of a specific construction risk in each category.
A risk that is known,s one that is easy to predict and is commonplace. For example, a construction company in a Midwest state has extensive project records showing union labor will add an average of 30% to the estimated non-union labor costs. If a project site changes from a non-union to a union locale, the construction contract price will increase because of the change in labor costs. Known risks are typicallyaddressed in the scope of work and the contract price.
A known unknown risk is a predictable event, although the precise impact of the event cannot be quantified (contrast this type of risk with the easy-to-predict and easy-to-quantify union labor risk example). Known unknown risks are excellent candidates for allocation and mitigation in the construction contract. For example, if the Midwest construction company above experiences an owner’s change in the design or function of the owner-provided material handling system interface on 75% of its projects, then the construction company knows the source and probability of the risk but not the engineering, construction, cost, and schedule impacts on the project. A clause in the construction contract entitling the contractor to a change order for cost and schedule impacts due to owner changes to the material handling system is an example of allocating this risk to the owner (where it belongs in this example).
The last category is unknown unknowns. In short, this type of risk is quite unpredictable at best and unforeseeable at worst. An example of an unknown unknown risk is a hurricane at the construction site that floods the entire site for 45 days – three years after the construction contract was signed and located in a geography that has only had a major hurricane once in the last 100 years. In the construction contract, you would address this type of risk in the force majeure provisions.
Identifying, Eliminating, Allocating, and Mitigating Construction Risks
In addition to the primary consideration of money in exchange for a functioning project, the purpose of the construction contract is to address the numerous project risks. Good project management also plays an important role in construction risk management, but it is far better to identify, allocate, and mitigate risks in the construction contract – the PM will be stuck with managing the risks without having influenced who bears the risk. The project participants must address construction risk early in the project during the development phase and the contract phase because there is little room for movement on major issues by the time they reach the final construction contract negotiation (the parties have likely agreed uponprice, schedule, and scope by this point).
It is important to remember that construction project costs follow the “S” cost curve – with little expenditures at the beginning and end of the project and with exponential expenditures between the contractor’s notice to proceed and substantial completion. As the project progresses from the development phase to the contract phase to the construction phase, there are exponentially more risks in earlier phases and dramatically less risks in the later phases because the project becomes more defined. However, the risk of financial exposure to the project participants, in contrast, steadily increases until the project reaches substantial completion at the end of the construction phase. Again, it is essential that the project participants address construction risks early.
Beginning early, the first step is to indentify risks. Union versus non-union labor costs, brownfield project sites, and newtechnology, are examples of risks that you need to identify. The second step isto assign a probability of occurrence and money value to the indentified risks. For example, if the risk is a brownfield site, what is the probability of environmental contamination and estimated remediation costs?
The third step is for the project participants to eliminate risks. An example here is the risk of increased labor costs from union labor. One drastic way to eliminate this risk is to locate the project in a right-towork state that does not have active union activity in the construction trades. The fourth step is to negotiate who will bear these risks, understanding, of course, that the schedule, scope of work, or costs may change. The classic example is whether the owner or the contractor bears the risk of unforeseen site conditions.
The fifth step requires the project participants to mitigate any risks that have been allocated to them. For example, if equipment productivity shortfall is a risk, the engineer may oversize the equipment or the contractor may include contingency money in the contract price to improve the equipment’s performance in the event of a shortfall. Another example of risk mitigation is the owner’s purchasing builder’s risk insurance to cover the risk of injury to the owner’s property if there is a fire at the construction site.
In conclusion, the cost, schedule, and performance of construction projects depend upon the proper identification, elimination, allocation, and mitigation of construction risks. Furthermore, everyone on the project has interest in addressing these risks. Lastly, take a hard look at risk earlier rather than later.*
*The information in this article does not constitute legal advice and is for general educational purposes only.