R E P R I N T

CONSTRUCTION FINANCIAL MANAGEMENT ASSOCIATIONT he S ource & Resource for Con st r uc t ion Financial P rofessional s

September-October 2010

BY CALVIN E. BEYER & LINDA CONRAD

PROTECTING PROFITABILITY FROM

DisastersDisRUPTIONs AND

R i s k M a n a g e M e n t

September-October 2010 CFMA BP

Risk awareness and the sophistication of risk managementpractices in the construction industry continue to reach newheights. Today’s CFMs are skilled in such core strategic riskmanagement disciplines as:

• Balance sheet and profit protection through surety, riskretention, or assumption;

• Risk finance and transfer through insurance; and

• Indemnification and contractual risk transfer.

However, as new risks emerge, CFMs must continually adaptto the changing risk landscape – they must apply differenttools and learn new risk management techniques to helpkeep risk at a reasonable level and within the parameters oftheir company’s individual risk appetite.

Supply chain management has become increasingly criticalto contractors, both as a profit driver and a way to minimizepotential loss. To gain a new perspective on this evolvingexposure, ask yourself the following questions:

• Is your company’s supply chain resilient, or is it vulnerableto disruption?

• Has your company assessed the potential financial andreputation risk of a project’s disruption due to subcon-tractor default or supplier insolvency?

• Has your company considered whether it is at risk from routine business disruptions, including natural catastrophesor man-made disasters?

• Has your company calculated the insured and uninsuredcosts of disruptions that threaten its stability – if not itssurvivability?

Supply Chain Risk: Universal, Yet Unique

Supply chain risk is universal, yet it is fundamentally unique toeach company. Risk of supply chain disruption is embedded in

a company’s business model and is impacted by strategic pri-orities, operating platforms, and tactical decisions.

Supply chain risk arises from the procurement of raw or fin-ished goods, the assembly of finished materials or products,the movement or storage of raw goods or finished products,and the selling and/or receiving of such goods or products.

Supply chain risk emanates from the direct and indirect rela-tionships between producers, suppliers, distributors, inter-mediaries, and end-users or consumers in B2B transactions.

Supply chain disruptions come in various forms and from mul-tiple sources. Even the best-managed internal procurementprocesses can be subject to unanticipated external challenges.(The exhibit on the next page lists both common causes andpotential sources of supply chain risk.)

Supply Chain Risk & Interdependency

Interdependency results from closely aligned relationships inwhich the activities, processes, or results of one businessaffect those of another business. Organizations that are inter-dependent are subject to a unique potential risk: the rippleeffect known as contingent risk, which can unfold in “if this,then that” scenarios. The greater the degree of interdepend-ency, the higher the resulting risk of an adverse consequencebefalling both parties when an adverse consequence strikesone of them.

Extreme Events Are on the Rise

Extreme events are characterized by very low probabilitiesand very high severities. According to Daniel Hofmann, ChiefEconomist for Zurich: “When the financial crisis hit, it wasseen as a 10-sigma event – an event expected to occur onlyonce in 10,000 years. But, between 1987 and 2008, there wereeight severe financial crises with global ramifications.”

AS SUPPLY CHAINS BECOME MORE SOPHISTICATED, IT’S CRITICAL THAT CONTRACTORS ADAPT.

DISRUPTIONS CAN COME FROM ANYWHERE – FROM NATURAL DISASTERS TO SUPPLIER INSOLVENCY.

Y O U R C O M P A N Y M U S T B E P R E P A R E D .

Unfortunately, such 10-sigma events are not limited to thefinancial world. In recent years, the world has experiencedback-to-back-to-back hurricanes in the Gulf of Mexico, the9/11 terrorist attacks, and a series of severe natural catastro-phes in Europe and Asia.

These events impacted complex supply chains and finely cal-ibrated just-in-time delivery systems, with collateral lossesoften exceeding the initial loss. A world in which extremeevents appear to have become routine poses specific chal-lenges for CFMs and enterprise-wide risk managers.

As supply chains become more sophisticated, many are strug-gling to understand how their risk landscapes have changed. A2009 survey conducted by the Business Continuity Instituteshowed that 74% of the survey respondents had sustained asupply chain disruption, and 88% of the companies expectedto experience a disruption in the coming year.

Other major findings concluded that supply chain risks aremultiplying; businesses are underprepared and ill-equipped;and more disruptions are expected in the future.

Negative Consequences of Supply Chain Disruption

The numerous negative consequences associated with supplychain disruption include:

• Customer dissatisfaction;

• Poor project quality from substitute products/materials;

• Decreased productivity;

• Increased or unallocated overhead;

• Schedule delays;

• Impeded cash flow leading to a financial crisis or bankruptcy; and

• Negative media attention and its associated reputation risk.

Supply Chain Risk Exists at Three Levels

The construction industry is replete with supply chain risk dueto the high degree of interdependency among the links in theconstruction supply chain. Moreover, supply chain risk struc-turally and systemically exists at the industry, company, andproject levels.

AT THE INDUSTRY LEVEL

At the industry level, the traditional split between the design,engineering, and construction functions creates contingentsupply chain risks between the various parties – in addition tothe supply chain risk created by the multiple parties involvedin the construction activity itself (GCs, subcontractors, sub-tier subcontractors, and suppliers).

It’s also important to recall the pricing volatility of labor,commodities, and construction materials in the aftermathof regional disasters.

Remember what happened to the availability and pricing oflabor, steel, lumber, and drywall following the 2005 hurricaneseason of Katrina, Rita, and Wilma? Supply and demand eco-nomics prevailed as bidding wars ensued and material short-ages occurred.

AT THE COMPANY LEVEL

At the company level, supply chain risk is influenced by thesegment of the industry served and the delivery methodcommonly used.

Industry Segment

Contractors in each construction segment face supply chainrisk: GCs, heavy/highway contractors, specialty trade subcon-tractors, and sub-tier subcontractors.

GCs rely on trade subcontractors to complete specialty

CFMA BP September-October 2010

SUPPLYCHAIN

RISKScoMMon causes and

Potential souRces

NATURALCATASTROPHE

it failuRe oR

cyBeR-Risk

PoweR

outage

laBoR

disPutes

suBcontRactoR

failuRe oR default

SUPPLIER INSOLVENCY

tRansPoRtation

disRuPtion

delay at

suPPlieR’s

suPPlieR

BReach of

contRact

incReased PRoduct

deMand oR

inadequate

PRoduct suPPly

MECHANICALBREAKDOWN

PRoduct

Recall

PRicing

volatility

Business

inteRRuPtion

PiRacy of

ocean caRgo

September-October 2010 CFMA BPSeptember-October 2010 CFMA BP

scopes of work. Subcontractors rely on sub-tier subcontrac-tors, and all parties reply on suppliers to keep the constructionprocess running smoothly.

The chart in this article highlights representative primary sup-ply chain risk exposures for each main construction segmentand representative risk management strategies.

Many contractors gain a false sense of security about theirsupply chain risk exposure because they have contractuallytransferred their legal duties and financial responsibilities tothird parties.

However, in spite of this contractual transfer to subcontractorsand suppliers, there are still tangible and intangible conse-quences from supply chain disruptions that could impact GCs.

One major consequence is indirect financial losses. In addition,the project owner may suffer unintended financial and repu-tation consequences that could undermine the relationshipwith the contractor’s project team.

So, what appear to be well-founded actions taken to reduceshort-term costs and/or improve operational efficiencies canactually create greater risk. Hence, a company may inadver-tently increase its overall costs, damage owner equity, and un-knowingly expose its profits and reputation to risk.

Delivery System

A contractor’s choice of major delivery system also influencesthe scope of its supply chain risk. In our experience, theEngineer-Procure-Construct (EPC) and EPC-Operate (EPC-O)delivery systems appear to have more inherent, structural sup-ply chain risk than others.

Since these systems encompass the procurement, commis-sioning, and testing of specialty equipment and machinery,they are frequently used for large capital construction proj-ects in the energy and power generation markets.

In these specialties, the advance lead time required to pur-chase turbines and other power generation components/equipment ranges from many months to several years.

So, the embedded risk of delayed shipping, receipt, assembly,and installation (or testing and commissioning) can involvemillions of dollars due to lost profits, liquidated damages, andnonconformance to contractual performance standards andefficacy output requirements.

AT THE PROJECT LEVEL

At the individual project level, the specific master constructionschedule and sequencing of trades affects supply chain risk –as can such project factors as weather, quality assurance andcontrol requirements, and site safety performance.

Escalating Supply Chain Risk

It can be argued that both the scope and level of supply chainrisk has recently expanded and will continue to do so in thefuture. Why? Because the following industry trends increasethis type of risk:

• Lingering economic uncertainty from the ongoing global economic recession has dramatically impacted the construction industry and exacerbated instability in the construction supply chain.

Such issues as supplier insolvency and subcontractordefault are lurking as hidden dangers in the constructionsupply chain.

• Design-build project delivery and accelerated fast-trackprojects continue to pressure construction supply chainsby tightly compressing schedules and sequencing beforedetailed construction drawings can be completed.

Fortunately, this factor is partially offset by the positiveadvances in “clash detection” afforded by building infor-mation modeling (BIM) systems.

• Just-in-time and lean construction methods are gaining ground in the construction industry. Lean construction has its roots in just-in-time manufacturingand lean optimization for waste reduction and projectperformance improvement.

However, this could create the unintended consequenceof minimizing the safety buffer of positive float, therebymaking supply chains more vulnerable to disruption.

When a company relies on a “thin inventory,” there is little margin for error and even a small disruption canhave a significant impact on production, with all of its associated cost consequences.

• Green construction poses inherent risks whenever newmaterials or components are used. Contractors engagedin green construction projects must be careful not toaccept all of the risks associated with the new materialsand components specified by the owners and architects.

• Global sourcing improvements in transport and logistics

SUPPLYCHAIN

enable companies to source materials from virtually anywhere in the world.

While globalization provides increased flexibility andpotentially significant cost savings, it can also producesupply chains that are more complex, more exposed, and therefore, more difficult to manage.

• Single sourcing means relying on a single source for aparticular supply, which can mean increased leverage withthe supplier and potentially lower procurement costs.

However, the reverse is also true: Relying on a singlesource can also result in increased vulnerability to supply disruptions.

• New partnerships and/or strategic suppliers can significantly change your company’s operating model.

Many construction companies are entering into long-term agreements with business partners and key suppliers. These arrangements help provide stability and enable a construction company to focus on its core competencies.

However, such arrangements also result in greater interdependencies and operating uncertainties, and the need for wider risk management approaches.

Identify, Assess & Improve

Changes in customer expectations, the introduction of newbuilding techniques and materials, and the ongoing expansionof suppliers from around the world are all issues that must becarefully considered.

For example, contractors may be tempted to select new sup-pliers of materials based on costs or project location. However,sourcing these new building products and processes demandsa rigorous hazard analysis.

In addition, contractors should consider whether any of the fol-lowing potential risk-changing events have already occurredand how these changes could adversely impact enterprise orproject risk:

• Has your company begun working with new owners,including the public sector with its unfamiliar regulatoryrequirements?

• Has it entered into joint ventures (JVs) for the first time or with new JV partners?

• Has it employed different project delivery systems,including private-public partnerships (PPPs)?

• Has it, or any of its subcontractors, ventured into projecttypes, occupancies, or scopes of work that differ fromprevious experience and expertise?

• Has it, or any of its subcontractors, made changes to current building processes or procedures?

• Has one of its subcontractors recently changed suppliers?

• Has one of its subcontractors’ primary suppliers started using a new manufacturer?

• Has one of its subcontractors incorporated new products or different materials?

If the answer is “Yes” to any of these questions, consider thatsuccessful construction companies have moved well past arudimentary “after the fact” post-mortem analysis to a “beforethe fact” risk assessment.

Remember: The major goal of risk assessment is to improvethe business decision-making process by identifying expo-sures early and implementing mitigation strategies that helpreduce or eliminate risks, such as supply chain exposures.

A proactive, comprehensive risk analysis can help facilitatethe identification of vulnerabilities and loss triggers, and mit-igate potential adverse consequences that can hinder timelycompletion and your company’s profit margin.

Supply Chain Risk Management

The Supply Chain Risk Leadership Council (SCRLC) definesSCMR as:

“The practice of managing the risk of any factor or event thatcan materially disrupt a supply chain whether within a singlecompany or spread across multiple companies. The ultimatepurpose of supply chain risk management is to enable costavoidance, customer service, and market position.”

To help manage resilience and results, a hazard analysis – suchas a supply chain risk assessment – can be a critical tool to helpidentify potential disruptions and mitigate exposures. Theexhibit on the last page illustrates the key action steps andoutcomes from the supply chain risk assessment process.

RISK ASSESSMENT SPECIFICS

The aim of a supply chain risk assessment is to accuratelymap and calculate the anticipated loss of profit in the eventof a reduction in supply that causes a reduction in produc-tion output.

CFMA BP September-October 2010

SUPPLYCHAIN

GENERALCONTRACTOR

Subcontractorfinancial failure leadingto breach of contract and/or default

• Expanded prequalification of subcontractors

• Annual renewal of subcontractor approval

• Monitoring lien waivers to ensure suppliershave been paid by subcontractors

• Monitoring aggregated financial exposure from each subcontractor simultaneously working on multiple projects

• Requiring surety performance bonds or using subcontractor default insurance

• Diversification by spreading projects to moreprequalified firms to reduce exposure whenaggregation is deemed to be too concentrated

• Conducting pre-bid, pre-award, and post-awardscope review meetings to clarify expected scope and quantities by trade

• Lean Construction project planning and delivery process

• Post-contract completion performance evaluations on subcontractors

SPECIALTY TRADE

CONTRACTOR

Schedule and sequence delays

• Participating in GC pre-bid and pre-award scope reviews, as well as post-award constructability reviews

• CAD in constructability reviews

• BIM for clash detection

• Component prefabrication and self-performed modular construction to control the value and supply chain to improve quality, achieve schedules, and increase margins

• Participating in Lean Construction processes for scope, schedule, and sequence planning

• Expanded prequalification of sub-tier contractors

• Annual renewal of sub-tier contractor approval

• Monitoring aggregated financial exposure from each sub-tier contractor simultaneously working on multiple projects

• Diversification by spreading projects to moreprequalified sub-tier subcontractor firms to reduce exposure when aggregation is deemed to be too concentrated

HEAVY/HIGHWAY

CONTRACTOR

Supplier disrup-tion and resultant pricing volatility

• Identifying back-up suppliers of commodities in case of supplier disruption

• Redundancy of dual transportation modalities(train vs. trucking) in case of supplier disruption

• Secure off-site storage of fuel and emulsionsin case of supplier disruption

• Price escalation adjustment clauses where allowed

• Force Majeure contract clause for supplierfailure due to natural disasters or “Acts of God” beyond contractor’s control

• Hedging on fuel prices

PRIMARY SUPPLYCHAIN RISK EXPOSURE

REPRESENTATIVE RISKMANAGEMENT STRATEGIES

TYPE OFCONTRACTOR BY TYPE

of contRactoR

SUPPLYCHAIN

Risks and RePResentative

Risk ManageMent

stRategies

September-October 2010 CFMA BP

Such an analysis will help you determine and prioritize theappropriate mitigation steps, ranging from risk retention torisk financing or risk transfer through insurance. A compre-hensive analysis/assessment includes studying the:

1) Vulnerabilities to disruptions;

2) Probabilities of a significant disruption;

3) Consequences of a significant to catastrophic disruption;

4) Costs that are direct or insured, indirect or uninsured,and opportunity costs relating to the disruption; and

5) Capital allocation that includes return on equity (ROE),return on capital (ROC), and/or revenue replacementcosts to offset foreseeable loss costs.

RISK ASSESSMENT QUESTIONS

A key aspect of supply chain risk management is to re -duce the likelihood and severity of disruptions. Follow -ing are several key strategic questions that should beasked to gauge the effect of business disruptions onyour company:

• What role does our company play and where does it sit in the supply chain?

• Where in the construction life cycle are our projects or products?

• How interconnected and interdependentis our company to its subcontractors and/or suppliers?

• How much inventory of key products and materials is available and do we havereliable back-up suppliers?

• Can we quantify the cost of a down day, down week, down month, or the total cessation of our operations for a longer duration?

• How large a loss can we sustain and remain in business?

Conclusion

Historically, supply chain risk manage-ment has been viewed as a function ofprocurement and logistics professionals.Today, supply chain risk management isan integral tool for business resiliency and

continuity planning, so its management has become theresponsibility of senior leadership.

The growing complexity of risk and the globalization of thesupply chain have ushered in an era where supply chain man-agement should be integrated into enterprise risk manage-ment (ERM) for companies of all sizes. ERM cascades riskmanagement systems, processes, and thinking throughout theentire organization.

Understanding your company’s supply chain risks and takingsteps to mitigate them could be a major strategic advantagefor consistent corporate sustainability and profitability.

Addressing supply chain risks will help ensure a resiliententerprise which is better able to anticipate surprises, recoverfrom disruptions, adapt to changing conditions, and leverageemerging opportunities. Robust supply chain managementcan help you build both better projects and a more profitableenterprise. n

IDENTIFYVulnerabilities

QUANTIFY/

BENCHMARKRisk Exposures

PRIORITIZEMitigation

Actions

INFORMEDDecision- Making

SUPPORTOperational Profitability

Review Mitigation

Plans

SupplierProfits & Loss

Mapping

CalculateFinancial Loss

Scenarios

Alternatives ifSupply Chain

Fails

DetermineCritical Supplies

& Suppliers

SUPPLY CHAINASSESSMENT

RecommendImprovements

SUPPLY CHAIN RISK ASSESSMENT

PROCESS AND OUTCOMESundeRstanding wheRe and how Much youR suPPly chain is vulneRaBle

CFMA BP September-October 2010

SUPPLYCHAIN

CALVIN E. BEYER is Manufacturing Practice Leader atZurich North America Commercial. He is based in Schaum-burg, IL.

Cal has 22 years’ experience in the insurance industry invarious capacities, including extensive experience in riskassessment, strategic risk improvement, and risk manage-ment best practice development in the construction andmanufacturing industries.

He has spoken regularly at CFMA’s Annual Conference &Exhibition, is a frequent presenter at CFMA regional con-ferences, and is an established author for CFMA BuildingProfits.

Cal earned a BA in Political Science and AmericanInstitutions from the University of Wisconsin-Madison anda MPA from the University of Kansas, Lawrence, KS. Heis a DBA student at Argosy University.

A member of CFMA’s Twin Cities Chapter, Cal served onthe Executive Committee and as National Secretary for2009-2010. He is a former long-term member of CFMA’sConference Planning Task Force, as well as a formernational At-Large Director and a Spring Creek alumnus.

Phone: 847-330-4783E-Mail: calvin.beyer@zurichna.comWebsite: www.zurichna.com

LINDA CONRAD, SIRM-E, is Director of StrategicBusiness Risk Management for Zurich Services Corpor-ation. She is based in New York, NY. Linda leads a glob-al team responsible for delivering Enterprise Risk andResilience Management (ERM) solutions and insights tomultinational customers.

Prior to her current role, Linda was the global head ofCapability Development and Knowledge Managementfor Zurich Risk Engineering in Zurich, Switzerland. She isa frequent author and speaker, and was a presenter atCFMA’s 2010 Annual Conference and Exhibition.

Linda serves on the Supply Chain Risk Leadership Counciland on the Board of the Institute of Risk Management. Shehas been featured in business media interviews and televi-sion appearances, including CNBC and Fox Business News.

She earned a BA in Policy and Management Studiesfrom Dickinson College, and studied at Temple Univer-sity’s Fox School of Business in Philadelphia, PA and theGraduate Institute of International Studies in Geneva,Switzerland.

Phone: 410-664-5207E-Mail: linda.conrad@zurichna.com

Website: www.zurichna.com

WEB RESOURCES

1. The Association for OperationsManagement (APICS) – Customer-Focused Supply Chain ManagementCourse:www.apics.org/Education/Courseware/CFSCM.htm

2. Business Continuity Institute SupplyChain Resilience Survey Report 2009:www.supplychainriskinsights.com/pdf/bci_supply_chain_resilience_survey_2009.pdf

3. CFO Magazine Webcast Archive –How to Sustain Your Company’sFinancial Health Through BusinessContinuity Planning: www.cfo.com/webcasts/index.cfm/l_eventarchive/14490602

4. Council of Supply Chain ManagementProfessionals: http://cscmp.org

5. Supply Chain Council: http://supply-chain.org

6. Supply Chain Risk Leadership Council:www.scrlc.com

7. Zurich North America Supply ChainMicro Site co-sponsored by The WallStreet Journal:www.supplychainriskinsights.com

8. Zurich Risk Insight, 2009 Supply ChainIssue, “Protecting Profitability if theChain Breaks”: http://zdownload.zurich.com/main/reports/supplychainriskinsight09.pdf

SUPPLYCHAIN

September-October 2010 CFMA BP

Authors’ Note: The information in this publication was com-piled from sources believed to be reliable for informationalpurposes only. All sample policies and procedures herein shouldserve as a guideline, which you can use to create your ownpolicies and procedures.

We trust that you will customize these samples to reflect yourown operations and believe that these samples may serve as ahelpful platform for this endeavor. Any and all information con-tained herein is not intended to constitute legal advice andaccordingly, you should consult with your own attorneys whendeveloping programs and policies.

Copyright © 2010 by the Construction Financial Management Association. All rights reserved. This article first appeared in CFMA Building Profits.Reprinted with permission.