All construction projects are risky. The work is risky for both workers and the companies involved. Everyone must plan ahead to handle potential problems that may occur on each project. Construction risk management is a necessary process to ensure that companies are successful and can thrive for years to come.
What is construction risk management?
Risk management is the process of identifying potential future risks and evaluating the procedures available to mitigate their impact.
In construction, this means planning, controlling, and monitoring risks on each project. Since every project is different, they must be reviewed individually to identify the pertinent risks and plan how to address them.
Categories of construction risk
A risk is any threat to the progress and completion of a construction project that creates potential loss exposure. Construction companies face many risks, which can be broken down into four main categories.
1. Financial risk
Financial risks include lack of sales, slow payments, material cost increases, and cash flow problems. These risks directly affect the financial standing of the company and can potentially lead to business failure if not addressed. All construction companies should have plans in place to mitigate financial risks. For example, protecting lien rights greatly reduces the risk of cash flow issues due to nonpayment.
2. Safety risk
Construction is one of the most dangerous industries, leading to more worker deaths than any other sector. Companies must know the hazards of each job so they can prevent exposure, protect workers, or avoid the hazard altogether.
3. Project risk
Project risks include schedule delays, rising costs, resource management, lack of funding, and environmental conditions, such as weather and unseen conditions. All of these have the ability to derail a project and cut into profits.
4. Economic risk
Economic risks include the effects of a recession on the construction industry and the company’s particular trade or market. and the constant risk of business failure.
The 5-step process to risk management in construction
There is a process that construction companies can use to help them manage the risks mentioned above. It includes identifying risks, assessing them, controlling them, financing potential costs, and seeking to recover damages when a loss occurs.
1. Identify risks
The process of identifying risks involves asking the question: What risks are presented by the project or customer? Companies identify risks by viewing project information, the scope of work, site conditions, and the financial standing of their customer. For example, they can review a customer’s credit and payment history to see if there is a threat of slow payments.
2. Assess risks
After identifying risks on the project, the next step is to determine the frequency, probability, and severity of these potential risks. Ask yourself, what is the worst that could happen? For example, if a customer does not pay in a timely fashion, the company would have to cover costs they weren’t planning to pay. During the assessment of the project, the company would determine the probability of this happening and how severe the damages would be. Based on this information, they would decide how to control the risk of nonpayment.
3. Control risk
Risk can be controlled through avoidance, prevention, or reduction. To avoid the risk of nonpayment, contractors can choose not to work with certain customers who have a history of slow payments. Or they can prevent the problem by requesting a down payment to cover initial project costs. Or they can reduce the risk by sending preliminary notices that notify the customer of the right to lien their property in cases of nonpayment.
4. Finance to cover risk costs
Companies need to manage their financial resources to ensure they can cover costs in case one of the risks comes to fruition. This includes using a cash flow projection report to identify upcoming gaps between payments coming in and those going out. Other times, the gap may not be possible to predict, but it can still be planned for.
For example, contractors are always at risk of late payments that pushes them into negative cash flow. Opening a line of credit or using material financing can allow them to buy building materials without depleting their bank balance. Keeping credit card balances low in case of emergency is another option to finance risk.
5. Recover & review
When a loss occurs, a company should seek to recover damages, and as much as possible. If a customer doesn’t make a payment, the company should file a mechanics lien to recover the money lost. This helps limit the out-of-pocket damages the company has to absorb. This may also mean filing a claim with the customer’s insurance company or against a payment bond.
The construction risk management process should be reviewed periodically and improved on as necessary. Companies will begin to learn what risks are most common on their projects and the best ways to avoid or prevent them.
Accounting for the cost of risk
Managing risk comes with a cost, whether it’s the cost of protective equipment, supervision, or protecting your lien rights. Planning for these costs ahead of time can help you absorb them without breaking your business. However, make sure you understand the true cost of each risk management strategy and build it into your estimating and bidding process.