EPC Companies Can Bring Realized Profit at Par with Budgeted Profit
By Nilesh Riswadkar
Engineering Procurement and Construction (EPC) companies engaged in the development of power infrastructure networks often discover that their realized margin by the end of a project is significantly lower than what they were anticipatingduring project initiation. EPC consultants offer delays in project execution and cost overruns as the main culprits behind this.
No surprise, therefore, when one realizes that EPC companies have put in mammoth efforts to reduce their lead times. Some companies have been successful in this attempt.However, this does not mean the end of all their troubles. They have not been able to realize their budgeted margins totally. While it hovered between 8% and 10% earlier, it now lies between 2% and 5% - a significant erosion still! This is because the gross margins of EPC companies are usually in the range of 5% to 10%.
What can we conclude from this? It is pretty straightforward. No doubt timely completion of projects is quite essential, but that alone will not save EPC companies from going under. The root cause remains to be unearthed if a true solution is to be discovered and implemented.
Material Mismanagement -- The Main Culprit behind Margin Leakage
A deeper and closer examination of any EPC project will reveal material management or mismanagement as the main culprit behind this disparity between realized and anticipated margins. The various ways in which material wastage happens are given below:
a) Inventory excess at project end:Unutilized material at project end is, usually, worth up to 5% of the contract value. This impacts the bottom line for the project, and by extension, the company directly.
b) Sub-contractor in possession of unaccounted material: To compound the problem faced by EPC companies, the EPC construction consultants point out, material worth as much as 0.5% to 1% of the contract value are in the possession of EPC sub-contractors, and this is a significant chunk of material! The last nail in the coffin for EPC companies is stuck when they realize that they have very little chance of getting this material back from their sub-contractors, as this material is often issued without collecting any financial collateral/guarantee from the sub-contractor.
c) High outstanding owing to inter-project transfer of material:Project sites are often plagued by issues of material shortage, and they have very little time at their disposal to procure new materials. They overcome this challenge by transferring material from one project/ client to another. It goes without saying that such transactions must be regularized with both the clients involved (the sending and the receiving entities). If this is not done, it leads to inventory-related anomalies in the books. Moreover, clients will not release the retention amount without the required documentation for this regularization.
d) Operating expenses going through the roof: EPC companies busy trying to complete their projects on time, often, delay this documentation task. These pending documentation tasks related to material management delay the project's financial completion, forcing EPC companies to keep their stores open, resulting in increased operating expenses.
e) Wastages/damage cost:While some sites face material shortage issues, others experience the opposite problem – materials are dumped much earlier than the actual need-by date. As you can imagine, thisresults in damages and wastages to the material owing to multiple handling, inadequate/inappropriatestorage facilities, etc.
Misguided and ineffectual solution approaches
Since they have excess inventory at their disposal, EPC company managers try and negotiate to get additional work from their clients with the view to utilize this material in a productive manner and cut their losses. This is a desperate measure, as there is still no guarantee that all the surplus material will get used up (that is, assuming that the client agrees to increase the work scope). On the other hand, this additional scope might necessitate the EPC companies to procure additional material!
Another way by which EPC companies try to improve their margins is by going after their sub-contractors who are in possession of excess material, and which they refuse to return to the EPC companies, using the legal route. The result? Lengthy legal battles, senior management wasting their time and effort in these futile activities which they could have utilized more fruitfully on more productive and value-adding tasks.
But before we start discussing the solution, let us pause and analyze the dilemma faced by site engineers.
“Shall I focus on executing the project or in reconciling material?”
The dilemma is real, as both tasks are equally important as far as the site engineers are concerned. While the completion of the physical work is a project execution-related task, reconciling the quantity of material issued with the quantum of material consumed is an example of a material reconciliation-related task. And even though both activities are expected to go hand in hand, that does not happen. Getting the project underway is the more critical task during the initial phase of a project, as project progress is what the management wants to see.
It is only towards the end of the project that top management starts to focus on collection through the closure of work fronts. However, closure can occur only when all the open issues are resolved. However, most of the open issues are related to material availability necessary to complete the pending project scope. And, in order to know the amount of material that is needed to complete the pending scope of work, EPC companies must know how much of the procured material has already been used. Hence, the focus shifts to material reconciliation. Unfortunately, by this time, significant damages may have been created already by this delaying of reconciliation tasks.
It is not that Project Managers are unaware of the necessity of completing material reconciliation on time, but the simple truth is that they cannot focus on both tasks simultaneously because of their limited bandwidth.
So, then, what is the way out?
Why do we assume that the same engineer must be involved in both tasks? Make the required information available and ask another engineer to take up the reconciling activity of any entity. EPC companies now have two sets of dedicated teams focusing on both critical tasks. Sounds too simple? Where will the new team of engineers come from? How can EPC companies afford this new team?
Truth of the matter is, EPC companies do not need to hire extra engineers to implement this solution.
If adopted, this model ensures that companies stay focused on a limited number of worksites at a time both for execution and reconciliation, that they undertake 3-way material reconciliation at an entity level, that there is discipline in the way handovers happen, and that there is proactive management focus on resolving execution issues. So, this allows EPC companies to execute projects with shorter lead times and releases significant capacity. So, if there are 100 engineers, 90 can be assigned to the project execution tasks, while 10 engineers can focus on the reconciliation task. True, the total number of engineers focusing on project execution has come down, but this leaner team can achieve more as they are multi-tasking between execution and material reconciliation tasks very infrequently.
Implement these steps and see projects getting completed faster and with little or no material-related margin leakages. Result? The gap between budgeted profit margins and realized profits can be brought down significantly.
Nilesh is a Partner with Vector Consulting Group. He is a seasoned professional with over 15 years of rich consulting experience in area of project management. The companies Vector has worked in the area of EPC include Bajaj Electricals (EPC), Godrej E&E, KEI, Tata Bluescopeetc, just to name a few.
