Using Additive Project Management to increase a construction project’s financial utility

Or, how to make more money on projects while increasing client service.

Abstract

In this article we consider two well-executed construction projects. The first project is well-modeled and well-planned in advance of the project’s start. The second project cannot be fully-modeled and requires constant adjustment due to changing information. The two projects are identical in all other respects: Projected costs, duration, expected margin, etc. We explore a hypothetical project manager’s execution in these two environments and learn a surprising lesson: Strategically metering resource commitment (labor and material) over the life of the project increases the project’s value 37% compared to typical project management practices.

This article explores the financial utility of a construction project through the lens of Net Present Value, or NPV. For details on the conceptual framework behind NPV and why it is such a powerful tool for evaluating and comparing projects, visit our previous articles:

1. How can contractors deploy limited resources in a way that maximizes return? An introduction to capital budgeting, Part 1.
2. How can contractors deploy limited resources in a way that maximizes return? An introduction to capital budgeting, Part 2.

The NPV Investment Decision Rule is:

When making an investment decision, take the alternative(s) with the highest NPV, which is equivalent to receiving the NPV in cash today. Take all positive NPV projects that the firm’s constraints allow. The higher the NPV, the better.

Using NPV for Construction Projects

Let’s consider two nearly identical projects. Each project is expected to last 12 months, have $1,750,000 in costs (50% material, 50% labor), and offer a 15% margin (and thus $2,012,500 in revenue). The only difference between the projects is in the amount of information available.

Project 1 offers full details up front. The client knows exactly what she wants. We’ve worked with this client before and we know she is reliable in terms of sticking to the original plans. The project can be well-planned and modeled before work starts and we can start prefabbing components up front based on detailed models.

Project 2 offers far fewer details up front, but there is a strict budget in place. Total costs cannot exceed the budgeted amount, but there is enough unknown information that we cannot accurately model the project before work begins. Because of the uncertain nature of the project, we can only prefab components just before they are needed.

Of course, we would never CHOOSE to have less information, but it turns out that having less information allows us to learn something powerful.

On each of these projects, you place your field and management rock stars. They are going to nail the budget and make the projected 15% margin with either project. How is each project likely to unfold?

We can start prefabbing Project 1 on day one, and we do. We release the material, have it delivered to the fab shop, and start work as soon as possible. Let’s assume a “typical” schedule of costs and progress payments. Most of our labor and material costs are encountered up front (let’s say 70% within the first three months of a twelve-month project) because we’re all over it. Crushing it. Our external client is fair but firm, so we get paid as material is on site, creating a three-month delay between submitting a pay app and receiving progress payments. The cash flows for this project might look something like this:

Now let’s consider Project 2. Our project manager is cautious due to the uncertain nature of the project. She forecasts the work to be completed each week and releases the vendor to order only as much material as necessary. She only has material and equipment delivered to the job site and fab shop a week or two before it is needed because that is all the project’s information will allow. Installation of material happens at the same pace as Project 1, and so progress payments are the same, but payments for material and labor are delayed because the material is not delivered from the vendor’s yard and prefabrication does not begin until just before the material is needed. The cash flows for this project might look something like this:

Let's compare the value of the projects with a picture:

At this point we should pause to pick our jaw up off the ground and make sure our brains are correctly interpreting the images our eyeballs are reporting.

The NPV of Project 1 is $153,192. The NPV of Project 2 is $210,138.

Project 2 creates an additional $56,946 in value for the firm. That’s a 37% increase in the value, despite having the same gross cash flows.

Let’s say that another way: Performing Project 2 three times creates more value for the firm than performing Project 1 four times ($630,413 for Project 2 versus $612,768 for Project 1). Or we could say it this way: Performing Project 2 three times creates enough additional value to buy Project 1.

What is going on???

In an effort to control uncertainty, our project manager stumbled onto a novel and valuable method of managing resources. By strategically metering the flow of material and labor over the life of the project, she reduced the size of upfront costs, reduced the time between making payments and receiving them, and left resources available for productive use on other projects. And that is worth an additional 37% in value to the firm.



There are multiple advantages to managing projects this way. First, the firm can keep more cash on hand at any given time. This cash can remain available in an interest-bearing money market account to cover unexpected expenses. While short-term interest rates are currently at historic lows, it’s preferable to having the cash tied up in material that won’t be needed for another six months. Second, and more profoundly, the unused resources can be invested in other projects that offer much higher returns than a money market account. With Project 1, the firm committed 70% of the project’s cost in the first three months. That’s $1,225,000 million worth of cash tied up in the project within three months. With Project 2, the firm committed just 24% of the project’s costs, or $437,500, in the first three months. That’s a difference of $787,500 in resources that the firm had available to invest in other projects.

This is the key reason for the difference in Net Present Values between the two projects. Every dollar invested in a project carries the opportunity cost of the investment that otherwise could have been made. By smoothing the timing of resource commitments, contractors can have more resources on hand, take on more projects, and earn additional income. The potential benefits are difficult to understate.

Pause for just a moment and consider what the implications of this for all construction projects. Our project manager remained agile and was able to serve the client as additional information became available throughout the life of Project 2…all while leaving additional resources available in the critical first months of the project! Even if we find ourselves in an idyllic setting with a perfectly planned and modeled Project 1, there is substantial value in managing it as if it were Project 2.

Contact us to learn how to become ProjectFIT.

-Steven Stelk, PhD, FP&A; Financial Strategist, Cycle Rate Performance