Bringing the realized profit at par with budgeted profit for EPC companies

by Shantonu Ghosh, Vector Consulting Group

To their dismay, Engineering Procurement and Construction (EPC) companies engaged in developing power infrastructure networks often find that their realized margin at the project end is considerably lower than anticipated at the beginning of the project. Delays in project execution and cost overruns are the main culprits behind this, a fact that organizations have noted. Unsurprisingly, companies have put in significant efforts to try and reduce their lead times (reduce delays), and some companies have succeeded. Despite this, however, they have not been able to realize their budgeted margins completely (while it was a deficit in the range of 8% to 10% earlier, it is now 2% to 5%).

While this may look like a victory, even a loss of 2% does hurt the infrastructure businesses since their gross margins are usually in the range of 5% to 10%. The conclusion one can draw from this is straightforward – timely completion of projects is quite essential, but that alone does not protect their gross margins. Some other factors that eat into project margins are also at play here.

Factors leading to margin leakage

Closely examining any project will show that material management or mismanagement is the main culprit. The different ways in which material wastage happens are detailed below:

1. Inventory excess at project end: Often, at the end of a project, there is unutilized material worth up to ~5% of the contract value. This unutilized material directly impacts the bottom line for the project and hence the company.
2. Unaccounted material with sub-contractor: Of this left-over material, it is common for the sub-contractors to have a significant chunk of it (often as much as 0.5% to 1% of the contract value). Often, this material is issued without any financial collateral/guarantee; this material is often not returned to the EPC company!
3. Inter-project transfer of material leading to high outstanding: When project sites face a shortage of materials and with little or no time to procure new materials, they tend to transfer material from one project/client to another. Such transactions must be regularized with the clients involved (both the sending and the receiving entities), which leads to inventory-related anomalies in the books. Moreover, the clients will only release the retention amount with the required documentation for this regularization.
4. Increased operating expenses: All these pending documentation tasks related to material management delay the project's financial completion and force EPC companies to keep their stores open, resulting in increased operating expenses.
5. Wastages/damage cost: Some material is usually delivered at the site far before the actual need-by date. This, sometimes, results in damages and wastages as the material gets damaged because of multiple handling, inadequate/inappropriate storage facilities etc.

Futile approaches to solving these issues

When confronted by excess inventory, EPC company managers may negotiate to get additional work from their clients to utilize this excess material. But even if the client agrees to increase the work scope, there is no guarantee that all the surplus material will get used up or will not create a need for additional ordering and consequent excesses.

If their sub-contractors have much of this excess material, EPC companies may resort to the legal route. Protracted legal battles and a huge amount of effort required from senior management, making them lose focus on more vital matters, is likely the result.

So, what is the solution? Before discussing the solution, let's understand the dilemma site engineers face at the root of this problem.

Site engineer dilemma: Focus on project execution or material reconciliation?

Site engineers have two primary responsibilities – project execution-related tasks (eg, physical work completion) and material reconciliation-related tasks (eg, reconciling the quantity of material issued with the quantum of material consumed). Though these two activities are expected to go hand in hand, that does not happen. During the initial phase of a project, the focus is on getting the project underway. Moreover, project progress is what the management wants to see as well.

Towards the project end, however, top management focuses on the collection through the closure of work fronts. However, closure requires the resolution of open issues, most of which are related to material availability necessary to complete the pending project scope. But to know this, companies must know how much of the procured material has already been used. Hence, the focus shifts to material reconciliation. Unfortunately, by this time, considerable damages may already have been done by this delaying of reconciliation tasks.

Project Managers are aware of the necessity of completing material reconciliation on time. However, they cannot focus on both tasks simultaneously because of their limited bandwidth.

What, then, is the way out?

This dilemma exists because companies assume that the same engineer must be involved in both tasks (project execution and material reconciliation). If the required information is available, any other engineer should be able to take up the reconciling activity of any entity. This way, companies can have two sets of dedicated teams focusing on both critical tasks. However, what must be noted is that this is easier said than done. Where will the new team of engineers or the extra capacity come from?

For this, first, the projects have to be executed with the following rules:

• Follow a 3-way, entity-level reconciliation process. Material reconciliation is typically done at the contractor level, which can lead to revenue leakage and difficulty in tracking differences in material issued and consumed by individual contractors. Reconciliation at the entity level allows for identifying differences in material issued, consumed, and billed to the client. ERP systems cannot handle entity-level reconciliation, so a separate module is needed. The benefits of this addition include real-time visibility and transparency, proactive problem resolution, and faster financial closure of projects.
• Limit work fronts for a site engineer. For example, in a village electrification project, take only five villages for execution & four villages for reconciliation at a time. After completing the execution of each village, pass it to the reconciliation team. If reconciliation work stalls, the engineer waits until the team catches up.
• Before passing work to reconciliation, the execution team must meet the criteria for a clean handover. Stage gate control filters non-compliant entities quickly and give signals for corrective actions.
• The handover kit for meeting stage gate criteria for the start of reconciliation should include everything to complete the work. Full-kit eliminates waiting, interruptions, rework, and delays.
• Despite steps taken, reconciliation may face obstacles. Daily management and issue resolution is needed for proactive management attention.

Following these rules will allow companies to execute and reconcile projects with shorter lead times and release significant capacity. So, if there are 50 engineers, 45 can be assigned to the project execution tasks, while five engineers can focus on the reconciliation task. Even though the total number of engineers focusing on project execution will come down, they can achieve more as the multi-tasking of site engineers between execution and material reconciliation tasks will come down.

So, not only will projects will get done faster, and there will be no or little material-related margin leakages. Therefore, bridging the gap between budgeted profit margins and realized profits.