Capital intensive businesses such as processing, manufacturing, mining and data centers amongst others, must invest in various projects to optimize capacity, bring new products to market and to conform to regulatory requirements. Investments are made based on the expected cost, schedule and revenue. Even though attempts are made to make allowances for typical cost and schedule overruns, actual industry wide performance data is clear this is woefully insufficient. Schedule delays are particularly damaging as they drive up costs and most importantly delay the time to revenue. Overall, this creates an unstable business that is unattractive to investors.
But cost and schedule overruns are just the tip of the iceberg. A bigger issue lies in the unnecessary use of cash during project execution. Cash that can be used for other investments including more projects, or cash that does not have to be borrowed or cash that can be returned to shareholders.
At the root of the problem is an ineffective approach to managing projects. The approach has not changed much since the middle of the last century despite the development of numerous methods and enabling software products. Tackling the cost and schedule overrun problem along with unlocking the unnecessary use of cash requires rethinking how projects are managed. And since the asset owner derives the benefit (not the contractors), owners, especially the CFO, are in the best position to understand and solve the problem.
Whether a new production facility or major expansion to existing facilities, routine maintenance including shutdowns / turnarounds and small cap projects, capital intensive companies almost always have projects underway. To determine the profitability or potential return on investment for those capital projects, companies often use financial metrics such as net present value (NPV), return on invested capital (ROIC) or an equivalent measurement. The goal of which is to invest cash in the most productive way possible.
But when it comes to capital projects, several factors impede a company’s ability to productively use their capital. The reasons for this include a flawed approach to managing the project delivery process, accounting practices that perpetuate this approach and misaligned recognition / reward policies that profit from it.
All of these together increase time to revenue and extend the time cash is tied up on the project, adversely impacting the transition from negative to positive cash flow.
The use of Operations Science (OS) enables identification of where and when cash flow will be less than optimal prior to making any serious financial commitmentsSpecifically, where extended project durations constrain the ability to realize revenue and where and when work-in-process or WIP (a production term, not to be confused with work-in-progress, a project management term) is being created increasing cost and unnecessarily using cash.
Understanding and applying fundamental OS relationships is critical to identifying conditions that are negatively impacting cash flow. These relationships include: 1) growth in WIP increases duration as well as cost and use of cash, 2) increase in capacity utilization (think labor productivity) extends duration while cost and use of cash increases and 3) variability will accentuate both conditions. Additionally, it is important to understand if there is insufficient WIP, the schedule will be extended… and if too much WIP exists the schedule will be extended.
Using OS, companies can identify where unnecessary time, cost and use of cash is being created along with how to mitigate the situation.
Flawed Approach to Managing Project Delivery
It should not be a surprise that the construction industry has seen no increase in productivity since the beginning of the last century while cost and schedule overruns are commonplace. Despite modern approaches and technology that could address the issue, being a service-based industry, the construction sector shows little if any interest in improvement. At the root of the problem is an overemphasis on administration and under investment in understanding and using concepts and tools to effectively manage the work (the actual design, make, transport and construct process). Thinking developed by Frederick Taylor and John Hauer in the early 1900’s to the advent of project management as we know it today beginning in the mid 1950’s.
Constructs based on driving use of capacity to the maximum (how to maximize use of equipment and labor), critical path method schedules, earned value management and its rules of credit, tracking of labor utilization i.e., “time on tools”, and contracts that unduly shift risk to contractors form a perfect recipe that drives excessive WIP, resulting in excessive schedule duration, cost, and use of cash.
Accepted Accounting Practices– Percentage Complete Method
Current project accounting methods mask or hide true cost and often result in the unintended consequence of increasing cost and use of cash. And they perpetuate the above approach to managing capital projects. Accepted accounting methods typically ignore the cost of inventory including work-in-process. And often reward the creation of WIP, believing it will help in reducing project duration (time to revenue) and cost.
Project based accounting methods do not recognize WIP and focus on reducing the cost / improving the efficiency of each operation or step in the process. As we have learned in manufacturing, the focus must be on throughput (getting work through the process not increasing productivity at each point in the process).
This is further compounded by how rules of credit use for measuring progress and contractor / vendor payment often result in the unintended consequence of creating excess WIP and using unnecessary time, cost and cash. In reality, the solutions put in place to achieve reliable outcomes are exactly the ones that are preventing us from achieving them.
Recognition & Reward Policies (Employees & Contractors)
The different responsibilities, objectives and associated perspective people have in a company shapes their perspective as does the objectives of the asset owner and the network of contractors needed to design and execute the work. Predictability is one objective that all parties can agree on. However, how each party works to achieve predictability may be at odds with others. Project managers and their team use inventories of inbound materials and WIP to shield the project from variability. The idea is that if we have everything in place in advance and if we provide each contractor with largest chunk of work possible prior to them starting, they will be in a position to execute the work in the least amount of time. Though this may be true for each discipline in engineering or trade on the construction site, the reality is that the time it takes to create these chunks of work (i.e., inventory of work) significantly increases the overall project duration while increasing consumption of cash. What is good for each independent player in the value chain or project delivery process is not good for the asset owner looking to get to revenue at the right time.
The question we often hear is, “why does it matter when I perform the work or purchase something if we are going to spend the money at some point anyway?” Unknowingly, this attitude negatively influences cash flow and investment metrics particularly for the enterprise.
In one simple example representing a small amount of cash, the plan was to hold $238K of piles onsite wherein the optimal policy (a policy that ensured demand would be met and schedule achieved with minimal cash outlay) only required $32K of piles onsite with no increase of piles at the fabricator. This represents an 85% reduction in cash needed to hold the piles (not to mention the additional space, equipment, labor, and holding costs, along with the risk of obsolescence). In another example an onshore E&P company could reduce the cost per well by 19.57%, while reducing cash outlay by 27.43% resulting in 57.97% improvement in NPV over the life of the project.
The latest strategy in an attempt to reduce project duration, specifically duration of site construction, is to move work offsite and adopt modular type construction solutions. Once again, the increase in WIP associated with this approach will require more cash be invested in the project sooner with the bet the overall project will get to revenue sooner. So far this has not always been the case.
What Should CFOs Do?
Though it often seems asset owners are afraid of their contractors, or at least afraid of getting in the way of their contractor, since the owner has the most at stake and the most to gain, the owner must take charge of the situation. This does not mean the owner needs to play contractor, what it means is the owner needs to be deeply involved in the project. And as one of the primary people responsible for efficient use of cash, CFOs and their team should not be afraid to look under the hood.
CFOs should leverage production-based modeling tools to understand how cash will be used during the project execution process including identifying where cash is unnecessarily being used and revenue being constrained.
Todd R. Zabelle is a Founder of the Lean Construction Institute and the Project Production Institute, and author of the new book, Built to Fail: Why Construction Projects Take So Long, Cost Too Much, and How to Fix It, (Forbes Publishing, January 2024).