Creating Efficiency in Capital Projects with Smart Contracts
Project owners understandably exercise considerable vigilance in managing cash flow and the cost of money. This is also true of engineering, project and construction management, procurement and finance.
Too often, payment terms on capital projects are leveraged as an opportunity to exercise cash flow measures, but does the owner fully understand and consider the total cost of long payment terms on contractors? How do delayed payments actually increase the total cost of a project?
Like safety and workforce development, capital efficiency happens on a learning curve. Owners need to be shown how their actions affect contractors who typically operate with low profit margins and minimum cash flow and simply cannot maintain large cash reserves to temporarily fund project costs.
Without timely owner payments, contractors must cover costs until an owner payment is received, and with limited cash reserves, most contractors rely on some form of borrowed capital. Since contractors are often small or medium-sized companies with few assets, their cost if capital is much higher than that of the typical owner or developer. Long payment terms at high interest rates mean expensive capital costs, which flow back to owner in the form of higher overhead mark-ups and inflated billing rates.
Furthermore, contractors know which owners are consistently slow payers and adjust their cost estimates accordingly. They may even choose not to work with certain owners, thus limiting an owner’s capacity to attract the best contractors.
WHY IS CHANGE SO CRITICAL?
Capital projects are a significant contributor to the U.S. economy with more than 680,000 employers and 7 million employees creating approximately $1.3 trillion worth of structures each year. However, poor performance on projects is common — 70% are not completed within 10% of budgeted cost or schedule and 95% are not completed within 3% of budgeted cost or schedule.
The problem is even worse on megaprojects over $1 billion where 98% experience cost overruns averaging 80% coupled with schedule delays of 20-months. But perhaps the most troubling fact is that on the average nonresidential project, 40% of the total installed cost is wasted on non-value-added transactions.
As an industry with notably thin margins and poor cash flow, most projects lack flexibility, predictability, capital efficiency, effective information sharing and other critical components necessary for sustainable returns on investment. Amid the current economic downturn, COVID-19 and the subsequent hamstringing of building practices with ramifications that have yet to play out, the construction sector can no longer afford to maintain its current mode of operation.
Excessive friction among counterparties and disjointed, manual workflow processes must be addressed now to radically improve the business model. The industry must embrace healthier behaviors and new technology to make capital projects financially viable and the businesses that build them more sustainable.
OLD SYSTEMS, OLD ISSUES
Historically, construction and project execution processes are rooted in a paper-based culture of spreadsheets, emails, phone calls and disconnected databases across company boundaries. The industry’s core management science — including critical path method scheduling, earned value analysis, etc. — were developed in the 1950s and 60s. And, while other industries have adopted more modern management science like what has manifested in "Manufacturing 4.0,” the construction industry has not evolved nearly at the same rate. This is evidenced by countless productivity studies and generally poor performances by construction companies in the stock market.
To improve agility, cost savings, and overall productivity, the industry must move to capture lost or hidden value. McKinsey Global Institute noted that there is a significant productivity opportunity in construction with $1.6 trillion of value that can be derived from moving to streamlined digital processes that will eliminate waste and improve financial performance.
Doing business using paper-based work processes, even if automated, or using siloed legacy systems exacerbates cost escalation. Most transactional and informational waste can be attributed to a lack of trust between participants. Combine this distrust with complex, fragmented projects; slow, onerous procurement processes rife with time-consuming bidding practices often focused solely on initial cost; compounded markups within a hierarchical supply chain; and poor cash flow due to late payments, and the industry arrives at a significant opportunity to recapture lost value.
SMART CONTRACTS IMPROVE CAPITAL EFFICIENCY
Smart contracts facilitate the much-needed trust in capital projects and thereby hold significant capability to disrupt the construction landscape.
Smart contracts are computer protocols that essentially contain business logic designed to automate the performance of any contract of any type in the construction industry. With configurable conditions, counterparties negotiate and agree on terms upfront, then the pre-agreed terms are linked to data sources such as project execution tools, existing business management systems or other office or field data sources. Real-world, physical project events are captured in a digitally verifiable way.
Transactions executed by smart contracts are posted to blocks in a distributed ledger that is viewable to all involved parties, along with the immutable relevant data and documentation required to verify or audit consensus. The technology enables a shareable, single source of truth that uses automatic payments, removes the invoicing process, minimizes disputes and reconciliations, encourages higher productivity and quality, and vastly decreases Day Sales Outstanding from the typical 90 or 120 days down to literally net one day, if so desired.
BENEFITS ACROSS THE BOARD
Creating capital efficiency means changing the portfolio and project environment across its many layers. Examples of the many benefits smart contracts deliver to construction industry service and product providers include:
- eliminate contract leakage for contractors/suppliers and capture lost revenue;
- reduce overhead costs for contractors/suppliers by 10-20% through automating the invoicing and payment process (i.e., eliminate manual/paper invoices, and associated indirect costs);
- improve accuracy of invoicing and measurement of completed work for contractors/suppliers through automation;
- improve the velocity of cash flow enabled by “micro-payments” for completed work across the entire supply chain;
- minimize disputes and claims, improve relationships with clients, and benefit from increased trust and transparency; and
- position for future industry transformations and digitalization.
Examples of the benefits for owners/developers include:
- help owners become a “client of choice,” where they can attract the best contractors/suppliers and their best teams, experiencing improved productivity and quality;
- receive early pay discounts and achieve lower billing rates through a reduction in the cost of capital;
- only pay for what is received;
- reduce overhead costs in a similar fashion to the contractor/supplier benefit described above;
- provide complete provenance and traceability of all materials and services with go to commission and startup of facility; and
- position for future industry transformations and digitalization.
Regarding provenance, an industrial-focused, immutable blockchain enables projects to:
- capture and store engineering and vendor design deliverables, operation and maintenance manuals, warranties, and other documentation for materials and equipment on the distributed ledger;
- capture and store material specifications and certifications through the complete project supply chain, such as steel from the steel mill to the pipe fabricator to the contractor to operations;
- store post-project maintenance history and change management data for each piece of operating equipment on the distributed ledger; and
- achieve full digital twin capability.
RESPONSIBILITY TO IMPROVE
The prevailing capital project model is inherently problematic and places enormous burden on the multiple layers of the supply chain in the built environment. Smart contracts leverage technology to digitize project and operating systems, bringing the construction industry up to speed with other industries and removing transactional waste for a more efficient, transparent and trustworthy business approach.
Changing how owners, engineers, contractors, and suppliers interface with one another and placing trust and transparency at the center of the operating model, is the clearest and fastest way to transform projects and improve capital efficiency.
This article was co-authored by Michael Matthews, SVP, Data Gumbo and Pete Dumont, CEO, PrairieDog Venture Partners and originally appeared at Construction Executive Magazine.