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Subcontractor Performance Risk

Use the Results of Subcontractor Prequalification to Mitigate Risk

Cheri Hanes | February 1, 2019

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Building materials

At the earliest stages of a construction project, preparations are being made for a long and challenging journey, even in the best of conditions. On this journey, you will need your wits as well as the very best equipment. A subcontractor prequalification is a powerful resource when composing your toolkit: it is the preparation and research that tells you which tools are of the highest quality and in the best working order.

Many take the path of least resistance and just pick up the closest, cheapest tools. But when you're out in the wilderness, and your knife is dull, or your canteen leaks, you may regret that decision dearly. It is surprisingly common to learn that all the hard-won analytic information from the subcontractor prequalification process was ignored simply because a subcontractor was the lowest bidder or was the one that the project manager had a history with.

Collect the Information. Analyze It. Act on It.

Today's builders have invested tremendous amounts of time and resources into the collection and analysis of subcontractor prequalification information, and those investments open up a whole new level of risk awareness, mitigation support, and loss avoidance. After prequalification, you should have much more insight into your subcontractors' capacity—both financial and operational. The process, at its core, is straightforward.

That third step—acting on the information obtained during the subcontractor prequalification—is where things sometimes fall apart. The data shows that in over 35 percent of potential defaults, issues were identified during the prequalification process but were not addressed. Once you have the information, it is critical to act on it. Award decisions and risk mitigation plans are opportunities to use the insights the prequalification process provides, and yet, in situations where a subcontractor has failed to perform, hindsight often shows that this critical step—which is really where the return on your prequalification process shows up—is often skipped, glossed over, or poorly communicated/acted upon. Decisions to award are ultimately made based on price alone. Risky subs are signed on without mitigating the risks your own process uncovered. And headaches ensue.

An Example of Problems from Ignoring Data

On one project, the wood frame subcontractor showed signs of financial weakness in the prequalification process, and it was also revealed that labor would be performed with brokered manpower rather than internal forces. The bidder was low by 20 percent, and the lure of such a large cost savings overcame the desire for caution. The subcontract was awarded with no risk mitigation plan required.

Over the course of construction, the subcontractor did not manage quality well due to a lack of supervision and constantly changing workforce, resulting in systemic quality defects, which only surfaced as other trades mobilized. Because of the subcontractor's financial state, it could not bear the cost of the required rework and abandoned the project. The final cost to complete the scope was 240 percent of the original subcontract value. The 20 percent delta—or the cost of adding extra supervision and support for the subcontractor—would have been a bargain, comparatively.

What could have been done differently? The following were major red flags that were ignored to utilize this subcontractor.

  • Insufficient financial strength
  • Brokered labor
  • A bid spread over 10 percent

Each of these red flags was an opportunity for avoidance or mitigation of risk—opportunities that were missed.

Weak financials compound the risks when a subcontractor's bid comes in low. Cash cures many things, and a sub who has none is fragile. Any hit to its cash flow can result in the abandoning of the job or the builder having to basically become the sub's banker. Often, the price of using a sub with subpar financials eats up management time and attention that could be better used elsewhere on the project. It is questionable whether the sub in this example should have even been allowed to bid on the project.

If the financial challenges can be overcome in a way that makes you comfortable considering the bid, then the next consideration should have been understanding why the bid was so low: What made up that 20 percent? Is the subcontractor in a desperate situation and bidding so low just to try to stay afloat? Did it fully understand the project and catch all the scope in the bid? Will there be adequate manpower and supervision? In the end, the delta to the next sub could have been a good investment—depending on performance capability and financial health of the next bidder, of course.  

If the decision was made to carry on with this subcontractor after pausing to understand its capacity and bid, what risk mitigation plan needed to be in place to ensure success? Brokered labor often leads to schedule and quality issues. Adding supervision specific to this trade might have helped, and increased quality assurance/quality control (QA/QC) inspections might have caught the defects before they were repeated throughout the entire project and might have led to a better outcome for all.

Other Examples

In another recent example, the builder awarded two projects to the same roofer. This subcontractor was familiar to the builder and had done similar work with good results in the same market. However, while the individual project sizes were each within the sub's capacity per project, the aggregate amount of the two simultaneous projects far exceeded the aggregate capacity calculated by the builder's own prequalification analysis. This caused the sub to broker labor to staff the work and resulted in two roofs being installed with severe quality defects that will each have to be fully reworked—with a large percentage of the new material having to be completely torn off and replaced. The final cost of this default is not yet known but will likely double the original subcontract value. What happened? The subcontractor's bid was 15 percent lower than others, and it also offered a discount if awarded both jobs. The case could have easily been made to award this sub one of the contracts and use another for the second, but that did not happen.

In a third example, the cabinet and granite tops subcontractor's bid was significantly low compared to the next bidder. In addition, they were a relatively new organization and a first-time sub for this builder. References revealed that they had issues with failures to complete work and challenges with shop drawings. Any of these should have given serious pause. Additionally, the sub's materials were coming from overseas, and a deposit was required to order the materials.

There are two distinct but related risks in this situation: supply chain risks from overseas materials and an immediate overpayment situation compared to the percent of work in place. Deposits are not a favored strategy, but if one is necessary, risk mitigation might include a bond for the deposit or an equal amount placed in escrow. And, when materials are coming from overseas, verification and tracking of the materials are called for. However, none of this was put in place, and on the day installation was scheduled to begin, the builder learned that no materials had ever been ordered. The subcontractor had simply pocketed the deposit. The total cost to make this right was 167 percent of the original subcontract value.

Risk Mitigation Is Key

So many opportunities for risk mitigation missed! It makes you cringe, doesn't it?

One thing is certain—no one wants to be on the other side of a default saying that they knew there were issues and decided to engage with that sub anyway without addressing them. It's easy to see that in retrospect; it's sometimes hard to make those decisions on the front end.

What can you do to make sure this doesn't happen in your organization? The following are some strategies.

  • Utilize your prequalification investment. Heed the warnings your prequalification is providing. Prequalification shows you the territory your team is about to walk and provides an opportunity to map out the smoothest path to the finish line. This is a time for strategy. Take full advantage.
  • Empower your teams to make the right decisions, even when dollars are involved. Support and recognize employees who do make the hard decisions to come down on the side of caution.
  • Implement the use of a defined decision matrix to support purchasing decisions based on best value, not just price. Performing a risk/reward analysis on bid discrepancies can increase the likelihood that any savings aren't likely to be lost through elevated risk.
  • Back up your prequalification with a robust risk mitigation plan (RMP) process. Field teams should help develop these plans. They need to know when a subcontractor has shown warning signs during prequalification and will be responsible for the implementation of these plans on site. Their buy-in and understanding of the risks are crucial.
  • Address both financial and operational risks in your RMP process. Financial measures (joint checks, lien waivers, letters of credit, etc.), operational capacity (schedule, manpower planning, monitoring, etc.), and quality management (checklists, inspections, additional supervision, etc.) all have a place in the RMP process.
  • Observably track the implementation of RMPs. A variety of dashboard-type metrics can be tracked to demonstrate that plans are being implemented as intended: QA/QC inspections, schedule milestones met, percent paid versus percent complete, noncompliance report numbers, time to closure, etc. Pick the parameters that work for your projects and make them visible and auditable at the project and corporate level.
  • Cultivate a continuous improvement mindset. The construction landscape is constantly in flux, and prequalification and risk mitigation plans should be too. Don't let them get stagnant. Consider the forces that are bearing on subcontractors today and in the future in your marketplace and address them proactively. Hot labor market? Jumbo projects? New construction type in the market? All of these present unique emerging risks.
  • If a default has occurred within your organization, do your very best to learn from it. What could have been done differently? Understand the factors that led to bad outcomes. Figure out how your organization wants to handle that same situation in the future, and incorporate those measures into your prequalification and risk mitigation systems. Some even go as far as capturing "near misses" or trending on notices to cure with regard to potential sub performance issues. Encourage sharing and strategizing for things that "almost happened."

There are no guarantees of a smooth journey in construction, but by using these strategies, you give yourself the very best odds of surviving, thriving, and—just maybe—enjoying the adventure. Take full advantage.

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