How to Increase Margins on Construction by Effective Procurement Management

The construction industry is very competitive, Yes – you already know that.

But do you know that you can reduce your cost by 8-10% through effective project procurement management?

Imagine how much your profit margins can increase,  for individual projects and collectively as a company.

The main causes of cost overruns are

1. Scope creep due to design changes or additional scope.

2. Limited cost controls/ Cost overruns

3. Material wastage

Scope creep due to design changes can be managed effectively through project management and a change control process.

Material wastage, on the other hand, could be managed through better inventory controls and site inventory inspections.

Cost overruns can be managed through an effective quote to the cash management cycle and that is what we will cover in this blog post. If you can manage the cost-effectively, you can increase your profit margins in the long term.

What Is A Project Procurement Management?

Project procurement management refers to the procurement activities performed by a construction company for a specific project.

The specific steps in project procurement management are

1. Planning
2. Negotiations
3. Execution

Let’s detail what all is included in these activities

Procurement Planning

In the procurement planning phase, you are documenting the needs for a given project.

For example, your company is bidding on the construction of a new building then the resource requirements would depend upon the scope of services you are providing.

For example, you are just doing design or both design and construction is in the scope of work.

There are two types of costs which are involved in this phase

Design costs: This includes the cost of architectural design services or any other services which are required to complete the project.

These might be inhouse resources or outside vendors depending upon the size of your organization.

Material costs: These costs include the cost of material, labor, etc. which is required for any given project.

The idea of the planning phase is to identify all the cost elements related to the project.

A potential next step is to assess the specific requirements for that project.

For example, how many units of material you would need, what equipment you need to rent for this job or how much labor would be required to manage the project?

Procurement Negotiation

A logical next step is to then start looking at the sources for the material or services you would need to complete the project.

For example, you might have inhouse resources for design or architecture services or you might be using a third party contractor for this.

If you are a general contractor, then, of course, you would have different sub-contractor performing the job.

For materials, you might have existing vendors from which you source the material.

Alternatively, if this is a new material then you probably have to find sources of supply.

The other point to note here is that even if you have existing vendor relationships, it might be worthwhile to negotiate the cost for each project.

It could be that increased scope can provide you with better price points. For some materials, the demand and supply situation keeps on changing, so it is doesn’t hurt to check the market every time you have to source the materials.

Procurement Execution

The final step in project procurement is the execution through a purchasing process.

This step is very critical because this is where we realize the cost savings by effectively managing the purchasing process.

Through an effective execution of the purchasing process:

1. You can control the cost by purchasing only what is required.
2. You can control costs by purchasing from the preferred vendors at the preferred price.
3. You ensure that you are getting the volume discounts by levering the various volume price tiers.

A Framework For Procurement Cost Management In Construction

This section is focused on the execution phase of procurement management in construction.

Essentially, how a product or service is purchased from external vendors to fulfill a customer job.

We will focus on the typical issues we see during the execution phase of the procurement and how that leads to savings leakage or cost overruns.

Following are some recommendations on how companies can leverage to increase the efficiency of the procurement process during the execution phase

Integrating Quote To Cash Cycle

It is not uncommon for companies to have different systems for the different stages of the customer life cycle. For example from the initial quote to the billing and receiving payment from the customer.

Let’s break the process into individual steps

1. Creating a quote for the customer

You might have one system for creating the quotes for customers’ jobs and sending it to the customer.

In some cases, you might have a Master Services Agreement (MSA) and every time you need to do a job, you need to submit a quote for approval.

If you are manually sending the quotes for approval, it would be difficult to later track the approvals or what price you have quoted.

In case you have different rates for different customers, then you would probably need to ensure that the rates you have in the contract are quoted on the job quote.

You also need to maintain the proper markups for materials. Your contract might allow you to charge a markup or you do markup irrespective.

So the first step is to ensure that the quote is correct in terms of pricing and quantity and you are accurately tracking customer orders

2. Creating a work order

The next step is to create a work order so that work can be scheduled and the required services can be rendered. This generally includes issuing purchase orders to vendors for materials or services required to complete the job.

In this step, you need to ensure that data is entered correctly, especially for the services so that you can recover the cost with margins.

3. Creating a purchase order

This step includes creating the purchase order for materials or services you need for completing the construction project.

The biggest challenge here is to ensure that you keep the cost under or equal to what you have quoted the customer.

Let us explain with the help of an example.

Assume that you have quoted customer materials for $100,000. However, when you order the products, you are ordering many types of material – for example, concrete or steel or wood.

So how do you make sure that the cost of the purchase orders doesn’t exceed the cost of materials you have quoted to the customer?

The short answer is that you need to meticulously track the cost for each order and lines quoted on the quote.

We cover more about this in the later sections

4. Billing the customer

The next step is to invoice the customer. The invoicing could be over time based on the agreed milestones with the customer.

5. Reconciling the Sales order with Purchase order and billing

In the end, you need to ensure that quotes, purchase orders, and billing have the same amount, minus the margins you have added on the quote.

If there is a discrepancy you are probably losing money on the project.

As you can see there are so many different steps in the execution of procurement for a construction project.

If all the above steps are managed in different systems, chances are you would land up with a lot of issues because of the data not being in sync.

The best way to reduce the chances of errors is to have a system that can capture a lot of steps or at least integration between different systems so that it is easy to automatically move the data between systems.

Details Budgets For Projects

One of the main reasons projects are over budget is because of the lack of detailed budgeting at the project line level.

We are not suggesting that companies don’t track budgets related to projects. But we are suggesting that the budget details might not be granular enough for you to track items that went over budget.

Let’s say you are bidding on a new construction project. You did the scoping exercise and responded to the request for a quote from your customer.

Assuming you win the project, you probably would set up a budget for the project. Let’s say 200,000.

Now let’s say instead of a high-level budget, you had a detailed line level budget created for the project.

Let’s say out of $200,000 total cost, you are spending 100,000 on materials and 100,000 on the services/labor associated with the project.

At the end of the project, you can calculate the actual money you spent on the project, if you are under, you are doing great but what if you went over?

Then you have to dig down, find invoices and calculate where you spent more money than budgeted.

How about a proactive approach?

Let’s play this out again.

Instead of having a generic budget line for material, let say you have a detailed break up of different line items you are going to purchase for the project. For example

Concrete: $40,000

Floor tiles: $40,000

Other Misc materials: $20,000

So now we have 3 budget lines instead of one budget line.

Now imagine that every time you want to purchase something, you are using this budget and the moment you go over the budget, you would immediately know the line item where you went over.

This not only gives you proactive control over purchases but also helps you troubleshoot the root cause of why you went over budget.

For example, you went over budget because you landed up paying more than what you expected to pay for materials.

Or it could be that you underestimated the material requirements.

Once you know the root cause, you can come up with different mitigation strategies for future projects.

For example, for cases where you paid more than what you have budgeted for – you could negotiate a deal with the vendor that the pricing is not going to change for a fixed timeframe.

Alternatively, you could bid the project and choose the vendor with the best cost/value.

Linking Projects To Purchases

The next step in the framework is to link the projects to the purchasing process.

We talked about setting up detailed budget lines in the last step, but setting up a budget is not of much value if it is not linked to the actual purchases.

There are two main benefits of linking purchases to the project/ project budget lines.

You Get Instant Visibility

Since all purchases are linked to the projects, you can get instant visibility into the project spend at any point in time. For example, how much spend we have on open orders or how much is already invoiced.

This also helps you to forecast whether you are going to run out of the budget before the project is complete.

Let’s say you are working on a project which is going to last for 6 months.

2 months into the project and you have consumed 80% of the budget.

That might be an indication that you would probably need more money than allocated in the budget. This might not be true in case you would do the material purchase upfront.

You Can Proactively Control Costs

The second benefit of linking projects to purchases is that you can proactively control the cost and hence prevent the project from going in a budget overrun scenario.

Let assume that you have a purchasing cost control mechanism in place so that all purchases need to be approved before the order can be placed with the vendor.

If your budgets are linked to purchases, you should be able to check if the purchase is under budget or not.

If not, you can ask questions and see what can be done to keep the cost low.

Also, you can see how much of the budget is consumed, so that you are in a better position to forecast the spending.

Spend Analysis For Cost Reduction Opportunities

In the previous section, we talked about the framework companies should follow to better track the cost against the purchases.

In this section, we will talk about strategies companies can follow to reduce the overall cost of the materials or services being purchased.

The previous section was more focused on the process, this is more on the specific tactics for cost reduction. So for example, these strategies won’t help if you have a poor planning process.

Unit Cost Analysis

This is the most basic technique for reducing the cost of the construction material or services being purchased to complete the project.

At a very basic level, the idea is to look at the current spending and find opportunities for cost reduction.

There are a couple of opportunities here for cost reduction

1. Reduce the Unit cost

Let’s assume you purchase certain widgets for construction projects.

If you look at the cumulative spend over a year, you would see that in aggregate you are probably purchasing a large quantity.

Once you have the total quantity, check if the demand is consistent over the years, in other words, you have the same or similar spend year on year for this widget.

If the demand is projected to be consistent, then see if you are purchasing these items from one vendor or multiple vendors.

Based on the locations, you might be purchasing these items from different vendors.

So the opportunity here is to consolidate the spend to a few vendors and get better overall pricing.

You can probably go to a national vendor who can serve all the different locations.

Vendor consolidation is beneficial for many reasons

• You have one vendor to deal with me instead of multiple vendors, so collaboration becomes easier.
• You can work with a vendor over the long term to identify collaboration opportunities which could lead to cost reduction for both of you.
• You normally get a volume discount because you are able to aggregate the spend and get better volume discounts

2. Optimize the order quantity

Sometimes, it is not feasible to change the existing vendors. Or you are in a situation where there are only limited supply options.

If that is the case, then you might want to look at purchasing a larger quantity at one time.

Most of the vendors can give you volume discounts if you purchase items in bulk.

It reduces the shipping cost for them, but the drawback for you is that now you are sitting on a large inventory and that could be an issue for working capital.

If Cashflow is not an issue for your company, then you could use bulk purchases to reduce the overall unit cost.

3. Review your product specifications

A very common scenario we see is that the construction crew has brand preferences for materials.

We all have brand preferences, and that could be influenced by our past experiences or influenced by the vendor’s persuasion techniques!

It is often helpful to use specifications instead of brand names while sourcing these products.

So instead of saying, we need GE 100W bulbs, you could say we need 100W bulbs which would last for 100 days.

Of Course, this is a very simple example.

You probably need to work with your SME (Subject Matter Experts) to identify the exact specification of the material.

This approach would certainly help you find low-cost alternatives for the products without compromising on the quality of the materials you are purchasing.

4. Eliminate certain supply chain partners

In certain cases, it might help for you to eliminate certain supply chain partners.

In most cases, manufacturers sell the product through their preferred partners, also called “Distributors”.

Distributors charge a markup on the manufacturer’s cost for the value-added in the process.

On top of it, some manufactures don’t even have a direct channel so they do rely on their supply chain partners to ship the product to end consumers.

If your volume is high enough, you might be in a position to go direct to the manufacturer and reduce the cost. Generally, you can save at least 3-5% of the cost.

This approach makes sense if

• You have a high purchase volume.
• You can purchase in bulk
• You have enough cash flow to fund the large inventory.

Shipping Cost

Often companies focus on the unit cost of the material and not so much on the freight cost, which is charged by the suppliers to deliver the product.

But that could easily add up to 10% or more of the total purchase cost.

To better understand your shipping cost, you would need to pull the shipping cost information from the vendor invoices.

It is ideal to pull the last 12 months so that you can understand annual trends.

Some points you should consider

• How often material is being delivered?
• From where the product is being delivered. Cost is not just determined based on the volume but also on the distance.

Once you have this data, you could look at opportunities to reduce the cost.

Here are a couple of suggestions to reduce the cost.

Use landing cost for your cost analysis and not the unit cost.

Let’s say your existing vendor has a warehouse that is 100 miles away. You asked for quotes from other vendors and you found a local vendor who is just 10 miles away.

So even though the unit cost is the same, you should look at the total landing cost.

Maybe the local vendor can ship often and offer free shipping.

That not only leads to lower inventory, that leads to the lower overall cost.

Markup Analysis

Most of the construction companies out there charge a 10% markup on the materials they use in the construction jobs.

For example, you purchased a certain widget for $10 and you charge your customer $11 to cover up your overheads.

If the material is a significant portion of the project procurement spend, then the 10% markup can add to a significant portion of your project profit margins.

The challenge though is ensuring that you always billing the right cost to your customer.

Since most companies have multiple systems for a quote, purchase orders, and customer billing, the process is error-prone.

To ensure that you can accurately bill your customers you should look at an integrated Quote to cash cycle.

What do we mean by that?

Imagine a system that allows you to easily create customer quotes from predefined catalogs. The catalogs have your pricing with markup for materials and services.

That way, you ensure that you are always sending the correct quotes to your customers.

The customer now has the opportunity to review the quote and approve it within the system itself.

Once the quote is approved, you can create a sales order and convert that into a purchase order. 

You can send one or multiple purchase orders to the respective vendors.

Once the product is delivered, you can then convert the sales order into a customer bill and invoice the customer.

If all modules are integrated, then it is easy for information to flow and you can eliminate the chances of any error due to data entry from one system to another.

Moreover, you can capture the right markup.

Reduce Inventory Levels

Do you carry Inventory so that you can complete customer jobs on time?

If yes, then you might want to look at reducing the inventory to the minimum or implementing a JIT model.

There are two benefits of reduced inventory.

Lower Working Capital Requirements

If you carry less inventory, your working capital is low.

And sometimes you might be able to fund the purchase of materials from customer advance payments.

The only reason you want to carry inventory is to ensure that complete jobs in a timely fashion but if the jobs you work on have a long lead time, then it doesn’t make sense to carry a lot of inventory.

Lower Inventory Carrying Cost

The Inventory carrying cost is the cost of holding the inventory. This includes the warehouse cost, insurance cost and other costs related to managing inventory.

Generally, this cost is around 20% of the inventory value. So let’s assume you are carrying $100,000 worth of Inventory, then the Inventory carry cost is approx. $20,000.

So look at your supply chain and see if it makes to carry less or no inventory at all.

Conclusion

There are two main things you need to do to increase your profit margins,

One, Implement a cost control framework.

This includes an end to end quote to cash cycle which ensures that the information flows seamlessly through the systems and you are accurately billing your customers.

The second aspect of that is to have detailed project budgets so that you can easily track spending against different cost elements and take corrective action where required.

Second, you should reduce your unit cost for product and services

You can look at your past purchasing history and see if you can negotiate better rates for the materials you purchase frequently. Even if you can negotiate a 5% reduction, that is a straight increase in your profit margins.

Now it is your turn, what are you doing to increase your profit margins?