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Construction : Guest Article | May 2016 | Source : CW-India

Industrial Construction Margins

RAMANA MANAPRAGADA provides an insight into the many factors that cause an adverse impact on margins.
Realisation of margins in the construction of industrial projects is a major challenge faced by all corporates - domestic and multinational - in today's environment. The following factors are believed to have an impact on project revenues and margins:

Market determinants: Fierce competition; fluctuations in demand; uncertainty of investments by corporate; delay in project takeoff.
Project revenue determinants: Ambiguity in contractual terms; frequent changes in design; scope reduction by client; non-acceptance of variation claims by the client.
Project execution determinants:
Issues relating to material procurement; labour productivity; consequences owing to non-meeting of agreed project deliverables (project delays); underutilisation of resources and under absorption of overheads.
Finance and taxation determinants:
Project cash flows mismatch; high cost of borrowing; complicated taxation.

Let's analyse each of the above factors and devise the optimum risk strategy to protect margins.

Fierce competition
What are the most common margins prevailing in the industry? (The margins in the table below are purely indicative
Net margins may vary between 3 per cent and 5 per cent depending on effective working capital management and tax optimisation strategies. A company with 3 per cent margin enters the market and discovers that competitors are charging 4-5 per cent lower and decides to make up the same during project execution. Hence, it lowers its margins by 6 per cent with a 3 per cent negative net margin. The marketing or business development team emphasises upon the client being most prestigious and will make multiple investments in the near future, further improving margins. Hence, the executive committee management team approves the project with a negative 3 per cent margin. Under-pricing is the first and foremost temptation by the corporate to improve the order book or sustain business operations.

Demand fluctuations
Market conditions, economic reforms and political stability will influence FDI in India. The last few months witnessed a positive trend of new investment proposals by FII. In case of a lower demand situation, corporate resources will be underutilised and pressure to secure the order at any price will affect margins adversely later. Demand fluctuations will strongly influence corporate business strategy.

Uncertainty of investments
Corporates sometimes defer their investments in anticipation of more incentives from the government, simplification of taxes and other regulatory reforms. This will lead to lower demand of construction phase of the project and create a situation where many players are chasing a small number of available projects through the under-pricing strategy.

Delay in project takeoff
Once the corporate decides to invest and shortlist a contractor for construction, the project may still get delayed owing to internal approvals and statutory clearances from external agencies.

Ambiguity in contractual terms
Sometimes, contractual conditions between the client and contractor are not clear, such as compensation for workmen in case of accident or death during construction on account of natural calamity; compensation policy on account of deferment of the project during construction stage; compensation to the contractor by the client on account of negative variation in the project value; etc. This results in drop in revenue or increase in cost for the contractor.

Scope reduction by client
The client may decide to defer part of the project outlay indefinitely owing to organisation changes at the top level; in case of Indian subsidiary, instructions from the parent company to defer manufacture of some products owing to weakening of global demand, etc. This will have a direct bearing on the contractor's revenue and margins.

Non-acceptance of variation claims by the client
Work will be carried out in anticipation of client purchase orders. Discussions take place during fortnightly meetings between the client and project execution team and are recorded as minutes.

At the time of project closure meetings, the client can express unwillingness to regularise all the variation claims and negotiate both on number of claims and the price. If the project is of a long duration (say more than two years), the client also negotiates to consider the original price, not the current price รป this will result in higher costs and lower margins.

Issues relating to material procurement
Material cost (including subcontract) will constitute a major cost component (between 65 per cent and 75 per cent) for a construction project. A major dilemma for the corporate is whether to centralise procurement, decentralise it, or do a mix of both. Many corporates have a centralised setup with buyers at project sites as coordinators between the project team and centralised corporate procurement team. Another challenge is coordination between the site planner and procurement team in terms of sequence of activities to complete a particular milestone. Project teams often blame the procurement team for delay in selecting the vendor, release of the purchase order, release of the advance and delivery of material by supplier to the site. The procurement team, in turn, blames the project team for not following the material lead time norms and delay in providing technical specifications for sourcing quotations from suppliers. While the question of who is at fault remains, the result is higher costs and drop in the margin.

The next major issue in material procurement is the link between the BOQ (quantity and price) with the client and procurement of the material (both quantity and price) for that particular activity. Corporates using ERP systems like SAP or Oracle can exercise control through tight budgetary control mechanism with proper authority matrix of approvals for the deviations. Claims (from client) vs pay (to vendors) need greater attention to protect margins. A clear procedure is needed for approval of deviations and their impact on the margin.

Another issue is that whether the contractual terms with the subcontractors for services rendered contains the DLP (defects liability period) clause, in line with the contractual terms with the client.

This is especially required for long projects (say two to three years). Normally, the subcontractor DLP clause exists for a period of one year from the date of completion of work. In case any rectifications are required, this will result in additional costs and reduction in margins. In some cases such as government projects, there will be an extended DLP period, say three years. In such cases, care needs to be taken to extend product and service warranties to avoid pressure on margins.

Last, emergency purchases at project sites need to be controlled - both those that form a part of the client BOQ and additional purchases mainly on account of rectification works. Additional works result in variation claims from the client on regularisation with PO, but rectification works will have a dent in margins if not properly analysed. Emergency purchases are required to avoid project delays. The project and procurement teams jointly analyse those situations and take a decision on procurement so that there are no project delays or dilution in margins.

Labour productivity
Labour is the most important cost component in construction. Corporates have a major dilemma in choosing between self-performance or subcontracting activities. Each option has its own merits and demerits. In case of self-performance (engaging own labour), major problems are attrition and absenteeism. Challenge to the administration department include continuous recruitment, induction (health checks and safety training, etc), providing benefits (accommodation, transportation, insurance and food), statutory compliances (PF, ESI, etc), administration (attendance, leave, overtime and wages) and welfare (safety, first aid, number of shifts, paid holidays).

As for subcontracting, key challenges are proper evaluation of the subcontractor (technical and financial), competency to complete assigned work as per agreed timelines, adherence to statutory compliances and safety norms, quality of work and ability to support the contractor till the final clearance from the client.

The most important element is deploying the right number of people at each phase of construction in line with the plan. Idle time and overtime need to be monitored carefully as both directly impact margins. The project team has a tendency to keep a higher number of labourers than required to protect themselves from absenteeism and attrition. Constant monitoring of plan vs actual numbers and percentage of completion of work at regular intervals is the key to maintain margins.

Project delays
Project delays can happen on both the client side (delay in approval of drawings, changes in design during the field visit, temporary suspension of work, delay in obtaining clearances from statutory authorities, increase in scope of the work, delay in clearances of material specifications, delay owing to internal clearances, etc) and the contractor side (delay in procurement of material, shortage of labour, finalisation of subcontractor, delay owing to natural calamities, etc). Reasons for delays need to be documented and agreed upon by the client and contractor. Any additional cost impact on account of delays needs to be approved by the management committee after carefully examining the facts. Confirmation from the client needs to be obtained at periodical intervals for the extension of time on account of delays from client, to avoid imposing of LD penalties by the client later.

Underutilisation of resources and under absorption of overheads
Corporates often increase the head count of service functions during peak times. In case of a sudden recession in the market, they cannot drastically reduce this. In case of MNCs, apart from regular corporate overheads, parent company overhead allocation also exists towards the share of centralised common services like IT, finance, procurement, etc, and reimbursement of expenses of the senior management and the salary of the senior management team from the parent company for the time spent in the Indian subsidiary. Salary and taxes for the expats who are deputed to support the project team are an additional cost if not envisaged during the construction stage at the time of quotation. This will have a direct impact on the profitability of existing projects.

A gap exists between overheads considered at the time of quotation, and overheads need to be absorbed during the execution stage on account of slowdown. This will reduce the margin. Functional cost analysis need to be performed at regular intervals to monitor overheads and carry out the cost reduction exercise accordingly, to minimise impact on margins.

Project cash flows mismatch
In a corporate, there are two different teams to finalise the contractual terms with the client, and with suppliers and subcontractors. The interface between these teams is the CFO and his team, and they need to ensure effective working capital management. If the gap exists between inflows and outflows, the same will be bridged through bank borrowings. Interest payable on those borrowings will affect the margins. Cash flow management through short and long-term cash forecasts is crucial to minimise the impact of mismatch between cash inflows and outflows.

High cost of borrowing
In the above table, we have seen that the net margin from the construction projects ranges between 3 per cent and 5 per cent, whereas the interest on bank borrowings cost will be in the range of 10-12 per cent. Proper cash flow planning through forecast and better payment terms with suppliers and subcontractors will reduce dependency on banks for borrowings.

Complicated taxation
The number of direct and indirect taxes involved in construction are many, like excise, import duty, VAT, CST, service tax, octroi, labour cess, LBT, TDS (receipts from client and payments to subcontractors), professional tax, etc. In the absence of GST, the setoffs available between input and output taxes are quite complex. In between, changes in the rates of taxes (increase of service tax from 12.36 per cent to 14 per cent) and introduction of new taxes like Swacch Bharat cess (by 0.5 per cent on services) will add to the complexity. Several times, clients insist on an all-inclusive price. But precise evaluation of taxes at the time of quotation is not practically possible, and any additional outflow with regard to taxes during the project execution stage will have a direct impact on margins.

As we have seen above, there are a number of factors that cause an adverse impact on margins, if proper checks and balances are not exercised during the execution of the project by corporates.

About the author:
Ramana Manapragada is a qualified chartered accountant and management accountant with over 24 years of experience in the industry. His latest assignment was with a European multinational company engaged in industrial construction as a CFO.
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