Overseeing supply chain management to prevent budget blowouts

By Raja Sahulhameed | March 22, 2023

Major capital projects are fundamental to organic growth in resources sectors. When calculating the value of a major project, CFOs have traditionally provided a fixed capital cost to the market, but the cost of megaprojects is becoming increasingly difficult to estimate, which is causing budget blowouts. Supply constraints for building materials and metals, a decrease in global crude oil supplies, high freight costs, and labor shortages are all contributing to uncertainty with the planning and delivery of megaprojects.

As a result, organizational leaders need to become more involved in supply chain management in the current volatile market of inflated costs.

An analysis by the Grattan Institute shows that governments in Australia spent US$22.7 billion more on transport infrastructure than first estimated, and that there was a 21% total cost blowout of over US$13 million for projects in the last 20 years[1]. Data from the Flyvberg Database, which has tracked 16,000 megaprojects globally over the last 30 years, indicates that a mere 8.5% of projects met cost and schedule targets[2]. In the UK, the estimated cost for the Transpennine project, a long-term railway infrastructure program to improve connectivity between York and Manchester, has ballooned from under US$350 million in 2011, to 10 times that number in 2019, before rising again to around US$12 billion in 2021[3].

In order for these budget blowouts to improve, organizational leaders must start normalizing the concept of communicating a variable cost on projects to stakeholders and begin to manage ongoing cost expectations by overseeing supply chain management.

Decarbonization is another driving influence on the CFO role. With sustainability and net-zero targets at the forefront of the mining and minerals sector’s key priorities, CFOs are becoming more actively involved across their supply chains in order to gain greater control over manufacturing processes and materials.

For example, Elon Musk recently announced the possibility of Tesla becoming directly involved in lithium mining and refining business because the cost of metal—a key component in manufacturing batteries—has become so high. Similarly, Chile’s SQM (Sociedad Química y Minera de Chile S.A.) signed an agreement with LG Energy Solutions to supply lithium products required to make high-quality cathode materials for EV battery cells [4].

The trend here leans toward CFOs involving themselves across the entire project value chain, including procurement and supply chain policies. This secures a strategic advantage for organizations to ensure cost expectations are met and the entire supply chain is green or carbon neutral.

End of fixed-price projects for the resources sector

The Australian mining, manufacturing, construction, and services industries price index rose 5.6% from June 2021 to June 2022. This is the biggest increase since 2008 off the back of the GFC. Elsewhere, the UK construction material price index increased by 27.2% between 2021 and 2022[5], while in Saudi Arabia in 2021, the price of aluminum, copper, and iron ore increased by between 45% and 51%, and the price of steel reinforcing bars rose by as much as 46%[6].

This increase is primarily due to supply constraints for building materials and metals; a decrease in global crude oil supplies in construction with increased demand in response to the easing of COVID restrictions; high freight costs; and labor shortages.

The cost escalation presents a significant challenge when initiating and executing infrastructure projects. Bidders may be unwilling and/or unable to adhere to fixed price bids which are favored by governments and private companies who typically look to secure prices within their budgetary constraints.

From the investor’s perspective, a cost overrun can be detrimental because it increases the investment required while the return diminishes or remains the same. Any increase in costs without an increase in potential revenue severely impacts the financial viability of the project.

In other words, without effectively managing project investment decisions and looking at alternate supply chain options, megaprojects are at serious risk of cost overrun.

However, there is a way for the mining and metals industries to make project investment decisions during this challenging time: by shifting the way their supply chains operate by using these three tips.

1. Players in the mining and metals sector should avoid signing lump sum contracts and adopt collaborative contract models, such as Integrated Project Delivery (IPD) and NEC4 Alliance Contracts.

These models are common in other sectors but are not yet used widely in metals, mining, and energy projects. Under such models, stakeholders work together during an agreed preplanning period to develop the project scope, schedule, and budget.

Conventional procurement contracts allocate specific project responsibilities and risks to each participant. Under a collaborative contract, however, the project becomes a collation of sub-projects, where each non-owner participant is rewarded by reference to the performance of the sub-project for which it is responsible, rather than the performance of the entire project. This provides far more protection and less risk.

2. Companies should utilize alternative supply chains to minimize cost inflations and supply disruption.

Around 20% of a company’s supply chain can be changed. Companies could look to India and South-East Asia for alternative materials and components: Since 2014, exports from India have increased from around US$880 million per financial year to nearly US$9.8 billion, demonstrating a strong shift to alternate supply markets.

For example, global technology company ABB has committed to a “Made in India” policy, making India a global hub for electrical equipment manufacturing [7]. Siemens Gamesa Renewable Energy has been expanding production in India, including for its next generation wind turbine [8].

3. Expanding on the idea of branching out to alternative markets, companies should investigate opportunities to purchase pre-designed modules. This can make projects more efficient in an environment where project start dates are already challenged and reduce the number of production staff needed when labor shortages are an issue.

This approach assists in making cost-effective decisions in the current environment of inflation and disrupted supply chains.

At Hatch, we help leading public and private organizations solve complex business and technical challenges in the metals and mining, energy, and infrastructure sectors. Our multi-disciplinary team of consultants, industry experts, and operations leaders work together with clients in developing strategy, prioritizing and optimizing capital investments, executing large scale growth and energy transition projects, and improving supply chain and operations.

Contact us to find out how we can help.

[1] The rise of megaprojects: counting the costs - Grattan Institute

[2] Oxford Professor's Latest Book Examines Roots of Project Failure | Engineering News-Record (enr.com)

[3] Megaprojects often end up late and hideously over budget. Why? | Financial Times

[4] Chile’s SQM signs long-term contract to supply LG with lithium - Green Car Congress

[5] Monthly Statistics of Building Materials and Components - Commentary, June 2022 (publishing.service.gov.uk)

[6] Impact of Price Inflation on Middle East’s Construction Sector (jll-mena.com)

[7] ABB's "Make in India" strategy comes full circle (linkedin.com)

[8] Siemens Gamesa's Engineering Centre in India grows to become one of its largest hubs for wind energy technology in the world (prnewswire.com)