【Haichuan Chemical EPC】How do construction companies manage EPC projects?

From the perspective of the \"smile curve,\" construction companies are at the bottom end of the profit margins in the industrial chain; relatively speaking, the profits they earn come from hard work. During the period of rapid growth over the past 10–15 years, these companies were able to make some profits, so there weren’t any major problems. Both the scale of the industry and the number of workers in it have been increasing sharply. Of course, this growth was of an extensive nature, and there has been no qualitative improvement in the productivity per worker in this industry (which is also one of the reasons for overcapacity in this sector). However, times have changed. Against the backdrop of our country’s economy shifting to a slower growth pace and developing at a \"moderately high\" speed, on the one hand, there are fewer domestic projects, competition has intensified, and profit margins have shrunk ； On the other hand, factors such as raw material prices, labor costs, and industry regulations also exert pressure on the industry’s profits to varying degrees, making things difficult for everyone involved. To this end, the paths available to construction companies can be broadly divided into two categories: market diversification (national and international expansion) ； Diversification and integration of business. Therefore, expanding into the upstream and downstream segments of the industrial chain in order to enter areas with higher profit margins is one of the important options available to construction companies.

So, is entering businesses with higher profit margins the reason why construction companies are transforming into EPC businesses? It shouldn’t be! Overall, the total revenue of the design industry is around 2.7 trillion, with profits of around 200 billion; the average profit margin is 7.6% (this figure includes services related to overall project management. Among the 21 sub-sectors within the design industry, profit margins vary – industries that are more monopolistic or semi-monopolistic have higher profit margins, while those with a higher degree of market competition have lower profit margins). The construction industry, on the other hand, has revenues of around 17 trillion and profits of around 650 billion, with an average profit margin of around 3.8% (this figure also includes certain design and investment-related activities; differences in management quality also affect the profit margins, with construction companies having an average profit margin of around 2-3%). The combined average profit margin for these two industries is around 4.3%. Based on these figures, it might seem like a good reason to shift to EPC business, but there are two issues that need to be considered:

1. Most construction companies engage in EPC projects, with the E portion being subcontracted out; it’s very difficult to obtain a profit from that part. The same is true when design firms shift to doing EPC work – there’s no way to make a profit from the C portion as well. Of course, construction companies can also acquire or take control of a design firm, but this too incurs costs; there is no such thing as a free lunch. Overall, if the goal is simply to move up the value chain, adding design services will not help improve a company’s existing profitability. 2. Is a net profit margin of 4.3% our ultimate goal? Based on the author’s recent discussions with personnel from international engineering companies, there is essentially one principle they follow regarding projects in their home country: they absolutely refuse to take on projects with a net profit of less than 10%! The foundation underlying this principle is their business model – the most commonly used models in China are the EP and EPCM models, with the EP model being particularly prevalent; in other words, what they provide is technology plus management! As construction companies transform into EPC firms, our goal should not be to raise the net profit margin from 2%-3% to 4.3%, but to aim for something higher – a net profit margin of 10%! At the very least, when construction companies transform into general contractors, their net profit margin can fall within the range of 4.3% to 10%! It’s wonderful just to think about it!

Given such large profit margins, the next question to answer is—how do construction companies manage EPC projects? Based on my many years of experience in establishing EPC project management systems for design firms, it is necessary to do a good job with the “132” approach.

“1”, a transformation—a shift in mindset. For construction companies to transition to EPC business, they first need to change their mindset. We are not simply adding elements together; interpreting EPC in a simplistic way as E+P+C will result in profit margins that remain below 5% as long as we hold such a perspective. We need to perform multiplication: in most engineering projects, 70% of the cost is determined during the design phase. For construction companies to transition to EPC business models, it is essential to make full use of the role of E, so as to facilitate the seamless integration of P and C, thereby achieving the result of E×P×C. How E can play a driving role is reflected in two main aspects: costs and schedule — reducing costs through optimized design ； By considering procurement and construction in the design phase in advance, a proper overlap is achieved to reduce the project duration.

“3”, three approaches — “separate”, “combine”, “individual”. How can construction companies acquire E capabilities? Viable approaches are: subcontracting, collaboration, and independence. In the early stages of transformation, it’s possible to adopt a more straightforward approach by subcontracting the design work, infiltrating the \"enemy’s\" organization first to understand its operations and gain management experience. Relatively speaking, design institutes do not have a range of methods and approaches for secondary and tertiary business operations like construction firms, so the risk of loss of control over design subcontracting is lower. During the transition and advancement phase, or for large-scale projects, construction companies can consider forming consortia with design firms to carry out business. Of course, there are two types of consortia: loose and tight. But regardless of the type, once a consortium is formed, the design firm and the construction company become partners in sharing interests (with regard to the project). Through the actual operation of the project and the establishment of relevant systems, the construction company can gain a thorough understanding of design management while also earning excess profits. At the mature stage, construction companies must possess independent full-process EPC capabilities; they can acquire design capabilities rapidly through mergers and acquisitions and manage them effectively.

“2”, two tools — limit design and design optimization. Of course, there is still a difference between active and passive use for these two tools. Limited-design refers to a design process in which technical requirements are met within set limits; it is a more passive approach. When carrying out designs, engineering firms generally follow relevant codes and standards. In the absence of any constraints or a sense of ‘safety net’, they tend to adopt a more conservative design approach. Moreover, due to differences in experience, the quality of the designs produced by different engineers varies. Construction companies can request engineering firms to adopt limited-design based on the terms of the contract and their own experience; as long as the criteria set are appropriate, there is still room for flexibility. However, this will result in more work for the designers and greater coordination needs between different specialties. Relatively speaking, design optimization is more proactive. In the design industry, there are generally two types of optimization related to design – design optimization and optimization of the design itself. It may sound complicated, but the main difference lies in who initiates the optimization process. Design optimization occurs when the client, construction party, equipment manufacturers, or others request changes to the design from the design firm for various reasons; this is what is meant by design optimization. In practical operations, we pay more attention to \"design optimization\", that is, it is better when designers proactively propose design optimization solutions.

How to get designers to propose ideas “proactively”? This requires considering the characteristics of designers; by nature, designers are \"intellectuals\" who possess traits of arrogance and delicacy. “The design industry has long been at the forefront of its field; it was even once referred to as having \"little bosses,\" and its professionals tend to have a high level of education, with an underlying sense of arrogance ； At the same time, designers usually carry out their work in offices, where the working conditions are good; they are not accustomed to the working conditions on construction sites and are relatively more delicate. Therefore, the best approach to deal with these issues of arrogance and delicacy is to take the paths of \"promotion\" and \"finance\" – by \"promotion\", it means creating a suitable career advancement pathway that allows designers to feel that they have a promising future and are valued ； “\"Money\" refers to designing appropriate incentive mechanisms; a good practice in this industry is to establish systems that ensure the benefits of optimized designs are shared with the designers, so that they have the motivation to carry out optimization work proactively. Of course, this article mainly shares some of the author’s humble opinions from the perspective of the weaknesses in building companies’ management of EPC projects; it does not imply that other elements of project management are unimportant. One must first be strong in one’s own area of expertise – if we cannot manage construction properly, we should not expect to handle EPC projects well! Author | Hu Jian, Business Partner at Shanghai PanChengDe Enterprise Management Consulting Co., Ltd.

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