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Managing Capital Project Risk

By Joseph Kucharz, Glenn Boardman

November 4, 2019

Healthcare organizations should have a renewed appreciation and understanding of the risks associated with construction and technology spending. Lack of attention to overall capital construction and technology spending, particularly in the increasingly volatile environment, can lead to strategic and financial decisions that greatly increase the day-to-day risk of operating the organization.

As healthcare leaders strive to help their organizations remain competitive — while they expand, modernize, and integrate the facilities with the latest in technology — leadership has less time to focus on the total amount of risk the organization is taking on as it endeavors to achieve its targeted strategic position. However, the bottom line is clear: The increased risk associated with construction and technology spending puts added pressure on the hospital’s financial position. Capital allocation becomes tighter and other strategic initiatives may need to be put on hold, delayed, or even abandoned. In the current and future environment, the role of leadership is also clear. The C-suite must now step up and engage in active oversight and scrutiny of capital spending projects to help ensure their hospitals and systems remain financially viable.

ACCESS TO CAPITAL

For some hospitals, access to capital markets for construction and IT funding has become increasingly difficult. Particularly troubling is that smaller organizations that need to be responsive to the marketplace and industry challenges are likely to have problems accessing capital to support expansion/renovation projects and the very technologies they need to stay competitive. A key to attracting capital will be an organization’s ability to demonstrate a plan of action that addresses risk.

The need to better manage risk remains, as many factors such as antiquated facilities, the need for technological advancements that enable hospital efficiency and quality, code compliance (such as California seismic requirements), and the aging baby boomer generation, pose challenges. The overall effects of tighter access to capital and declining reimbursement all have an impact on healthcare capital projects. Essential projects will continue to be implemented. Therefore, hospitals and health systems need to ensure that they are appropriately focused on capital spending and the risk associated with it.

Hospital leaders can play a critical role in focusing their organization on managing risks by addressing the following questions:

  • How will the current capital markets affect capital spending risks?
  • What is the strategic plan for the institution over the next three to five years?
  • What risks should leadership address as part of their project oversight responsibilities?
  • What constitutes the overall development continuum of a major capital spend?
  • What is the business plan for the project?
  • Will the investment deliver a clear, measurable benefit?
  • What are the true costs of the planned new or renovated facility?
  • What is the optimum project delivery method?
  • What operational improvements have been identified and are being designed into the new facility?
  • What might happen if project risks are not properly understood or managed?
  • How do we balance project costs with desired quality and life cycle benefits?
  • How do we recalibrate project scope and reduce operating costs to offset increased cost of capital/debt service?
  • What alternative nontraditional sources of capital can we access to fill a void, if needed?

THE DEVELOPMENT CONTINUUM

The development continuum graphic shown on the next page identifies activities that occur from the beginning to the end of a capital project. The continuum can help the board of directors and hospital leadership organize, visualize, and oversee these activities. Although presented in a linear format, many of the activities occur simultaneously, to both accelerate the project to market and reduce risks. This section will discuss each part of the continuum and identify issues and opportunities hospital leaders must address to ensure that projects are successfully funded and completed.

It is vitally important that leadership critically examines and explores options for how these projects will be managed (both internally and externally). Time and experience needed to manage these projects toward a successful outcome are often underestimated and underappreciated. A project executive who has a history of working on successful large projects will be invaluable to this process. Below are some additional points on assessing the leadership required for capital projects:

  • Who will oversee the project?
  • Is the current CEO involved or has a new senior executive been hired or appointed?
  • Will the project be overseen by a committee?
  • How will management maintain its focus on current operations?
  • What has been management’s history and experience with other sizable expansions?
  • Were these expansions completed on time and on budget?

The first part of the development continuum (up to the first go/no-go decision point) represents the activities that need to be completed to allow the board to make informed decisions about the strategic, market, operational, facility, financial, and capital aspects of the project. The project business plan should respond to an organizational strategic need. The plan should explore all viable options. In most cases, the need for objectivity dictates the use of a third party. At this point in the decision-making process, prior to board approval of the expenditure, a key risk-mitigation strategy is to use the two-party approach in which one group generates the plan and a second group tests/opines on the plan. At a minimum, the market assessment, volume projections, and financial pro forma should be prepared by experienced healthcare consultants recognized and respected in the healthcare financial community. Completion of these tasks is marked by a definitive go/no-go decision by the board.

In today’s environment, boards are encouraged to introduce a second go/no-go point as noted between the design and build steps in the project implementation section of the continuum. This second decision point coincides with the resolution of the final plan of finance for the project. For a relatively small percentage of the overall capital spend (in most cases, no more than 4 to 6 percent), management can advance a strategically necessary project up to the start of construction while other critical success factors, such as physician recruitment, are achieved or trending favorably, so as not to lose market timing. At the same time, hospital leadership can fulfill its stewardship role by not allowing project construction to begin until the plan of finance is completed. Along with the timing of the plan of finance comes a significant amount of certainty concerning the final scope, schedule, and cost of the project. This certainty is becoming more important as the credit markets closely scrutinize the degree of risk prior to completion of financing.

The project implementation portion of the continuum depicts execution of the business plan and represents activities that need to be completed to effectively implement the plan. The emphasis on ‘business plan’ rather than ‘project’ is deliberate. A major capital project is only one component of a business plan developed to meet specific strategic objectives of the organization, not the result. Implementation activities need to be carried out in a systematic, controlled manner to allow ongoing monitoring and reporting to reduce risk related to schedule, budget, and/or variations in project scope.

As shown at the bottom of the continuum, the capital expended is relatively small during the early stages of the project, while the ability to affect the project’s alignment with strategic needs is significant. Conversely, as the project moves into the construction stage, the ability to affect alignment with strategic needs is minimized and the capital expended increases rapidly. Key activities within the development continuum are discussed in more detail below.

A new facility can be the catalyst to change the way the organization does business, and, in a sense, can help transform the organization. New facilities can and should be designed to deliver patient care more efficiently and effectively, along with better-quality outcomes, and improved patient experience.

Capital construction project development continuum.

STRATEGIC PLAN

The management team defines the direction of the organization through a strategic plan that typically extends three to five years into the future and should be revisited and modified as often as needed, depending on market and financial conditions. To achieve strategic goals, new or reconfigured facilities are often needed to house new service lines, expand patient care areas, house new technologies, and/or replace antiquated facilities.

The most successful projects are those that have evolved to address defined strategic objectives. Ratings agencies and financial markets will be very sensitive to understanding and appreciating the organization’s strategic plans and supporting business plans.

If an organization plans to replace an aging physical plant, it is the board’s obligation to ask, “Are we spending significant dollars to build a new version of the present?” and, “What will be different about the way we are able to deliver care in this new facility?” If these questions cannot be answered satisfactorily, the business case for the new facility is not as robust as it should be. Further, reducing operating costs to help offset increased debt service should be mandated to achieve a project’s return on investment.

DEFINING THE PURPOSE — PROJECT MISSION/VISION STATEMENT

Prior to implementing the business plan, a project mission/vision statement and guiding principles should be established. For all major projects, and when diverse groups are involved, beginning with an educational component can help set the context for fresh thinking and a common understanding of the vision. Inviting a futurist along with industry experts to address a board/leadership planning retreat, for example, can create an atmosphere of innovation and thought leadership.

The project vision statement describes the purpose, organizational direction, and expected outcome the project will provide. The project vision statement should:

  • Be memorable and provide guidance.
  • Be a clear road map for the future.
  • Be challenging and about excellence.
  • Be inspirational and emotional.
  • Inspire employees, physicians, and other stakeholders.
  • Prepare for the future.

GUIDING PRINCIPLES

Guiding principles are values, goals, and rule statements established by an organization’s leadership and set the stage to remake the organization’s design, culture, and practices.

Guiding principles are used as a communication tool with all project participants and to ensure that overall project goals do not become subservient to stakeholder special interests. They should be used to evaluate options and make choices during the project planning and design stages. Guiding principles may address such things as:

  • Goals for improvement, which may include:
    • Quality of care.
    • Efficiency of care.
    • Patient satisfaction / experience.
    • Staff satisfaction and retention.
    • Financial performance.
  • Cost.
  • Flexibility.
  • Sustainability.
  • Patient and staff safety.
  • Image.
  • Culture.

Guiding principles should be developed in conjunction with hospital leadership because it is their role to ensure risk mitigation and alignment of the project focus with the hospital’s mission, goals, and values. The guiding principles will be used continually throughout implementation to assist in evaluating choices and the inevitable compromises needed to deliver a successful project. The guiding principles are the primary risk mitigation tool used for controlling ‘scope creep’, or proliferation of out-of-scope activities, during the implementation process.

BUSINESS PLAN

All major capital projects should be driven by strategic objectives. A business plan is used to develop the storyline, the basis from which to create, analyze, and ultimately recommend an option that meets these objectives. Components of a business plan include:

  • Internal project management organizational structure — project leadership by a designated senior project executive and a steering committee composed of board committee members, physicians, and executive leadership.
  • Project guiding principles that include operational/performance improvement metrics and objectives.
  • Independently validated market-based volume projections.
  • Cohesive physician integration strategy and buy-in.
  • Right-sized facility plan, including projected inpatient and/or outpatient and ancillary space capacity requirements based on service line volume projections.
  • Independently validated financial feasibility study.
  • Five- to 10-year financial projections with risk analysis.
  • Experienced external team, including program/project management, design, construction management, and other qualified professional consultants.
  • Realistic and well-thought-out total project budget, schedule, and cash flow analysis.
  • Project risk management tools and processes in place, such as scope, budget, schedule, and controls.

OPERATIONAL PLANNING/PROCESS IMPROVEMENT

There are times when a green light exists that allows for the planning and implementation of fundamental change in a healthcare organization — change that otherwise may not be achievable. Planning and undertaking a major capital project is often that green light and can be an agent for fundamental change, a transformation that is lasting and profound.

Existing healthcare operations can be plagued with parochial, ineffective, and inefficient processes embedded within the environment that, unless addressed, will result in underperforming operational improvements. Formal operational process improvement or redesign can be very effective tools, but facility configuration may be a barrier to achieving best-practice operations and related metrics. A project approved for its strategic and financial merit can be a catalyst for rethinking how operations and related facility configurations also can be accomplished in a new inpatient or outpatient facility.

Operational planning defined by creating/documenting process flows for key patient, staff, and clinical/support activities within the organization should precede new space programming and design. By taking a ‘clean sheet of paper’ approach, organizations can create the desired patient experience within the context of a project’s guiding principles. New process flows can lead to aggregation of services and space in ways that challenge and eliminate historical departmental silos. New position descriptions and cross-training should be employed as part of newly developed staffing models, which can reduce labor costs and achieve a higher level of service.

It should be noted that effecting such change as part of a capital development initiative does not happen easily. Cultural change must coincide with requisite operational and facility changes. Not all levels of management within the organization may have the experience or aptitude to navigate the barriers and pushback that can occur when fundamental, not just incremental, change is necessary.

Not all organizations are ready to embrace the fundamental change that will result from operational process improvement. Therefore, some healthcare organizations are now planning differently for major capital development projects. Rather than engage existing users in the planning process, these organizations are using a small group of senior thought leaders who are surrounding themselves with best-in-class program managers, planners, architects, and others, and allowing innovative and best-practice thinking to prevail. Like many successful non-healthcare service organizations, they will later train commonly new staff in the culture and operating/facility paradigms that have been developed.

The keys to success of the operational planning process are:

  • The organization’s project executive is engaged early in the process and is a champion of operational change.
  • Operating performance metrics are established up front.
  • Operating plans and facilities are designed around the needs of the organization.
  • Technology spend should be determined based on a true enabling of operational changes so that there is a measurable benefit to the investment.
  • Staff are recruited and trained to deliver patient experiences and outcomes that may not have been achievable without this process.
  • Leadership and board commitment is necessary to make an effective and lasting change.

BUDGET AND COST OVERVIEW

Board members and leaders often do not understand the total cost of projects.

Construction costs themselves, while a significant part of the total project cost, are only a part of the cost. We often see significant lack of understanding and accounting for the components that make up the rest of total project costs, as well. Whether an organization is renovating or undertaking a new facility, spending components are categorized as follows:

  • Land costs.
  • Site work (on- and off-site).
  • Construction:
    • Shell and core.
    • Build-out (new and/or renovated).
  • Furniture, fixtures, and equipment (FF&E), including technology, office, and medical equipment.
  • Soft costs.
  • Owner’s contingency.

An on-budget project maintains spending within the total of the categories listed above and is referred to as the owner’s approved budget (OAB). The OAB is set to match the objectives of leadership and a project pro forma aligned with the marketplace.

Each spend category must be carefully considered and accurately developed so that a proper OAB is developed. One miscalculation within any category can result in a project that is over budget. To reduce the possibility of this occurring, benchmarking within the categories can provide confidence that a successful budget has been established. This is particularly useful because very little detail is known early on when a budget is set and plugged into a project pro forma. Categories that are most at risk due to unavailable information or high swings in scope definition are:

  • Off-site work. Unanticipated costs generally arise during the zoning and permitting process related to negotiated owner contributions toward community improvements.
  • FF&E in regard to information systems and technology.
  • An underdeveloped soft costs itemization. A robust list of line items should be used that includes financing, tests, legal and accounting, design and engineering, fees and permits, taxes, and consultants.

OWNER’S CONTINGENCY

Owner’s contingency should be set with the expectation that all of it may be spent. Experience has shown that as a project moves through the development continuum, expenditures will become evident and monies will move from the owner’s contingency to fund them without affecting the overall OAB. Contingency should be set as a percentage of each spend category of the overall budget. As construction, site work, and FF&E costs increase, so do the soft costs associated with them. For example, in a well-managed project, 5 to 6 percent of the contingency should be considered available to transfer to other budget categories to allow for better scope definition and to give the user flexibility in programmatic decisions.

A good rule of thumb is to have a reserve of 4 to 5 percent in the owner’s contingency that should be retained when entering construction. This will allow for the normal course of changes and unforeseen conditions that will occur during the construction process. If there is less than 4 percent left in owner’s contingency when entering into construction, cost reduction options or an adjustment to the OAB should be considered.

Giving deliberate, scientific, and artful attention to this methodology will help avoid the industry pitfall of committing to an approved budget based on hearsay of cost per square foot or cost per bed without benefit of additional analysis.

CONCLUSION

Healthcare organizations that do not completely understand capital project risks and how to manage them will reduce their flexibility to overcome uncertainty and succeed in their respective markets. Organizations that decide to manage risk by abandoning or delaying essential capital projects may find themselves in an uncompetitive position. Organizations need to plan for tomorrow’s success.

Healthcare organization boards and leadership should seek a proper balance between capital project spending, deploying aggressive project delivery risk management, and maintaining a conservative approach to fiscal and operational management. The following tips can help achieve such a balance:

  • For strategic growth projects (such as ambulatory facilities, new market facilities, new service lines, and increased capacity) spend the soft costs today to put your organization in a better position to launch construction tomorrow. You can always choose not to move forward.
  • Re-evaluate your business plans, overall capital allocation plans, and project specifics. Modify assumptions to current/forecasted market conditions, build in a cushion, and prioritize spending accordingly.
  • Utilize project delivery methods that align incentives and increase the accountability of all stakeholders.

Prioritized strategic capital decisions must be executed for healthcare organizations to remain competitive and meet the needs of our communities. Strong governance and laser-focused leadership must prevail.