Managing Risks of Advanced Payments in Projects

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Categories: Risk Management


In most projects, the issue of "advanced payment" vis-à-vis procurement management is very valuable. An advance payment is a prepaid expense from the client, paid to a vendor in advance for goods or services. The balance is paid after a successful project delivery.
 
Advance payments are meant to provide financial aid to the vendor by providing initial funding for jump-starting the project. It also shows financial commitment and project approval from the client.

Advanced payments are beneficial to the supplier, but are very risky for the client because the prepaid goods or services may not get delivered as planned. What if the vendor disappears with the advance payment? This would attack and distort the project's time and cost objectives.

In order to mitigate this project risk, the project manager may request a sort of surety before supplying the required advance payment. Most project managers would settle for an Advance Payment Guarantee (APG) from a reputable bank.

But banks often confuse the main goal of an APG on projects. Many times, the banks take care of operational risk while ignoring the aspirations of managing project risk.
 
For instance, banks in Nigeria, where I work, may request a 100 percent cash backed prerequisite for an APG. The insistence of 100 percent cash backup connotes seizure of the funds, which are meant for the project (as provided by the client).
 
It's good risk management on the bank's part. If the vendor flees with the advance payment, the bank would live up to its guarantees by taking the seized funds back to the client.

To a discerning mind, this antagonizes the essence of project risk management. The funds from an advance payment are primarily meant to be an inflow into the project to mitigate the initial funding challenges of the project. But the vendor would be exposed to sourcing the same funds that had been provided by the client, which would delay the project.

Any bank that is familiar with risk management should be willing to cater to the peculiar needs of the project objectives. There could be other ways of monitoring advance payment disbursement to the vendor as opposed to seizure of the entire funds while still expecting performance with the seized funds.

What do you think? Do you use APGs on your projects? What issues do you face? How do you mitigate the risks of advance payments?

Read more about risk management.

Check out PMI's Communities of Practice for more information about Financial Services
Industry and Project Risk Management.
Posted by Lambert Ofoegbu on: July 13, 2011 11:04 AM | Permalink

Comments

Ahmed Esmail
Nice article, but it takes one side of view which is what if the contractor is bad. The other point of view, what if the client is bad, or not able to fulfill his obligations.

For the first case, you get your advanced payment, the bank issued APG, which is handed to the client. You are doing your job, but the client refuses to decrease the amount of the guarantee.

Although it has been cut off from the contractor invoice, it becomes a dispute, extra costs for lawyers, mediators, or even arbitrators. Plus the extra costs of APG until ending up this issue, the loss of the backup amount, especially if you have a great inflation rate. If you didn't cover the APG 100%, the bank can put a loan rate for the uncovered amount. This is completely a loss.

The second issue, what if the client has some troubles in funding the project, and is not able to pay the money on time, and have to give extension of time, or even hold the project for some years? You will have to pay the costs of APG plus the loss because of inflation rate. Arising it to dispute, extra costs for lawyers, mediators, arbitrators.

The decision to have an advanced payment shall be carefully studied from both sides, because each side has his own risks.

YU Shuk Man
Could you tell me why the word 'Advanced' is used in 'advanced payment' in the first line of the first paragraph as well as the first line of the third paragraph? Is it a typo or the term 'advanced payment' carries a special meaning in project management or just a common practice in project management? Thanks.

Lambert Ofoegbu
The topic focused on mitigation of ‘Advance Payment’ exposure in favor of the client.

During advance payment, the contractor is at no risk. Because the contractor would be collecting funding in advance with little or no work accomplished, against the client who would be making advanced payment.

However, the Bond/Grantee for advanced payment in most circumstances should be time bound (between 3 to 6 months) and it is usually liquidated automatically once obligations covered under the advanced payment is satisfactorily executed. Any client objections against the vendor on Advanced Payment liability should do that before the expiration of the Bond/Guarantee.

The issue of general contract performance is slightly different. In some projects, both Advance Payment Guarantee and Performance Guarantee may be required from the vendor. General Performance Bond/Guarantee is usually the percentage of the contract that had not been covered by Advanced Payment.

In contract and project negotiations vis-à-vis Project Risk Management, the contractor could as well request for Performance Guarantee/Bond from the client if the risk of non-performance is identified during risk identification and analysis.


Lambert Ofoegbu
The usual term is 'Advance Payment'. When it is consumed it becomes 'Advanced Payment'. It is a matter of semantics. 

It can be used interchangeably without connoting a different concept in Project Management.

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