Farsighted project contract management
incomplete in its entirety
Professor J. Rodney Turner, Department of Marketing and Organization, Rotterdam School of Economics, Erasmus University Rotterdam
Projects are temporary organizations to which the owner assigns resources to achieve their development objectives (Turner and Müller 2003). As with all organizations, it is in the owner’s interest that all their “employees” are motivated to achieve their objectives. It is through the project contracts that the owner employs outside resources to work on the project, and attempts to align the resources’ objectives with their own by properly motivating them. That is what Organization and Management Theory would suggest, but is often not the case on projects. Often on projects, a system of conflict exists, where the owner and contractors try to outdo each other, to win a greater share of what they see as a fixed-sized cake in a win-lose battle, which often results in a lose-lose outcome. Organization and Management Theory would suggest the owner should create a project organization based on cooperation, in which all resources are motivated and incentivized to achieve their objectives. Project contracts should attempt to create a win-win outcome, which is in the owner’s best interest.
Transaction Costs Economics proposes a schema for contracts, to judge their ability to create a cooperative organization and provide appropriate incentives, whereby they are judged against three parameters: the reward; the risk; and the safeguard. Where there is no risk, there is no need for any safeguard, and the reward can be lowest. Where there is risk, there may or may not be a safeguard. If there is risk and no safeguard, then the reward should be the highest. Where there is a safeguard, the reward can be some intermediate level.
This ex ante incentivization would be all that is necessary if the project conditions were entirely predictable throughout its life. However, projects are not that predictable. Thus farsighted contracts are necessary; contracts that are able to deal with any new risks or uncertainty that may arise as the project progresses, that are able to deal with unforeseen events, both adverse and beneficial. However, these farsighted contracts will be unavoidably incomplete; they will not be able to deal with every eventuality. Ex post governance is needed to provide farsightedness and the adaptation required to deal with incompleteness. Transaction Cost Economics introduces a four-dimensional vector to describe the nature of governance provided by different contract types, and their ability to provide farsightedness and deal with incompleteness. The four parameters in this vector are: incentive intensity; ease of making uncontested bilateral adaptations; reliance on monitoring, administrative controls, and other transaction costs; and reliance on court ordering.
This paper analyzes different contract types, against the three-dimensional schema to assess their efficacy to create a cooperative project organization. That is to provide ex ante incentives to align the project participant’s objectives with the project’s objectives, to ensure that the owner’s “employees” are motivated to achieve the owner’s desired outcomes. It then analyzes the contract types, or their variants, against the four-dimensional vector to assess their efficacy in providing farsighted ex post governance to deal with incompleteness of the contract and project organization in different risk scenarios. That is to deal with unexpected eventualities, both adverse and beneficial, to maintain the cooperative project organization, and maintain alignment of the project participant’s objectives with the owner’s, even as the latter’s need to change. A contract strategy model is then developed to help contribute to the selection of contract types under different risk scenarios.
Project Organization: Cooperation versus Conflict
There are two ways of viewing a project organization, what I would consider to the correct way, and the normal way, respectively:
• A temporary organization, (Turner and Müller 2003), through which the owner assembles resources and motivates them, in a climate of cooperation, to achieve their (the owner’s) objectives.
• A market place, in which the owner attempts to buy the project’s outputs at the cheapest possible price, in a climate of conflict with their contractors, in which one is going to win and one lose (Scott 2001).
In the more common approach, the client adopts the mindset that they are going out to buy the project’s outputs in the local bazaar, and they must negotiate hard to achieve the lowest possible price from the vendor (contractor). The negotiation is viewed as a win-lose game, in which one will gain the greatest share of a fixed cake. Therefore a climate of conflict develops where the client and contractor try to outdo each other, and this spills over into project delivery, where the climate of mistrust continues. The client mistrusts the contractor throughout, assuming that the contractor is trying to claw back money through the project’s delivery. This usually leads to a lose-lose outcome.
Turner and Müller (2003) viewed the project as a temporary organization, through which the client tries to assemble resources to achieve their development objectives. As in any organization, the owner should view the resources working for them as their employees, (albeit this will be a temporary employment relationship), and motivate their employees to achieve their objectives. Because it is a temporary employment relationship, the owner will often employ resources from an agency, and will ask the agency (contractor) to do the work on their behalf. Effectively, their “employees” will be a company (contractor) rather than a person, what the Dutch would call a legal person rather than a natural person. But the owner should view these legal persons as much as their employees as natural persons, and motivate them to achieve their project objectives.
Levitt and March (1995) say about the purpose of organizing:
The problem of organizing [is] seen as one of transforming a conflict (political) system into a cooperative (rational) one. A conflict system is one in which individuals have objectives that are not jointly consistent. It organizes through exchanges and other interactions between strategic actors. A cooperative system is one in which individuals act rationally in the name of a common objective.
Their comments were made in the context of a permanent, functional organization, but apply to a temporary, process-based one. The aim of project organization should be to create a cooperative system in which individuals, legal persons, and natural persons, work together in a rational way, to achieve a common (the owner’s) objective.
It is through the project contracts that the owner creates the project organization and “employs” legal persons (the contractors) to work on their projects. Therefore it is through the contracts that the owner should try to motivate the contractors to achieve their objectives, and it is widely recognized that this is best done through a win-win game. Pfeffer (1995) argues that organizations and the individuals who work for them are interdependent, and so organizations must be viewed as social entities. It is therefore essential to develop a climate of cooperation in organizations through the incentive systems. His comments are also made primarily in the context of a permanent, functional organization, and about natural persons, but they apply equally to temporary organizations, and he does say they also apply to organizations (legal persons).
Thus, when developing a project contract strategy, the owner should choose a contract type that develops an appropriate social relationship between themselves and the contractor, and provides incentives to motivate the contractor to achieve their objectives. It also needs to be recognized that because projects are temporary organizations (Turner and Müller 2003), they entail risk and uncertainty (and sometimes opportunity). Thus to provide an appropriate incentive, the contract needs to recognize that risk and provide appropriate safeguards to protect the contractor (and indeed to enable the owner to share in the exploitation of any opportunities). The contract should be designed to encourage the owner and contractor to act rationally together to achieve their common objectives, and achieve the best outcome for both, within the context of the expected risk.
However, that rationality is almost certain to be bounded by human frailty (Williamson 1996). It is bounded by the project participants’ inability to precisely and unambiguously:
• Communicate with each other
• Process information to interpret events
• Foretell the future.
Therefore, not only does the contract strategy need to provide incentives and safeguards to deal with the risks as envisaged in advance (to provide ex ante incentivization), it needs to be flexible enough to deal with unforeseen circumstances as they arise; the ex ante contract is unavoidably incomplete. In order to maintain a climate of mutual cooperation, the contract needs to be flexible enough to be adapted to deal with these circumstances through mutual agreement and cooperation, not through one party making use of them to make gains over the other party. The contract needs to provide a flexible, farsighted ex post governance structure that:
• Allows adaptations through mutual agreement
• Provides a communication structure to identify how the project is progressing, and to identify any problems arise so that they can be dealt with in a cooperative fashion
• Continues to provide an incentive for the contractor to deliver the client’s objectives
• Does this without either party feeling the need to resort to the law (which automatically is a lose-lose scenario—the “winning” party just losing less than the other).
Transaction Cost Economics and a Theory of Contracts
Transaction Cost Economics suggests two schemas or vectors to describe the ability of contracts to provide ex ante incentivization, and flexible, farsighted, ex post governance (Williamson 1995a, 1995b, 1996).
Ex Ante Incentivization
Williamson suggests a schema to describe the ability of a contract to provide ex ante incentivization, Exhibit 1. The contract is described by three parameters:
1. The reward it provides the contractor to share the owner’s objectives and perform
2. The associated risk
3. The safeguard provided by the owner through the contract to shield the contractor from the risk
If there is no risk present, then there is no need for any safeguard, and the reward can be low. If there is risk present, there may or may not be a safeguard. If there is no safeguard, then the contractor buys all the risk off the owner, and a high reward is required. If there is a safeguard, the owner underwrites the contractor’s risk and the incentive can be lower. Note, in some case the safeguard only provides protection against extreme risk. For lower levels of uncertainty, the contractor takes the risk. However for extreme events, the client underwrites the contractor. This is the case with target price contracts, or where the contractor only claims for variations over a certain size. However, in the cases the reward can be less than if there is no safeguard at all.
Williamson is writing about contracts for supply of a large number of units, not for the supply of once off, unique, novel, and transient projects. He assumes the cost of work is independent of the contract type, there is a natural cost associated with the task. The incentive is part of the transaction costs associated with the contract, additional costs over and above the basic cost of works (Cox and Thompson 1998). However, Turner and Simister (2001) showed that the incentive can come from the contractor sharing in savings in the cost of works, (even keeping all the savings). However, that does not change the basic approach.
Flexible, Farsighted, Ex Post Governance
Although the schema above assumes a safeguard risk, it can really only deal with risks that are foreseen. If properly motivated, the project’s participants should behave rationally towards a common (the owner’s) objective. However, because of human frailty, rationality is bounded, mainly by their ability to communicate, to process information, and to foresee the future. Thus, every project contract is almost certainly incomplete. Farsighted, ex post governance is required to deal with unforeseen circumstances. Williamson suggests four parameters to describe the ability of a contract form to provide flexible, farsighted, ex post governance:
• The incentive intensity
• The ease of making uncontested, bilateral adaptations to the contract
• The reliance on monitoring and related administrative controls (transaction costs)
• The reliance on court ordering.
Incentive intensity: Greater incentive intensity will elicit greater performance and sustained effort from the contractor to achieve the owner’s objectives, and greater flexibility in accepting changes to adapt to unforeseen circumstances.
Bilateral adaptation:This describes the ability of the parties to a contract mutually to accept changes. Some contracts inhibit changes even if both parties are willing to accept them, others encourage them. Although this is described as “bilateral adaptiveness,” it is not always the case that both parties need to be party to the decision to adapt. It depends on the ability of parties to solve problems. We will see it is often the case that the client can make no contribution to problems solving. Then what is best for cooperation is to leave the contractor to get on with it, and decide (within the constraints set by the incentive) what is the best way of dealing with the changes.
Reliance on monitoring and administrative controls: Some contract forms require very intrusive systems for monitoring and control, leading to high transactions costs, while others allow quite light control. Turner and Simister (2001) showed that the transactions costs associated with monitoring and control procedures can be small when compared to the savings to the costs of works through appropriate motivation of the contractor. Thus, incentive intensity has a stronger impact on project costs than reducing control procedures. However, if appropriate incentives are chosen, there may be no need for monitoring and control procedures, since the contractor can be allowed to work on their own.
Reliance on court ordering:If the contract discourages cooperation and encourages conflict, then it may be necessary for the client and contractor to settle their differences in court. Thus reliance on court ordering is a measure of how much the contract encourages cooperation, and encourages the client and contractor to settle their differences of opinion in ways other than resorting to the law. If it is necessary to resort to the law, then the project has become a conflict system, and all parties stand to lose, just some more or less than others.
Traditional Contract Types and a Theory of Contracts
I compared traditional contract forms to the two schemas above. I consider the following contract types:
1. Cost plus contracts
• Cost plus percentage fee, (c + %f)
• Cost plus fixed fee, (c + ff)
• Cost plus incentive fee, (c + if)
• Alliance contracts, or cost plus gain share, (alliance).
2. Remeasurement contracts
• Remeasurement based on a schedule of rates, (r-sor), effectively cost plus
• Remeasurement based on a bill of quantities, (r-boq)
• Remeasurement based on a bill of materials, (r-bom), effectively fixed price plus variations.
3. Fixed price contracts
• Fixed price based on a detailed design, (fpdd), effectively remeasurement
• Fixed price design and build based on a scope design
• Fixed price design and build based on cardinal points (a functional specification).
• Target cost
• Time and materials to budget, or guaranteed maximum price.
The incentive profiles of the contract types are summarized in Exhibit 2 and the governance profiles in Exhibit 3. These tables also show the profiles of the traditional contract forms (markets and hierarchies) for routine supply.
Cost plus Fee
Incentive:These are adopted on contracts of high risk, where the cost plus nature provides a high safeguard for the contractor. It could be said that this contract form provides a high reward for the contractor, but it is the wrong reward. With cost plus percentage fee, the motivation is for the contractor to overspend and go late. The reward is misaligned with the client’s objectives and success criteria. With cost plus fixed fee, there is a very small incentive for the contractor to finish to cost, because the higher the cost, the lower their percentage profit. With cost plus incentive fee, there is a medium-level incentive to achieve whatever success criteria the incentive is linked to: cost (usually); time (penalties for late completion); quality and performance; safety.
Governance: These contracts are very adaptive, but also have very high costs of monitoring and control. But once the mechanisms of monitoring and control have been put in place, they remain fixed, regardless of the amount of risk encountered and adaptations required. Because of their flexibility, disputes should be low, and so there should be little reliance on court ordering. However, mistrust of the contractor by the client can be high.
The profile is wrong, there is high risk, but also high safeguard and incentive, and the incentive is not directed at achieving the client’s success criteria, finishing to time, cost, and functionality. There is no motivation to reduce the cost and scope of work—the exact opposite in fact. Where it is appropriate to use this form contract is where:
• There is very high risk and uncertainty
• The contractor can make no contribution to reducing risk and uncertainty.
For example, this form is used on construction management contracts, where the client’s design consultant does the design, but the construction management contractor is responsible for procurement and construction site management. The construction manager then has no control over the scope. However:
• The construction manager is usually paid a fixed price (with incentives) for their role.
• The New Engineering Contract (Institution of Civil Engineers 1995) recognizes that the construction manager needs to be given incentives to choose the cheapest subcon-tractors, not the easiest to manage.
• The construction manager also has no control over unit rates; for simple contracts or subcontracts, where the contractor does have control over their unit rates and productivity, remeasurement contracts should be preferred to cost plus.
The other context where this type of contract has traditionally been used is in product development, specifically weapons system development. The thinking is that at the start of the product development process, the scope of the project is unknown, and so there is high risk. So the safeguard of cost plus is built in, but the incentive is misaligned with the client’s objectives. In recognition of the uncertain future, the form is very flexible, but there is a high price in the form of high transaction costs.
A variation of the cost plus contract is the alliance (Scott 2001). The client and contractor work together in a spirit of cooperation, working together to reduce the scope of works and hence the price. They also work together to achieve other key performance indicators set by the client, such as time, performance, safety, and environmental performance. The client establishes a gain share fund, which is split between the client and all the contractors working ion the project according to their overall achievement against the client’s performance indicators. This form of contract only works where both the client and the contractors can make a contribution to reducing risk and the achievement of the performance indicators.
Incentive:There is clearly considerable uncertainty in this type of project. It is only worth adopting where the client and contractor can achieve considerable potential cost savings, other wise the high transaction costs cannot be justified. There is some safeguard built in, and in two ways:
• The client shares some of the risk (and potential gains) through the sharing of the gain share fund.
• Usually there is a cap on the downside risk born by the contractor; above a certain level of loss they are born entirely by the client.
Governance: There is high incentive intensity: the gain share fund, linked to the client’s key performance criteria, provides high motivation to the contractor to achieve the client’s objectives. There is also high flexibility, but there is a price to pay in terms of high transaction costs. Recourse to the courts is avoided through an escalation procedure built into the alliance agreement.
Summary: In an alliance contract, well implemented, the ex ante incentivization and ex post governance are well aligned. However, there are high transaction costs, and these are necessary. This form of contract needs to be tightly managed. An alliance does not imply laissez-faire management (Turner 1999).
In remeasurement contracts, the contractor is rewarded according to the amount of work they do, according to a pre-agreed formula.
SoR:Ifa schedule of rates is used, the amount of labor and materials used is measured, and the contractor rewarded according to agreed hourly and unit rates. This is effectively cost plus. There is no motivation on the contractor to control productivity levels. It suffers from all the problems of costs plus. There is a high safeguard, but the contractor’s reward is not aligned to the client’s key performance criteria. There are high transaction costs, but the contractor’s incentive is not aligned to the client’s objectives. This should be used where the work and material requirements are very clearly defined, by the client or their design consultant, and contractors are then used to provide agreed amounts of labor and material against industry standard rates.
BoQ: If a bill of quantities is used, standard work elements are identified, and the contractor is rewarded according to the number of work elements completed. The contractor is now motivated to control productivity levels. This is appropriate where a project consists of clearly identifiable work elements, but the exact number is uncertain at the outset. Again, the client should not expect the contractor to suggest improvements for the benefit of the client, because that will actually reduce their reward. The contractor may try to find ways of improving the delivery of the work elements, but will not pass those improvements on to the client. The contractor may even take shortcuts to the client’s detriment. So there are medium level transaction costs again giving the client little benefit.
BoM: If a bill of materials is used, standard, larger work packages are identified, and the contractor is rewarded according to the number completed. In this case, once the price for the work packages has been set, the contractor is not motivated to suggest improvements. However, in the early stages of the project, the client and contractor can work together to optimize the design of the work packages, and the client can ask contractors to bid competitively for the work package rates. Transaction costs are now lower, because there are much larger elements of work to monitor, requiring less need for monitoring and control.
Remeasurement contracts are the closest in a project context to the market in routine supply, especially in the SoR and BoQ cases. In the former, the client is buying labor and bulk materials in the bazaar, and in the latter, they are buying standard components. Therefore, these will be appropriate where there is low specificity, and relatively high competition to provide the labor and materials or supply the standard project components. With the BoM form, there will be higher specificity, requiring closer cooperation between client and contractor while the work packages are defined, but enabling lower monitoring and control costs once work starts.
Fixed Price Contracts
Fixed Price Based on a Detail Design
The client or their design consultant produces a detailed design of the project’s output (facility), which is awarded to a construction contractor for delivery. The construction contract may either be bid under competitive tendering, or it may be awarded according to a standard schedule of rates or bill of quantities. Either way, this is effectively a remeasurement contract, since any variations will be completed according to a schedule of rates or bill of quantities. However variations will be sought by the contractor, since typically these contracts are bid under tight margins, and so they will seek to increase their profit through variations. Variations will also equally be resisted by the client. These types of contract can lead to the largest mistrust between client and contractor.
This form is the worst from the contractors’ perspective. There is little reward and no safeguard, but if the design is well done, little risk. Because of this, incentive intensity is low. There is little motivation for the contractor to achieve the client’s objectives; they are just trying to do the minimum work for the minimum cost. There will be no adaptiveness, unless the contractor sees it as a way of making extra money. Transaction costs are high, to process the variations that arise, and because there is a strong climate of mistrust, there is a heavy reliance of the courts.
Design and Build Based on a Scope Design
In this case, the client, or a design consultant, performs an initial scoping design of the facility, and the contractor is required to do the detail design and construction. If the scope of supply also includes commissioning, then this type of contract is sometimes called lump sum turnkey.It is usually said that this type of contract is used where it is possible to specify the final facility quite tightly, and so the risk will be low. However, Turner and Simister (2001) showed it can also be used where the facility can be specified quite tightly, but there may be some uncertainty in the method of delivery, and only the contractor has the skills to reduce the risks. The client or their design consultant can make no contribution to the delivery of the plant.
If the risks are low, the safeguards will be low and the rewards low. Where risks are low, there will be several contractors able to do the work, and so they will all bid with tight margins. The cooperative organization is best served by the client keeping well away from the project during its delivery, and so the contractor is free to make whatever adaptations to the process of delivery they see fit. If margins are tight, the contractor may try to claw back additional profit through variations and that will increase transaction costs. However, if the client were to increase the contractor’s profit to cover variations under a certain size, which are almost inevitable, transaction costs can be reduced. If an incentive is built in to control variations, it can lead to a cheaper outcome.
Cardinal Points or Functional Specification
The client specifies the functionality and key performance indicators (cardinal points) of the facility to be delivered by the project, but leaves it to the contractor to find the best solution both in terms of the design of the facility to achieve those, and the method of its delivery. Turner and Simister (2001) show that this form is best used where there is some uncertainty about how best to deliver the facility, and the client can make no contribution to solving that problem. The contractor buys all the risk through a fixed price contract, and makes their reward by finding the best solution. This contract form was used in the case of the Botlek Tunnel under the Oude Maas River, part of the Betuweroute (Dutch High Speed Freight Line) from the Port of Rotterdam to the German border. This solution gave the client a price lower than they could get by any other contract form, but still let the contractors make a reasonable reward through the solution they found to the project. They were motivated to reduce the scope of works by the form of contract.
Incentive:The contractor’s risk is high, but there are suitable rewards. In the case of the project just described, by and large there were no safeguards. The contractors bought all the foreseeable risks. However, there were some potential, very low likelihood but very severe, insurable risks, which the client, the Dutch, state-owned railways, underwrote. This enabled the contractors to bid a lower price than if they had to underwrite those risks themselves. In the event, these risks were not encountered.
Governance: The contractor’s incentive comes from their ability to find an effective solution to the problems, and so can be high. The form of contract is very adaptive, in that the contractor is left to work on their own to find the best solution, and so transaction costs are low. If well formulated there should be little need for recourse to the courts because the cardinal points can be quite clear. And if the extreme risks are properly underwritten there should be no need to make claims.
Other Forms of Contract
A target price contract provides a fixed price for an agreed range of out-turn costs around the target price, with the client and contractor sharing the result of any underspend or overspend outside the agreed range. Often the client also puts a cap on the contractor’s exposure for overspend above an agreed level. Within the agreed range this contract acts like a fixed price contract. However, there is a potential for the contractor to achieve higher rewards, but at exposure to greater risk. The incentive intensity is higher than for fixed price contacts, but higher transactions costs are needed to monitor regular performance. However, with those monitoring and administrative procedures in place, variations are easier to process. These contracts can still lead to arguments, requiring recourse to the courts. But with the contractor motivated to save cost, they will not be pursuing variations to increase their profits, when that can be achieved more easily by saving costs.
This contract form can lead to quite collaborative working between client and contractor, as in the case of the alliance contract, since it is in both their interest to save cost. The New Engineering Contract (Institution of Civil Engineers 1995) treats fixed price as a special case of target cost, with the target range extended to infinity. However, we see that the two types of contract do have subtly different profiles, and require different monitoring and control regimes.
Time and Materials to Budget or Guaranteed Maximum Price
This contract form really is a fools’ game:
• Contractors who accept it are fools because it is weighted so heavily in favor of the client.
• Clients who push it on their contractors are fools because contractors operating under it are completely demotivated, and absolutely do not have the clients interests at heart.
The contract is cost plus to a target price, and then fixed price beyond. The contractor takes on all the downside risk, but shares none of the upside opportunity.
Incentive: The contractor has no incentive to achieve the client’s objectives. The rewards are low, the risks are high, and there is no safeguard.
Governance: The governance structure has all the disadvantages of cost plus and fixed price, but none of the advantages. The incentive intensity is low: the contractor makes big losses if the project is overspent, but small profits if it underspent, and the more underspent the contract, the smaller the contractor’s profits. High transaction costs are required to monitor what the contractor is actually spending, so the client can claw back money if they under-spend. There is no adaptiveness. The contractor is totally unwilling to take on additional work, and the client, to adopt this type of contract must be in an uncompromising position. And the reliance on court ordering will be high, as the contractor tries to prove that any overspend is due to the client’s errors.
This contract form is a fools’ game. It is conflict organization. It is lose-lose project management.
Developing a Contract Strategy
This section develops a process for selecting contract strategy based on the above considerations and the need:
• To provide the contractor with incentive to achieve the client’s objectives
• To provide flexible, farsighted governance to deal with incompleteness, but at minimum transaction costs.
It also draws on the work of Turner and Simister (2001) and Turner (1995, 303 [Table 19.1]). See Exhibit 4.
The contract strategy depends on several questions:
1. Who controls the risk?
• The client
• The contractor
2. The nature of the project?
• Large, complex, multistage.
3. The location of the uncertainty?
• In the project’s product
• In the process of delivering the product
Client Controls the Risk
If the client (or their consultant) controls the risk, then the appropriate types of contract are cost plus incentive fee or remeasurement depending on the complexity.
For low complexity projects a remeasurement contract based on a schedule of rates or bill of quantities is appropriate. The Dutch rail infrastructure company operates a take-it-or-leave-it approach, (Turner and Simister 2001). The client’s consultant designs the facility, which is priced using a standard schedule of rates or bill of quantities. That gives a price for the job, which the contractor accepts or refuses. Any variations are priced using the standard schedule. This is effectively fixed price with flexibility built in to deal with variations.
Incentive:The risk is low, there is a small safeguard in the accepted variations, and the rewards are low.
Governance:There is an incentive to control cost, and rewards/penalties for time, quality, and safety can be built in if needed. There is some flexibility in the accepted variations. The administrative procedures to monitor variations can be routine, but if the specification is critical, costly inspection procedures will be necessary. Penalties built into reward structure for poor performance post commissioning are too late, and may not compensate for poor performance. There should be little need for recourse to the courts if the variation process works.
For high complexity projects a cost plus incentive fee management contract (Turner 1995, 254 [Figure 17.1]) may be appropriate. The contractor is paid a fixed price with incentive for their contribution, which is the procurement of subcontractors and the management of the work. Subcontracts, including work done by the main contractor, should be priced as remeasurement as above.
Incentive: The risk is high, but there is a safeguard in the form of the cost plus contract. The rewards should be medium.
Governance:With an incentive fee, there is an incentive to control cost, and rewards/penalties for time, quality, and safety can be built in if needed. There is total flexibility in the cost of subcontracts. The administrative procedures to monitor the contract are part of the project monitoring, the responsibility of the management contractor. The main contractor has no incentive to cut corners, but the subcon-tractors might, so if the specification is critical, costly inspection procedures will be necessary. There should be little need for recourse to the courts if the process works.
I have heard of cases where the client has deliberately underestimated the scope of the work, and the management contractor finds herself managing a job three times as large as they expected for a fixed fee. (I am not going to give references to preserve anonymity.) That is immoral, and I guess a client that has done that will not flexibly adjust the fee. But if it truly was a mistake, then flexibility may need to be built into the contract so that the fee can be reviewed if it does not truly reflect the scope of work as it turned out to be. This would be the case if there were very high uncertainty in the extent of the project, and the result would be a cost plus percentage fee contract. But changes and adjustments to the fee must be strictly monitored.
Contractor Controls the Risk
Now the type of contract depends on where the risk is:
• In the process
• In the product and process, (product only implies product and process)
Risk in the Process
The project’s product can be clearly defined; the uncertainty lies in how it is to be delivered. The contractor has control over that risk. The most appropriate contract is fixed price design and build, with the product defined by cardinal points. (Design and build is what this type of contract is called in the building industry. In the Engineering Construction Industry it is called turnkey or engineering, procurement, and construction [EPC].)
Incentive: The contractor’s reward derives from finding the optimum solution to the delivery of the project. Substantial reward can derive from finding a good, cost effective solution.
Governance:The incentive to find a good solution is high. Sometimes this is the only way the client can afford the project. Flexibility is high if the client leaves the contractor alone. If the client meddles it can become expensive. Monitoring and control costs are those required to monitor the project anyway, so transaction costs are low. Acceptance tests may be required to check that the functional specification has been delivered. Again, post completion penalties for poor performance will not compensate the client. If the functional specification is well defined there should be little need for recourse to the courts.
Risk in the Product and the Process
If there is risk in the product that the client cannot control, then the client has a functional requirement, but does not have any skill in house to deliver it. If there is uncertainty in the product, then there must also be uncertainty in the process. (Turner and Simister, 2001, based on Turner and Cochrane, 1993, assume that information system projects, may have uncertain product, but follow a well-defined life cycle. So it is possible to have uncertain product with certain process. However, the nature of the project will either be that both the product and process are uncertain, or neither is.)
A common approach in this case is prime contracting with a target price contract. It is expected that the cost of the project can be predicted within certain ranges, and within that range the contract is fixed price. Outside that range the client and contractor share any savings if the project turns out easier than expected or any overspend if it turns out more expensive. There is usually a cap on the contractor’s exposure, above which the contract becomes remeasurement, and the risk reverts to the client.
Incentive:If the project hits the target cost, the contractor can make useful profits. There is an opportunity to make greater profits with a downside risk for less profit or even loss. The cap provides a safeguard.
Governance: The incentive to perform is high. Flexibility is best served by the client remaining aloof, but being on call if required. Costs do need to be monitored, however, so transaction costs are high. With a good relationship, there should be no need for recourse to the courts.
Design only contracts by the client’s consultant also fall into this category. It is normal for these contracts to be done on a time and materials (remeasurement based on a schedule of rates). Careful monitoring is required to ensure that the work done is essential. The client is in a very dependent position on the consultant. The consultant’s reputation as a professional is one of the things that motivate them to work in the client’s best interest (Turner and Müller 2003—and viz the fallout from Enron over Andersons). The contractor’s profit margin will either be built into the schedule of rates, or will be an added percentage, so this arrangement is very close to cost plus percentage fee, it is just that the unit rates are set in advance. There may be no other option for a design only contract, but if the consultant becomes manager of the construction phase, a fixed fee, or fixed price contract, or standard schedule of rates for the works should be adopted (see previous).
Incentive:The rewards are useful, the risks can be high, but safeguards exist. The consultant’s professional reputation is also part of the reward structure.
Governance:Unfortunately the consultant is incentivized to expand the work, but their professional reputation helps motivate them to achieve the client’s objectives. Flexibility is high, with a good professional relationship between client and contractor enabling them to work in harmony. But monitoring and control costs need to be high, to check that only necessary work is done, and that it is done effectively and efficiently. The consultant’s professional reputation reduces the need to take recourse to the courts.
A fixed price or remeasurement contract can be used, as described previously under Contractor Risk—Process or Client Risk—Simple, respectively.
If the risk is shared, then the strategy depends again on whether the complexity is high or low.
If the complexity is low, the contract form adopted could be remeasurement, fixed price, or target price, depending on where the balance of the residual risk lies, with the client, with the contractor, in the process, or the product. The appropriate considerations above apply.
If the complexity is high, the appropriate form of contract is an alliance (Scott 2001).
Incentive: The rewards from an alliance contract can be high for both the client and contractor, if there is a successful outcome. The risks can be high but there is a safeguard in the form of:
• Shared problem solving
• Shared rewards
• Ensuring that the best result is achieved for the project as a whole and not any parties (client or contractors) individually.
Governance:The incentive intensity is high. There is high flexibility. But there are high transaction costs. This usually means that alliance contracts can only be used on larger projects. (Scott suggests the should be greater than $15 million.) However:
• That is implied by the fact that the project is complex
• With experience they can be applied to smaller projects.
This paper adopted the premise that the purpose of project organization is to create a cooperative working relationship between all the parties involved, especially the owner and their contractors. The contracts are the method by which the owner creates the project organization and brings the contractors in. Therefore the contracts should aim to align the contractors’ objectives with the owners, by providing appropriate incentives.
A three dimensional schema, (reward, risk, safeguard), was used to analyze the efficacy of different contract types to do this. Contractors will behave rationally to optimize their economic position, so the owner needs to ensure that all their contractors’ economic positions are aligned with theirs.
Project contracts are also unavoidably incomplete. Bounded rationality will mean that people would like to behave rationally, but through human frailty will not do so perfectly. Bounded rationality is caused by an inability to communicate and process all information, and foresee the future. Thus the contracts also need to be able to respond to unforeseen circumstance. A four-dimensional schema, (incentive intensity, adaptiveness, reliance on monitoring and control, reliance on the courts), was used to analyze the governance efficacy of the different contract types.
The results of this analysis was used to develop a contract selection strategy, depending on whether the risk is controlled by the client or the contractor, whether the project is simple or complex, and whether the risk is on the project’s product, method of delivery, or both.
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Proceedings of PMI Research Conference 2002