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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Major Projects are Delayed by Months or Years, and Cost Millions More Than Budgeted, Because of Common Mistakes Made at the Contracting Stage Organizations that invest huge amounts of capital in major building/industrial projects almost never do the engineering and building themselves. They hire engineering and construction contractors to do it for them. Unfortunately, selecting contractors and negotiating the terms of a major project is one of the most difficult aspects of project management...and organizations waste billions of dollars and "bake in" months or years of delay by doing it wrong. Contracting is also the area of project management that is most prone to firmly held opinions unencumbered by any facts. We intend to remedy that situation with this book. Drawing on a properietary detailed database of over 1100 major projects, the world's leading industrial engineering project consultant, Ed Merrow explains: Key Principles of Contracting for Major Projects: * Owners are from Mars; contractors are from Venus * All the biggest risks in contracting belong to the owner * Contracting "games" will normally be won by contractors, not owners * Most risk transfer from owners to contractors is an illusion * Contractors do good projects well and bad projects poorly * Contractors may have shareholders, but they are not your shareholders! * Mixing different contract types with different contractors on the same project is unwise * Economize on the need for trust; trust only when being trustworthy has value Merrow also explains: * Which contract incentives work and which don't and WHY * Which of over a dozen contracting strategies work best and which ones hardly ever work and WHY The strategic advice in this book is designed for owners and contractor project managers, team members and supply chain, executives, and other business leaders involved in major projects. It's also an indispensable resource for engineers, leaders of industrial firms, bankers, and academics studying the messy realities of the construction and engineering industries.
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Seitenzahl: 430
Veröffentlichungsjahr: 2022
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Table of Contents
Cover
Title Page
Copyright
Dedication
Acknowledgments
Introduction: What This Book Is Aboutintroduction
Point of View: What Constitutes Success?
The Context
Defining the Elements of Contracting Strategy
The Organization of the Book
The Applicability of This Book
Notes
CHAPTER 1: Ten Key Principles of Contracting
Principle 1: There Is No Free Lunch
Principle 2: Contractors Do Good Projects Well and Bad Projects Poorly
Principle 3: Complex Projects Need Simple Contracting Strategies
Principle 4: Owners Are from Mars and Contractors Are from Venus
Principle 5: Large Risk Transfers from Owners to Contractors Are More Illusion Than Reality
Principle 6: Contractors Have Shareholders and They Are Not
Your
Shareholders!
Principle 7: Contracting Games Are Rough Sport
Principle 8: Assigning a Risk to Someone Who Cannot Control It Is a Fool's Errand
Principle 9: All Contracts Are Incentivized
Principle 10: Economize on the Need for Trust
Summary
Notes
CHAPTER 2: Data, Methods, and Nomenclature
Description of the Database
4
Summary
Notes
CHAPTER 3: Contracting and Project Outcomes: The Common Strategies
The Key Performance Indicators and Their Measurement
The Primary EPC Options
Contracting Strategies and Project Results
Contract Type and Safety Performance
Cost Competitiveness and Cost Predictability
Schedule Competitiveness and Schedule Deviation
When Speed Is King
Contracting for Regulatory Compliance Projects
Summary
Notes
CHAPTER 4: Exploring Why They Work the Way They Do
Traditional EPC‐LS (Design‐Build Fixed Price)
Understanding EPC‐Reimbursable
A Deeper Dive into EPCM
The Downsides of EPCM
Why EPCM Contracting Is Problematic
Making EPCM Work Better
Understanding the Split Strategies
Differences Among Re/Re, Re/LS, and LS/LS
Why So Much Reimbursable Construction?
Summary
Notes
CHAPTER 5: The Unusual EPC Lump‐Sum Strategies
Functional Specification Contracting (Duty Spec)
Design Competitions
Convert to EPC Lump‐Sum (Convertibles)
Key Problems in Convertible Contracting
Guaranteed Maximum Price (GMP)
Summary
Notes
CHAPTER 6: Collaborative and Relational Contracting Strategies
IPD/Alliancing: In Search of Collaboration Through Contracting
Case Studies of One‐Off IPD/Alliances
The Six Pillars in Context of Results
Partnering/Long‐Term Alliances
Repeat Supply Chain Contracting
The Effects of Scale on the Unusual Contracting Forms
Notes
CHAPTER 7: Prequalification
Contracting Market Assessment
The Purposes of Prequalification
Forced Changes of Contracting Strategy
The Prequalification Process
Does Prequalification Improve Contractor Selection?
The Key Prequalification Criteria
Safety First
Contractor Finances
Technology Experience
Local Construction Experience
Quality of the Contractor Team
Location of Contractor's Home Office
Data Transparency, Transfer Methodologies, and Ownership
Selection
Summary
Notes
CHAPTER 8: The Use of Supplemental Incentives
The Conceptual Basis for Incentive Contracting
When and What Incentives Are Used
Cost Incentives and Outcomes
Schedule Incentives and Schedule Outcomes
Liquidated Damages (LDs) for Delay
15
Do LDs Work?
Operability Incentives
Safety Incentives
What Contractors Think (But Often Don't Say) About Incentives
Conclusions About Supplemental Incentives
Notes
CHAPTER 9: It's All About Risk
The Meaning of Risk
Principles of Risk Assignment and Pricing
Key Risk Areas
Schedule
Site Conditions
Interface Management
Local Content
Labor Availability
Notes
CHAPTER 10: Who Should Control Contracting Strategy?
The Role of the Business Sponsor in Contracting
Owner Legal Organization
The Projects Organization Should Control Contracting
Notes
CHAPTER 11: The Effects of Scale
Notes
CHAPTER 12: Toward Fair, Balanced, and Smart
What Contracts Should Do
What Contracts Should Not Attempt to Do
The Primacy of the Owner Role
Returning to a Normal Relationship
Suggestions for Owners
Suggestions for Contractors
Notes
Appendix: Description of Independent Project Analysis, Inc.
The Source of Project Data
Glossary
Index
End User License Agreement
List of Tables
Chapter 2
TABLE 2.1 Contracting Database
Chapter 3
TABLE 3.1 For the Businesses, Success Is Determined by Underruns, Not Compet...
Chapter 11
TABLE 11.1 How Contracting Strategies Respond to Increasing Scale
List of Illustrations
Chapter 2
FIGURE 2.1 Standard stage‐gated project development process.
FIGURE 2.2 Project sample geographical distribution.
FIGURE 2.3 Project sample industrial sector distribution.
FIGURE 2.4 Project sample project type distribution.
Chapter 3
FIGURE 3.1 What industries prioritize schedule during FEL?
FIGURE 3.2 Front‐end time responds to schedule priority.
FIGURE 3.3 Reporting rates distort safety results.
FIGURE 3.4 The industrial sector drives safety outcomes.
FIGURE 3.5 Cost competitiveness and cost growth by contract approach.
FIGURE 3.6 Schedule competitiveness and slip by contract approach.
FIGURE 3.7 Cycle‐time competitiveness by contract approach.
FIGURE 3.8 Speed and cost when schedule‐driven.
FIGURE 3.9 Contract strategy performance for compliance projects.
FIGURE 3.10 Contract strategy performance for schedule‐driven compliance pro...
Chapter 4
FIGURE 4.1 Bid duration drives EPC‐LS cycle time.
FIGURE 4.2 The timing of uncertainty reduction is key.
FIGURE 4.3 The scalability of cost performance varies greatly by contracting...
FIGURE 4.4 Contractors make higher estimates for themselves.
Chapter 5
FIGURE 5.1 Functional specification project results are highly variable.
FIGURE 5.2 Design competitions produce excellent projects.
FIGURE 5.3 Most design competitions include three or more competitors.
FIGURE 5.4 More players improve design competition results.
FIGURE 5.5 Convert to EPC lump‐sum is a problematic strategy.
FIGURE 5.6 GMP is cost predictable.
Chapter 6
FIGURE 6.1 IPD/alliancing is expensive and slow.
FIGURE 6.2 Repeat supply chains provide the best value overall.
Chapter 8
FIGURE 8.1 The larger the project, the more consequential the FEL.
FIGURE 8.2 Owner performance drives project performance.
FIGURE 8.3 Incentive use increases with project size.
FIGURE 8.4 Incentives are most used on EPC‐R and EPCM.
FIGURE 8.5 Use of supplemental incentives is declining.
FIGURE 8.6 Types of cost incentives employed in different contracting settin...
FIGURE 8.7 Schedule slip is a serious problem for industrial projects.
FIGURE 8.8 Schedule incentives accelerate split strategy projects only.
Chapter 9
FIGURE 9.1 Evaluation risks should be included in contract negotiations.
FIGURE 9.2 Incomplete FEED drives projects to slip.
Guide
Cover Page
Title Page
Copyright
Dedication
Acknowledgments
Table of Contents
Begin Reading
Appendix: Description of Independent Project Analysis, Inc.
Glossary
Index
Wiley End User License Agreement
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CONTRACT STRATEGIES FOR MAJOR PROJECTS
MASTERING THE MOST DIFFICULT ELEMENT OF PROJECT MANAGEMENT
EDWARD W. MERROW
Copyright © 2023 by Edward W. Merrow. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per‐copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750‐8400, fax (978) 750‐4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748‐6011, fax (201) 748‐6008, or online at http://www.wiley.com/go/permission.
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Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Further, readers should be aware that websites listed in this work may have changed or disappeared between when this work was written and when it is read. Neither the publisher nor authors shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.
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Library of Congress Cataloging‐in‐Publication Data is Available:
ISBN: 9781119902096 (Hardback)
ISBN: 9781119902119 (ePDF)
ISBN: 9781119902102 (ePub)
Cover Design: Wiley
Cover Images: Top: © RistoArnaudov/Getty Images
Bottom: © Avigator
Photographer/Getty Images
Author photo: © Stephanie Dupuis Photography
I dedicate this book to the memory of Iain A.R. Smith.
The world was a better place with you in it.
Acknowledgments
The IPA staff of dedicated professionals around the world made this book possible. Without the data garnered from their careful evaluations of nearly 1,200 capital projects, there would have been nothing to write about. The thing that unites my IPA colleagues above all else is our love of projects and commitment to seeing them done better.
My reviewers for this work were extraordinary. In alphabetical order because their contributions were uniformly excellent:
Bill Cherne was formerly chief executive officer of Cherne Contracting Corporation. With Bill as its hands‐on leader, Cherne was a leading industrial constructor in terms of overall quality in the United States. An all‐union shop, Cherne professionals understood construction and construction management at a level that was the best. Bill brought that knowledge to his review.
Michael Loulakis is a construction lawyer of the first rank. Mike was trained as an engineer before turning to law. He combines deep knowledge of construction law with an engineer's feel for projects. He has been awarded all sorts of honors, is a member of the National Academy of Construction, and is a fellow of the American College of Construction Lawyers. Mike continues an active practice of bringing sound advice to owners and contractors.
Jason Walker is one of the finest researchers I have known in my career—and I have known a good many fine researchers at Rand and IPA. Jason was until very recently the principal deputy director of IPA's Research Division and was responsible for client‐funded research. Jason contributed to this effort in two ways: he executed some of the research on which I relied, and he provided excellent review and comment as I wrote.
Graham Winch is a professor at the University of Manchester Alliance Business School. Graham's work has moved the understanding of projects forward in both public and private sectors. He is respected by academics and practitioners alike. He is one of the few academics I have met who understands projects to be a serious field of study in addition to being about project management.
I am really lucky to have these four distinguished members of the community willing to carefully review and critique my work. I am even luckier to be able to call all four of them dear friends. If there are mistakes in my conclusions, they belong to me and me alone. These gentlemen may well have tried unsuccessfully to fix them.
My hearty thanks to Kelli Ratliff and Jeanine Clough for turning my scribbles into understandable graphics. This is a complex subject, and graphical representations are often essential to comprehension. If you find the graphics sometimes opaque, you have no idea how difficult they were before Kelli and Jeanine applied their magic.
Thanks to my Wiley editor, Richard Narramore, and the entire Wiley crew that worked to make the book a reality.
Finally, my thanks to everyone at home and work who put up with me writing this book while trying to keep up my day job.
Introduction: What This Book Is About
When a manufacturer or resource development company wants to build a new facility or refurbish an old one, the owner personnel put together the business case for the new project, develop a scope for the project, and assemble the preliminary design. If the facilities require a good deal of exacting engineering, an engineering contractor usually performs the final stage of preparation on the engineering side, while owner personnel put together the execution plan. Few companies in the process industries1 maintain the people resources needed to engineer the final stage of preparation on their own. After owner authorization, a contractor will be required to execute the detailed engineering, and that contractor will also usually procure all of the major equipment and the engineered materials for the project. The owner will require a construction contractor to build the facility. Contractors may or may not be involved in the commissioning and startup of the facilities depending on the skills and preferences of the owner.
The process of figuring out how the contractors will be selected, how they will be paid, how much work any one contractor will do on the project, and the legal framework under which the work will be done (the contract terms and conditions) is what we call contracting strategy. For reasons that will become obvious, the owner must form the contracting strategy for a project early in project development or the contracting decisions will be entirely tactical and expedient rather than strategic and thoughtful.
For some, contracting strategy is a matter of strongly held beliefs that sometimes resist any appeal to facts. This point was underscored for me recently when I asked a project system director of a large, publicly owned airport if he wanted to join a study of contracting strategies for airport projects we were proposing. His answer “No! I know integrated project delivery2 is the best contracting approach, and I don't want anybody trying to prove otherwise!” For many others, the contracting strategy followed on any particular project is more accident than design. By the time contracting strategy is broached as an issue with an owner project team, it is often too late in project development to make any changes: “Well, we are just doing what we always do.” Or my favorite response: “We are just doing what the FEED3 contractor suggested.”
Employing engineering and construction contractors to execute a project may not seem like an inherently difficult task. As individuals, we hire professional service firms all the time—doctors, lawyers, dentists, and so forth. Hiring engineering and construction contractors is much more difficult for a number of reasons. Projects are joint products of an owner and the contractors. It is not a simple matter to parse out who is responsible for what, even in retrospect. As projects get larger and more complex, control of the project and the contractors' performance becomes progressively more difficult. The lack of transparency gives rise to endless variations on the “principal‐agent” problem, which, as we will later discuss fully, is the problem that sits at the heart of contracting. Finally, the contracting entity for projects is not a person but an organization—a corporation—and exactly who makes the decision about the contracting strategy and process within that corporation often materially affects how well the decisions are made. Decision‐making responsibility is often assigned to the wrong entity within owner organizations or is assigned ambiguously.
My first goal for this book is to bring facts to the discussion of which contracting strategies work best and in what circumstances. Contracting strategy is the most difficult problem for most project managers. Contracting for engineering and construction services is always a combination of hoped for collaboration and feared conflict. For that reason, contracting strategy is less about the legalities of contracts and much more about human behavior. Some facts about what works should be the start of any contracting discussion, but owing to lack of reliable data, anecdote and opinion often have had to suffice as poor substitutes.
My second goal is to provide insight into why different contracting strategies produce different outcomes. That goal requires that we discuss the underlying principles that shape the effects of contracting strategy, for example, the principal‐agent problem, the principles of risk pricing and risk assignment, and the principles of sound project preparation by owners. A focus on the principles that underpin contracting is essential because the principles provide the basis against which we must test any particular contracting strategy. When a contracting strategy flouts a core principle, that contracting strategy will lead to grief.
My third and ultimate goal is that an accounting of the facts of what works and what does not in contracting for industrial projects might facilitate reform of the sorry state of owner/contractor relationships. It is an understatement to say things have not been going well. Many contractors are just barely profitable. Many owners are frustrated and unhappy with contractor performance. The problems are deeper than the current state of contractor demographics. My hope is that some focus on the facts will help start positive change.
Point of View: What Constitutes Success?
To have a coherent discussion of contracting, it is necessary to define what successful contracting means. Success, of course, is defined differently depending on who is defining it. Throughout this discussion, I will be considering the various dimensions of success and failure from the viewpoint of those investing in the asset that the project will create. Contractors may object that defining success in this manner leaves their welfare out of the picture. But upon reflection, I believe that contractors would have to agree that if a contracting strategy routinely produces poor‐quality, high‐cost assets in which contractors are the only ones making money, the model is not sustainable. Conversely, if an approach produces good results for owners, that approach is ultimately sustainable only if contractors are successful as well. The problem is mostly one of finding a stable mutually beneficial model.
I find that many owners as well as contractors wonder if the current engineering and construction market is a sustainable business model. I share that concern, which is one of the reasons I felt compelled to write this book. My position, which is supported by data throughout, is that the key weaknesses in the current market start with weaknesses in owner project organizations. Owner project organizations are too weak to create a stable, self‐enforcing business relationship between owners and contractors. Those driving the relationships on the owner side are frequently too transactional in their approach to foster a stable market. It is my hope that this book may help move the discussion toward more sustainable and robust relationships in the future. Just to be clear, however, I do not believe that gimmicky contracting approaches will accomplish that goal. The focus on project fundamentals must remain strong.
The Context
Contracting for a project must start with the project. How big is it? How many distinct elements of scope does it contain? Where is it going to be geographically? Geography is the single most important element in understanding the contractor market for most projects. How technically difficult is the project? Does the project use routine technology or require something new to the owner or even new to the industry? We will discuss all of these issues later as we explore how the project and the contracting strategy interact.
Next, we need to consider the competence of the owner projects organization to undertake this particular project. Does the owner have the personnel needed to front‐end load—fully define—this project? Does the owner have estimating, planning, and scheduling capability? Can the owner field a strong controls team? Does the owner have the capability to do quality control and inspection of engineering and construction? Has the owner built this sort of facility recently, and are those who remember that project still around? Owners with weak project organizations struggle with all forms of contracting, but some forms are poison for them. Blithely assuming that one can do anything by simply buying consultants, agency personnel, or individual contractors from the market suffers from the defect of not actually being true.
Defining the Elements of Contracting Strategy
Like any other aspect of project management, contracting requires a series of activities and decisions, which need to be supported by work processes that guide how things are done at a given owner company. I see seven major elements of contracting strategy, each of which needs to be navigated successfully. Often discussions of contracting strategy begin and end with the compensation scheme that will be used: fixed price (lump‐sum) or reimbursable. Although compensation scheme is important, it is but a single element in the mix, and compensation scheme is often dictated more by the market than by owner strategy.
Structure:
By phase and activity, how much work should any one contractor do? I consider structure to be considerably more important than the compensation scheme in understanding contracting. In many projects, a single contractor is asked to do all of the work from front‐end engineering right through startup. We dub this structure an “FEPC.”
4
Alternatively, the owner could, in principle, select different contractors for every phase of the work: a FEED contractor, a detailed engineering contractor, a procurement contractor, a construction contractor, and lastly a commissioning and startup contractor. This is rarely done, but that doesn't mean it hasn't happened. Engineering and procurement of equipment and engineered materials are so intimately integrated that engineering and procurement are almost always structured together. However, separation of FEED, detailed engineering and procurement, and construction is quite common. Structure is important to project outcomes in ways that may be surprising. It is certainly more important than any other single feature of contracting. Structure is the primary topic in
Chapters 3
through
6
and is an important consideration as we discuss incentives in
Chapter 8
.
Compensation:
For any given work, will the contractor be paid a fixed amount, or will the compensation be based on hours expended or “units” of work performed? Compensation scheme is often the feature that owners think about first, but it probably should be down the list of concerns. We come back to compensation in virtually every chapter of the book.
Supplemental incentives:
Closely related to the basic compensation model is the decision to use additional incentives or not. Years of research into the application of incentives in contracts has taught us that incentives rarely work the way owners think they will. We explore the use of supplemental incentives with data in
Chapter 8
.
Contractor selection:
By what process will contractors be selected? Contractor selection processes vary considerably from owner to owner and project to project. Some owners use rigorous prequalification processes, while others select primarily based on prior experience with the contractor. Some owners have formal competitions for all major projects, while others select with an unstructured process. The selection process should start with an effective prequalification process, which we discuss in
Chapter 7
.
Packaging:
How will different physical work scopes be bundled? Smaller projects tends to have only a single scope package or possibly two. Very large projects have little choice but to have multiple scope packages, also called the
vertical splits of work
, because there is too much work for a single contractor to take on or because different parts of the work require very different skill sets. Packaging is discussed in
Chapter 11
when we discuss how contracting effectiveness is affected by project scale.
Risk assignment:
How do the terms and conditions in the contract allocate responsibilities between the owner and a contractor? This really comes down to the owner philosophy toward risk and negotiation with the contractor about which risks belong to whom. In risk assignment, the compensation scheme and the terms and conditions are both important contributors.
Control of the contracting process:
The contracting process within owner companies often suffers from the problem of too many cooks in the kitchen, all of whom think they are the chef. A number of owner functions need to be involved, but only one can be in charge. I will argue in
Chapter 10
that it is often the wrong one.
The Organization of the Book
When planning the writing of this book, one of the things I learned very quickly is that contracting does not lend itself to a neat chronological narrative. Instead of moving along in a line, the story tends to spread out rather like Bruce Springsteen's “river that don't know where it's goin'.” While hoping to keep the subject within some banks, here is how it is laid out:
Chapter 1 discusses what I see as the 10 key principles of contracting. Contracting strategies that violate a key principle are likely to be unsuccessful. Sometimes owners and contractors are violating a key principle without even being aware of it. When thinking about a contracting strategy, test it against the 10 principles.
Chapter 2 presents the database and methodology. My editor always wants this data stuff in an appendix, but I argue it is too central to relegate to a place no one will go. The data help tell the story of contracting and do so in a way that is unique. The methodology is straightforward enough, and especially so for readers familiar with Independent Project Analysis, Inc. (IPA).5 I will do my best to explain for those who are not.
Chapter 3 starts by defining the six most common contractual forms for industrial projects. It also introduces what many readers may find a peculiar way of thinking about different forms; I argue that how we structure the amount of work given to a contractor is considerably more important than how we pay the contractor. In Chapter 3 we get to the heart of the matter: how do the most common contracting strategies affect project outcomes? The outcome that most project, C‐suite, and business6 professionals care about most is cost, and the story there is really quite interesting. We look at schedule as well and then look at projects with different drivers—schedule‐driven projects and compliance‐driven projects.
Chapter 4 explores why different contract forms behave the way they do. And Chapter 4 addresses what I consider one of the great paradoxes of contracting: why do owners so often choose contracting strategies that contribute materially to poor results?
Chapter 5 is devoted to unusual EPC contracting strategies: functional (duty) specification contracting, design competitions, convert‐to‐EPC‐LS, and Guaranteed Maximum Price (GMP). As we will see, some of the strategies are not used often for good reasons, but others are good performers that are overlooked and underappreciated.
Chapter 6 discusses three more unusual strategies for industrial projects: integrated project delivery (IPD)/alliancing, partnering alliances, and repeat supply chain contracting. IPD seeks to use contractual arrangements and language to foster improved collaboration between owners and contractors on a one‐off basis. Partnering alliances use both the contractual arrangements and active relationship management to support collaboration over multiple projects. Repeat supply chain effectiveness is supported, not by additional contract language and agreements, but by careful relationship development and maintenance over time and multiple projects.
In Chapter 7 we take up contractor selection and in particular contractor prequalification. Failures in prequal often start our contracting headaches for a project. If we can fix prequal, then contractor selection will go better and be a bit less perilous.
Chapter 8 is about trying to deal with the core problem in contracting: the principal‐agent conundrum and the silver bullet that some owners believe they have in their guns: the use of various incentive schemes to supplement the incentives of the basic contract. We will discuss such schemes at some length and explore whether and how they work.
Chapter 9 is about risk allocation and risk pricing. Every contract assigns responsibilities to the parties. If the contract is well crafted, those responsibilities are accompanied with downside risks for nonperformance. But projects are intrinsically joint products of owners, contractors, and other vendors and suppliers. The joint product nature of projects often makes the risk assignment messy, imprecise, and downright confusing. Further complicating the problem is that owners often want to shift as much risk as possible onto the contractors and often believe that doing so is smart business. Contractors in turn want to avoid as much risk as possible; they know that is smart business! Further complicating risk allocation is the fact that owners and contractors are usually very different in their abilities to carry financial risk. Industrial owners are highly capitalized firms; contractors are very thinly capitalized.
Chapter 10 addresses one of the thorniest questions within owner organizations—who should control project contracting? My answers will ensure that some readers will hate me; my modest ambition is that everyone won't.
In Chapter 11, we discuss how the effectiveness of various contracting strategies changes with the scale of the project and the role of packaging the scopes of work and the complications that multiple scope packages create. Many of our worst contracting problems are with large projects. Finding strategies that do not degrade seriously with project size is an important consideration.
We conclude in Chapter 12 with a review of what I believe are the most important conclusions. I offer my recommendations to owners on the development and articulation of their contracting strategies. There will be no silver bullet, and the implementation of changes in contracting approach may be quite difficult for some organization as it may require building people infrastructure before changes can take hold. But the potential payoff is huge—over the long term getting project contracting strategies right may be the difference between company success and failure.
I have never met a project manager who thought that the process of hiring the right contractors for a project was fun. One told me, “Contracting is like second marriages: a triumph of hope over experience.” I have found many project professionals and owner purchasing folks who believed passionately in some particular form of contracting but rarely the same form of contracting. And as one PM said wryly, “The worst contractor ever was the one on the last project, and the best contractor ever will be the one on the next project.” He dubbed his position “realistic optimism.”
I don't think the contractors like the process any better. They spend a great deal of time and emotional energy putting together bids or proposals for projects, often knowing that their chances of winning are low. They often feel they must say things that are borderline implausible about the owner's capabilities and shoddy front‐end work and their ability to work around it so they will not be kicked out of the competition. And all that for a “hand‐to‐mouth” existence.
Everybody agrees, it isn't easy! Regrettably, this book cannot promise to make contracting easy, but we can at least bring systematic facts to the discussion and hope to clear away some of the dense fog surrounding the subject. If you, the reader, agree that end is accomplished, I will consider it a success.
The Applicability of This Book
As I will discuss in the next chapter, the data that underpin my discussion are all drawn from industrial projects, that is, projects that produce products to be sold in hope of making an economic profit. I believe, however, that the results of our analysis and the conclusions drawn apply to all projects, but with some caveats.
A good deal of our discussion deals with the cost effectiveness of different contracting strategies. To the extent that cost is not a concern for a class of projects, the conclusions regarding cost effectiveness are simply not relevant. However, adherence to cost budgets is relevant for virtually all projects everywhere, so conclusions about cost predictability of different strategies still apply.
Broadly speaking, I believe the conclusions in this book apply to public‐sector infrastructure projects as fully as to industrial projects. However, public projects tend to have what in the industrial sector we would call weak owners. A weak owner is one in which the owner does not maintain a sufficient number of experienced project staff and lacks the work processes that are characteristic of successful project systems.
Notes
1
By the process industries, I mean the sets of firms around the world that produce oil and gas, minerals and metals, commodity and specialty chemicals, pharmaceutical products, and food and other consumer products. One of the characteristics of process industry projects is that they usually require substantial amounts of engineering.
2
Integrated project delivery (IPD) is a particular type of contracting strategy that will be discussed in
Chapter 6
.
3
FEED is an acronym for “front‐end engineering design,” which is part of the work that should be completed just prior to the final investment decision (FID).
4
FEPC means “FEED, (detailed) engineering, procurement, and construction.” FEED is an acronym for “front‐end engineering design,” which is a major element of the final preparation of a project prior to execution.
5
All of the data for this book were gathered as part of IPA's normal project evaluation process. More about IPA and its role in the process industries is discussed in the appendix.
6
Often business sponsors profess to care more about schedule than cost, but as we will see in
Chapter 3
, that is often not really the case.
CHAPTER 1Ten Key Principles of Contracting
Writing a book about contracting strategy is a good deal harder than it might seem. Contracting is a subject that is full of exceptions. There are relatively few conclusions that appear to hold universally. Contracting is sensitive to the locale, the state of the market, the capabilities of the owner, the pool of available contractors, and, of course, the nature of the project under consideration. But over many years of studying contracting strategies and practices for industrial projects, I have arrived at a set of conclusions to which there seem to be few, if any, exceptions. These conclusions are what I call the 10 principles of contracting. As I explore the ins and outs of contracting strategies for industrial projects over the next 11 chapters, I will return to these principles again and again. If one pursues a contracting strategy that flouts one or more of these principles, it is very likely that trouble is ahead. If circumstance forces one to adopt a strategy that runs afoul of a principle, it is vitally important to understand that and mitigate the damage. The 10 principles of contracting are
There is no free lunch; the principal‐agent problem is ever‐present.
Contractors do good projects well and bad projects poorly.
Complex projects require simple contractual approaches.
Owners are from Mars; contractors are from Venus.
Risk transfer from owners to contractors is often an illusion; the big risks stay at home.
Contractors have shareholders, but they are not
your
shareholders.
Contractors normally win contracting games, not owners.
If you assign a risk to a party who cannot manage it, the risk will go unmanaged.
All contracts are incentivized; the question is always, how?
Economize on the need for trust.
Principle 1: There Is No Free Lunch
Economists like to remind us that no matter how little we personally pay for lunch, somebody somewhere paid for it fully. In contracting, I like to use the “free lunch” lesson to remind everyone that no contracting strategy is without problems. What is a good strategy in a down market may be a mess in an up market. What works for a smaller project may not work for a larger project. What works for a standardized project may well not work for a bespoke project. In contracting, there is no formulaic approach that is bound to succeed. All attempts to find a silver bullet will be disappointing. There are no successful gimmicks.
Over the years, IPA has worked with many companies who thought—for a while—that they had found the perfect contracting strategy. For one, it was incentivized reimbursable contracts; for another it was integrated project delivery (IPD), which is also called alliancing; for another it, was LSTK;1 and so forth. Any strategy that is one‐size‐fits‐all‐for‐all‐time is bound to fail sometimes. Often when failure comes, it is in spectacular fashion.
By far the most damaging contracting strategies are those that appear to be working while they are actually disastrous. Let me offer an example. A major chemical company was in a long‐term “partnering alliance” with a prominent engineering, procurement, and construction (EPC) contractor. The contractor did all of the chemical company's major projects on a sole‐source reimbursable basis. It was a seeming miracle that every project came in on budget and on time, and the owner was very pleased. When the company finally benchmarked and discovered that the projects were nearly 30 percent more expensive and 20 percent slower than their competition, it was too late to save the company.
This regrettably true story brings us to the core problem that prevents any free lunch in contracting: the principal‐agent problem. When we contract, an owner (the principal) hires someone (the agent) to act on their behalf. Even in the best of circumstances, the behavior of the agent is unlikely to be exactly what the principal wants. The agent's understanding of the objectives is unlikely to be identical to the principal's understanding, and, of course, the agent probably has goals that are not perfectly consonant with the principal's. The principal‐agent problem sits right at the heart of what makes contracting so difficult. We will come back to it repeatedly.
The key antidote to the principal‐agent problem is transparency. The more transparent a contractor's performance is to the owner, the less room there is for the contractor's performance to wander away from the owner's objectives. The more transparent the owner's behavior is, the less anxiety the contractor will have about being taken advantage of. We will return to the theme of transparency as well a number of times. It is very important.
An old friend and U.S. federal judge, T. Rawles Jones, used to remind me: “Contracts should always say what they mean and mean what they say.”
Say What They Mean
Part of the process of generating transparency is the use of straightforward and simply stated contracts. The clearer the contract, the clearer everyone's understanding of their obligations. Complex and arcane language works directly against one of the most important elements of a good project contract: risk assignment. An owner needs to know how a contractor will make money on the project. The smart owner always welcomes the contractor making a profit. But the owner needs to foreclose any nonobvious and unintended ways that money can be made. Simplicity and transparency help generate that outcome.
Mean What They Say
Contracts place obligations on both parties. Those obligations need to be taken seriously. So if the contract provides audit rights for the owner, then it behooves the owner to audit from the start. If the owner doesn't bother, those rights will soon be gone. Any later claim of unexercised rights is often dismissed by the contractor and later by the arbitrator or court. If the contract stipulates no “reservation of rights,” then get a monthly release of rights to make claims later.2 If the contract establishes a change process, then it behooves the owner to get that change process in place immediately, not down the road when change orders have started to accumulate on the PM's desk.
Principle 2: Contractors Do Good Projects Well and Bad Projects Poorly
At first glance, this principle may seem to be a tautology. It is not. Owner behavior shapes contractor performance. This is a reality that IPA research has demonstrated over and over again. When the owner has clear objectives for the project, has a competent, fully staffed, cross‐functional team, and completes the front end of the project with excellence, the contractor's performance is systematically splendid. When the owner has hazy or conflicting objectives, the project fails. If owner operations and maintenance people have been left out of decision‐making, late major changes will occur or fundamental errors may have been made in scope development. If the cost or schedule targets are not achievable by humans, the project will fail. If the front‐end engineering and project execution planning are deficient, the project will fail. After years of hammering away at these issues with the data, the project management community around the world accepts these things as true. Any of these deficiencies, none of which are controlled by a contractor, will nonetheless leave the contractors looking stupid and incompetent. Owners have the most leverage in projects. Owners set direction and set the table for the projects. Therefore, it is inevitable that owners will make the big mistakes—poor business case, wrong scope, disgruntled stakeholders, and so forth. Contractors will inevitably make lots of little mistakes, but very few projects bleed to death from a thousand paper cuts.
Contractors may make convenient scapegoats, but they are rarely to blame for bad projects. A little reflection will make clear why this must be true. The situation in which a deeply incompetent contractor could survive would be outside a market system. Markets ruthlessly weed out incompetent contractors. In most places in the world, engineering and construction contracting is very competitive.3 Owners award very few projects without competition of some sort.
When one appreciates that owners shape project outcomes and not contractors, it is immediately apparent that contracting is a second‐order issue for projects, not a dominant one. Being a second‐order issue, however, does not mean that contracting is unimportant.
Principle 3: Complex Projects Need Simple Contracting Strategies
Complexity is the enemy of transparency. Complexity exists in projects in a number of dimensions.
Scope complexity increases with the number of distinct scope elements. A project with a lot of infrastructure development, for example, will always be a complex project.
Shaping complexity increases as the stakeholder set becomes larger and more diverse. Problems with host governments and regulators and local communities all add to project complexity.
Basic Data complexity occurs when the basic technical data for the project are in development during the front end rather than fully available and confirmed. This is almost always the case for new resource extraction projects and occurs in other sectors whenever new technology is involved.
The three dimensions of complexity mentioned will almost always generate organizational complexity for the project. More subteams will be required with more functions involved, many of which do not speak the same professional language.
Higher complexity should encourage those generating the contracting strategy to keep things as simple as humanly possible. Contracting with complex incentivization schemes should be avoided because the situation will make it harder to separate out who was responsible for what. Clear risk assignment should be the order of the day. Generally project complexity means there will be more interfaces to manage with more contractors and third parties working side by side. When possible, it is best to have all contractors working on the same basic contract form in such situations.
Principle 4: Owners Are from Mars and Contractors Are from Venus
To borrow from the wonderful book title, owners and contractors could not be more different sorts of economic entities. Owners earn from assets. Projects are a cost center that creates the assets. Markets measure owner success and failure by the returns and cash flows that their assets produce. Industrial owners tend to be heavily capitalized with big balance sheets, and most assets are fixed. Once an asset is in place, it can produce large amounts of free cash if prices are good.
Contractors are almost exactly the opposite. Rather than earning from assets, contractors earn via a markup on staff hours sold and markups on transactions, such as procuring equipment and material. Contractor balance sheets are asset light. The amounts of money that move through a contractor may be huge, but the margins tend to be very thin on that volume, and free cash flow is modest at best.
The economic differences between industrial owners and contractors have profound implications for contracting because they shape perceptions and reality of project‐related risk. The biggest project risk for an owner is that the prices for the product the project makes will fall or the volumes that can be sold will not approach capacity. Project overruns and schedule slips, while very unwelcome, are rarely catastrophic. For the contractor working on a fixed price contract, even a small overrun means no profit, and a large overrun can ruin the year (or worse).
A simple mind experiment shows the difference. If a capital project overruns by 25 percent and the owner absorbs all the overrun, that extra 25 percent is added to the corporate balance sheet as an asset, and the business now has to earn against a larger asset than they had hoped. But, if the contractor absorbs that 25 percent overrun, the amount is subtracted from the corporate balance sheet, and the contractor has no asset to show for it. And recall, those balance sheets were asset light at the outset. When we discuss the pricing of risk later, these economic differences become front and center. The economic differences between owners and contractors also show up in disagreements about contract terms. Because the contractor is typically short of free cash flow, timely payment is extremely important. Many owners find those concerns overblown and posturing. They shouldn't.
Principle 5: Large Risk Transfers from Owners to Contractors Are More Illusion Than Reality
When I work with some owner lawyers on contracting for projects, I am struck by their belief that contracts change reality. For example, if we assign risk for the timely delivery of critical equipment to the contractor, we will no longer have to worry about the equipment arriving late. Although it is true that transferring the risk may cost the contractor money, at the end of the day the project is still late, which means that our cash flow is late, and the customers who were promised product are still unhappy with us, not the contractor. The consequences of risks in projects will eventually come back to the owner whenever the risks are not effectively managed regardless of risk assignment.
There are examples in which contractors have in effect subsidized the asset balance sheets of owners. Sometimes contractors significantly underbid a lump‐sum project and proceed to deliver that project with excellence. But, there are not very many such examples. Most of the time, contractor losses on projects do not translate into owner gains. Lump‐sum contractors in large loss positions search for ways to shift those losses back to the owner. Sometimes it shows up in claims; sometimes it shows up in poor quality; sometimes it shows up in an unwillingness to bid on the next project.
There are not many examples of wealth transfer from contractors to owners for the simple reason that contractors do not have much wealth to transfer! If losses on projects were routine, there would be no contractors, or at least there would be no lump‐sum projects. All of the big downside risk has to end up in the owner's lap. If the project is the wrong asset for the business—a huge risk—that is purely an owner risk, although it probably also results in a badly developed and executed project. If the project has operability problems, that ends up as the owner's risk even if the contractor is hit with big performance penalties. Penalties do not operate plants. Contractors live with a project for a short while; owners live with the resulting asset for a generation.
