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Does Contracting Strategy Matter?

Executive Summary

Few topics evoke such controversy among project leaders, both owners and contractors alike, as much as contracting strategy. Deeply held beliefs reinforced by structural foundations drive decisions on contracting strategy regardless of what actual performance data suggest.

Owners and contractors are not inherently misaligned. Owners want competitive, predictable cost, schedule, safety and production performance. Contractors want to meet customer expectations and make a fair profit.

However, the outcomes of a number of recent major capital projects, whether cost, schedule, early production, or any combination of the three, offer a sobering view of the industry1. A significant body of research has been conducted as to how and why these results occur. Included among the findings is the role contracting strategy plays in exacerbating poor results when projects encounter difficulties.

Admittedly, contracting strategy alone is not responsible, but it frequently pits owners and contractors in contentious positions. Of the range of contracting strategies typically used, Lump-Sum Turnkey (LSTK) variants appear to be the most prone to such challenges. Underlying this susceptibility is the inappropriate allocation of risk. Owners falsely assume that they can transfer cost and schedule risks to the contractor, but contractors are not in a position to assume these risks for most major capital projects.

In fact, given the disastrous performance under fixed-price contracts, a number of EPC contractors have declared they will no longer seek work under a Lump Sum Engineering, Procurement and Construction Lump Sum contract (EPC LS), or Lump-Sum Turnkey (LSTK) contracting strategy.

“EPC lump-sum construction risk is completely off the table, it goes away” – Stuart Bradie, CEO of KBR

“Fluor’s energy and chemicals business will now only carry out reimbursable or open-book lump-sum conversion engineering, procurement and construction (EPC) work.” – Energy Voice, September 2020

Considerable attention has been paid to the interface between contracting strategy and engineering definition and execution planning. However, even after addressing these elements, poor outcomes persist. Until both owners and contractors adopt a new perspective and approach to project delivery, the perils of misallocating risk through imprudent use of contracting strategies will continue.

Clearly, change is needed.

Contracting strategy is not the silver bullet some believe it to be. Until the foundational issues are addressed, material improvement cannot be realized. Why? Projects by their nature are an amalgamation of production systems subject to the laws of Operations Science (OS)2. When projects are viewed as production systems, the reasons for poor project performance become obvious. Contracting strategy is notably absent from that list.

Although it is not one of the levers of Operations Science, the contract type does drive many of the production system design/configuration decisions via the Five Levers. The question is: what and who are the levers going to benefit based on what the owners are buying and contractors are selling?

In any case, the laws of OS can be used to map, model, simulate, analyze, optimize and control these project production systems enabling projects to perform as intended.

In other words, using OS and the associated levers of Project Production Management (PPM), owners and contractors can design and implement a project production system to deliver desired outcomes of meeting or reducing cost, meeting/accelerating schedule, optimizing the use of cash to improve returns, or a combination thereof. This approach is independent of the contracting strategy. However, the practical use of PPM methods will vary depending on the owner’s desired outcomes, posture with the contractors and appetite for direct involvement in the execution of the work.

For owners who are seeking only predictable project outcomes and believe using a form of EPC lump-sum contracting transfers execution risk to the contractors thus ensuring some degree of predictability, the recommended approach is to design the production system using Production System Optimization (PSO) to inform decision making at the beginning (e.g., pre-award) then using Production System Analysis and Production System Monitoring to provide a course correction instruction to the contractors throughout the life of the project.

For owners who are seeking predictable project outcomes, reduced cost, shorter schedules and less use of nonproductive capital through the duration of the project, the recommended approach is to design and optimize the project production system using Production System Optimization (PSO), control work using Project Production Control (PPC)3 and control flow of materials to the craft using Supply Flow Control (SFC)4.

In this approach, contracting strategies that pull the contractor and owner together in a combined force to execute the work are necessary. This includes various forms of reimbursable and unit rate contracting.

Introduction

For over a century, contract types have barely evolved to keep up with the complexity of today’s projects. Regardless of contract type, today’s contracts continue to assign risk to the owner or contractor, or both. This itself is a myth – owners have and will always carry the risk. This fact has not changed the financial burdens that contractors carry to their own detriment.

The construction industry accounts for 13 percent ($11 trillion) of global GDP, with construction being the largest and one of the most important industry sectors in the world. It employs 7% of the world working population. However, the sector has seen anemic improvement in performance when compared to other industries and claims continue to grow. Why? Because there exists a gap between expectation and actuality which means that the appearance of risk transfer to the contractor is not as complete as might be expected by owners.

This gap has manifested itself in colossal value destruction in engineering and construction. A 2021 report on global construction disputes5 finds that regardless of the type of contract used, claims continue to grow. Global construction claims average 4%-6% ($480-660 billion) per year. This amount would rank as number 22 in a list of countries by GDP.

From 2019 to 2020, the global average value of a claim $33 million (the highest average claim is the Middle East at $62 million and lowest is the US at $13 million). The global average length to resolve a claim is 15 months. The number one reason for claims: Owners and contractors fail to agree on contractual obligations and the majority of claims arise during construction.

Following scope definition, contracting strategy and methods are thought to be a key element of project management in the capital project arena. In forming a contracting strategy, owners pre-qualify contractors based on, among other criteria, who is capable of doing the work, safety records, financial fitness to assume risk, current and projected workload, delivery track record, as well as the complexity of the work. Further analysis is conducted to determine how much risk contractors are willing to assume, ie how much “skin in the game” and a set of metrics are used to evaluate which contractor provides the highest overall value to the investment.

On the other hand, contractors look at strategies that will win profitable work, build their backlog, increase market share and brand awareness, shift or share risk with subcontractors and joint venture partners to bolster shareholder value or returns to owners.

After choosing a contractor at the start of a major capital project, both owner and contractor are typically optimistic. All too often, however, when confronted by the variabilities that plague execution, alignment erodes, and corrective actions often exacerbate rather than mitigate the challenges. Ultimately, schedule delays increase, costs grow, divisions between the parties emerge and all too often the claims begin to build up, take shape and each party commences to bolster its position to either defend or contest claims.

Understandably, this situation can arise regardless of the contract form in place because the work that needs to be completed remains the same. However, the contracting strategy can accelerate the occurrence of problems. One critical element that is frequently overlooked by both parties, but especially by owners, when developing contracting strategies is specifically how the work will get done. Further, because no one common process exists on which both parties agree regarding quantitatively establishing true project status, ignoring how work will be performed takes on an even more significant influence.

The Same Old Story

Despite attempts to shift risk to contractors through contracting strategy, owners have and will always hold the execution risk. Ultimately, it is the owner’s asset, shareholder value, profit and reputation that suffer the long-term damage from delays in start-up, unnecessary use of cash and poor quality. Contractors suffer as well, up to and including bankruptcy, if the contract terms are particularly onerous and the project outcomes especially poor.

Lump-sum or fixed-price contracts stand as the most notorious strategies that pit owners and contractors as adversaries from the outset fueling the deterioration of collaboration while project performance is worsening.

The lump-sum form of contracting strategy has resulted in many EPC firms filing for bankruptcy or refusing to take on EPC LS-type contracts which are fraught with pitfalls that destroy capital, erode profits and destroy trust on both sides. However, the most insidious aspect is what happens to the actual work. Under an EPC LS contract, the actual work is pushed from the owner to the contractor, who then pushes it to a sub-contractor(s), who then often pushes it to another sub-contractor (or even below that). The net effect is that the owner’s view, involvement and control of the actual work becomes less and less transparent and out of their control. It should surprise no one that these projects often go off the rails.

Maybe it’s a good thing that contractors are starting to push back and not accept this kind of work.

Collision Course

Considering the nature of contracting today owners and contractors appear forever locked in a game of mutual destruction that is not sustainable. Why?

Conventional project management practices focus on the what, when and who, but not on the how. As discussed earlier, a lack of understanding and focus on how the work will be done or is actually being done is a significant contributor to why projects fail to meet expectations.

This is not to say that owners must control the work. However, owners must have a mechanism to understand and monitor how the work is being done and have the means to take corrective actions, if necessary and desired.

Critical path scheduling, earned value management, advanced work packaging / workface planning and adverse contract terms such as liquidated damages are thought to improve performance and align owners’ and contractors’ expectations by providing visibility and predictability. They tend to do this at least at the start of a project.

However, these practices reward starting, but not necessarily completing work, and makes it difficult for the owner to capitalize on changes that would improve project profitability, which in turn:

  • Drives the generation of significant volumes of work in process
  • Ignores the rates at which work must be completed
  • Optimizes individual parts of the project at the expense of the whole
  • Protects each step in the work processes with an accumulation of inventory (knowledge work and physical)
  • Builds a fraught but long-held premise

Further, with their origins in DuPont’s critical path scheduling method, they stem from the long-held belief that the “Iron Triangle” of scope, schedule and budget is immutable. The Iron Triangle rigorously maintains that two out of the three can be achieved on a project, but not all three simultaneously.

 

In simple terms, it is believed that to go faster, the cost must increase and that the only way to reduce both cost and schedule is to reduce quality/scope. However, OS refutes the axioms of the iron triangle. OS6, which ironically predates the invention of the critical path method, focuses on how work gets done, not just the who, when and where.

Why is this important? Until the underlying issues regarding how the work will be done are addressed, contracting strategy will only exacerbate the shortcomings in performance. Flipping it around, contracting strategy (and in particular EPC LS) cannot solve the underlying issues created through conventional project practices.

The Real World

While contracting strategy should be a second-order issue, this can fly in the face of a company’s cultures and longstanding practices. Examining those practices reveal something deeper at work here.

Simply put, owners have a wide range of project goals. These range from seeking predictability to those who want predictability, lower cost, shorter cycle time and less use of unproductive capital. These underlying goals are a direct result of the decisions made by owners on the contracting strategy to be utilized.

Owners who want predictability typically have a longstanding culture of paying upfront for predictability by transferring execution risk to contractors using some form of EPC lump sum contract.

These companies believe the contractor is responsible for the outcome. They expect the contractor to determine the means and methods and use their own processes and systems with minimal owner involvement. Contractors are held accountable to deliver on contract requirements often with penalties for late delivery. Owners using this strategy only intervene if a major risk is identified and the value of intervention outweighs the risk of involvement.

Owners who want predictability, lower cost, shorter cycle time and less cash tied up during execution are typically willing to staff up and be involved. These companies believe, regardless of the contracting strategy, they are responsible for the outcomes financially and reputationally and are willing to take the steps necessary to achieve their goals.

Accountable and engaged owners rely on “relationship” type contracting using some form of minimal risk sharing such as reimbursable unit rates in order to create transparency and partnership with the contractors to drive cooperatively towards project goals. The owner’s systems and processes are often used in place of the contractors.

One such relationship-type contract, known in Lean circles as Integrated Project Delivery or Integrated Form of Agreement, is worth talking about in more detail. The intent of this form of contracting as stated in the ‘Integrated Project Delivery – An Action Guide for Leaders’ is:

The process of negotiating and executing an IPD agreement should be a positive step that aligns the entire IPD team to the project goals and creates a commitment to execute the project collaboratively. It will require effort—and likely assistance— to manage properly, but it will provide benefits that significantly outweigh the cost and effort.

The overall contract value for an IPD project is a combination of all design and construction costs, including the total of all fixed profit amounts for IPD team members plus a negotiated contingency for the team. Typically, there is a shared savings plan negotiated by the IPD team for finishing the project under the negotiated contract value. This is set at some point during the design process, as early as immediately after validation or as late as the middle of construction. There is more opportunity to drive down costs if the shared savings plan is set earlier in the design process, since there is more certainty around the costs as the project progresses. Have the overall contingency and savings plan reflect when the IPD team commits to the contract value.

This type of agreement is not new, with similarities to the UK energy sector’s CRINE initiative back in 1992. This form of agreement theoretically enables transfer of work from one party to another based on what is “best for the project” and optimally positioned to do the work. However, in the real world this form of contracting is challenged, as individual companies seek value from other aspects of the project outside of profit such as building volume discounts with suppliers, brand enhancement, obtaining data, retainage of key personnel, replacing aging construction equipment, building key relationships with regulators, obtaining market share, etc. In addition, when the project invariably goes south, major disputes between contractors can fracture the whole agreement and the owner is left holding the bag.

While there is no doubt getting the entire team aligned and motivated to achieve project goals is beneficial, many owners think IPD will solve the underlying issues that drive poor performance, but it cannot.

Enter Operations Science and PPM

If contracting strategy cannot solve the underlying issues, then what does?

Production systems transform raw materials into finished products and are governed by the laws of Operations Science (OS). While not immediately obvious, when viewed through the lens of OS, projects are in fact production systems and therefore subject to its laws. A considerable body of work has been conducted to develop the means by which the laws of OS are applied to projects. It is called Project Production Management (PPM).

Historically, project management was thought (and continues to be) as the coordination of scope, schedule and resources (the analogs of what, when and who). To date, the entire engineering and construction project delivery industry, especially contracting arrangements, has been built on this foundation. Sadly, the foundation has cracks and it ignores the laws of OS, which has five levers, as shown in the figure below. PPM offers owners and contractors the power to manipulate those pillars as levers to map, model, simulate, analyze, optimize and control the outcome of a capital project.

In contrast to current project management practices, PPM focuses on the rates7 of work being done and not dates when the work is being done. PPM focuses on managing work in process (WIP)8, reducing variability9 and adjusting capacity10 to meet the flow requirements as shown below.

From an owner’s perspective, PPM generates an efficient flow of the work through the entire project life cycle, starting with the design of the project production system and which results in:

  • Unproductive capital minimized
  • Status of physical work becoming transparent
  • Barriers to progress highlighted
  • Solutions to the right problems identified
  • Single source of truth of what really happened

From the contractor’s perspective, use of PPM ensures that:

  • All parties are aligned and focused on the substantive matters that affect actual work
  • Owners actively participate and are not simply focused on managing the contract
  • Teams/crews plan their work and deliver on those plans
  • Concurrent engineering enables optimal and less expensive construction
  • Exhaustive project controls reports are no longer required

Such an environment benefits all parties involved and yields far better project outcomes. In the end, the owner’s performance expectations are satisfied, even exceeded, and the contractor earns a profit and a repeat customer.

A contracting strategy that enables the PPM environment will outperform all others.

Generating Value Using PPM

PPM methods can be adapted to support both ends of the spectrum as shown in the table below.

Strategy, Company Resulting Culture & Personnel Mindset The contractor responsible for outcomes – Company only intervenes if major risk is identified, and value of intervention outweighs not acting The company is responsible for outcomes and will take necessary action to achieve objectives (beyond commercial/contracting mechanisms)
Desired Result Predictable Project Outcomes Reduce Cost, Duration and Use of Cash
Commercial Strategy Transactional Agreement

(LSTK / EPC LS)

Relational Agreement

(Unit Rate, T&M)

Systems Company relies on contractor process and systems

(CAD, Project Controls, Procurement, etc.)

Company dictates process and systems needed to align with Company’s digital platform
PPM Approach ANALYZE & MONITOR OPTIMIZE & CONTROL
PPM Purpose / Objectives Identify risks to project objectives by providing visibility and transparency of production decisions Optimize and Control use of capacity (equipment, labor and space), work-in-process and manage variability
PPM Solution Production System Design Production System Analysis & Monitoring Production System Optimization Project Production Control Supply Flow Control
Focus Core team designs production system pre-bid Small team monitors production using contractor provided data Identify opportunities to reduce cost, duration and use of cash and design production system configuration to capture value Engineering and craft work Flow of materials and permanent equipment to site
Responsibilities

 

Company or 3rdParty Company Company or 3rdParty Contractor Contractor

However, the value realized will depend on whether the organization or contractor desires to achieve predictability or realize lower cost, shorter duration and less unproductive capital tied up during the life of the project as depicted in the figure below.

Owners who are seeking predictable project outcomes using LS contracting can utilize PPM on the project to map, model, simulate, analyze and monitor progress.

This begins with the owner at concept selection. Using Operations Science methods to design create a project production system (starting in concept select and finishing at the end of FEED) to deliver the project objectives including contracting strategy.

This means determining where and at a high level how the work will be done, sequence of work and key milestones, rates at which the work must be completed, capacity required to complete the work and the most effective split of work between various contractors. These parameters or policies are included as requirements in the various bid documents.

In addition, specific data requirements needed for the owner to adequately monitor production of the work will be identified and also included as contract requirements.

Post-award, a small owner’s team receives required production data from the contractors to update the project production system modeling and generate specific models as needed to observe and capture contractor plans along with progress in the form of production plans.

This data is captured in software to provide key analytics for the early identification of high-risk problem areas. (Capture of the production plans can be done by the owner’s team, third party or as a contract requirement.)

These actions to monitor and analyze the project production system give the owner profound insights on the implications of decisions being made (knowingly or unknowingly) by the contractors, flag significant risks and provide the owner with an opportunity to intervene and correct.

Owners who want to have more influence on the outcome will map, model, simulate, analyze, optimize and control the project production systems. This starts at the concept select phase of the project to create a production system that is designed and optimized to capture the best possible outcome consistent with the owner’s objectives.

Production system optimization continues through the life cycle of the project by taking advantage of beneficial variability (product/process variations or design changes that improve business cases, things that go better than anticipated) and adjusting for non-beneficial variability (product/process variations, negative iterations that don’t improve the business case or things that don’t go as expected or planned).

The project production system design and optimization (PSO) is used to help determine where and at a high level how the work will be done, the sequence of work and key milestones, rates at which the work must be completed, the capacity required to complete the work, appropriate levels of Work in Process or WIP and the most effective split of work between various contractors along with the optimal form of compensation.

This could include fixed-price contracting for portions of the work where the contractor is not accustomed to executing the work under different terms or where the work is basic and largely within their control.

PSO coupled with Project Production Control (PPC) apply to knowledge (engineering) and physical work through commission and start-up. Specifically, within PPC, production plans are generated to support the completion of activities by multi-disciplined (engineering) or multi-functional (craft) teams and updated weekly for engineering and daily for construction. Roadblocks that prevented planned work from being completed are captured so project leadership can focus on solving those problems and take necessary steps to prevent them from recurring. Sequence of work is maintained, and work activities within a sequence or sequences are completed before starting new activities.

The requirement to use PPC is included by the contract formulator (Owner, general contractor, subcontractor) in all contract types regardless of the form of compensation.

Supply Flow Control, SFC, is also employed to pull materials and equipment to the craft at the optimal time thus avoiding a buildup of unnecessary inventory and WIP and tying up unnecessary resources including cash. Contract requirements also include the use of SFC.

Of course, there is a range of alternatives between these two bookends of Analyze & Monitor vs Optimize & Control, including the application of both methods on different portions of a project.

It should be noted that in some jurisdictions the use of lump sum is mandated by a country’s contracting rules and regulations. However, if the owner still wishes to have a predictable outcome, contracting terms should be configured to require full use of PPM under some form of value sharing arrangement.

What Should Owners Do?

Owners need to recognize that the current approach to delivering capital projects regardless of the contract type is not working and that change is required.

They also need to establish goals and boundaries – what is the desired outcome taking into account cultural norms that dictate owner / contractor roles? Some key questions to ask:

  • Is predictability the desired outcome or is it predictability plus lower cost, shortened cycle time and less cash tied up during the project?
  • Who is ultimately accountable for project outcomes?
  • What form of contracting could be used? Flexible or must it be lump sum?

Owners must answer these questions early. Depending on the answers to those questions, owners recognize that using OS and PPM methods provides predictability, less use of cash, cost and schedule reductions.

However, in all cases:

  1. Use technology and OS to configure the desired outcome through a Project Production System
  2. Use Project Production Control to monitor or control the work within that system
  3. Infuse contracts with requirements for PPM methods selected
  4. Share benefits with the contractor(s) to become part of the solution

What Should Contractors Do?

For contractors to earn fair returns and build their backlog, contractors must:

  1. Embrace PPM as the new foundation for planning and executing the work regardless of contracting strategy imposed by owners or owner support for PPM
  2. Use OS coupled with technology to model, optimize and control the work
  3. Understand how the work should and will be done before settling on a pricing model

Digital is Changing Everything

It should be noted that the current debates around contracting strategy will and are being overtaken by advancements in how the work is done through digitalization of the work. We are not talking about digitizing current methods that are not effective, such as project controls or advanced work packaging. That is simply making something ineffective easier to use.

Instead, we are talking about changing fundamentally how the work is done with digital capabilities. For example, many contractors are already moving from service provider to product provider. Projects are becoming more often an amalgamation of product components instead of designed and built from scratch.

Engineering is becoming more automated. Soon engineering will be done with little human intervention. Imagine how different contracting will be when, in a short period of time, during concept select a wide range of digitally produced alternatives will be generated, fully costed, scheduled, key milestones laid out and with engineering nearly done producing an accurate bill of materials. Contractors will no longer be selling engineering and project controls hours but will be selling a digital product instead. Owners will be forced to depart from past contracting practices, or will miss out and become uncompetitive.

Conclusion

Regardless of contracting strategy, major capital project outcomes will continue to disappoint owners, EPC contractors will continue to collapse and vast amounts of capital will continue to be squandered unless the industry recognizes the levers of Operations Science that are at work and affect project outcomes.

Most importantly, getting started with Project Production Management is a learn-by-doing process. Get started now by applying OS and PPM, and experience firsthand the impact instead of just studying what others have done or are doing for an extended period of time.


Footnotes

    • [1] McKinsey & Company (2013) Mega-Project Study, Industrial Mega Projects. Ed Merrow 2011
    • [2] Factory Physics defines OS as the study of transformation of resources to create and distribute goods and services. OS (OS) focuses on the interaction between demand and production and the variability associated with either or both. OS also describes the set of buffers (inventory, capacity and time) required to synchronize demand with production.
    • [3] Project Production Control is any action, process, mechanism, system or combination that organizes and enables control of production, or work execution. Project Production Control uses human, physical and software systems for implementing control in the production system. Project Production Control requires regular and timely attention to the details of executing work – every day, every week, every work cycle – before work is done as opposed to after work is done. It is not a process that is performed once a month or an ad-hoc basis like Project Controls. Sources: Project Production Institute
    • [4] Supply Flow: All processes necessary to engineer, fabricate, assemble, transport, install and commission a specific system. Sources: Project Production Institute
    • [5] Arcadis, 2021 Global Construction Dispute Report. Source: https://www.arcadis.com/en-us/knowledge-hub/perspectives/global/global-construction-disputes-report
    • [6] Operations Science: The study of the transformation of resources to create and distribute goods and services. Operations Science (OS) focuses on the interaction between demand and production and the variability associated with either or both. OS also describes the set of buffers required to synchronize demand with production. Sources: Project Production Institute
    • [7] Rate – a fixed ratio between two things. For production systems, rate is a measure of throughput or output and is stated as units per period of time or tasks per period of time. Sources: Merriam-Webster on-line, Project Production Institute
    • [8] Work in process or WIP is the set of entities that are partially transformed within any given process. WIP does not include stock inventory which is composed of completed entities. WIP typically accumulates while waiting for available capacity in front of an operation. Stock accumulates between two or more processes (e.g., finished inventory between a process and its demand). Sources: Project Production Institute
    • [9] Variability is the term used to describe any dissimilarity between specific instances of a particular operation or process, particular entity output from an operation, or a particular demand. The dissimilarity may manifest itself in terms of attributes of the entities/ operations or in the timing of those entities/operations. Sources: Project Production Institute
    • [10] The maximum average rate at which the items/units/tasks/products can flow through a process or system. Capacity is the upper limit of throughput. Having installed capacity above average demand allows the Stock Inventory and Backorder Time buffers to remain small. If the process had infinite capacity, there would never be either Stock or Backorders as the process could satisfy demand instantly.” Sources: Project Production Institute, “Factory Physics”, W. J. Hopp and M. L. Spearman, Third Edition, 2011, Waveland Press