Incentives for value engineering
Commenting on one of my earlier insights, an associate argued that a major reason for infrastructure projects failing is the greediness of contractors. Greed however can be a good thing if managed properly. It is the lack of the appropriate greed management that makes it bad, be it in construction works, delivery of goods, or in complex turnkey contracts.
The default commercial behavior of a contractor is to maximize the profit while minimizing risk. This behavior takes place within a set of regulatory and contractual constraints. Regulatory constraints are imposed in advance and may evolve during the contract lifecycle; a good contract allows for accommodating them as they are mostly outside of the contractual parties’ power to influence. Contractual constraints – in public sector contracts at least – are defined mainly during the preparation of a tender dossier and by the contracted price at the end of the procurement process. These constraints may likewise change over time based on consensual or adversarial adjustments of contract terms, to the degree allowed by procurement framework and applicable laws.
In tendering, the prospective contractor seeks to win the contract first. Aggressive price competition, which most often happens in saturated, stagnant, or shrinking markets, can lead to underpricing, i. e. selling at loss, without necessarily leading into range that can be defined as “abnormally low” and dealt with up front by unilateral upward price adjustments during tender evaluation by the purchaser, or by outright rejection of the bid.
Thus, contractors begin the implementation of an awarded contract facing internal pressures to deliver the project at a set profit while being constrained by the low price that often does not end up covering the costs, be they foreseen or not. Exploration then begins to find the corners to cut at minimum risk.
Counter-intuitively, in scenarios where competition is distorted or absent altogether and the contracted price contains significant buffers, the same corner-cutting can happen due to the absence of the efficiency and accountability culture and due to expanded room for waste and graft and low perceived risk of such behavior.
In both cases, contractors can breach regulatory and contractual requirements in their pursuit of profit: supply lower quality goods or lower quantity of materials, slacken with time and labor management, needlessly claim additional costs, or otherwise endeavor to maximize profits, including through fraud. All this increases the contractor profit but at the same time destroys value in the project and exposes the project and its stakeholders to major risks later – catastrophic technical or structural failures, additional repairs and renovations, implementation timeframe being extended to after elections, service breakdowns, or environmental damage.
The first line of defense against this kind of greed is professional construction supervision or technical inspection teams that the client can deploy (also called owner’s engineer or FIDIC engineer depending on specific setup and type of contract). They inspect goods and materials, measure quantities and compliance with norms and standards, and verify the contract implementation against contractual terms, thereby increasing risk to the contractors for undue behavior, changing their profit versus risk calculus. While this is a regular feature envisaged by all commonly used contractual frameworks and standards, it often fails to work as intended and prevent the damage a contractor’s greed can do to the project. The commonly encountered reasons are:
- Insufficient budget and expertise of the supervision team – they do not have the time to be there regularly, nor the skill to spot the problems.
- Collusive relationship between the client and the contractor – the contractor relies on the supervision findings not being enforced.
- Collusive relationship between the contractor and supervision – supervision team covers the problems up or enables fraud.
The collusive relationships can exist prior or evolve during the contract implementation, weakening control over time. A certain flexibility and willingness to unofficially compromise in day-to-day situations does help in smoothening and speeding up contract implementation, however it requires robust integrity from all sides to maintain healthy boundaries. Some possible mitigating tactics are:
- An early-stage demonstration of the “rules of engagement”, e. g. by strict count of quantities or precise emission measurements and penalty enforcement combined with selective leniency where justified.
- Planning on replacing the supervision team midway through the project.
- Appointing an independent second-level supervision (often in the form of a lender’s monitor) to periodically verify the work of both the contractor and the primary supervisor.
The latter two options impose additional cost but may serve well in longer or more complex projects to maintain control over the contractor’s profit versus risk calculus.
Where can the contractor’s greed be put to a good and legitimate use, though? Project objectives can possibly be reached with less cost and time than what the client can imagine – specialized contractors generally have better knowledge to determine the right approach. The procurement process can be structured to allow for competitive dialogue or alternative proposals in order to find out.
However, even during contract implementation later on, new approaches can come to light that could optimize the project outcomes. This can happen after a regulatory change (e. g. change in emission norms or approval of a new technology), unanticipated market developments (e. g. permanent changes in cost or availability of a particular fuel or material), unplanned environmental factors (experimental surveys revealing geothermal potential in the area) or sudden changes in use patterns (e. g. Covid-19 and new sanitary expectations in buildings or vehicles).
The contractor does not have a reason to proactively come up with the proposals if there is no clear mechanism in the contract how they will benefit themselves from the cost decrease, time saving, or additionally created value, beyond the generic provisions in contract templates. The supervisor will not be supportive of the process if there is no visibility of additional budget to cover their extra effort.
A two-pronged approach should be used for the right set of incentives. Both the contractor and supervisor need to have the incentives so that they do not block each other out:
- A formula for sharing the cost savings and monetizing time savings in the works, supply or turnkey contract, to show the contractor a path toward an increased profit.
- A value engineering mandate for the supervision team, supported with a contingency budget for related analysis and design support activities.
At the same time, value engineering incentives for the contractor and the supervisor should be designed to oppose each other, to avoid collusive approach at the client’s expense. For example, the contractor should be incentivized for achieving the additional time and cost savings, whereas the supervisor should only have the additional value engineering budget released when the project quality parameters are achieved.
Director Infrastructure and Development Financing