Contracting & Construction Projects: Types And Differences

A contract in relation to capital projects functions as a legally binding, enforceable, and reciprocal commitment governing the collaboration between owner and contractor (Berends, 2015; Turner, 2003). A contract should clearly define the roles and responsibilities of all parties involved as well as establish a clear framework that outlines the implementation of design processes, procurement strategies and construction methodology. It is designed to align the goals of the owner and contractor to meet a mutually favourable outcome (Turner, 2003). However, the inherent complexity, scope and scale, and long duration of major infrastructure projects makes them susceptible to future uncertainties and turbulence (Drexler and Larson, 2000). As a consequence, new risks and unforeseen events may arise as the project progresses which in turn cause potential disputes and breakdown of the relationship.

Conceptually, the choice of contract type depends upon a number of factors. And, it remains somewhat unclear as to why some contracts are used on certain projects, as there does not seem to be definitive process for contract selection (Badenfelt, 2008). Several factors have been presented in the literature, including the preferred risk allocation (relative risk appetite of the parties, ability to manage change), the project owner’s preference (relative importance of program, cost and quality, the desire to avoid moral hazard attitudes), the contractor’s capabilities, the project’s characteristics (complexity and definition) and the relationship between the parties (desire to cooperate and be fair).

Contract selection is becoming an increasingly important process, as more and more studies begin to identify the major cause of project failure to be the selection of an inappropriate procurement method (Love et al., 2008). Love et al. posits that project costs can be affect-ed by up to 5% depending on the procurement method (or contract type) selected. This proposition suggests that a large amount of infrastructure projects in Australia are still failing to reach an optimal outcome, which ultimately results in an inefficient use of company or government funds.

Even though the concept that contract selection can have significant financial impacts is becoming increasingly known, a survey conducted by Love et al. of senior project managers in Australia found that the traditional form of lump-sum contracts is still the preferred option, despite the acknowledgement that other forms of procurement could optimise project success.

CONTRACT TYPES, INCENTIVES & RELATIONAL CONTRACTING

In construction, the fragmented nature of the industry has led to unsatisfactory results in the past, which has prompted in-depth analysis into methods that could be used to improve it. One such approach is the concept of relational contracting, as the client-contractor relationship is said to be an important element in the delivery of major infrastructure projects.

The four contract types that are being explored in this study can be distinguished into traditional con-tracts (like lump-sum and cost-plus) and relational contracts (alliances and PPPs).

Traditional Contracts

Under a traditional contract, both parties are owed compensation in one way or another. For example, a project owner will pay a contractor in return for a new building that meets the quality and specifications of the contract. On the other hand, the contractor is owed payment for constructing the building for the owner. As such, both parties’ expectations exist in tension. These contracts require a clear allocation of risks and responsibilities from the outset to allow an accurate project cost to be calculated. However, as is inherent within any project, unforeseeable risks occur which are not allowed for, and disputes often break out regarding who is responsible for the costs.

Lump-Sum Contract

Under a lump-sum contract, the owner assumes a clear scope of works that distinctly outlines the performance specifications and functionality requirements. The contractor, for a fixed sum, is responsible for meeting these requirements in a way that they best see fit (Smith, 2002; Turner, 2003). The solution and delivery methodology are flexible, so long as the contract details are met. Because of this assumed certainty of scope, the project owner is likely to be less involved in the project during delivery (Suprapto, 2016; Berends, 2007), as the contractor assumes all the responsibility for any risks.

However, the downfall of a project procured under a lump-sum project can often be attributed to the ‘hands-off’ approach adopted by the owner. Limited coordination and information on project progress give rise to an attitude of ‘it’s not my problem’, generating an adversarial relationship. Contractors can often interpret clauses differently, and the lack of communication between contractor and client can result in more costly disputes and delays.

Cost-Plus Contract

A cost-plus contract is typically employed when there is more uncertainty in project scope and variance in design (Suprapto, 2016). This type of con-tract adopts a very different risk allocation, with the owner taking on all the risks (Muller and Turner, 2005). There is a common misconception that con-tractors will take advantage of the cost-plus contract by over-supplying and incurring unnecessary costs to gain more profit (Muller and Turner, 2005). In response, the project owner typically employs more re-sources to monitor and survey the progress and quality of the contractor’s work. This environment can institute feelings of distrust between the parties, em-phasizing the point made by Müller and Turner that the increased interaction under a cost-plus when compared to a lump-sum contract does not equate to a more collaborative and aligned relationship.

Relational Contracts

Under a relational contract, there is one core element of mutual co-operation and teamwork (Rahman and Kumaraswamy, 2004a). Alliancing and PPPs are underpinned by the principles of relational contracting, which considers a contract to be not just a legally binding document, but also the formation of a relationship between the parties by encouraging long-term provisions, allowing for degrees of flexibility and founded on a common understanding of objectives (Macneil, 1981).

Relational contracting was a concept first posited by Macaulay in 1963 as a social contract theory that enhances contractual relations from both an economic and social perspective (Macneil, 1981). Over time, many scholars have conducted further research and identified a set of norms that are essential to relational contracting. Ivens emphasised the need for a high degree of information exchange, a detailed conflict resolution platform, mutuality, and flexibility under the terms of the contract, and a long-term arrangement that encourages relational planning (Ivens, 2004).

The applicability of relational contracting in the construction industry attracted the attention of re-searches as a concept that could lead to more collaborative relationships and more successful project outcomes (Rahman and Kumaraswamy, 2004a). The typically conflicting attitudes of contractors and project owners under traditional construct-only lump-sum contracts can potentially be alleviated under a contract model that uses the concept of relational contracting as a basic framework to create a collaborative relationship as its primary objective that directs the project down a path of ‘win-win’ for all parties.

Alliancing

An alliance contract is a particular form of cost-plus or reimbursable contract where both the contractor and project owner are responsible for a project’s final costs. Typically, the parties will agree to a gain-share / pain-share arrangement whereby all parties to the contract share in the profit if the project performs above expectations, but all parties are liable to cover any losses if the project incurs any program or cost overruns. For example, a contractor and project owner enter into an alliance contract whereby both parties agree to take on 50% of the risks. If the project makes a $10 million profit, both parties will ‘share’ the profit in accordance with the percentages in the contract, in this case, $5 million each. However, if a contract overruns by $10 million, each party is only liable for $5 million each. The idea of making all parties liable for cost and program overruns is to align the goals and objectives of both parties and en-courage everyone to strive for the best outcome.

By aligning the objectives of both parties, an alliance contract aims to integrate clear dispute resolution mechanisms and joint risk management procedures founded on a culture of trust and collaboration towards a common goal (Suprapto, 2016). Alliancing instigates a cultural shift in the contractor-client relationship from a ‘best for self’ to ‘best for project’ and no-blame culture (Ross, 2003).

Public-Private Partnerships

Due to the unique relationship that is formed by a PPP contract, the project performance is dependent on the balance between public and private sector re-sources (Benítez-Ávila et al., 2018). Thus, it is understandable as to why literature is indicating that relational contracting is a critical element of success for PPPs (Tang et al., 2010).

The public sector remains strictly accountable for the profit-orientated private sector in the use of state and federal funds. Thus, the relationship be-tween the two sectors, and the parties’ managers, must be transparent and aligned to maintain control over risk transfer and infrastructure spending. This heightens the need for relational contracting.

Relational norms, as defined by Macneil (1981), in a PPP arrangement context enable an increased level of interaction between the parties, that translate contractual provisions as binding promises into opportunities to cooperate towards achieving a better project outcome (Benítez-Ávila, 2018).

Incentives

Incentive provisions are another common method of encouraging an increased level of contractor performance (Suprapto, 2016). Bubshait (2006) introduced four types of incentives common in the construction industry: (1) program incentives; (2) cost incentives; (3) performance incentives; and (4) safety incentives. Berends (2006) conducted a case study investigating the use of incentivisation in construction contracts and concluded that the use of one or multiple incentives generally enhanced the owner and contractor relationship.

Meng and Gallagher (2012) also deduced that the use of incentives can be used as a trigger to align the objectives of different parties and create a more collaborative atmosphere within the project team.

CONTRACT TYPES, INCENTIVES & PROJECT PERFORMANCE

Project success has been given many definitions in the literature. For the purposes of this research, a project is considered to be successful if it meets three main criteria: the correct cost, by a certain deadline and achieves a fit for purpose level of quality (Ghadamsi and Braimah, 2012).

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However, project performance can often be interrupted differently by different parties. Where clients and project owners often consider project success to be a product of satisfying the desires of key stake-holders, contractors tend to place a heavy emphasis on cost and duration (Ghadamsi and Braimah, 2012).

Suprapto (2016) suggested that improved construction performance can be traced back to the use of a more collaborative or relational contract instead of the traditional construct only lump sum and cost-plus contracts. However, Merrow (2011) showed that this assumption does not always hold true, with a study of 318 projects highlighting that alliancing does not necessarily result in a better project performance.

Parker and Hartley (1997) investigated the merits and results of collaborative contracting by studying the procurement of the UK defence. The UK’s defence procurement adopted a policy of partnership sourcing as the superior value for money approach due to its wider economic benefits. However, the results of the study showed that partnership sourcing and implementing a long-term buyer-seller relation-ship did not necessarily result in a more cost-effective solution when compared to traditional adversarial and competitive procurement.

In line with this view, Lowe (2007) postulated that project performance is not dependent on the contract between the two parties but relies more on the relationship between them. Whilst traditional contracts are believed to be more adversarial by nature when compared to alliancing or PPPs, Lowe believes that the relationship between the parties is par-amount to project success. Several scholars, whilst they tend to agree, argue that the contract type has an impact on the relationship by the level of collaboration and team-work that is inherent within those contracts (Berends, 2007; Müller and Turner, 2005). As such, the contract selection can be a key tool in promoting a relationship that is aligned towards the success of the project.

Lump-sum and cost-plus contracts tend to create a relationship between contractor and owner that does not require an alignment of interests. This can lead to information asymmetry, increased level of disputes and lower project performance. Suprapto et al. (2015), in the alternative, quantified the positive effect of teamwork, collaboration and relational attitudes on project performance.

Public-Private Partnerships

Raisbeck et al (2010) conducted a detailed analysis into the performance of PPPs in Australia when compared to projects completed under traditional forms of contracting such as lump sum construct only. The investigation took the available data from 21 PPP projects and 33 traditional projects in Australia and compared the cost and time outcomes of the project. Whilst these measures are not the only forms of quantifying success, these are typically the first deliverables that people consider.

From a cost perspective, Raisbeck et al’s (2010) results demonstrated a significant advantage when it came to projects procured under a PPP contract rather than traditional contracts.

During the delivery phase of a project, the con-tractor holds the biggest influence on the project outcome under any form of contracting (Raisbeck, 2010). Under a lump-sum contract, the contractor would be 95-100% responsible for the outcome due to the nature of the risk allocation in the contract. Under a PPP the risk allocation would differ significantly, but the contractor remains the party primarily responsible for the construction of the project. The results of the study identified a cost overrun of $672.5 million under traditional procurement methods, which represented 14.8% of the expected costs. This is in stark comparison to projects procured under a PPP where they experienced only a $57.6 mil-lion overrun, or 1.2% of the expected costs.

Specifically, for major infrastructure projects, projects procured under traditional methods were generally completed over budget and by a significant margin (Raisbeck, 2010), whereas the three largest projects procured under a PPP came in on budget. This research clearly demonstrates the greater cost discipline under a PPP contract when compared to traditional projects.

Similarly, from the same research study, PPPs were found to compare favourable to traditional procurement methods in relation to delivery a project on time (Raisbeck, 2010). Whilst the numbers showed the more traditional projects were completed on time than PPPs, a number of factors were suggested as an explanation.

Firstly, traditional projects generally begin once the design and specifications are known to the client and contractor, which allows the contractor to assume the responsibilities of any risks. PPPs, on the other hand, these aspects of a project are developed during the early phases of the project (Duffield, 2008).

Secondly, PPPs are generally subject to more scrutiny from the public due to the involvement of local, state, and federal governments, meaning the decision-making process can be longer due to the need to consult key stakeholders throughout the process.

These factors reflect PPP’s as a favourable comparison to traditional contracting when it comes to delivering a project on or ahead of schedule.

However, PPPs are not without their drawbacks. A concept labelled ‘opportunism’ can often be present in PPP arrangements. O’Brien and Williamson (1976) defined opportunism as the act of “self-interest seeking with guile”. Opportunism tends to arise in prolonged PPP arrangements and when there is an imbalance in the access to information (Xu et al., 2007). Due to the principal’s reliance on the con-tractor for a lot of the information regarding the construction of the project, the level of dependence can be taken advantage of inappropriately. The quality of the relationship between the two parties will ultimately determine the level of opportunism acted up-on by the contractor of the principal.

Incentives and Project Performance

Incentivisation has been posited as a key contractual strategy with significant potential to increase project performance issues on major infrastructure projects (Meng and Gallagher, 2012).

However, it has been found that positive incentives are not necessarily bound to improve the likelihood of project success (Merrow, 2011; Berends, 2006).

Whilst it is not statistically significant, the success rate of projects under incentivisation was less than those without incentives. Now, this proposition is not to say that incentives should not be used as they show no benefits in improving project outcomes. The sample of projects taken for this study may not be flawless, and other factors may have been at play that affected the project outcome. For instance, the contractor, whether under a contract with a financial incentive to complete the project ahead of schedule or not, may have not been capable of completing a project of such magnitude. Or, the incentives were inappropriate for the circumstances of one particular project. Merrow (2011) argued that project execution is about achieving target cost and duration, and not necessarily to create ‘value’ in the form of profit. For this reason,

Prior to this research, Bubshait (2006) identified four common types of incentives that could be used in isolation or in conjunction with other incentives to improve project performance.

Schedule incentives are designed to encourage contractors to complete the project on or ahead of schedule. On occasions, disincentives can also be implemented to penalise contractors for finishing be-hind schedule. Price incentives, as are common in cost-plus contracts, are often discouraged because they create a positive incentive for contractors to in-crease costs. Performance incentives are activated when the contractor reaches a predetermined level of quality of technical specification. Safety incentives are less researched and are yet to be proven as capable of improving project performance (Bubshait, 2006)

Meng and Gallagher (2012) followed this with a quantitative and qualitative analysis of incentivisation, providing empirical evidence to establish a link between incentivisation and project performance.

Ultimately, contractual incentives are designed to align the interests of the owner and contractor, and when employed correctly and in the appropriate circumstances, they can enhance team-working which leads to increased project performance (Suprapto, 2016; Meng and Gallagher, 2012).