Risk management - The contractor
The contractor
Risk assessment positioning
The client is not the only interested party in carrying out a risk assessment. Any contractor may wish to carry out their own risk assessment prior to submitting a bid and after the bid has been accepted.
How it is carried out and its focus will depend on the interests of the individual parties.
From a client perspective they may wish to allocate as many risks as possible (for managerial or legal reasons) but may not be in the best position to assess some of the risks if they lack the necessary skill set.
A contractor may or may not have the benefit of the risk assessment, carried out by the client, in the tender documents.
The approach will depend upon the amount of risk allocated to the contractor. The contractor will be keen to strike a balance between costing to gain the contract and making a suitable profit bearing in mind some of the uncertainty still retained by the client. The contractor may wish to assess the reliability of the client from a business and an ethical view.
A winning contractor is likely to performance risk management to secure their own profits and may begin from the risk assessment provided by the client in the tender.
The relationship between the contractor and client is key to the project management [see ‘The Complete Project Management package’] and [see 'The Complete Project Management plus PRINCE2'] success. Each party will judge success on their own terms.
Each side will perceive risk differently. Conflict can quickly lead to stalemate, project collapse or even bankruptcy of one of the parties.
The allocation of risk in a fair manner is important.
The contract
The client will control the actions of the contractor via the legal contract.
This will often consist of:
- Payment details
- Monitoring arrangements
- Possibly identify specific risks
In the latter case risks may be implied due to the nature of the project and its size. A lack of detail of risks may cause some issues.
Two major types of contract are used.
- Cost plus fixed price. Here the client takes on all of the risk.
- Fixed price. Here the contractor take on all of the risk.
These are extremes with the ‘fixed price’ being the most common.
Cost plus fixed fee
The client pays the contractor a fixed fee and the contractor then claims for the costs for labour, equipment, materials etc. The client is responsible for any errors and unforeseen issues are carried by the client.
In this way, costs match the activity which do not allow the contractor to gain too much profit.
However, there is no incentive for the contractor to manage those costs efficiently if many area where ‘error’ or ‘unforeseen’ issues arise result in the client covering the cost.
There may be occasion for a contractor to ‘add’ costs in terms of :
- Work being carried out that is not really required
- Excessive equipment purchases
- Inefficient purchase of materials
This can be exacerbated if the fee is based on a percentage of the actual project cost.
Trying to satisfy all of these needs in a contract can prove difficult. The definition of reimbursable costs can cause problems.
Some costs may be included within the fixed fee which will encourage the contractor to manage these more efficiently.
Fixed price
The client tries to move all of the risk to the contractor at a fixed price based upon bids from many companies.
The contractor is in the position to make a good profit if costs turn out to be a lot less than anticipated but, conversely, could be in a very poor position if things don’t go according to plan.
Because of this, the contractor is highly motivated to manage costs to maximise their profits.
Naturally, this approach could lead to reduced performance or poor quality of the product. Although the aim is too move the risk into the contractor’s camp the client will still be exposed to extra costs if the contractor can reasonably argue that certain unforeseen problems bore legitimate claims for compensation. Particular risks may not be within their control.
This may encourage bids which are too low. Such contractors may try to boost their position with excessive claims for costs.
When trying to negotiate contracts at an early stage in the project, with poorly defined specifications and objectives this can be a greater problem.
It may be better to initiate contracts using the ‘cost plus fixed fee’ in the early stages where the client will bear most of the risk and move to ‘fixed cost’ tendering later as specifications etc become less fluid.
One way to alleviate the problems of fixed cost bids is to request that the contractor clarifies their bid by identifying the ‘expected cost’ of the project and those costs allowed to manage the risks together with any assumptions and comments relating to their perception of the impact of those risks and how they might manage them.
Although the aim is to transfer all risk to the contactor this is clearly not always practical. Those remaining with the client will need clarification.
It is possible to organise a contract that falls between the ‘fixed price’ and the ‘cost plus fixed fee’.
These ‘incentive contracts’ are based upon formulae that consider expected and target project costs and introducing a variable for risk sharing.
Screening
In order for the client to get the best contractor for the job they should have some sort of screening method of potential candidates.
Low costs from contactors may lead to problems with claims for reimbursement cost and reduction of product quality.
- Required expertise
- Reputation for quality work
- Good financial business position
Having assessed the companies on the above criteria the company accepted for the contract should:
- Provide the best cost for uncertain risks and potential claims etc.
- Show confidence in the light of high risks and possible detrimental affects on the company
- Be eager to obtain the contract
- Have a reputation for finishing on time and to a high quality
These features of a contractor may not be enough in the case of a ‘fixed price’ contract if the risk uncertainty is very high.
Fixed price contracts can fuel excessive claims.
Remember that the lowest price is only truly best if all the contractors are on an exactly equal footing which is never the case.
Transferring risk
The danger of transferring risk is the lack of control. The client may transfer it to the contractor and the contractor to a sub-contractor.
The transfer of risk does not mean that the risk has now been avoided. In many cases, the risk is best placed with those people that have the specific expertise to deal with it. The client must still have control mechanisms in place to monitor progress and issues.
Legal advisors may try to move much of the risk elsewhere to reduce the potential of litigation which may not be in the best interest of the project.
In order to bear the risk the contractor must:
- Have a clear idea of the risk definition and the potential impacts.
- Must receive adequate reward for taking it on.
- Be financially sound to bear the consequences should the risk materialise.
- Have the ability to manage the risk in the first place to try to avoid the occurrence or plan for it as a contingency.
Just because a company is willing to bear the risk does not mean that they should. They may be ignorant of the issues involved. This ignorance can lead to low bid prices being submitted.
Naturally, contractors should be allowed the time to ascertain the costs after careful review of the risks involved.
Joint identification of risks between the client and the contractor could be very efficient. A more detailed list should result and understanding will be uniform.
The client wants the tendering process to proceed as fast as possible. So, it will be in the client’s interest to carry out some of the risk assessment to reduce the time for contractors to assess the project and submit a bid.
From the contractor perspective, the presence of risk assessment data puts them all on a level playing field. The ability to carry out the project will not be the only consideration for the contractor.
Others to think about will include:
- The security of the client company
- Payment terms
- Cash flow
- Raising finance and its cost etc.
It seems logical that if the client is able to bear most of the risks then the ‘cost plus fixed fee’ may be more beneficial to the client when dealing with a contractor. If the contractor is best placed to absorb the risks then the ‘fixed price’ method has merits for the client. The client will be trying to reduce costs at the expense of carrying risk while the contractor will be trying to balance maximising profits with the taking on of risks. However, this approach doesn’t always look at the risks in their own right and who is in the best position to manage them.
The exact nature of a contract will depend on this balance of the risk allocated.
If the contractor company is small and the client company large their view of risk within a single project will be biased accordingly. The project may be one of many for the client but be critical to the contractor in terms of the ability to suffer the consequences of risk.