You want to deliver superior project outcomes, on time or early, on budget or below—with all the scope the project called for. You have to rely on outside organisations to provide products and services. What’s your ideal contracting strategy?
[ Listen to audio version, read by David Hodes]
Your investment and costs are your suppliers’ revenues and profits. Every dollar they make is a dollar you spend. How do you spend it wisely?
Essentially, you have two basic choices—time and materials or a fixed price. The first is based on a schedule of rates for the resources and materials you will consume. The second is a lump sum for a defined scope of work. Let’s take a closer look at these two scenarios and their tradeoffs.
Scenario 1 — time and materials: I use an engineer who charges out at $200 per hour; he submits timesheets for the number of hours worked; he is paid $200 for every hour worked. The owner party usually defines the scope of work and estimates how long it will take. A time and materials contract holds the buyer accountable for the payment of all the hours worked and materials consumed.
Scenario 2 — fixed price: I have defined the scope of work I want—for example, replacing an important piece of equipment in my plant. I go to my supplier, detail precisely what is needed and ask them to give me a fixed price to do the work. It’s then up to the supplier to estimate the time and materials required for the job and bid accordingly.
Given that you can’t buy from the same supplier for the same scope of work on two fundamentally different contracting arrangements, which strategy should you adopt? How do we solve the dilemma? What issues arise when adopting one scenario versus the other? What should go into your thinking?
We’ve already stated we want to deliver superior project outcomes. But from a contracting standpoint, what necessary conditions must we satisfy to do so consistently? On the one hand, we must effectively mitigate business risks; on the other, we need to optimise business benefits.
These two ideas do not contradict each other but simply look at the two sides of the coin of superior performance.
Projects, by their nature, are risky endeavours. Many things can go wrong, and we need to mitigate risks. There is, of course, an assumption that we have the capability to develop and manage effective risk plans and that we would never undertake a project that could destroy the organisation in its entirety. It would be better, in that case, to stop and think again.
On the flip side, we achieve superior project performance when we deliver the optimal business benefit from the investment we make in time and money. We don’t do projects for the sake of doing projects; we do them because we are looking for a business outcome. Delivering consistently superior project outcomes thus depends on optimising what the project does for the business.
“Do we really know what goes on in the mind of the supplier?”
Let’s look first at the risk management branch of the argument. Conventional wisdom tells us we can effectively mitigate business risks by establishing a contract based on a fixed-price arrangement. In this way, we have passed the risk on to the supplier, and it is up to them, based on their expertise and appetite for risk, to determine what price they charge for the scope of work we are asking them to perform. We further assume that if we put a competitive tender for the work in place, we will prevent the successful supplier from overpricing their risk into their bid to us.
But, do we really know what goes on in the mind of the supplier? How well do we understand their business conditions? Are they desperate for work and ready to underbid just to keep work coming in the door? Do they suspect we are pretty hopeless at clearly defining scope so that they feel confident raising subsequent variation orders will recover a lowball bid made to knock out the competition?
Why do we assume they are better at managing the risk of the project than we are? What is the effect on us to have a substandard supplier winning the contract on costs when we will wear the long-term consequence of their shoddy work? Procurement might feel they’ve done a great job getting the lowest price, but Operations suffer the enduring consequence.
And, let’s take a closer look at the inevitable arguments that will arise from changes in scope. How good will we be in the heat of project execution in determining the validity of a variation order? What will happen to the project manager as they see their project costs increasing, knowing they will have to explain away these variations all the way to the top. What will it do to the quality of the relationship between the owner and vendor parties if every day brings a new battle as to whether or not an additional payment should be approved? What will happen to the speed of project execution if the supplier becomes wary of doing anything not preapproved before the work contained in the change order can be started?
Now let’s look at the branch of the argument that calls for optimisation of the business benefits. Can this need best be served by engaging in a time and materials contract? Let’s assume, and it’s a big assumption, that we have the means to manage execution risk effectively. It’s an innovation, a way of planning and performing work that is better than any that has come before. It’s a gamechanger in terms of theory, method and tools. Grounded in robust reasoning and backed by a comprehensive and diverse swag of empirical evidence proving that it works.
Let’s also assume that we can convince our suppliers to use this innovation for the planning and performance of their work. This ask is no simple matter; as the saying goes, to change the way they work, they will have to change the way they work. Whatever methods and tools they are habituated into using, they will have to abandon. In contrast to the fixed-price contract, we will demand they be far more tactically flexible to meet the work when and where it arises, according to what is best for the project—not necessarily what is best for their pocketbook.
We will have to respond to their legitimate anxiety that if we can get through the work quicker, without compromising safety or quality, they will, on the face of it, earn less overall. On the other hand, we will need to build trust with our suppliers not to drag their feet as a means of increasing their billable claims. We ourselves will have to live with the idea that we will not always have productive work for everyone to do. Nevertheless, we will pay them for availability, realising the benefit to us of them being precisely where we need them when we need them there. We will be delivering the project and its associated benefits sooner, dwarfing the excess costs.
The way of squaring the circle of our investments and costs being the revenue and profits of our suppliers is to look at the whole project system from above and include in it the complete value chain. Everyone wins when the owner wins big. As my first boss taught me—it’s easy to be generous out of profits. If you know the value of a day on your project regarding investment, costs and margin, you can escape the myopia of focusing only on screwing your suppliers down on cost.
The change from standard thinking to Theory of Constraints (TOC) is both profound and exhilarating. To make it both fun and memorable, we use a business simulation we call The Right Stuff Workshop.
We’d love to run it with you. To learn more:
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