APM Revised Procurement Guide : Chapter 4 Contracting Strategy

4.0 STAGE 3 DEVELOP PACKAGE CONTRACT STRATEGY.

1. Concept & Feasibility 2. Develop Project Procure -ment Strategy 3. Develop Package Contract Strategy 4. Draft Contract & Detail Requirements 5. Select Contractor & Enter Contract 6. Delivery of Requirement & Manage Contract 7. Operate : Deliver Outcomes & Receive Benefits 8. Disposal or Upgrade

This chapter covers the development of the contract strategy for each individual contract package. It is important because research has shown that contract strategy has as large an effect on a contracts success as any technical decision. In pr At a higher level, contract strategy means deciding how the main risks associated with each contract package will be allocated to the parties to that contract and through what mechanisms. As contracts allocate risk, these high level decisions should be made prior to selection of any industry or sector standard conditions of contract and before any subsequent drafting is done. By risk, we mean both : threat, which is a negative risk and if it occurs will have a detrimental effect on the project and / or risk owner; and opportunity, which is a positive risk and if it occurs will have a beneficial effect on the project and / or risk owner. In this incidence, by risk owner we mean the party that bears the consequences, as opposed to manages the risk. If a risk is contracted out to a party, then while they may bear the negative consequences if the threat occurs, they may well gain the positive consequences or benefit either if it does not occur and they have included a contingency in their project sum or if they manage in an opportunity. In a bi-party contract, theoretically risk can be completely allocated to the Client, completely to the Contractor or it can be shared either at a contract level by a pain / gain share mechanism or for a specific risk type by specifying a threshold at which point the risk above this point is transferred. For instance, in construction projects, the contractor takes the risk of adverse weather up to a defined threshold and should therefore allow some contingency. Beyond that threshold, the Client takes the additional risk over and above that point. Before continuing, it is worthwhile considering some principles of risk allocation and sharing as they affect virtually all aspects of this chapter. When allocating or sharing risk consider in order,: 1. if the risk occurs, the effect on the organisations business : for a threat, if it is completely allocated to the contracting party, they will take all the pain. However, they will almost certainly add in a contingency to the Contract sum to partially cover this. The smaller the contracting party is, the larger this contingency is
Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

APM Revised Procurement Guide : Chapter 4 Contracting Strategy

likely to be as it is a larger risk relative to their size. And if the contingency does not cover the cost of the threat then, if the risk occurs they may well devote considerable energy to try and find other ways of re-gaining this money through the contract. This could detract from them focussing on what is important to the client. In extreme cases, they may go bankrupt which means the consequences of the threat will revert back up the contractual chain. 2. who can best influence it happening : On the basis that prevention is better than cure, this principle comes before the next one. Obviously, opportunity wants to be managed in and threat out. By allocating a risk to the party best able to manage it in or out, they become motivated to manage it in or out. 3. for threat, who can best minimise the consequences : by allocating a risk to the party best able to minimise the consequences they are motivated to do so, rather than make the most of the other parties misfortune. 4. clarity over above for minor risks, allocating more frequently occurring minor risks to the contracting party : For minor risks, the first principle does not apply. All other things being equal, the parties are relatively indifferent over who takes minor risks. However, if a minor risk is likely to occur frequently and it is allocated to the client party, there may well be frequent arguments over adjustments to the contract sum. To avoid this, it is best if they are allocated to the contracting party. As these are principles, in the real world there may well be contradictions. For instance, a small specialist software services company may be the best organisations to manage in the opportunity for a critical part of an IT system due to their specialist knowledge, but unable to take the consequences e.g. the full damages if they fail to. Equally, if the client is planning to exploit the system on the open market, they will not wish to allocate the full benefit to the service company. INPUTS The Inputs to this Stage are the outputs of the previous stage, which are used as the starting point for the development of the contract strategy for each contract package or grouping of packages by type. That is the Project Procurement Strategy Document which, as well as giving the overall procurement philosophy and approach for the whole project, includes for each package : its scope the interactions and interdependencies with other packages and proposed responses to manage these and the nature of the relationship sought with the supplier. This is primarily what is developed in this stage.

Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

APM Revised Procurement Guide : Chapter 4 Contracting Strategy

INPUTS
Project Procurement Strategy Document, giving overall approach & summarising for each major package or category of packages :

ACTIVITIES
1. Information Gathering

OUTPUTS

2. Prioritising & Getting Specific

Briefing Document for those drafting contract and detailing the Requirements

Package Scope Interactions & dependencies + proposed responses The Nature of Relation -ship sought

3. Choosing best fit contract strategy

4. Second order risk allocation : Additional risks & thresholds, Use of incentives

5. Means of Redress : warranties, bonds etc

6. Select best fit standard form of contract (if practicable).

Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

APM Revised Procurement Guide : Chapter 4 Contracting Strategy

1. Information Gathering. This stage is predominantly about gathering more detailed information about the contract package and the participants to it. This information is equally valuable for the Stage 5 when selecting the supplier. It is suggested that three inter-related main headings are used to gather information under. Participants Drivers & Constraints : The client organisation needs to be clear about their drivers for the contract as opposed to the project. For instance, the contract may be time driven as it is on the critical path of the project, while the overall project is not or vice versa : the overall project is time driven, but the contract is off the critical path and so is not. In addition, what is the clients attitude to risk versus their desire for certainty. This is different from their ability to take the consequences of a risk. For instance, the public sector mentality is often very risk averse, yet very few organisations have a greater ability to bear risk than the government. Likewise, what are the probable drivers to be for the likely supplier participants ? It is all too easy to say that a supplier is only driven by money. While this is partly true, it is often a simplification : suppliers ultimately want to make profit, but how important is it for them to, for instance : be cash flow positive maintain market share in order to preserve workforce and get return on capital gain market share be willing to sacrifice some short term profit from the contract in order to have a long term profit stream from a client have certainty of profit versus the opportunity to maximise profit if the contract goes well, the opposite of which is making a loss if it does not. This is reflected in their willingness to take contractual ownership of risk. In boom times, this may mean transferring risk to a supplier will carry a high price for a client. In recessionary times, the client may get better value. In some cases, the opposite of a driver is a constraint : i.e. the need to be cash flow neutral, otherwise they cannot do business. However, constraints can take a number of forms. A good high level aide memoire is the acronym PESTLE which stands for : Political : for instance, is there a political imperative to use a UK supplier Economic : for instance, the need for an even spend in successive financial years Social : for instance, the need to ensure local sub-suppliers or labour is used. Technological : for instance, on a large project, there may be a need for common IT management platforms amongst all suppliers. Legal : for instance, in the construction industry, construction contracts have to comply with an act of Parliament with regards to payment and dispute resolution procedures. Environmental : for instance, the need to comply with environmental constraints in a planning application.
Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

APM Revised Procurement Guide : Chapter 4 Contracting Strategy

Strengths & Weaknesses of the Likely Parties principally applies to the parties : commercial ability to bear financial risk. For instance, a 250,000 risk might be a relatively minor risk to a 1 billion turnover company, yet bankrupt a 1 million turnover company. The former might price the risk competitively and as a statistic (similar to an insurance company), while the latter might price it higher in absolute terms as relative to their size it is a large risk. This is despite them potentially being much more entrepreneurial and willing to take on risk. commercial and technical ability to manage different types of risk. Contract specific threats and weaknesses : so far project level risks should have been identified. These may well be high level generic risks which can be developed down to more tangible contract level risks. For instance, in a construction project, unforeseen ground conditions may have been identified as a generic project level risk. In order to gain greater certainty, further investigation might have revealed more detail about the location and type of ground risk and consequence should it occur. Alternatively, they may be specific risks related to that contract and / or its interactions with other parallel contracts. The PESTLE acronym can be used to generate sources of risk. 2. Prioritising & Getting Specific From the mass of information generated from the above, it is important to pick out the key drivers, pertinent strengths and weaknesses and main risks, prioritise in terms of importance and get specific about them. For instance, of all the drivers mentioned by the various stakeholders, which are the important ones for this contract, how precisely are they going to be expressed for this contract i.e. as specific objectives and, if an opportunity, are you going to put extra emphasis on their achievement by incentivising them in a way which matches the contracting parties drivers. Where constraints are identified, they can be challenged and potentially made broader by asking two simple questions : who or what says this has to be constraint ? which identifies the cause; and what would happened if we did not have this constraint ? which identifies the consequences. Generally, the fewer constraints or restrictions on how the contractor can deliver the contract, the more leeway there is for innovation. As a result of this, the important and real constraints are left in, while the less important ones are relaxed, re-expressed or disappear.

Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

APM Revised Procurement Guide : Chapter 4 Contracting Strategy

For all the risks identified, which are the main risks and how precisely will they be expressed and, in accordance with the principles of risk allocation and sharing, allocated under the contract given the likely parties strengths and weaknesses. It could be argued that precisely defining objectives, constraints and risks at this stage is unnecessarily detailed. However, without this precision, then (a) stakeholders and the project team may think they agree, but in reality not and (b) lawyers and technical people who will draft the contract and detail the requirements may define them incorrectly. 3. Choose best fit contracting strategy. Choosing the best fit contract strategy is about selecting the most appropriate big picture risk allocation given the contract objectives, constraints, risks and the strengths and weaknesses of the likely parties to the contract. Below is a diagram which reflects the most likely best fit contracting strategy for the contract.

What Sort of Contracting Strategy ?

High
Design Build Finance Arrangements Joint Ventures

Complexity / Degree of Uncertainty

Partnering Style Contracts - Strategic Alliances : frameworks, outsourcing, partnerships - Project alliances - Target costs contract Input Based Contracts : - Management contracting - cost reimbursable - fee based arrangements Fixed price contracts - activity schedule - lump sums - milestone payments Bill of Quantities

Low

Schedule of Rates

Short

Medium Long TIMESCALE

Permanent

We will now briefly go through each of these contractual arrangements identifying the key features of each, how terminology might vary from industry or sector to sector and when to use them.
Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

APM Revised Procurement Guide : Chapter 4 Contracting Strategy

Schedule of Rates : A schedule of rates is where the client organisation puts together a list of pre-identified services or goods, possibly with quantities against each item, and asks potential contractors to tender against these rates. Once selected, quantities are called off and the contractor is effectively paid quantity multiplied by rate. A Schedule of Rates is typically used where the client can define what they want, but not necessarily the quantity wanted. Often, this is for commodity type goods or services where there are multiple suppliers. Consequently, the client gets value for money by open competition with the supplier being chosen on the lowest total price for the combination of goods or services. A Schedule of Rates can also be used for a longer term call-off contract, perhaps with multiple suppliers : for any given order the client evaluates which supplier will give the best deal and places the order accordingly. Bill of Quantities : A Bill of Quantities is very similar to a Schedule of Rates with the key difference being that the quantity of work is much harder to forecast, so the supplier or contractor gets paid for the quantity of work they have actually done as opposed to that called off by the Client. For instance, in civil engineering, the Bill of Quantities upon which the contractor tenders is an estimate of, for instance, the volume of earth by type that needs to be moved. This volume is re-measured once the work has been done, with the Contractor being paid tendered rate x quantity of work done. The problem with this approach is that the costs to the contractor of doing the work are not solely related to the quantity of work done : method and time taken as well as, in the case of the earthworks example, the ground found and weather can have major effects on the contractors costs. Consequently, the rate charged is often subject to change. Fixed Price Contracts. Fixed Price Contracts are a generic category of contracts based on the establishment of firm legal commitments to complete the required work. A performing contractor is legally obligated to finish the job, no matter how much it costs to complete. Consequently, they should be used only where the client can clearly describe what it is they want, the constraints in which it is developed and the risks for the contractor are small. They are normally used where the contract describes a sub-project in itself. The description of what is wanted can be a fully developed or detailed design or a functional or performance specification leaving the design to the contractor. However it is expressed, the important points are that it is a full and unambiguous description, which is unlikely to change. Likewise with the constraints. Virtually all literature states that if there is likely to be a high degree of change then this is unlikely to be a suitable contracting strategy, as contractors use the lack of visibility in pricing to charge more than the true cost for changes. On the other hand, contractors would argue that because they are priced keenly and planned in detail any change causes delay and disruption costs, which one extensive Canadian study of construction projects found typically amounted to twice as much as the direct costs of the change.
Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

APM Revised Procurement Guide : Chapter 4 Contracting Strategy

Linked to this is the degree of risk retained by the Client : if too much is retained by the client, then as and when it occurs, this will be paid as extra under the contract. However, if uncontrollable risk is transferred to a contractor, then the client may well pay a high risk premium. Consequently, while this method can be used for very complex projects, the important thing is that the Contractor is experienced in this type of work, so the risks are small for him or her. There are several variants on fixed price contracts in terms of how the contractor is paid : Milestones payments where the contractor is paid when he or she has met milestones specified by the client. This has the drawback that the contractor adjusts his programme to get early payment as opposed to minimise costs and, as the milestones are typically high level and do not fully correlate with the programme, provide little transparency of cost for when change occurs. Lump sums are where the contractor breaks the works down into operations and is paid at regular intervals according to percentage completion of each operation. This provides more transparency of cost than milestones as the lump sum operations match the programme. However, each operation is described at quite a high level and arguments do result over the percent of work complete. Earned Value Analysis can be used with this method. Activity Schedules are like lump sums except the contractor only gets paid for completed activities. Consequently, the contractor will break their activity schedule down into more detail than lump sums, which provides greater transparency and better monitoring. It is, however, more work for the tendering contractors. As fixed price contracts are often tendered against functional or performance specifications, the contractor has to do some design or developmental work pre-contract to derive a price to tender. Clients often want to check this work to ensure it complies with their requirements. This is then incorporated into the contract. However, depending on the type of project, doing this design or developmental work to a level where a meaningful price can be tendered can be quite onerous on the tendering contractors. Consequently, some clients ask for outline designs and indicative prices. They then select the best combination and work with the preferred contractor to de-risk the contract package and develop the design to give the client sufficient certainty of what will physically be delivered. As a result, the contractor can price more accurately and the client gets a more sharply priced contract to enter into. This is called a Preferred Contractor route. Unfortunately, once a preferred contractor is chosen, even though the client has the option of going to another contractor, as time progresses the client becomes increasingly tied into using this contractor and this is can be exploited. Consequently, this approach is usually used by repeat order clients with a small group of favoured contractors, where there is a longer term overarching commercial relationship.
Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

APM Revised Procurement Guide : Chapter 4 Contracting Strategy

Turnkey contracts are usually let as fixed price contracts. A Turnkey contract is a comprehensive contract in which the contractor is responsible for the complete supply of a facility, usually with responsibility for fitness for purpose, training operators, precommissioning and commissioning. It usually has a fixed completion date, a fixed price and guaranteed performance levels. Partnering Style Contracts. Partnering is defined as an arrangement between two or more organisations to manage a contract between them cooperatively, as distinct from a legally established partnership. While partnering can be done under other previously mentioned contracting strategies, certain strategies lend themselves to this approach due to way in which they provide cost transparency and align commercial objectives. Under these arrangements the primary means of re-imbursing the contractor is through direct payment of their costs, plus a fee of some sort for head office overheads and normal profit. To be re-imbursed the contractor has to be able show his costs, hence the cost transparency. The commercial alignment comes from a meaningful target being established around which savings and over runs of cost plus fee are shared. This is often referred to as a pain / gain share mechanism and creates the incentive for both parties to work together to minimise costs. Essentially this means that there needs to be sufficient scope within the requirements to take out cost either through managing out threat or managing in opportunity through joint working. In other words, there is little point in using this type of contracts for a fully defined and detailed requirement where the client is not going to contribute. There are a number of types of contracting arrangements which reflect the scope for cooperation and innovation. Target Cost Contracts : are between two parties, where a contract target price is agreed, tendered, negotiated or built up on an open book basis. This target essentially comprises the contractors costs, an allowance for the risks included within the target and their fee. The pain / gain share operates around this target. During the contract, the target is adjusted for pre-defined reasons normally to do with the client changing something, not doing something which they are contractually obligated to do (which would otherwise be a breach of contract) or a limited number of third party events over which the contractor has no control. A specific type of target cost contract is the Guaranteed Maximum Price (GMP) Contract. The essential difference is that at some point, often the target, the clients share of any over-run is capped, so the contractor takes all the pain beyond this point. In addition, the reasons for adjusting the target are often reduced to the legal minimum.
Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

APM Revised Procurement Guide : Chapter 4 Contracting Strategy

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Project Alliances typically have the following characteristics compared with target cost contracts : There are more than two parties tied into the alliance incentive mechanism. There is usually a courting phase where the parties work together at cost to develop a sufficiently robust requirement and hence alliance target, whereby all are comfortable in entering into it. Note though that if the requirement is over developed it defeats the point of entering into an alliance. This alliance target is much more extensive in its coverage, including almost all risks normally borne by the client as well as their project related costs e.g. of management and, in construction, land take etc.. Note : the costs of auditing the parties accounts are usually excluded from the alliance costs for obvious reasons. As a result of the previous two points, the reasons for adjusting the alliance target are far fewer than under a target cost contract. The Early Contractor Involvement (ECI) contracting strategy is a half way house between target cost contract approach and full project alliance. Here the Contractor works at cost with the client to develop the requirement to a point where it can be priced. At this point a target cost contract is entered into, but with the contractor taking responsibility for the current design i.e. under a target cost contract, if there is an error in the requirement, the client corrects it and the target is adjusted. Under ECI, the cost of any error is included within the target creating greater commercial alignment. Prime Contracting is similar to the ECI route with two developments : a greater emphasis on collaborative working down the supply chain, who are incentivised, and a fitness for purpose liability. In this sense, while the contractor is paid on an open book basis with pain / gain share, their liabilities are closer to the Turnkey contract model. Strategic Alliances take two main forms : Project based frameworks whereby a client enters into a framework agreement or contract to use the contractor for projects of a certain type over a period of time, although almost all agreements have a non-exclusivity clause whereby the client does not have to use the contractor. Indeed most clients keep their options open by having a number of contractors in any framework. This is both to promote some competition and avoid becoming dependent on one supplier. While the early projects may be defined enough to price, later ones will need development before a meaningful price can be agreed. As each project matures, a contract is let. Often this contract is let under one of the previous partnering style arrangements i.e. a target cost or project alliance. This arrangement includes the following advantages : it avoids the need to continually go out to the market; the need for a contractor to continually do a full tender on a speculative basis; allows the contractor to invest longer term as there is greater likelihood of future work; if programmed correctly, allows for continuity of use of resources as opposed to de-mobilising, doing nothing and re-mobilising; and allows for continuous improvement as learnings from one project are taken
Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

APM Revised Procurement Guide : Chapter 4 Contracting Strategy

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from one project and utilised in subsequent ones. All of these can result in progressive and sustained improvements in projects in terms of time, cost and fitness for purpose. However, there is a danger of complacency creeping into a relationship where a single contractor has all the work. Consequently, most clients have a number of framework contractors for a specific type of work, benchmark performance against each other and reward the higher performing ones with a greater share of the work. Term Service or Strategic Outsourcing arrangements, whereby a level of service is stated as a requirement. This could be for maintenance of an asset e.g. a road or building or for an IT based service. This could be delivered under a Schedule of Rates or Fixed Price contract, with a reason for termination being that performance falls below a certain level. What makes this a strategic alliance is : o whatever the service is, it is normally stated as a performance and / or functional requirement in order to allow for continual improvement in how it is delivered with both parties being able to contribute to the improvements. o the nature of the service operated tends to be strategic or business critical to the client organisation o the improvements can be in cost savings which are shared by a pain / gain formula and / or in measures around the quality of service against which incentive payments are paid.

Input based Arrangements Input based arrangements are where the Contractor is reimbursed their costs plus an allowance for his head office overheads and profit. They therefore rely on trust to operate effectively. The main drawback of all these arrangements is the lack of a direct contractual incentive to reduce costs. It was mainly for this reason that the target cost and project alliancing arrangements were developed. There are three main arrangements : Fee based arrangements whereby the contractor or service provider provides details of their fee per unit of time at the start of the arrangement. Within agreed parameters, they are then paid the quantity of time used multiplied by the rates. This arrangement is often used at the start of a project where poor decisions made or work done up front can have a large effect later on. Consequently, it is not worthwhile skimping on this stage. Having said this, many professional appointments are also made on this basis for the management of projects e.g. in construction management a contractor is appointed as a professional to manage the construction of the works with all the works contracts being direct with the client. This does, however, call for strong project leadership from the client. In other sectors, this role is sometimes referred to as that of the Project Integrator.

Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

APM Revised Procurement Guide : Chapter 4 Contracting Strategy

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Cost reimbursable contracts whereby the contractor does work at cost which could be both management and doing the project - and provided he or she can show that these costs were incurred in providing the asset or service, he or she is paid this cost plus a tendered fee. This can be a fixed fee or a percentage fee applied to the costs incurred. This arrangement tends to be used where there is an existing commercial relationship and time or quality driven work emerges, often with significant risks. For instance, in emergency work, it avoids the need for a requirement to be fully developed and then priced by the contractor, including for unknown or unquantifiable risk. Instead, they are appointed quickly and start work quickly. Management based contracts, whereby the main contractor only manages the work, much like a construction manager or Integrator. The difference is that all the works contracts are let through the contractor as opposed to directly with the client. This gives a harder contract as the management contractor has a fitness for purpose liability to deliver, as opposed to a reasonable skill and care liability and can have damages levied for late delivery. The downside is that the requirement has to be developed more for this fit for purpose liability and delivery date to be established. As the contractor now has commercial liabilities, he or she potentially has a position to defend which undermines their professional incentive to work in the best interests of the client. For instance, if the project is running late, there is an incentive to spend the clients money to avoid late delivery damages. Equally, if the client introduces a change, there is now a potential motivation to exaggerate the amount of additional time needed to cover up for other delays for which the contractor would pay damages.

A Joint Venture (JV) is a contractual arrangement in which resources are combined be they equipment, expertise or finance by two or more participants with a view to carrying out a common purpose. This typically takes one of the following forms : a consortium agreement. a limited liability company a partnership or a limited partnership (whereby the partners liability is limited). Another subtlety is whether they are : a vertical joint venture. For instance, a local authority and term services contractor would normally be in a more traditional client / contractor arrangement. Instead, in one arrangement, they formed a joint venture to both carry out this work and seek out extra work within that county for other clients. The profits were split by their respective share ownership. a horizontal joint venture whereby two or more parties to come together to jointly pursue and realise an opportunity which neither could pursue on their own. More specific reasons for forming a joint venture could include a combination of :
Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

APM Revised Procurement Guide : Chapter 4 Contracting Strategy

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Limitation of risk, whereby neither party could bear or wishes to bear the entire consequences of the downside risk on their own. Pooling of resources, either because the opportunity is too big for only one party (almost the opposite of limiting risk) or because they have complimentary expertise : neither party could deliver the opportunity without the other. Access to market, particularly for work in overseas jurisdictions, where a foreign contractor may have to form a joint venture with a local contractor. However, it could also be that one partner is already well established in that sector. A more integrated approach through eliminating contractual interfaces

The main disadvantages of a joint venture approach is the cost and risk of setting up one, meaning that the size of the opportunity has to be worthwhile this cost. The cost not only includes the legal costs, but also being clear about the commercial reasons and scope of the arrangement, the strategic direction and management of it once established, as well as the day to day integration of systems and cultures once it is place. There is a significant risk the joint venture may fail. Often Joint Ventures are formed to bid for the contractual approaches outlined below. Build, Own, Operate, Transfer (BOOT) contracts are where the client has a requirement for something to be supplied to them and this requires a specialist facility to be built. For instance, the client may require energy to be provided to a remote production facility close to the base resource. They therefore want a specialist energy company to take full responsibility for the building and operating of the asset, so they initially own it, but after a set period of time ownership is transferred. Typically, this is paid for as a combination of a lump sum for setting up the facility and as a Schedule of Rates / Bill of Quantities for delivery of each unit of, in this instance, power. Design, Build, Finance & Operate (DBFO) contracts are often, when the client is the public sector, known as Private Finance Initiative (PFI) contracts or more recently Public Private Partnerships (although this can include a number of other arrangements both informal and formal e.g. joint ventures). The main difference is that, such is the size of the project, that a financing organisation such as a bank, needs to be part of the Joint Venture. The project part of these contracts is design and implementation of a new or improved asset, service or system which is funded by the contracting organisation. The build part comes from their original use for construction projects. Once the asset is in operation, the client pays the contracting organisation for its operation, often with a large part of this payment based on performance. E.g. for a non-toll road, it may be percentage time that all lanes can be used and average traffic speed. These payments both service and progressively pay off the debt with an allowance for profit. If performance slips too much for a period of time, then the client can take over the asset. Often, built into the contract is a requirement to improve the asset towards the end of the operate part contract before ownership reverts to the client.

Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

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The typical contractual structure of such as deal is shown below.

PFI&PPP
Whatdoesitlooklikecontractually?
Prin cipal / Con cessionaire

Concession Agre ement Supp liers Supply Contract Off take Contract Use rs

Len ders

Loan Agre ement

Promoter

Ope ration Contract

Ope rator

Inve stors

Shareholder Agre ements

Construc tion Contract

Con stru ctor

The main advantage of this approach is the focus of the contract on performance or the capability it gives the client or even the benefits it delivers for them and, within this broad frame, the allocation of risk to the party best able to manage it. There are essentially 3 types of PFI deal : Pure PFI : which are normally commercially viable without financial support, sometimes identified & promoted by concession company e.g. Channel Tunnel Rail Link. Part PFI : which are not commercially viable on own, so sweeteners, such as existing assets are included in deal. For instance, in the second Severn crossing, the bridge was handed over to the concessionaire for them to derive income from both during construction and afterwards. Likewise Public Private Partnerships : where government holds a competition and selects a Concession company to run a service on its behalf or for it and pays the company for doing it. Being cynical, one could say that they were an attempt to re-branded the PFI projects with a more politically acceptable name. However, often they function as outsourced services, where the quality of the outputs from

Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

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the concession company are partially dependent on the inputs coming in from government client. i.e. there is greater interdependency between the two parties. The main drawbacks of the approach include ; The cost of setting up such an arrangement I.e. for a whole life cost of less than 20million it is almost certainly is not worthwhile. The performance required, capability required or benefits wanted must be tangible enough to be specified as a contractual requirement which can be measured and paid against. In addition, however these criteria are expressed, they must be sufficiently long lasting to be valid for the duration of the operate part. For instance, the purpose of a road may well stay the same for a 25 year concession, but for a hospital, the purpose, range of functions and demand for them for that duration will vary enormously. Consequently, change will occur for which (a) the contractor will want payment and (b) will mean the original criteria against which they are paid may become both invalid and / or unobtainable due to these changes.

Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

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4. Second Order Risk Allocation Having selected the primary risk allocation by choosing the best fit contracting strategy, the next step is to fine tune the contracting strategy by decide on : what risks are excluded from the contract sum and would cause an adjustment to it. In some instances this means defining thresholds. For instance, in construction contracts, this could be the level of rainfall in a particular month. the degree to which the Contractor will be incentivised to meet the contractual level of performance and exceed it if desired. 4a. Additional Risk and Thresholds. By deciding which risks will cause an adjustment to the contractual sum, you are, by default, deciding which risks will not. Having identified these risks and assessed them in terms of likelihood and impact, they need to be defined precisely and allocated or shared in accordance with the principles identified in the introduction to this chapter. A common issue which arises is the deletion (from standard forms) or non-inclusion of clauses that cause adjustments due to breaches of contract by the client or his representatives. This is pointless. Not having such a mechanism potentially leads to the contractor suing or claiming for breach of contract on completion of the contract for additional money and time. It could mean time for completion becomes at large. As well as the uncertainty, it is much more expensive and time consuming than managing and agreeing these changes through the conditions of contract as the contract progresses. Linked to this, is the importance of having clauses which allow for changed circumstances whilst the contract is being delivered e.g. changes to the Requirement whether in scope or upgrading its performance. Failure to have these will either result in the contractor refusing to do the work and the asset potentially not being fit for purpose or the contractor being able to hold the client to ransom by re-negotiating the contract on his terms. During the contract, discipline needs to be exercised in only instigating essential changes ! Lastly, 3rd party or uncontrollable risks for which the client will take some or all of the risk need to be identified and defined. These fall into two camps : Unlikely, but high impact risks : These are allocated on the basis of who can best bear the consequences, which will typically be the financially stronger party. For instance, the risk of a third party striking which eventually has an impact on the works. Frequently occurring, but minor impact risks where the issue is the cumulative impact of them occurring. For instance, if a contractor is working on a live asset such as a railway, where he or she has to stop frequently for trains to pass, but exactly how often and when cannot be defined. Inflation is another example. For the former, the risk transfer threshold may be set, for example, whereby the contractor takes the risk of the first week of any delay caused by the strike. For the latter, it may be decided that the contractor takes the risk of X stoppages of up to Y
Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

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minutes per month which is set a little above the normal amount to be expected. Above this point, the client takes the risk. 4b. Use of Incentives. Incentives can be either set negatively in the form of liquidated damages or pain or positively in the form of bonus or gain share. More often, only damages are used. A prerequisite for the use of incentives is that the level of performance, be it time, efficiency improvements, service level, cost savings etc. can be measured or described unambiguously. Another pre-requisite is more common sense : achieving the desired level of performance has to be within the control or at least significant influence of the party upon which the incentive is set. This leads us back to the principles of risk allocation and sharing in introduction to this chapter. The most common form of damages are for late delivery (delay damages), but can also be for performance below the level stated in the contract. (For performance damages to apply, the Requirement has to be stated as a performance specification.) If the quantum of damages per unit time or unit of performance are not stated in the contract, then the client can claim for the true cost, both direct and consequential, of this lack of attainment. This can be an expensive legal process and some contractors refuse to tender on work unless damages are stated. For this reason, it is normal practice to state the time related damages in the contract. For the majority of the world, with the notable exception of the USA, the level of damages cannot exceed a genuine preestimate of likely loss at the time that the contract comes into existence, otherwise they can be legally challenged as a penalty. The upshot of stating the level of damages is to state the maximum liabilities which can fall on the contracting party, which reflects the parties ability to bear risk and the premium the client is willing to pay for risk transfer. Typical limitations on liabilities include : maximum time related damages payable; maximum performance related damages payable; maximum liability for indirect or consequential loss; maximum liability for damage to clients property; maximum liability for design defects (if the contractor is responsible for design); and maximum total liability. The last form of negative incentive only applies to those where there is a pain share / gain share mechanism for cost i.e. the contractor bears a share of the pain under partnering style contracts. While some clients chose to cap their own liability for any over run through use of Guaranteed Maximum Price (GMP) contracts, others choose to go the other way, where they cap or more often considerably reduce the contractors share of any large over run. This typically happens on big contracts with a financially strong client (both relative to the contractor), where the contractor cannot bear the financial consequences of a contract that has gone significantly wrong. The other side of the coin to damages is bonuses, which are generally paid for performance above that stated in the contract or occasionally for meeting it e.g. the opening date of a venue which cannot slip. Obviously, it is only worthwhile specifying bonuses if the increase in performance is of benefit to the client. Equally obvious, the
Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

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client does not give all the benefit to the contractor as then none is left for the client ! However, it does have to be set at a level that makes it worthwhile for contractor to pursue. Bonus are not used as much damages in the UK. In the USA, they are used much more widely and research has found that a well thought out incentive plan stimulates superior contractual performance, whereas use of damages alone has negligible or even detrimental effect on project performance. Psychologically, this is because : it is always in both parties interests to strive for bonus payments. Consequently, even when difficulties are encountered, people continue working together to try and achieve them, whereas, when it becomes evident that the contractually defined level of performance is unlikely to be met, the contractor tries to put blame on the client in order to avoid paying the damages. The client tries to put this blame back on the contractor. Our view is that incentives should be used be more widely to stimulate superior contractual performance. With the expected rise in benefits contracting, we expect their use to rise in any case, as in complex situations with interdependent contractual obligations, it will be hard to show that the client no responsibility for the under performance of the contract and therefore hard for them to enforce damages. Consequently, basic contractual performance levels with be set low, with performance above this contractual minimum rewarded with bonuses. The last form of bonus is the sharing of gain under partnering style contracts. A note of caution though : if these gains are made entirely through the efforts of the contracting parties without, for instance, the collaboration of the client under target cost arrangement, then this may be viewed as lost profit by the contractor. Consequently, the initial target cost will be set higher by the contractor to make up for this loss of profit.

Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

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5. Means of Redress This section covers retention, guaranties, warranties, and, applicable if you are in the United Kingdom, The Contracts (rights of third parties) Act 1999. Essentially all are means of redress for under performance of the contract by the contractor or a subcontractor or sub-supplier. Retention is where a part of each payment is retained as the contract progresses in order to ensure satisfactory performance or completion of contract terms. Typically this is 3 to 5% of each payment. Once the contractor has completed the works, then half of this usually paid back and, following a period in which the contractor has to maintain the works (typically 1 year), the remainder is paid back minus the cost to the client of correcting any outstanding defects, which the contractor should have corrected. Its purpose therefore is to ensure that the contractor completes the works; that it has minimal defects in it; that if there are any, he or she will make a return visit to correct them; and if they do not, the client has some money to correct the defects themselves. The downside of applying retention is that it detracts from the cash flow of the contractor and he or she has to finance this cost. Consequently, they include this financing cost in their contract price. As a result, where there is an overarching repeat order commercial arrangement, more enlightened clients have stopped this practice. At the other end of the spectrum, some clients and contractors with their subcontractors - have abused the retention system so much, in terms of holding on to cash, that some contractors price on the basis that they will not get retention back at all. In addition, the sums retained after the works have been completed may not be enough to cover major defects in the work, leading to legal proceedings which having retention was intended to avoid. Guarantees are a legally enforceable assurance of performance of a contract by a supplier or contractor. Typically, a third party to the client and contractor provide a guarantee as to the performance of the contractor under the contract. Should the contractor not perform or refuse to rectify their lack of performance, then this third party guarantees to pay for the costs associated up to the point required under the contract. An independent party is normally required to witness the signing of a guarantee for it be legally effective and, should the need arise, (another) independent party is normally required to confirm non-compliance and that it is due to the contractor. The two most common forms of bond or guarantee are : Parent company guarantee : While the advantage of this is that payment from the contractor to take out this guarantee is likely to be minimal or non-existent compared with taking out a bond (see below), it is unlikely that this third party is independent both in mindset and / or finances. Consequently, in a dispute over who is liable for the lack of performance, the guarantor is likely to listen to and take the side of the contractor and be hesitant to pay out. Financially, if the

Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

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contractor defaults due to financial pressures from their parent company e.g. it goes into administration, then the parent company is unlikely to be able fulfil the guarantee. A Bond from a bank or other financial institution : The advantage of this over the parent company guarantee is that the financial institution is more independent and supposedly financially stronger (although at the time of writing in the credit crunch of 2009, this is arguably not the case). Consequently, they are more willing and able to pay if called upon to do so. The disadvantage is that the contractor has to pay for this bond and that cost is added onto the contract price which the client will pay.

A Warranty, in this context, is a promise given by a contractor to the client or owner regarding the nature, usefulness or condition of the supplies or services delivered under the contract, usually at a level set above that required under Statutory Law, with the remedy being damages payable. Two common forms are : A warrant for fitness for purpose : as a designer providing a service, under Statute Law, the consultant designer has to excise reasonable skill and care of the average professional. Providing he can demonstrate this, he should not be liable for damages if what he designs does fulfil its purpose due to the design. If the client insists on and the consultant signs a contract warranting fitness for purpose, then the consultant will be liable. Collateral warranties : Historically, the doctrine of privity of contract generally means that a contract cannot confer rights or impose obligations on any person who is not party to that contract (except by tort of contract, whereby a duty of care has to be shown to exist and negligence then proved). Collateral warranties create a relationship between parties who are not in contract with each other and normally last for 12 years from date of completion of the contract. For instance, a client has a new asset built, with various parts designed, supplied and installed by specialist subcontractors to the main contractor e.g. heating, cooling and ventilation. Should they not work, with a collateral warranty, the client can deal directly with the original supplier, who if they do not remedy the situation is liable for damages, as opposed to via the contractor who may not be that bothered or even in existence any more.

The downside to warranties is that for a large project with many sub-contractors and suppliers to the main contractor is, a myriad of additional contract terms are created all of which add complexity and cost (for lawyers to draft them). For this last reason, in the UK, The Contracts (Rights of Third Parties) Act 1999 was published. This allows a party who is not one under the contract to enforce a term of the contract if the contract expressly states that they may or a term confers a benefit on them. For instance, as a property developer who has the intention to sell on a completed building to an occupier, it allows that occupier to enforce the developers contractual rights on the contractor.

Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

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However, if as a contractor, you enter a contract with a government organisation where the beneficiaries are the general public, you could then find members of the public demanding their rights ! This would be costly and the client would pay as a result for this risk transfer. As a result of protests at the drafting stage of the act, it allows the parties to a contract to opt out of it, either be expressly stating which terms are not subject to the act or by stating a blanket opt out, with, if desired, expressly stating which terms are subject to the act and who can enforce them. Given this, a well drafted schedule of rights for third parties becomes much simpler and cheaper to put in place as an alternative to a myriad of interconnecting collateral warranties. 6. Choose best fit standard conditions of contract if applicable. In many engineering and construction sectors there are standard forms already published, often by an industry body 1, which cover many of the main contracting strategies and other aspects discussed in this chapter. The advantages of using a standard form include : They have already been written. Consequently, the client does not need to spend time and money having them drafted from scratch. They have, in theory, evolved and been fine tuned over time to take out ambiguities and inconsistencies which cause dispute. Where this is not the case, case law may exist to confirm their legal interpretation. Familiarity amongst practitioners with both their interpretation and the procedures needed to operate them. In some cases, this may mean a better the devil you know state of mind that a good contract ! The contra preferentum or constructor against the grantor rule will not apply to the standard terms. This rule means that when there is an ambiguity or inconsistency in the contract e.g. where there are two ways in which a term could reasonably be interpreted, then the interpretation most favourable to the party who did not draft it is taken. In standard conditions, neither party wrote them so this does not apply.

Consequently, where practicable, it is advisable to use a standard form. However, when this is so, it is likely that some fine tuning will be required and this is where the drafting team in the next stage need to be briefed and managed properly.

For instance in the chemical industry, there is the IChemE family of forms; in the heavy engineering industry, the MF series; in building the JCT family and in civil engineering, the ICE contracts; with the NEC3 family being sufficiently flexible to apply to all the previously mentioned sectors.
Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org

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OUTPUTS The output from this stage should be, for each package or grouping of packages by type, a briefing document for the contract drafters and those who will detail the requirements. For the drafting team, it should tell them : the best fit contracting strategy together with any nuances or alterations not detailed below. e.g. what and how exactly the contractor is to be paid, the testing regime etc. which form of contract to use (if applicable); the means of redress to be specified for what default and the quantum against each; what (additional) risks are allocated to the client and which are retained by the contractor and if already derived, the precise wording to be used; the extent of any pain / gain share (if applicable); the type and level of incentives, whether expressed as bonuses or damages, to be used and what measures they are payable against. For all of these factors, a note should be made of why the decisions were arrived at. This document should also be written in plain enough English for the more technical orientated people who will write the Requirements. They will also need to know : Key terminology to be used e.g. in more tradition construction contracts the key clients person was the Engineer or Architect. These were replaced with the Project Manager and Supervisor in the New Engineering Contract (NEC). When this started to be used instead, many contract documents still referred to the Engineer or Architect who do not exist in the NEC. The Scope of the Requirement and how it is to be expressed e.g. as a performance / functional specification or fully designed. This includes how it will fit in with what is already there e.g. what the Contractor can expect to find in terms of existing facilities; how a processing plant links in with existing processing capabilities; what outputs from other IT processes are the inputs to the new one etc.. constraints or boundaries on how the contractor can fulfil the Requirements e.g. in construction, hours of working, maximum noise levels, permissible access etc.

Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG, Association for Project Management, 2009 for publication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose. Please send comments to either jon@leadingedgecc.co.uk or post on the C&P Wiki at apmcandpsig.org