How to incentivise your supply chain to deliver the outcomes you seek

19 June

Below is an edited version of the presentation that Owen delivered at the Society of Construction Law Australia’s 2024 conference

Project owners are routinely disappointed with the outcomes they achieve on their construction contracts. You have all seen the statistics on the average cost and time performance of large construction projects. The problem is not unique to Australia — it’s a global phenomenon.

Many papers and books have been written on the root causes of this situation and what project owners and other project participants can do to improve the situation, so it’s difficult to offer a useful perspective that hasn’t been offered before. But my long career as a lawyer responsible for creating the contracts by which major projects have been delivered gives me a perspective that other industry participants and commentators don’t have, so I’m grateful to the conference organising committee for giving me the opportunity to share my perspective with you.

I’m cognizant, however, that I may not have picked the most receptive audience. The disappointment of project owners and other project participants has generated many construction disputes, creating a livelihood for many people in this room. Consequently, many of us are conflicted when it comes to addressing the underlying causes of the situation. Putting the interests of the industry ahead of our own is challenging when you have a mortgage to pay and kids to feed and educate.

But the reality of self-interest — of people putting their own interests ahead of others — is not all bad. It’s a law of nature that, once recognised and accepted, can be harnessed for good. We just need to accept the law of self-interest for what it is and learn how to harness it for the benefit of all project participants. The balance of this article will explain how project owners can use the law of self-interest to get their supply chain to deliver the outcomes they want.

Commercial entities exist to make profit

Commercial entities exist to make a profit for their owners. This is a fundamental truth or a law of economics. They are not charities, and their true purpose is not found in their statement of corporate values.

Being good corporate citizens with a social licence to operate is simply a means to an end. It’s the means by which they can achieve their real purpose, and that is to generate a reasonable profit for their owners. You can’t generate a profit selling widgets unless you have staff to make them and customers who want to buy them from you.

Employee benefit schemes and the like are not about sharing the wealth. They are about attracting and retaining the labour needed to make the widgets.

The same applies to corporate social responsibility and ESG programmes. While these programmes express a commitment to sustainable practices, ethical conduct, and contributing positively to communities, they do these things because they are now prerequisites to securing the social licence needed to continue making the widgets that generate the profit.

We like to think that good commercial entities do these things purely because it’s the right thing to do, but the reality is that they do it to fulfill their real purpose — to generate profit and create wealth for their owners.

Although there are lots of commercial entities within the construction sector that tell us their purpose is something like creating sustainable built environments that enhance the quality of life for communities, they say such things because they believe it will attract customers and staff, and thereby sustain or increase the profit and wealth they generate for their owners.

The profit motive is primary, and all these other things that customers, staff and communities want to hear are secondary — they are only done to the extent they have a positive impact, rather than negative impact, on the primary objective.

Project owners who expect their contractors, consultants and suppliers to subordinate their self-interest in generating a profit, in order to put the interests of the project first, are commercially naïve. They are living in fantasy land and need to return to the real world.

Commercially astute project owners understand that their supply chain is primarily motivated by profit, and they use this fundamental rule — the law of self-interest — to their advantage. They do this by abandoning fixed or lump sum prices for work and replacing these with pricing models link the amount of profit that a supplier generates from the work to how well the project performs against the outcomes that the project owner is seeking.

Lump sum prices don’t align interests

The fundamental problem with a lump sum price for a defined scope of work is that it fails to align the profit-making objective of the supplier with the various objectives of the project owner.

A project owner’s objectives usually revolve around the project's cost, time, and quality outcomes. Other objectives for project owners can include environmental sustainability, stakeholder satisfaction, social license, local industry participation, and other social objectives.

The objectives of the non-owner participants are much more straightforward. As commercial entities, their primary objective is, as I have already explained, to maximise their profit margin, or at least make a reasonable profit margin, on the work they perform on the project. A non-owner participant may also have secondary objectives, such as pleasing its customer with a view to obtaining further work, but not if doing so means it won’t generate a reasonable profit margin on the work it performs.

The project owner sets about optimising the project outcomes against its numerous objectives by including minimum requirements in each scope of work, and then putting contracts out to tender with a statement of its project objectives. It then relies on competitive tension to deliver it offers that seek to optimise against the price, time, quality and social objectives that the owner is seeking.

Once a lump sum contract is signed, the non-owner participant sets about achieving its primary objective by delivering what it promised for the minimum cost. It is against the non-owner participant’s interest to spend any more than the minimum needed to fulfill its contract obligations because every extra dollar that it spends reduces its profit by one dollar. If it spends more to improve quality, finish earlier, or improve social license, thereby doing what's best-for-project, it is penalised with a lower profit margin. Why would it do that? Doing what's best-for-project is contrary to the law of self-interest.

Similarly, if a problem occurs during construction that could be easily fixed by having the contractor do some corrective or extra work, but the contractor has an opportunity to blame another participant and have them bear the cost of fixing or overcoming the problem, then the law of self-interest will drive the contractor to the solution that's best-for-them rather than the one that's best-for-project. This is why we have the blame game on almost every project.

It never ceases to amaze me how many project owners fail to grasp this basic commercial rule. They continue to assume that tightly drafted contractual obligations will overcome the law of self-interest. Consequently, they continue to be routinely disappointed with the outcomes they achieve on their construction contracts — as the statistics on construction project cost, time and benefit realisation outcomes reveal.

A better way — at the project level

As stated earlier, commercially astute project owners understand that their supply chain is primarily motivated by profit, and they use the law of self-interest to their advantage. They do this by abandoning lump sum prices for work and replacing these with pricing models that link the amount of profit that a supplier generates from the work to how well the project performs against the owner’s desired outcomes.

The basic pricing model that they use will be familiar to those of you who experienced project alliancing in its pure form before government treasury departments started changing it. It has three limbs:

Limb 1 (cost reimbursement): The owner reimburses all direct costs incurred by each non-owner participant in carrying out the project;
Limb 2 (fee): The owner pays each non-owner participant a fee on account of profit and contribution to corporate overheads for business-as usual (BAU) performance of the relevant non-owner participant’s share of the scope; and
Limb 3 (gainshare/painshare): The owner pays a gainshare payment to each non-owner participant if the project outcomes against pre-agreed KPIs are better than BAU. Or each non-owner participant pays a painshare payment to the owner if the project outcomes are worse than BAU.

Importantly, the gainshare payment, when added to the limb-2 fee, enables each non-owner participant to earn a better than BAU profit margin if the project performs well. Conversely, a painshare payment, when deducted from the limb-2 fee, reduces each non-owner participant’s profit margin if the project performs poorly. This arrangement enables the law of self-interest to work for the project owner. The non-owner participants can achieve their objective of maximising their profit margin, but only by optimising project outcomes against the project owner’s objectives.

Under this model, the KPIs used to measure performance should be based on whole-of-project outcomes, rather than how well a particular non-owner participant performs its part of the scope. Whole-of-project KPIs encourage each non-owner participant to do what’s best for the whole project, rather than what’s best for its part of the scope. Good performance by one participant is no good for the project owner if it ends up delaying or disrupting other project participants and the project as a whole.

Whole-of-project KPIs, rather than package-specific KPIs, also encourage greater cooperation between the project participants, as doing what’s best for the project will result in a higher profit margin for each participant than doing what’s best for them.

The final point I’d like to make about this pricing model is that the gainshare payment is not solely funded from cost savings against the target cost. It is also funded from the additional value that the project owner expects to receive if a better than BAU outcome is achieved against a non-cost KPI. It is this last point that differentiates the 3-limb project alliance payment model from that being used in modern Incentivised Target Cost contracts in the Australian market, where the gainshare payment is solely funded from cost savings.

The key problem with the Incentivised Target Cost arrangement is that the cost outcome trumps everything else. If the project participants shoot the lights out on every non-cost KPI, creating significant additional value for the owner, but fail to bring the project in under budget, the non-owner participants get no uplift to their BAU profit margin. Indeed, if the project is slightly over budget, their profit margin falls even if the additional value created for the owner exceeds the cost overrun. In short, most Incentivised Target Cost contracts fail to adequately capture the trade-offs between cost and non-cost outcomes.

There’s plenty more I could say about the missed opportunities in Incentivised Target Cost contracts, and the counter-productive levels of complication that lawyers are building into them, but I’ll save that for another day.

A better way — over the longer term

Let’s now consider how project owners could really shift the dial on the value they get from their construction supply chain.

In a nutshell, it involves taking a longer-term view.

It’s rare in the Australian construction sector for a project owner to look for opportunities to improve value over a timeframe longer than a single project. The focus of most project owners is on optimising value for money on a project-by-project basis.

Responsibility for key decisions during the project planning and delivery phases (or for developing the recommendations that support these decisions) often falls on the owner’s project director, whose performance will be assessed based on the project’s outcomes.

While this framework can generate ‘best for project’ decisions, opportunities for the owner to optimise value for money on its capital works pipeline over the longer term are overlooked.

Consequently, project owners have a massive opportunity to improve value by removing their project-focused blinkers and expanding their thinking to supply chain initiatives that will improve value over their longer-term project portfolio.

There is growing evidence, both within Australia and internationally, that the best way to achieve this is for project owners to establish long-term multi-party collaboration contracts with their preferred contractors and consultants. These contracts provide a framework and incentives that reward initiatives that deliver improved value to the project owner beyond any single project. Some noteworthy examples are mentioned in the appendix.

In Europe, such contracts are referred to as framework alliance contracts. In the Australian context, I consider a more appropriate label to be a “strategic collaboration contract”.

The key features of these contracts are:

They are long-term in nature, enduring beyond any single project.
They incentivise investment in strategies that deliver improved value to the owner over the longer term, such as greater digitisation, modern methods of construction and supply chain collaboration. Improved value can take many forms, including cost and/or time savings; improved cost and/or time certainty; improved quality; improved operational performance; improved maintenance; improved warranties; improved staff and other resources; improved health and safety; and/or improved sustainability.
They don't replace project contracts. Each project will continue to be delivered under project-specific contracts, as usual. Instead, strategic collaboration contracts fill important gaps left by project contracts. For example:

they provide a ‘route map’ for long-term collaboration, by describing agreed processes for planning, risk management, problem-solving, shared learning and performance review at the portfolio level;
they overcome the ‘Groundhog Day of lost learning’ that occurs when good practices and innovations developed on one project are not easily transferrable to the next; and
they provide incentives for non-owner participants to collaborate with each other, the owner and their respective supply chains to discover how their supply chain arrangements can be optimised to deliver better value for the project owner across the portfolio (without simply squeezing supplier margins).

They reward improved value. Potential rewards could include allocating profit-generating project work to non-owner participants without a competitive tendering process. This reward arrangement can eliminate the cost and drain on resources associated with constantly tendering every package of work and allow such resources to be redirected to value improvement initiatives. It could also underwrite a supplier’s business case for investing in manufacturing facilities for modern methods of construction.
Rewards could also take the form of gainshare payments, where the project owner effectively shares a portion of the improved value with those who have created it.
They facilitate integration: Two-party contracts are a barrier to the communication needed for success. Multi-party contracts can overcome this barrier by creating the direct contractual links needed to facilitate the communication, information sharing, and integration needed to deliver long-term value improvements.

They build trust: They provide the foundations for agreed-upon activities needed to jointly develop strategies and build trust, which in turn creates and sustains a collaborative environment.

They protect confidentiality and IP rights: Information sharing requires appropriate protection of confidentiality and intellectual property rights. Documenting these rights within chains/tiers of two-party contracts is clunky and leads to gaps that inhibit information sharing. It’s easier to create the necessary network of confidentiality and intellectual property rights under a single multi-party contract to which all relevant participants are a party.

The opportunities that strategic collaboration contracts offer to improve value over the long term are massive. Some Australian project owners, such as the former Level Crossing Removal Authority, Major Road Projects Victoria and Sydney Water, recognise this and have taken steps to put these sorts of arrangements in place. But as an industry, we have barely dipped our toe in the water. Longer-term strategic collaborative contracting, my friends, is the next frontier for the Australian construction sector.

Conclusion

This article has sought to provide another perspective on how project owners can avoid the disappointment they routinely experience on their construction projects, by relying less on tightly drafted contractual obligations and instead using the law of self-interest to get their supply chain to deliver the desired outcomes.

It has explained how commercially astute project owners are doing this, on a project-by-project basis, and over the longer term.

It’s the longer-term opportunity where the most significant benefits lie.

Appendix – Examples of Long-Term Strategic Collaboration Contracts

Noteworthy international examples include:

The UK’s Crown Commercial Services use of framework alliance contracts for a wide range of construction services, on behalf of more than 300 project owners including Transport for London, Network Rail, National Highways and the Defence Infrastructure Organisation;

The Surrey County Council framework alliance with Kier Highways and others which used supply chain collaboration led by Kier to generate highway maintenance savings in excess of 12% over a 5-year period plus several other benefits;
Anglian Water's @one alliance which created an integrator alliance that aligned long-term supply chain relationships to Anglian Water's desired customer outcomes;
Ministry of Justice Framework Alliances for the Cookham Wood, HMP Berwyn and Five Wells projects
The Connect Plus collaborative framework to deliver a £350m highways asset management programme using two-stage open book within the 30-year concession.
The multi-client schools framework alliance created by Hampshire County Council, Surrey County Council, Reading Borough Council and West Sussex County Council under which three contractors jointly engaged with tier 2 and 3 subcontractors and suppliers to identify pipeline opportunities available, allowing the supply chain to contribute cost efficiencies and other benefits through early engagement;
The multi-client, multi-contractor framework alliance created by Hackney Homes and Homes for Haringey (together SCMG) to deliver their £240m housing improvement programme using Two Stage Open Book with Early Supplier Involvement (ESI) through strategic supply chain collaboration.

Australian examples include:

The Victorian Government’s Level Crossing Removal Program which has been delivered under several long-term Program Alliance Contracts;

Sydney Water’s Partnering for Success program which is being delivered under three long-term program alliance contracts;
The MTIA’s Program Development Approach for Victoria’s road building program,

albeit some don’t incorporate all the features explained above.

Further details on the above examples can be found in the below-referenced publications by David Mosey.