The bigger the project, the bigger the problems with lump sum contracts
Everyone loves a lump sum price
For many transactions, a lump sum price provides cost certainty.
It’s simple to administer:
No need to count hours/materials etc
No need to verify the actual cost, or that the actual cost is efficient;
No need for the contractor to ‘open its books’;
You can pay it in installments by reference to milestones or percentage complete.
It can be combined with a competitive tendering process to obtain and demonstrate value for money.
It’s become the ‘default’ option. You rarely have to defend a decision to competitively procure a fixed-price contract. Whereas alternative pricing methods are routinely questioned, and need to be justified.
As such, it’s a good option for many procurement situations.
But a lump sum price isn’t a great option for most construction projects
Perhaps controversially, my view is that a lump sum price isn’t a great option for most construction projects, even simple ones, because of the problems it creates in the construction context.
And as construction projects get bigger, so do the problems that a lump sum price creates.
The downsides of lump-sum prices are routinely underestimated.
Lump sum prices create misaligned interests
The main problem associated with a lump sum is the misalignment of interests that it creates and the adversarial behaviour that this causes.
To understand why this is so, we need to understand the interests of the various entities that are involved in any project, and how they differ.
For this purpose, the project participants can be split into two categories:
the owner participant; and
everyone else, collectively referred to as the non-owner participants.
The owner is the entity that decides to procure the project. It’s the ultimate client and generally sits at the top of the contracting chain.
The non-owner participants include contractors, subcontractors, suppliers, consultants, financiers, investors, operators, maintenance contractors, independent certifiers, and so on.
The non-owner participants are almost always commercial entities that exist to make a profit for their owners. They are not charities, and their true purpose is not found in their statement of corporate values. Being a good corporate citizen with a social licence to operate is simply a means to an end. It’s how the entity can achieve its real purpose, which is to generate a profit for its 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. Commercial entities within the construction sector tell us their purpose is something like creating sustainable built environments that enhance the quality of life for communities because they believe it will attract staff and customers and thereby sustain or increase the profit and wealth it generates for its owners.
We must therefore remember that the primary interest of each non-owner participant is to make a profit for its owners, 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 their primary interest.
The owner participant’s interests, on the other hand, are different. A project owner’s objectives usually revolve around 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.
Accordingly, our two categories of project participants have different interests. But having different interests doesn’t mean their interests are misaligned. It's possible to align the profit-making interest of each non-owner participant with the various interests of the owner participants, but not once a lump sum price is agreed.
The reason why this is so comes down to what I call the law of self-interest.
The project owner pursues its self-interests by setting out its price, time, quality and other objectives in a request for tenders, and inviting the market to submit tenders that seek to optimise the tendered solution against the owner’s objectives. Each potential non-owner participant is striving to achieve the owner’s objectives so that it can win a contract and thereby achieve the non-owner participant’s profit-generating objective. At this point in the process, the interests of owners and non-owner participants are aligned.
But, as soon as a lump sum contract is signed, the objectives of the owner and the relevant non-owner participant become misaligned. Once the lump sum price is agreed, the law of self-interest drives the non-owner participant to set about maximising the profit available to it under the contract by delivering what it promised for the minimum cost.
It is contrary to a 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, 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.
As projects get bigger…
As projects get bigger, the number of non-owner participants that are involved increases, and the need for interfacing participants to cooperate and collaborate with one another increases. Project owners will often impose obligations on their interfacing contractors to cooperate with one another, but if each of them is engaged under a lump sum price, each will want the other to do any work that is required to coordinate and interface the works because each dollar that they spend on such work is one dollar less profit that they will make on their contract. So both will refrain from undertaking any tasks that aren’t clearly in their respective scope and will assert that the owner should direct such activities as a variation. Again, it’s the law of self-interest that drives this behaviour.
A better way
It never ceases to amaze me how many project owners fail to grasp this basic commercial rule. They continue to assume (or hope) 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 confirm.
Project owners who contract on a lump sum basis and then expect their contractors, consultants and suppliers to subordinate their self-interest in generating a profit to the interests of the project need a dose of commercial reality.
Commercially astute project owners understand that their supply chain is primarily motivated by profit, and they use this to their advantage. They do this by abandoning lump sum prices and replacing these with pricing models that:
separate cost recovery from profit; and
link the latter to how well the project performs against KPIs based on the owner’s project objectives.
By linking the profit margin that each non-owner participant makes to the performance of the project against the owner’s objectives, we align the interests of the non-owner participant with the interests of the owner. Better than business-as-usual performance against the KPIs generates a win for the owner through better project outcomes and a win for each non-owner participant via a better-than-BAU profit margin. Conversely, worse-than-BAU performance against the KPIs results in the non-owner participants sharing the financial pain of poor project performance via a lower-than-BAU profit margin.
In my experience, it is best if the KPIs used to measure performance are based on whole-of-project outcomes, rather than outcomes on the scope performed by the relevant non-owner participant, as doing so will incentivise each non-owner participant to do what’s best for the entire project, rather than what’s best for its scope of work. This, of course, incentivises greater collaboration between the non-owner participants than will occur when each is operating under a lump sum price for its scope, which helps immensely with bigger projects involving the integration of different systems from different suppliers.
Need a facilitator?
Owen doesn’t just provide legal services to contract participants - he can also:
facilitate the establishment of alliances and other collaborative contracts on behalf of all contract participants,
be an independent chair of a project leadership team or
a standing neutral during the project delivery phase.
He is an Accredited Mediator and a board member of the Dispute Resolution Board Foundation, Region 3. Call Owen if you’d like to discuss these services.
