Incentives in construction contracts should we pay for

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CIB2007-253

Incentives in Construction Contracts: Should we pay for Performance?

Will Hughes, Iyassu Yohannes and Jan-Bertram Hillig

ABSTRACT Incentives and disincentives are common contractual tools to influence the behaviour of contracting parties. The type of incentivization differs according to the objectives involved. A contract may involve general objectives, for example, the enhancement of the client-contractor relationship, the establishment of long term relationships, or the use of certain business models. Other more tangible objectives concern the issues of cost, performance, and time/completion on schedule. In regard to the latter types of incentive, a range of different types of incentive may be used, e.g. monetary incentives such as fixed-price contracts, cost-plusincentive fees, cost-plus-award-fees, share-in-savings incentives, and nonmonetary incentives such as automatic extension of contract term, more frequent payments, letters of appreciation etc. There is little information available about how they are used and whether they are effective. Questions to be answered in this connection concern the scalability of performance, the choice of the appropriate kind of incentive, the frequency of their use, the percolation of incentives through supply chains and methods of incentive management.

KEYWORDS: Incentivization, Contracts, Performance, Procurement.

1. INTRODUCTION

A perennial question in construction contracting is how to get people to improve their performance. This is connected with the issue of what motivates people and organizations to do work, because if the motivation is right, then they will do their work better, quicker or cheaper. As Bresnen and Marshall (2000) have pointed out, despite a lot enthusiasm for the use

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of incentives, there has been little systematic research on the motivational principles and the assumptions underlying the use of incentives. Indeed, the idea that financial incentives (whether positive or negative) have a direct impact on performance seems so obvious that it is rarely questioned. For example, Arditi and Yasamis (1998) begin their study with the unquestioned assertion that "incentives are generally used along with disincentives to promote efficient contract management and to reward only successful contractors with high performance standards...". The purpose and efficacy of incentives were not questioned.

Recently in the UK, the question of performance has been dealt with as a "value-for-money" issue, but this often results in a confused agenda, because while notions of "value" are discussed widely, there is no consensus about what value is, the result usually being that parties to a contract focus on doing the same thing as they did last time, but more cheaply. In other words, for all that is written about it, value for money often translates into lowest price for a particular specification of work. This is a very well-established concept in business, and there has been much written about it over the years.

Incentives have long been used in attempts to improve performance. Reiners and Broughton (1953: p13) showed that the labour expenditure of main contractors who operated incentive schemes for their employees was considerably less than that of contractors not operating such schemes. Interestingly, Fleming (1967) concluded in a study about productivity in housebuilding that improvements could flow either from technological developments and increasing efficiency of individual firms, or from changing the nature of demand by altering the sizes of contracts or adopting contract procedures designed to encourage more efficient working methods. This has tremendous resonance with recent developments in UK government procurement practice, particularly in terms of bundling contracts and developments such as partnering, PFI and performance-based contracts. These two studies illustrate incentives operating at two levels: the employee and the firm.

Focusing at the level of the firm, Scherer (1964) showed that for US Defence projects, contractors who were financially incentivized to improve their performance behaved in unexpected ways. It appeared that the fact that their contracts included clauses that enabled them to renegotiate the price and/or duration of the project has a big impact on the effect of the incentives. Contractors did not even try to maximize the expected value of their profits. This may provide some background and context for understanding why simple financial incentives have little impact on construction contractors. It is certainly consistent with the findings of Bresnen and Marshall (2000) who showed that varying incentive schemes may have little impact on performance by comparison with other sources of motivation. Along similar lines, Rosenfeld and Geltner (1991) identified that there were important counter-productive effects of "adverse selection" that must occur in an incentive contract environment - to the extent that we should expect there to be a decline in their use.

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2. CONTEXT AND BACKGROUND

The idea of incentivizing performance usually boils down to finding ways of getting suppliers (or contractors) to perform quicker, cheaper or better (prosaic versions of the mantra of time, cost and quality). In fact, much that is written about improving performance in the construction sector usually falls short of actually specifying what aspects of performance are to be improved. There are many guidance documents from the UK's Office of Government Commerce, for example, that substitute "value-for-money" for improved performance, without going as far as dealing with what could be meant by the concept of value.

There is clearly a deeply held and widespread belief that financial incentives work. But, as noted above, there is sufficient reason to doubt that the effects of financial incentives are as significant as they might be perceived. One way to examine the notion of incentives would be to see how different disciplines approached the theory of motivating people and/or organizations to perform quicker, cheaper or better. A key aspect of this is the question of business relationships and the extent to which the continuation of long-term business relationships can motivate businesses to modify their behaviour.

There are several ways of looking at incentives. Some texts focus on economic issues, to do with the way that financial rewards can be used to induce changed in behaviour, connected with productivity and efficiency. Others focus on the extent to which the promise of future work might motivate suppliers to focus on producing better work than they would under discrete contracts, what might be termed a relational focus. A third view of incentives takes the legal view, in terms of the extent to which contract might include bonuses or penalties, and the extent to which the courts might interpret and apply such provisions. Finally, there are psychological aspects of incentivization and motivation that may be important in understanding how individuals and firms react to the measures put before them. Each of these perspectives is dealt with in more detail below.

2.1 ECONOMIC PERSPECTIVE

Incentive schemes have economic and financial consequences. In the normal course of events, contractors seeking to achieve performance targets may have to increase their resources on a project, and thus reduce their profit, unless they can renegotiate a better price during the execution of the work. Therefore, at its most basic level, the traditional approach of tendering a contract so that the price is agreed before the work starts acts as an incentive to the contractor, because if the contract is concluded quickly and efficiently, using fewer resources than planned, the contractor will make more money.

Incentive schemes are often set up as risk sharing arrangements, where the risk of things turning our differently to what was envisaged is shared between buyer and seller. Although this is very appealing at first

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sight, it not be quite so attractive on reflection. As explained above, with a firm price related to an agreed scope of works and an agreed time for completion, the contractor will be perfectly well incentivized to complete the work according to the price, time and quality targets. The introduction of an incentive scheme as an extra layer on to such a deal seems to be linked to either getting a better performance than would otherwise have been the case, or enabling the buyer to share in the savings that a conscientious contractor makes. If the buyer is also in agreement to sharing the losses, in the event that there are some, then this would be called "painshare/gain-share" arrangement. The twist to it is that without such an agreement, the contractor may have stood to gain more, in the event of efficiencies, and therefore the extra agreement is less of an incentive to achieving efficiency savings. Earlier work on the diversity of procurement arrangements in the construction sector (Hughes et al. 2006: 59) revealed, among other things, that contractors are sometimes subjected to painshare/gain-share arrangements both up and down the supply chain to such an extent that they might only collect 10% of the efficiency gains, even though they would have had to spend money to make the gains. In other words, these extra arrangements may not incentivize contractors at all.

2.2 RELATIONAL PERSPECTIVE

Important as they are, the use of financial incentives could be more successfully employed to effect "calculative trust" in inter-organizational relations at company level than in projects at operative levels (Bresnen and Marshall 2000). Individuals react not only to financial incentives but they can draw motivation from interpersonal relations and identification with a group or commitment to a cause. They may simply enjoy the work that they do. In other words, incentives as motivation operate not only at the level of the individual, but also, and differently, at the level of the organization. This is a key aspect of understanding why incentive schemes may not have the effects that their progenitors hoped.

Business relations are important. Collaborative working has become a popular topic, despite the lack of any evidence that it promotes more efficient/effective working (Gruneberg and Hughes 2004). Many recent developments to procurement practice have been based on the idea that repeat business is better than one-off contracts (not such a new idea, but the idea of partnering has taken firm root in the construction sector, as if it were a new concept). One potentially powerful incentive for contractors to perform quicker, cheaper and better is the potential loss of turnover and profit that would arise were they to lose the promise of future work from a particular client. Partnering and so-called collaborative working usually involve commitments on the part of contractors and suppliers, with no equivalent commitment from the buyer to actually put work their way (Hughes et al. 2006). A contractor who gets into such an arrangement is strongly motivated to perform well, as there is much to lose. However, Hughes at al. (2006: 43) discovered that prudent contractors rarely put

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more than 30% of their workload into such collaborative working practices, simply because of the risks of having too much work with one client. Clearly, there is much to be learned about incentives by looking at relationships in business. There are also important connections with ways of looking at the legal relationship, see below.

2.3 LEGAL PERSPECTIVE

A legal system in itself constitutes an incentive system and therefore legislation, regulations and judgements can be examined for their incentive effects (Veljanovski 2006: 44, 45). In the context of construction contracts entered into within the UK1 numerous incentives can be distinguished. One important example is the rules regarding the assessment of damages for breach of contract. By assessing these damages, the law puts tags on certain behaviours. Accordingly, Friedman describes the law as a "giant pricing machine" (Friedman 1984). Thus, the actors in a construction project can align their behaviour to the categories "cheap" and "expensive". If a dispute arises because a construction contractor has left a long-term PPP project before its end, and there was no contractual right to do so (breach of contract), the judicial assessment of damages will clearly affect the future behaviour of other construction companies involved in PPP projects. Owing to the fact that the assessment of damages is based on the compensation principle (compensation of the expectation interest), the promisor has an incentive to breach the promise if the value of the breach (for the promisor) is greater than the value of the performance to the promisee (Kreitner 2005: 27).

Another very interesting aspect of long-term relationships is how they are viewed in law, especially when they come to an end. Harrison (2004) asks whether a series of discrete contracts conducted within an environment of long-term business relations constitutes an implied contract. The case of William Baird who sued Marks and Spencer for ?56.3m when their relationship came to an end highlighted what could happen when suppliers are led to believe that they have an exclusive arrangement with a particular buyer. In that case, the court held that a long term relationship with no express terms could not be interpreted as an enforceable contract. The implied terms in such a relationship are too beset with uncertainty for an enforceable contract to be implied. In this case the supplier argued for an implied contractual term of a reasonable notice period, said to be three years, which would have prevented Marks and Spencer from terminating the arrangement without notice. However, the court of appeal rejected the implementation of an implied contract to this effect (Baird Textile Holdings Ltd v Marks & Spencer plc [2001] C.L.C. 999). Thus, English law motivates suppliers to enter into a contract and to insist on a clause that prevents the employer from terminating the

1 Although three legal systems exist in the UK, here we confine ourselves to the law of England and Wales which is commonly referred to as English law.

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