choosing contractor payment terms

International Journal oj Project Management 1994 12 (4) 2 16-22 I

Stephen Ward and Chris Chapman Department of Accounting and Management Science, Universiq of Southampton, Southampton SO9 5NH, UK

The paper considers how far contractual payment terms can be effective in producing project performance for a client. The mitigation of typical problems of contractor selection, motivation and risk sharing between client and contractor are examined in the context of cost plus fixed fee contracts, firm fixed price contracts, and incentive contracts. The latter offer possible solutions to the widely acknowledged diffhzulties with cost plus fixed fee contracts and firm fixed price contracts. However, there are other diffkulties with operating incentive contracts in practice, and these are considered in the paper.

Keywords: contracts, risk allocatmn, incentives

Situations in which one party delegates work to another are a common feature of commercial enterprise, and a neces- sary feature of projects. Individuals working together on a project may all work for the same organisation, but act as agents for different departments within the organisation. More than one organisation may be involved, as when a contractor acts for a client organisation. A contractor may subcontract work, and take on the role of client organisation to the subcontractor.

This paper is primarily concerned with the form of payment that is used in projects involving two or more different organisations. These projects may involve the supply of professional services, construction work, or some other product, such as a piece of equipment or software system. However, some of the issues discussed are also relevant to activity confined to a single organisation and the use of individual employees or departments within it.

Much of the uncertainty inherent in project management arises with the involvement of more than one party. Particular sources of uncertainty include

l poorly defined project objectives in relation to specifications, timescales and costs;

l the specification of responsibilities; l perceptions of roles and responsibilities; 0 communications across interfaces; l capabilities of parties; l the effectiveness of coordination and control.

Even if all the parties work for the same organisation, the problems presented by these uncertainties can be substantial. When the parties to a project are different organisations, these problems can be particularly challeng- ing. For example, typical added difficulties are

l client mistrust of contractors, and vice versa; l too many parties being involved in the project;

216

a clash of objectives between weak project management on unsuitable forms of contract;

parties; the part of the client;

uncertainty about complex contractual conditions and their effects; excessive claims; the lack of a clearly defined dispute-resolution procedure.

The above problems are manifestations of three fundamental problems that can occur in client-contractor relationships: moral hazard, adverse selection, and risk sharing’. Moral hazurd refers to the contractor’s failure to put forth the contracted effort. This can be of greatest concern to the client when it is particularly difficult or expensive for the client to verify that the contractor is behaving appropriately, as when specifications are inadequate or the client is inexperienced.

Adverse selection usually refers to the misrepresentation of ability by the contractor and the client’s difficulty in selecting a contractor with appropriate skills. The contractor may claim to have certain skills or abilities when hired, but the client cannot completely verify these skills or abilities either at the time of hiring or while the contractor is working. A selection problem can also arise when a contractor misrepresents the work that will be done or the likely final price. Once a contractor has been hired, it may be difficult for the client to ensure that costs are contained and that the work promised is what is actually delivered.

Risk sharing introduces important new elements into the problem of coordination. In particular, it raises concerns about the motivation of the various parties and the appropriate allocation of risk. Additionally, the client and the contractor may prefer different actions because of their different attitudes to risk.

One common approach to controlling moral hazard and adverse selection is to invest in information systems. Unfortunately, this can generate significant costs. Reve and

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Choosing contractor payment terms: S Ward and C Chapman

Levitt’ summarise the problem for construction projects, but their comments apply to any kind of project:

To compensate for the lack of trust between the parties to construction projects, elaborate surveillance and control systems are implemented, drawing upon performance measurement and quality-assurance systems. Transaction costs are generated by the addition of new layers of managerial hierarchy and specialized staff, the operation of control systems is also costly in terms of time spent in measuring and reporting by operative personnel. A further hidden element of cost lies in the efforts by those being controlled to look good along the performance dimensions observed. Manipulation of progress data is commonly observed in construction projects, where delays and cost overruns often come as surprises in the very final stages of construction project work. Finally, there may be additional hidden costs in detailed work surveillance resulting from possible negative effects on motivation and a certain amount of alienation among workers.

A second approach is to influence risk-management strategies and contractor incentives through the terms of the contract. The contract sets out what is to be produced, what the client will pay, how the client can assess and monitor what the contractor has done, and how things should proceed in the case of various contingent events. The client exerts influence over the contractor via contract conditions. A well drafted contract ought to maximise the chances of a satisfactory outcome for both the client and the contractor by providing

0 a clear specification of requirements; l a clear specification of responsibilities; l adequate authority with responsibility; l adequate arrangements for variations to the work; 0 timely transfer of appropriate information; l clarification of project risks and their allocation; l adequate rewards and incentives for the contractor; 0 sanctions for negligence; l an efficient resolution of disputes.

A key concern for the client is how best to select and motivate a contractor to perform as the client would prefer, taking into account the difficulties in monitoring the contractor’s activities. In particular, an effective payment scheme may considerably reduce the need for information- systems approaches to contractor control. The nature and size of contract payments is the primary means of motivating the contractor, and the manner in which payment levels are determined can be an important aspect of contractor selection.

The discussion below explores the extent to which various payment arrangements address these concerns. As a starting point, we consider the two simplest forms of payment: the fixed-price contract and the cost plus fixed fee (CPFF) contract.

Fixed-price contract

With a fixed-price contract, the client pays a fixed price to the contractor, regardless of what the contract actually costs the contractor to perform. The contractor carries all the risk of loss associated with higher-than-expected costs, but benefits if the costs out to be less than expected.

Normally, the client has to pay a premium to the contractor for bearing the cost uncertainty. From the client’s perspective, this premium may be excessive. Whatever the premium, the contractor is motivated to manage project costs downwards, for example by increasing efficiency or using the most cost-effective approaches. Hopefully, this is without prejudice to the quality of the completed work, although the client runs a risk of this to the extent that quality is not completely specified or verifiable. However, the difficulty of completely specifying requirements or performance in a contract is well known. This difficulty is perhaps greatest in the procurement of services, as compared with construction or product procurement. For example, it is very difficult to define unambiguously terms such as ‘cooperate’, ‘advise’, ‘coordinate’, ‘supervise’, ‘best endeavours’, or ‘ensure economic and expeditious execution”, and it cannot be assumed that contractors have priced work under the most costly conditions, particularly in a competitive bidding situation.

Despite these difficulties, awarding a contract to the lowest fixed-price bid in a competitive tender is common practice. The reason is clear: the bidding competition appears to be an efficient way of obtaining value for money, whether or not the client is relatively ignorant of the underlying project costs in comparison with potential contractors. Unfortunately, in the face of competition, tendering contractors (in any industry) are under con- tinuous temptation to pare prices and profits in an attempt to win work. Faced with the difficulty of earning an adequate return, such contractors may seek to recover costs and increase earnings by cutting back on the quality of materials and services supplied in ways which are not visible to the client, or by determinedly and systematically pursuing claims, a practice common in the construction industry. This situation is most likely to occur when the supply of goods or services exceeds demand, and clients are price-conscious and find suppliers difficult to dif- ferentiate between.

Even with prior or postbidding screening out of any contractors not deemed capable, reliable and sound, the lowest bidder has to be that member of the viable set of contractors that scores highest overall in the following categories:

l most optimistic in relation to cost uncertainties (this may reflect expertise, but it may reflect a willingness to depart from implicit and explicit specification of the project, or ignorance of what is required);

l most optimistic in relation to claims for additional revenue;

l least concerned with considerations such as impact on reputation or the chance of bankruptcy;

l most desperate for work.

This suggests that selecting the lowest fixed-price bid is an approach which should be used with caution, particularly when uncertainty is significant, performance specifications are not comprehensive, clear, and legally enforceable, or the expertise, reputation and financial security of the contractor are not beyond question.

More generally, a tentative conclusion is that fixed-price contracts are most efficient for the client when there is low uncertainty or when risks are controllable by the contractor. This suggests that fixed-price contracts should

International Journal of Project Management 1994 Volume 12 Number 4 217


be avoided in the early stages of a project when specifications may be incomplete and realistic performance objectives more difficult to set. A more appropriate strategy might be to break the project into a number of stages, and to move from cost-based contracts for early stages (negotiated with contractors that the client trusts), through to fixed-price competitively tendered contracts in later stages as project objectives and specifications become better defined.

Even when the client and the contractor share similar perceptions of project-cost uncertainty, a fixed-price contract may be inefficient for the client, in a risk-cost trade off sense, if the contractor is more risk-averse than the client. In this situation, the contractor will require a higher premium to bear the risk than the client would be prepared to pay for avoiding the risk. This situation can arise when the client is a relatively large organisation, for whom the project is one of many, but the contractor is a relatively small organisation, for whom the project is a major proportion of the contractor’s business.

Cost plus fixed fee contract

With a cost plus fixed fee contract, the client pays the contractor a fixed fee, and, in addition, reimburses the contractor for all the costs associated with the project: labour, plant and materials actually consumed, charged at rates that are checked and approved by open-book accounting. The cost of overcoming errors, omissions, and other changes is borne by the client.

Advantages for the client include the following: costs are limited to what is actually needed, the contractor cannot earn excessive profits from high-risk premia, and the possibility that a potential loss for a contractor will lead to adverse effects is avoided.

Disadvantages include the following: the contractor’s motivation to carry out work efficiently and cost effectively is considerably weakened, and contractors may be tempted to pad costs in ways which confer benefits in terms of other work they are undertaking (examples include expanded purchases of equipment, excessive testing and experimen- tation, generous arrangements with suppliers, and over- manning to avoid nonreimbursable layoff costs, which is a problem that is more pronounced when the fee is based on a percentage of the actual project costs).

A further, practical difficulty is that of agreeing and documenting in the contract what are allowable costs on a given project. However, it is important that all the project- related costs are correctly identified and included at appropriate charging rates in the contract. Particular areas of difficulty are overhead costs and managerial time. To the extent that costs are not specifically reimbursed, they will be paid for out of the fixed fee, and contractors will be motivated to minimise such costs.

The use of a CPFF contract presents problems when selecting a contractor that can perform the work for the lowest cost. Selecting a contractor on the basis of the lowest fixed fee tendered in a competitive bidding situation does not guarantee a least-cost outcome. It could be argued that it encourages a maximum-cost outcome.

CPFF contracts are generally most efficient for the client when there is high uncertainty, an incomplete project specification, risks are controllable by the client, or other adverse effects noted above, such as padding and lack of incentive for the contractor, can be fully controlled. Never-

theless, some clients appear to be willing to enter into CPFF contracts only as a last resort. For example, Thorn’ notes experience in the UK Ministry of Defence, in which the desire to avoid nonrisk contracts has frequently led to noncompetitive contracts being placed on a fixed-price basis, even when the specification has been insufficiently defined for a firm estimate to be agreed:

In such cases, the contractor is unwilling to commit to a fixed price without a substantial contingency to cover any unknown risks, and the Authority is unable to accept the high level of contingency required by the contractor. The result is that prices have been agreed at such a late stage in the contract that the amount of risk eventually accepted by the contractor is substantially reduced and, in some cases, removed altogether. The Review Board has frequently expressed concern at delays in price fixing, and has advocated the use of incentive contracts. These are intended to be used when the risks are too great to enable fixed prices to be negotiated, but not so great as to justify the use of cost

plus contracts.

Incentive contracts

Incentive contracts offer the possibility of sharing cost risk between the client and the contractor, and a position between fixed-price and CPFF contracts. Risk-sharing contracts have been extensively examined in the economics literature. However, much of this work is of a theoretical nature and based on mathematical models which adopt very specific assumptions about the contracting situation and the prefer- ences of the client and the contractor. This section provides a selected review of this literature with a view to identifying insights of practical significance.

In the simplest form of incentive contract, payment by the client to the contractor is given by

C’, = F + bE + (1 - b)C

and the profit to the contractor is given by

P=F+b(E-C)

where

C = actual project cost (which is uncertain at the start of the project)

E = target cost b = sharing rate, 0 < b < 1 F = target profit level

E, b and Fare fixed at the commencement of the contract. When b = 1, the contract is a fixed-price contract. When

b = 0, the contract is a CPFF contract. Note that, in Equation (2), if the cost C exceeds E by

more then F/b, the profit to the contractor becomes negative, and the contractor makes a loss.

In the situation described by Equation (2), which is sometimes referred to as a budget-based scheme, tendering firms select a budget (target cost), and the incentive profit is proportional to the budget variance5. Three parameters are required to specify the contract: the sharing rate b, the target cost level E, and the target profit level F. In theory, the target cost level should correspond to the expected value of project costs. Instead of specifying F, a target profit rate r may be specified, where F = rE. With this specification, the client must decide which (if any) values

218 International Journal of Project Management 1994 Volume 12 Number 4


to preset for E, B and F or r prior to inviting tenders. An alternative form of Equation (2) is

P=d-bC

where d is a fixed-profit fee, with

(3)

d=F+bE (4)

In Equation (3), only two parameters are required to specify the contract: the sharing rate 6, and the fixed-profit fee d. Tenders may be invited in the form of d if b is prespecified by the client, or for both b and d. Typically, if a ‘uniform’ value for b is prespecified by the client, the contract is awarded to the contractor submitting the lowest fixed-profit fee d.

Selection of appropriate risk-sharing rate

An obvious question is that of what level of risk sharing under an incentive contract is appropriate under various conditions. Risk sharing may be desirable from the client’s point of view when contractors are risk-averse, have superior precontractual information, or limited liability under the proposed contract. The arguments for risk sharing will also depend on whether the cost risks are controllable by the contractor, controllable by the client, or controllable by neither. In the latter case, the party bearing the risk acts as a quasiinsurer6, and the desirability of risk sharing is related to the relative levels of risk aversion of the contractor and the client. In the case of cost risks that are controllable to some extent by either party, risk sharing influences incentives to manage those risks.

An inherent problem with risk sharing is the reduction in a contractor’s sensitivity to adverse outcomes as the proportion of cost risk borne by the client increases. In the case of contractor-controllable risk, the contractor’s motivation to limit cost overruns and seek cost savings is reduced as the client takes on more risk. It follows that different levels of risk sharing may be appropriate for categories of risk which are (a) controllable by the contractor, (b) controllable by the client, and (c) not controllable by either.

From the client’s point of view, the optimum choice of risk-sharing rate b for risk which is not controllable by the contractor hinges on two counterbalancing factors. An increase in the sharing rate improves selection performance by increasing the chances that the lowest-(total)-cost contractor is selected. On the other hand, raising the share rate is likely to increase the risk premium required by the contractor.

Samuelson’ shows that, under ‘general conditions’, some level of risk sharing, with 0 < b < 1, should be preferred by the client over either CPFF or fixed-price contracts. The general nature of Samuelson’s analysis does not lead to any specific optimal values for 6, but the optimum value of b increases with the risk aversion of the client, and the controllability by the contractor of the costs. A further complication is that contractor risk aversion affects the actual level of contractor effort in controlling costs once the risk-sharing rate b has been negotiated. As Scherer’ notes, the greater the perceived risk of loss in a contracting situation, the more vigorously contractors strive to reduce costs for the sake of avoiding loss as well as for the sake of gaining increments of profit.

Of course, difficulties in specifying an optimum level for the risk-sharing rate need not preclude the use of incentive contracts and the pragmatic definition of risk-sharing rates

by the client. An alternative arrangement is for clients to require contractors to specify a value for the risk-sharing rate b as part of their bid. Contractors are then selected on the basis of bids for b and d in the situation described by Equation (3), or for 6, E and F or r in the situation described by Equation (2).

Selection of eficient contractors

If the client presets b and F (or r where F = rE), the selection of the contractor that bids the lowest value for E (or 6) is not guaranteed to minimise procurement costs for the client. There may still be difficulties in selecting the most efficient contractor. For example, McCall’ has argued that incentive contracts awarded on the basis of the lowest bid leads to ‘inefficient’ firms being selected. McCall’s analysis implies that relatively inefficient firms, whose actual costs are high, tend to submit estimated costs (bids E) that are lower than the actual costs, because they can share some of their losses with the client. Conversely, relatively efficient firms, whose actual costs of production are low, tend to submit estimated costs (bids) that are higher than actual costs. With the client sharing in any cost underrun, the less an efficient firm’s expected cost is, the more it must bid to secure a profit that is equal to that obtainable elsewhere. Hence, if the client chooses among firms on the basis of the lowest bid, then it is possible that it will select relatively inefficient firms (high actual costs) instead of relatively efficient ones (low actual costs). The probability of selecting a high-cost instead of a low-cost firm increases as the declared sharing proportion decreases.

In addition, where F and b are fixed by the client, Baron”’ shows that, if two firms are bidding for a contract, other things being equal, the more risk-averse firm will submit the lower bid (in effect the lower estimate of E from Equation (4)), and the probability of a cost overrun will be greater if that firm is selected. Thus a low bid for d may reflect a contractor’s wish to reduce the risk of not winning the contract rather than ability to perform the contract at low cost. This possibility is generally recognised in both fixed-price and CPFF contract situations.

However, the above arguments by Baron and McCall are of limited relevance when clients do not preset the sharing rate b. More usually, it might be expected that the fixed- profit fee d and sharing rates would be determined together, so that clients would bargain simultaneously for both low- cost targets and high contractor share rates. Thus, in general, the tighter the negotiated cost target is, the higher is the sharing proportion that is desired by the client. Canes” showed that, in these circumstances, there is a systematic tendency toward cost overruns, because contractors tend to submit bids below their actual estimate of the expected costs. According to Canes, only a subset of efficient firms will be willing to compete by simultaneously increasing the share rate that they will accept and reducing their target-cost bid. Inefficient firms and the remainder of the efficient firms will prefer to charge for higher share rates by raising target-cost bids, and, in Canes’ analysis, these firms correspond to the set of firms which submit bids below their expected costs. To the extent that tendering contractors are observed to charge for higher share rates in this way, cost overruns can be expected from such contractors. As a contract letting strategy, Canes suggests setting the target profit rate r (and hence the target profit level F, at zero, while allowing firms to choose share rates

International Journal of Project Management 1994 Volume I2 Number 4 219

Choosing contracfor payment terms: S C Chapman

subject to some minimum rate greater than zero. Canes argues that this policy should minimise clients’ costs of procurement while inducing firms to reveal the true oppor- tunity costs of their pr~uction.

However, an important assumption in the analyses of Canes ’ ’ and McCall’ is that the contracting firms are assumed to be risk-neutral (maximisers of expected profit). In situations in which contractors are significantly risk- averse, their conclusions need to be treated with caution.

Determining an appropriate target cost

A further problem in ensuring that an incentive contract is effective is the determination of an appropriate value for the target cost E. Ideally, the client would like the target cost to correspond to the contractor’s true estimate of the expected cost. Obviously, the benefit of an incentive element in the contractor’s remuneration is undermined if the target cost is higher than the true estimate of expected cost.

Suppose that firms are invited to tender values for b and E. A disadvantage of this invitation is that it can encourage a generally high level of tender values for E. However, the client would like to encourage truthful, unbiased estimates of the expected costs from tenderers. In principle, the client could achieve this by offering higher values of b for lower estimates of E. Then, submitting an overestimate of the expected costs will be less appealing to the contractor, because the associated lower sharing rate limits the contractor’s ability to earn large profits when costs turn out to be low. Conversely, if a contractor truly believes that costs will be high, the threat of low profits if costs turn out to be high will dissuade the contractor from submitting an underestimate of the expected costs.

Thus, the client could offer a menu of contracts, in terms of values of F and b for different values of E. By submitting a cost estimate, a tendering firm chooses one particular incentive contract given by the corresponding F and b values. Provided that F and b are suitably defined, such a menu of contracts can induce firms to provide unbiased estimates of the project costs.

A practical application of this menu approach, for rewarding sales personnel in IBM Brazil, is described by Gonik”. Gonik describes an incentive system which gears rewards to how close staff forecasts of territory sales and actual results are to the company’s objectives. A sales forecast S is made by each sales person for a given period and sales region, and this is used to determine each person’s level of bonus P. If the company quota is Q, and the actual sales achieved are A, the bonus payments are given by

S=A

P = B(A -t S)/2Q S<A (6)

P = B(3A - s)iQ S>A (7)

where B is a base level of bonus that is preset by the company.

In general, for a given sales forecast S, bonuses increase as A increases, but, for a given A, payments are maximised if A = S. Thus sales personnel receive more for higher sales, but they are also better off if they succeed in fore- casting actual sales as closely as possible. In principle, a similar system could be adopted in contracting to encourage contractors to provide unbiased estimates of project costs, and to control these costs to the best of their ability.

Other forms of incentive contract

The economic literature focuses on linear incentive contracts of the form of Equation (I), but, in practice incentive contracts often involve more than one risk- sharing rate over the range of possible prqject costs, and they may incorporate minimum and maximum levels of allowable profit. Two main types of incentive contract are usually distinguished: the fixed-price incentive (FPI) contract, and the cost plus incentive fee (CPIF) contract. These differ mainly in the treatment of cost overruns beyond some ceiling. In both forms of contract, the contractor’s profit from cost underruns is subject to a ceiling value, but risk sharing takes place for costs in some range around the target or expected cost. With an FPI contract, the contractor assumes a higher share of risk for cost overruns outside this range, and may carry all the risk above some set cost level. With a CPIF contract, the client takes all the cost risk above some cost level, and the contractor receives a minimum level of profit. Such variations on the simple linear incentive contract of the form of Equation (I), while of practical significance, make a general analysis of incentive contracts even more difficult. For example, Scherer* ex- cludes profit ceilings and floors in his analysis on the basis that. at least for fixed-price incentive contracts, ceilings and floors have rarely been penetrated. However. it is likely that the existence of ceilings and floors influences negotiations, and may affect the desirability of incentive schemes. Reichelsteir? notes that the intr~uction of cost ceilings may distort the incentives created by simple incentive contracts of the form of Equation (1). With a cost ceiling, the contractor typically bears 100% of all costs in excess of the ceiling, and the contractor will be better off submitting a bid below the contractor’s expected cost. Without a cost ceiling, the contractor could be induced to submit a bid which was a true reflection of the contractor’s expected cost, as noted in the previous section. However, in the presence of a cost ceiling, costs in excess of the ceiling will be penalised at the same rate irrespective of the bid. Therefore, the contractor has an incentive to bias his submitted cost estimates downwards.

Conclusions

Despite the risks inherent in fixed-price contracts, this is still a very common form of contract. A CCFF contract has weaknesses for the client which severely limit its use by risk- averse client organisations. Incentive contracts offer a variety of middle-ground positions, but do not appear to be as widely used as they might be. This may be because of a lack of awareness of the shortcomings of typical fixed- price contracts and/or of the value of incentive contracts in motivating contractors.

However, the additional complexity of incentive contracts may make them diflicult and time-consuming to negotiate. In particular, there are problems in selecting the lowest- cost contractor, and appropriate values for the sharing rate b and the target cost E. Unless firms can be motivated to provide unbiased estimates of costs (perhaps by arrangements such as those described above), client organisations may be wary of incentive contracts when they are unable to formulate realistic project-cost targets for themselves. Incentive contracts may be confined to procurement projects in which the client has a sound basis on which to estimate contract costs. and there are uncertainties that make a fixed-

220


price contract impractical, but the uncertainties are not so great as to justify the use of cost-plus contracts4. A further problem with incentive contracts is that the evaluation of the consequences of a particular incentive contract is not straightforward when the project costs are uncertain. This makes it difficult to carry out negotiations on a fully informed basis. A contributing factor is the still widespread unwillingness of parties entering into procurement contracts to explore the effects of project risk and ~ssibilities for risk management fully.

An underlying issue is the extent to which clients and contractors wish to cooperate with an attitude of there being mutual gain from trade. Unfortunately, an all too common approach is to try to gain the most possible at the other party’s expense, or at least seek to demonstrate that one has not been ‘beaten’ by the other party. This attitude can breed an atmosphere of wariness and mistrust. It appears to matter greatly whether the client is entering a one-off nonrepeating contractual relationship, or a relationship that may be repeated in the future. To the extent that the client is not a regular customer, the client can be concerned only with the present project, and may have limited expertise in distinguishing the quality of potential contractors and bids. Competition is then used to ‘get the best deal’. This is often manifested as seeking the lowest fixed price, on the rash assumption that all other things are equal. As we have seen, this practice brings its own risks.

Negotiating a fixed-price contract with a trusted or previously employed contractor may be a preferred alternative for knowledgeable clients, and it is perhaps worth pursuing by less knowledgeable clients too. Also, a move away from ‘adversarial’ contracting towards ‘obligational’ contracting’” may be mutually beneficial for both clients and contractors, and give rise to an atmosphere of increased trust and sharing of information. In these circumstances, there will be opportunities for increased mutual under- standing and management of contract risks.

From a risk-management perspective, it is important to

Stephen Ward is a senior iecmrer in the Department of Accounting and Management Science at the University Q Southampton, UK. He was responsible for setting up and managing the university’s MBA programme during 1990-92. He is ulso the founditlg editor of the OR So&f>: :v quarterly magazine for practltt0ner.Y. now in its seventh year. His research and consulting interests include project and contract risk management, strategic invrst- ment appraisal and managerial decision processes. He holds a BSc in ~the~ti~s and physi~~~ ~Univer~~t? of ~otti~lgha~~, UK) and an MSc in mwtagement science (Imperial Col(ege, London. UK).

identify categories of risk which are (a) controllable by the contractor, (b) controllable by the client, and (c) not controllable by either party. Different payment arrangements should be adopted for each of these categories of risk, implying different levels of risk sharing for each category of risk, so that appropriate allocation and positive management of the risks is encouraged where possible. The flexibility of incentive-contract forms of payment is attractive here, but more widespread use of such contracts may depend on the development of more ‘obligational’ contracting, rather than ‘adversarial’ contracting.

References

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Eisenhardt, KM ‘Agency theory: an assessment and review’ Academy of Manngement Review 1989 8 (I) 57-74 Reve, T and Levitt, R E ‘Organisation and governance in construction’ Int J Project Management 1984 2 (1) 17-25 ‘Standard form of management contract’ Joint Contracts Tribunal, Building Employers’ Confederation, UK (1987) Thorn, D G Pricing and Negotiating Defence Contracts Longman, UK (1986) 229 Reichelstein, S ‘Constructing incentive schemes for government contracts: an application of agency theory’ Accounting Review 1992 67 (4) 712-731 Ward, S C, Chapman, C B and Curtis, B ‘On the allocation of risk in construction projects’ Int J Project Management 1991 9 (3) 140- 147 Samuelson, W ‘Bidding for contracts’ Management Science 1986 32 (12) 1533-1.550 Scherer, F M ‘The theory of contractual incentives for cost reduction‘ Quarterly J Economics 1964 78 257-280 McCall, J J ‘The simple economics of incentive contracting’ American Economic Review 1970 60 837-846 Baron, D P ‘Incentive contracts and competitive bidding’ American Economic Review 1972 62 384-394 Canes, M E ‘The simple economics of incentive contracting: note’ American Economic Review 1975 65 478-483 Gonik, J ‘Tie salemen’s bonuses to their forecasts’ Harvard Business Review May-Jun 1978 116-123 Morris, J and Imrie, R ‘Japanese style subcontracting - its impact on European industries’ Long Range Planning 1993 26 (4) 53-58

Chris Chapman is a professor of muIlage~nent science in rhe Depart- ment of Accounting and Management Science at the University of South- ampton, UK. For over I5 years, his consulting and research have centred on the management of risk. Most of his consulting has been concerned with large energy projects in the UK. USA and Canada, but other concerns have included computer hardware and sojiware systems, and Jinanciai- asset and commodity-braking poryblio management. He holds a BASc in industriai engineering (Universily of Toronto, Canada), an MSc in 0perat~on~I research ~Utiiversit~f of Birmingham, UK) und a PhD in economics and econometrics fUniversity of Southampton, UK).

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choosing contractor payment terms

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