Construction Risk Management & Project Delivery Strategies
Construction Project Delivery Methods
Risk is inherent in construction and must be properly identified, analyzed and mitigated to ensure project success. Part of a successful risk management strategy in construction projects is assignment of risk to another entity besides the owner—often the general contractor, which comprises an important aspect of contract negotiation. In this article we discuss the methodologies and advantages of several construction project delivery methods of assigning contractual responsibility and financial risk to a general contractor.
Risk is anything that can go wrong on a construction project and can include:
- Development risk: entitlement, jurisdictional approvals to achieve the right to perform the project
- Financial risks: loss of funding, cost overruns due to uncontrolled change orders or unstable market pricing
- Unforeseen conditions: unidentified subsurface conditions, hazardous materials or unknown conditions discovered during renovations
- Disputes: deriving from misunderstandings, poor scope, contractual documentation or unrealistic expectations
- Schedule: if it’s over schedule it usually means it’s over budget
- Quality – potential for design or construction defects.
- Accidents or mistakes – responsibility for safety, insurance coverage and indemnification.
Allocate risks to the entity best able to manage them
It is essential allocate risks to the party best able to evaluate, control, manage and assume that risk. Resist the urge to attempt to assign unreasonable risk to an entity that wields little control over that factor. For example, we’ve had a client who demanded a general contractor provide a fixed price with no potential for change orders for a $10 million historic renovation with significant unknown conditions. Needless to say, it isn’t worth paying the general contractor an additional $5 million to cover every conceivable cost–better for the owner to carry a $1.5 million contingency and limit the scope of the contractor to what is specified and can be reasonably seen.
Choose the project delivery method based on assessment of the risks and assign them to the proper entity. Proper allocation of risk will yield a project that is less adversarial, with fewer surprises, cost impacts, and completed in a timely manner. Following is a brief sketch of the predominant project delivery systems for construction and their pros and cons related to financial risk for cost overruns.
Lump Sum Contract
In a lump sum or stipulated sum contract the contractor agrees to perform the work for a fixed amount and assumes much of the risk for cost overruns. This project delivery method works best with low risk projects such as new building, known conditions, standardized construction or commercial core-and-shell construction. Because the contractor is basing his bid upon the project drawings and specifications, this method is only as good as those documents. The owner should ensure that the Architect and professional team prepare 100% construction drawings. The scope of work needs to be clearly defined because any omissions or mistakes in those documents will subject the owner to expensive change orders over which the owner has less negotiating ability. In this method the contractor assumes the risk to build what is clearly documented in his contract, and the owner assumes the risk for any change after the contract is executed or variation/omission in the drawings.
Time and Materials Contract
In this project delivery method, the owner accepts most of the financial risk in exchange for what should be a lower contractor fee and reduced contingency. The scope of work and all change orders are performed at pre-negotiated hourly rates and markups. This method works well when there are many unknown conditions, eliminating the need for the contractor to include a huge contingency, which in a lump sum contract he would earn regardless of whether those costs were incurred or not.
Guaranteed Maximum Price (GMP) Contract
This project delivery system is a hybrid between the two extremes of lump sum and time and materials, and often spreads the risk fairly between the owner and contractor. Typically, early in preconstruction, a Request for Proposal (RFP) is generated to contractors who provide a quotation based on the schematic or design development drawing package including their fees and general conditions. Often the contractor will provide preconstruction estimating at a reduced or favorable fee in return for the negotiated contract. The owner selects the contractor based on competitive fee proposals, references, and relevant experience. Once the contractor is selected, the design team and contractor integrate all aspects of the project to determine constructability, prepare cost estimates, and get each party on track early in the process.
Prior to construction, bids are gathered by the general contractor from all subcontractors, maintaining competition both at the general and subcontractor levels. The beauty of this model is transparency and sharing of information, in that the owner and project team have 100% access to all documents including actual subcontractor bids, and therefore know what is included and what is not. They have the power to accept subcontractor bids based on their own criteria of quality, manpower and risk management, unfiltered through a lump sum contractor’s financial agenda, thus providing the owner more control. New construction and complicated renovation projects often work well with this type of contract because the project team works closely together with full access to information to solve problems quickly and collaboratively. This method typically requires an owner sophisticated in construction processes (such as a developer with an internal construction division), or a qualified construction management firm to review and vet subcontractor bids and manage the flow of paperwork.
This method combines both the design aspect and construction services into a single source of responsibility: the design-builder. A large general contractor may either have in-house design capacity or team up with an architect and engineering team to provide a GMP to fulfill the owner’s program. This model is most effective when the owner is experienced and has a well-articulated and clearly defined program. It is critical in this method that the complete scope and performance specifications are clearly provided by the owner to the design-builder to avoid disputes. The design-builder must have proper licensure and professional liability insurance to cover design as well as construction defects.
All of these options can be augmented by incorporating construction management as an integral part of the project delivery method. Educating the owner on the subtleties of risk management in construction and options for construction project delivery methods should be one of the first tasks performed. The most appropriate method can be achieved by retaining an experienced construction manager to perform an objective risk assessment and to oversee the retention of the architect, engineers and contractors.
The higher the risk, the more important it is to perform early planning and preconstruction services, and typically the better integrated and specialized the team needs to be. Some project participants are well suited to one type of project or delivery method, while some are better qualified for others. In addition, there are important contract and insurance language issues that should assign risk and responsibility fairly. An experienced construction manager will lead the owner through the quagmire of risk in design and construction, and typically earns a multiple of his own fee through achieving cost savings, reduced risk and an overall better project.
Owners must look carefully and honestly at their own experience, in-house capabilities and project type to determine if they can manage this process and minimize their risks. The less sophisticated the owner and the higher the risk, the more important it is to consult with a qualified construction manager to determine the best project delivery system to accomplish quality, schedule and cost goals—all at an acceptable level of risk.
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