Sharing of Endogenous Risk in Construction

Large and complex construction projects are often very risky; the total completion costs may be influenced by a range of unforeseen factors. The risk can be reduced, however, by careful planning ad specification of the project’s various components. But such planning takes time, and due to time costs it may be tempting to start a project with a limited amount of specification ex ante. Some risk will then remain, and it must be borne (or shared) by the buyer and the contractor. In order to motivate the contractor to control and possibly reduce construction costs, he must bear some risk. A fixed-price contract provides strong incentives for cost control, but leaves all risk with the contractor. A cost-plus contract removes all risk from the contractor, but yields low (none) incentives to reduce costs. Trading off risk bearing and incentives, the buyer will offer more incentive based compensation (less cost sharing), the lower is the remaining project risk. Since this risk is to some degree endogenous (it is influenced by planning and specification activities), the design on incentive contracts must be considered in conjunction with the amount of project planning that is to be undertaken. It is important to note that there are two ways in which the buyer can affect the risk faced by the contractor: (a) project design, and (b) contract design. As for the former, a high level of technical specification at the time of contract award reduces the contractor’s estimation risk when tendering for a contract. On the other hand, by reducing the design time income may come earlier, and thus enhance the potential net present value of the project. Usually, however, this is only achieved at the cost of increased risk. Starting construction before detailed engineering is undertaken introduces a possibility of cost overruns due to estimation failures, redesign, and reconstruction. Thus, the attempt to reduce lead times typically increases the volatility of costs. We present a simple model to study the combined project and contract design problem.