Contract Risk Management for Engineering Contractors

1.

Contract Risk Management for
Engineering Contractors
J. Barry Orr MBE
BEng (Hons), CEng, FIMechE

2. Pre-Contract

• Introduction
• Trends in the Transference of Risk
• Principal causes of loss
• Essential Elements of Contract Risk
Management (CRMP) – pre-contract
© BARRY ORR
FIG. 1

3. Reasons for Developing a Comprehensive CRMP

• Risk management is a continuous process from first
contact with a potential client to contract close-out
• Clients were transferring more risk to contractors
• Some risks were not being identified early enough
• The result was profit erosion after the point of sale
• Project managers were blamed for profit erosion
• ‘Disaster’ contracts were endangering the company
© BARRY ORR
FIG. 2

4. Trends in the Transference of Risk

• Tighter prices for the contractors
• Lump sum fixed prices were normal
• Technical change is accelerating – innovation
• Plant performance tests more onerous
• Trends towards re-vamping existing plants
• Novelty of client, country, culture, language, applicable law
• Clients becoming more commercially skilled
• Contract terms becoming more onerous
• Clients want predictability of cost, time, performance and
return on investment
FIG. 3
© BARRY ORR

5. Risk Assessment

• Identification of risks
• Response
– Rejection
– Amelioration
– Transference
– Acceptance
• Analysis of accepted risks
• Provisions/contingencies for accepted risks
© BARRY ORR
FIG. 4

6. Pre-contract Errors

• No structured objective enquiry acceptance procedure
• Inadequate quality of the proposal and estimate
• Inadequate priority in staffing the proposal team
• Inadequate involvement of senior management
• Inexperienced proposal management
• No structured tender approval procedure
• Inadequate/inappropriate contract conditions
• Failure to control the negotiation
© BARRY ORR
FIG. 5

7. TO BID OR NOT TO BID

Are sufficient resources available?
Has the client allowed sufficient time?
Are the ITB conditions compatible with the CRMP?
What are the chances of success?
Does client relationship demand that we bid?
The above questions are addressed at the Enquiry Acceptance Meeting
© BARRY ORR
FIG. 6

8. Sales Strategy

Reasons for bidding
The winning features of the bid
Importance of technical excellence
Project execution strategy
Commercial and financial aspects
Strategic alliances and the reasons for these
Government involvement
Client contacts
© BARRY ORR
FIG. 6(a)

9. Sales Strategy (Cont.)

Agents
Counter trade
Competition
Contractor’s weaknesses and strengths
Proposal documentation
Pricing
Tender evaluation by client - method and time
scale
• Visits to client pre-tender
© BARRY ORR
FIG. 6(b)

10. Pre-contract Errors

• No structured objective enquiry acceptance procedure
• Inadequate quality of the proposal and estimate
• Inadequate priority in staffing the proposal team
• Inadequate involvement of senior management
• Inexperienced proposal management
• No structured tender approval procedure
• Inadequate/inappropriate contract conditions
• Failure to control the negotiation
© BARRY ORR
FIG. 5

11. The P. M.’s ‘Trilemma’

Quality/Specn
Risk
Risk
P
PM
Cost
FIG. 7
Time
Risk
© BARRY ORR
Proposal
Management
Control

12. Pre-contract Errors

• No structured objective enquiry acceptance procedure
• Inadequate quality of the proposal and estimate
• Inadequate priority in staffing the proposal team
• Inadequate involvement of senior management
• Inexperienced proposal management
• No structured tender approval procedure
• Inadequate/inappropriate contract conditions
• Failure to control the negotiation
© BARRY ORR
FIG. 5

13. Some reasons why we take bad contracts

We do not recognise or we ignore:
• The effects of novelty in all its forms
• The ability to justify a ‘thin’ estimate
• Self delusion in avoiding under
recovery/redundancies
• Occasional technical weakness of our selling position
• Inconsistencies/conflict in the contract
documentation
• The dangers in the ‘thrill of the chase’
• The many other potential risks in a particular contract
© BARRY ORR
FIG. 8

14. Essential elements of CRMP – Pre-contract

Enquiry acceptance procedure
Tender approval procedures
Risk assessment and analysis
Contract start-up procedures
Contract control procedures for time, cost,
quality/specification
Contract review and reporting procedures
Staff training and development
Contract auditing system
Contract close-out reports
© BARRY ORR
FIG. 9

15. CRMP

IS NOT ANTI-SELL
IT IS INTENDED TO ENSURE:
OBJECTIVITY
CONSISTENCY
HONESTY
And
TO AVOID SELF-DELUSION
© BARRY ORR
FIG. 10

16. Tender Approval Procedure

Tender approval request
Tender approval summary
Estimate summary to standard format
Commercial and technical appreciation
Contract liabilities statement
Country clearance report
Risk assessment and analysis
Cash flow analysis
© BARRY ORR
FIG. 10(a)

17. Essentials of our Risk Analysis

• Based on collective experience of those involved
• Maximum experience should be assembled
• Participants need a common thought process –
standardisation
• Complete in one session
• Address maximum number of elements of the estimate
• Set a standard acceptable level of probability of breaking
even
• Simple and quick to operate and adjust
• Market situation must not affect it
© BARRY ORR
FIG. 11

18. What is a fair price?

PRICE
=
COST + PROFIT
COST
=
BASE ESTIMATE
+
RISK PROVISION
PRICE
=
BASE ESTIMATE
+
RISK PROVISION
+
PROFIT
© BARRY ORR
FIG. 12

19. Areas Addressed in our Risk Analysis

• Estimating accuracy – all elements
• Degree of definition – impact on
activities
• Contract conditions – risk areas
• Financial risks in contract execution
• Siteworks risks – if not covered above
© BARRY ORR
FIG. 13

20.

Element
RISK ELEMENT
1.0 Estimating Accuracy
1.1 Merchant Account Costs:
1.2 Manhour Costs – In-House:
1.3
1.4
1.5
1.6
1.7
1.8
Value
Mechanical Costs
Electrical Equipment
Instrumentation
Steel Structures
Bulk Materials
Bought-Out Design
Sub-Let Civil Works
Sub-Let Installation
Eng-Process
Eng-Piping
Eng-Elect. Instrumentation
Eng-Machinery & Vessels
Eng-Coordination
Procurement
Project Management/Control
Site management
Supervision of Construction
Supervision of Commissioning
Manufacturing In-House
Shipping & Transport
Expense Items
Direct Labour Hire – Site
Agency Manhours
Escalation Allowance – 1.1, 1.2, 1.3, 1.6, 1.7
Sub Total
© BARRY ORR
Risk
%
Amount
Benefit
%
Amount

21.

Element
RISK ELEMENT
Value
2.0 Degree of Definition
2.1 Additional Engineering
2.2 Additional Supply
2.3 Additional Construction
2.4 Plant Performance Tests
2.5 Other Sub-Elements Affected
Sub Total
© BARRY ORR
Risk
%
Amount
Benefit
%
Amount

22.

Element
RISK ELEMENT
Value
3.0 Contract Conditions
3.1 Late Completion Penalty
3.2 Prolongation Cost
3.3 Plant Performance Penalty
3.4 Rectification/Make Good
3.5 Defects Liability
3.6 Client ‘interface’
3.7 Norms and Standards
3.8 Licensor Default
Sub Total
© BARRY ORR
Risk
%
Amount
Benefit
%
Amount

23.

Element
RISK ELEMENT
Value
4.0 Financial
4.1 Non-Payment
4.2 Cash Flow Finance
4.3 Bonds & Guarantees
unfair calling-ultimate net cost
4.4 Duties & Taxes
4.5 Income Tax Equalisation
4.6 Escalation – if not in 1.8
4.7 Soft Currency Surplus
4.8 Exchange Rate Variation
Sub Total
© BARRY ORR
Risk
%
Amount
Benefit
%
Amount

24.

RISK ELEMENT
Element
Value
Risk
%
Amount
Benefit
%
Amount
5.0 Siteworks
(additional to elements 1 &2 )
5.1 Civil works growth
5.2 Erection works growth
5.3 Design Errors
5.4 Soil Conditions & Climate
5.5 Local Escalation
5.6 Acceleration Costs
5.7 Direct Labour Hire Disputes
Sub Total
Grand Total
Footnotes:
1.
The generic term ‘Expense items’ includes such things as cost of insurances, bonds and bank
guarantees, travel and subsistence, miscellaneous home office and site costs not included in
the overhead, Agents Commissions, Duties and Taxes.
© BARRY
ORR
2.
The above list is not exhaustive and specific
contracts
may contain other risk categories.

25. Corrected Risk Provision Calculation

P
100-P
Bt
Rc
BE
Benefit
R
P
R
O
B
A
B
I
L
I
T
Y
%
Rt
Risk
Cost = Price – Profit
(Base Estimate + Rc)
100 P
R
(R B )R
t
t t
100
and Rc = Rt - R
© BARRY ORR
FIG. 14

26. The Negotiation

• One leader and decision-maker and small team
• Prepare and identify the objectivity and walk away
point
• Retain the support of vendors and subcontractors
• Share the ‘pain of concessions’
• Continually update the risk analysis
• Negotiate reallocation of risk
• Data base for evaluation of scope changes
• Achieve a fair/acceptable deal or walk away
• Seek reapproval before settling
© BARRY ORR
FIG. 15

27. Re-allocation of Risk

Longer project schedule
Relax plant performance criteria
Reduce liquidated damages
Reduce defects liability period
Early freeze date for basic engineering
Apply international design standards
Client to provide insurance cover
Improve terms of payment
Relax bonds and guarantees
Client responsibility for duties and taxes
Client accepts tender-to-contract exchange rate risk
© BARRY ORR
FIG. 16

28. Contract Risk Management for Engineering Contractors

Part 2: Post-contract

29. The PM’s ‘Trilemma’

Quality/Specn
Risk
Risk
P
PM
Risk
Provision
Valve
FIG. 0
Cost
Time
Risk
© BARRY ORR
Risk
Management
Control

30. Post-contract Errors

• Inadequate attention to contract start-up
• Inexperienced Project Management
• Inadequate authority of the Project Manager
• Inadequate control procedures
• Inadequate reporting and forecasting
• Inadequate Risk Management strategies
• Poor Contract Administration
• Inadequate Involvement of Senior Management
© BARRY ORR
FIG. 1

31. Contract Start-up Meeting

• Background to the project
• The sales process:
–
–
–
–
–
–
Internal 1
Enquiry acceptance
Development of the proposal
Assumed contract execution strategy
The as-sold estimate
The contract programme
Tender acceptance documentation
Finally negotiated scope and responsibilities
Details of contract documentation
Client personnel and relationships
Third parties involved
Meeting led by Chief Sales executive
Preliminary handover to Operations
© BARRY ORR
FIG. 2

32. Contract Start-up Meeting

Internal 2
Introduction of key members of team
Confirmation of the as-sold scope
P.M.’s view of risk analysis
Strategy for execution and risk management
Responsibilities of each discipline
Cost control budget
Contract programme
Quality plan
Meeting led by Project Manager
Final take-over by Operations
© BARRY ORR
FIG. 3

33. Contract Start-up Meeting

With Client
As-sold scope
Project administration procedures
Contract variation procedure
Client responsibilities and timing
Reporting and review meetings
Basic design freeze dates
Client involvement and lines of communication
Training requirements
To set the ground rules for the contract
© BARRY ORR
FIG. 4

34. Post-contract Errors

• Inadequate attention to contract start-up
• Inexperienced Project Management
• Inadequate authority of the Project Manager
• Inadequate control procedures
• Inadequate reporting and forecasting
• Inadequate Risk Management strategies
• Poor Contract Administration
• Inadequate Involvement of Senior Management
© BARRY ORR
FIG. 1

35. Risk management – Key Requirements

• PM to review risk provision at contract start-up
• PM to develop strategies for each area of risk
• PM reviews strategies regularly (monthly)
• PM repeats risk analysis monthly
• Application of QA reduces risk
• Operational audits on contracts confirm
strategies
© BARRY ORR
FIG. 5

36. Essential Elements of a CRMP

Enquiry acceptance procedure
Tender approval procedures
Risk assessment and analysis
Contract start-up procedures
Contract control procedures for time; cost;
quality/specification
Contract review and reporting procedures
Staff training and development
Contract auditing system
Contract close-out reports
© BARRY ORR
FIG. 6

37. Contract Administration

• Full time contract administrator
• Detailed records and computerised retrieval
system
• Credit control
• Contract variations and change control
• Site controls and record keeping
–
–
–
–
–
–
Daily diaries
As-built programmes and drawings
Minutes of meetings
Dated progress photographs
Site instructions and valuations
Weather and lost time records
© BARRY ORR
FIG. 7

38. Control of Quality

• Quality plan should be part of contract controls
• Apply quality assurance – BS5750 (Part 1), ISO
9001
–
–
–
–
–
Engineering
Procurement
Construction
Vendors
Subcontractors
• Familiarity with quality manual
• Apply technical audits to engineering
• Implement quality control through inspection
© BARRY ORR
FIG. 8

39. Safety and Operability Reviews

• HAZOP studies
– Qualitative and systematic
– Based on PFDs and PIDs
• HAZAN studies
– Quantitative
– Based on fault tree analysis for major hazards
• Engineering safety reviews
– Checklist method
– Based on protection systems, site plans and area
classification
© BARRY ORR
FIG. 9

40. HAZOP Study Reviews

• Review 1
– Proposal stage
– Safeguards the estimate
• Review 2
– Soon after start-up
– Basic engineering confirmed
• Review 3
– Major review after basic engineering
– Provides sound basis for detail design
• Review 4
– Prior to AFC stage
– Provides sound basis for construction
• Review 5
– Prior to commissioning
– Provides final assurance that plant as built is fit for
commissioning
© BARRY ORR
FIG. 10

41. Contract Reporting (Part 1)

Internal PM’s Monthly Report
Executive Summary
Contract Financial Status Report
Progress Summaries – E, P, C1, C2
Claims Analysis
Areas of Concern
Risk Management Strategies
© BARRY ORR
FIG. 11

42. Contract Reporting (Part 2)

Report to client – lump sum contracts
• General description of scope including plant
layout
• Management summary
• Areas of concern
• Major events in the period
• Schedule review
• Commercial review
• Engineering/technical review
• Procurement/manufacturing review
• Construction/commissioning review
© BARRY ORR
FIG. 12

43. Contract Reporting (Part 3)

Report to client – Management reimbursable contracts
Project Director’s executive summary
Expenditure and commitment reports with ‘S’ curves
Approved budget changes report
Current budget.forecast variation report
Escalation report
Risk provisions review
Cash flow report
Detailed progress for E, P, C1 & C2
Force report
Photographic record of site progress
© BARRY ORR
FIG. 13

44. Principal objectives of a contract audit

• Compliance with the CRMP
• Adequacy of contract control
procedures
• Assess risk management strategies
• Carry out current risk analysis
• Produce cost report and profit forecast
• Recommend corrective actions/solutions
© BARRY ORR
FIG. 14

45. Contract Audit Principles

Impartial and objective
Competent audit team
Authority from Main Board
Comprehensive scope from enquiry
receipt to time now
© BARRY ORR
FIG. 15

46. Preparations for Audit

• Develop standard interrogation procedure
• Set up standard format for recording
responses
• Follow audit trail from first contact with
client to time now
• Advise parties in advance of
documentation to be available
© BARRY ORR
FIG. 16

47. Audit Execution - Presale

Full overview briefing by project manager
Interrogation of sales
Interrogation of proposals
Interrogation of estimating
Check risk analysis presale
Check tender approval submission
Review changes during negotiation
Check final approval
Review commercial contract
© BARRY ORR
FIG. 17

48. Audit Execution – Start-up

• Check handover procedure from proposals to
operations and start-up meeting minutes
• Review preliminary contract instructions
• Review as-sold scope documentation
• Review minutes of start-up meeting no.2
• Review final contract instructions
• Review minutes of start-up meeting with
client
• Review initial staffing of contract
© BARRY ORR
FIG. 18

49. Audit Execution – Contract Management

• Controls for:
– Time
– Cost
– Quality/specification
• Cash management
• Site controls – goods receipt to final
acceptance
• Control of vendors/subcontractors
• Client involvement
• Risk identification and management
• Contract financial status report – including risk
analysis
© BARRY ORR
FIG. 19

50. Contract Close-out and final actions

• Progressive dismantling of task force
– Staff appraisals
– Re-entry to home office organisation
• Agree outstanding claims from/on client and
subcontractors
• Confirm final acceptance by client
• Recover bonds and guarantees
• Invoice for remaining retentions
• Produce final contract financial status report
• Write close-out report
© BARRY ORR
FIG. 20

51. The contractors 12-point plan for project success

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
Formal enquiry acceptance procedure
Tight proposal management
Comprehensive risk assessment and analysis
Standardised tender approval procedure
Thorough preparation for and discipline during negotiations
Avoid pitfalls with ‘Letter of Intent’. And implement a formal contract
start-up procedure
Effective contract administration and application of time/cost/quality
controls from Part (1)
Accelerate design whenever possible to create float in the programme
Apply risk management strategies including regular technical,
managerial and safety audits and reviews
Site construction requirements to be paramount – locate project
manager on site
Thorough preparation for systematic handover to client and
expeditious completion of plants/systems performance tests, and
monitoring of client operations post handover
Comprehensive close-out of project including obtaining outstanding
retention/bonds, settling claims and issuing internal close-out report
© BARRY ORR
FIG. 21