Throughout the lifespan of a construction or infrastructure project, practices undertaken by contractors can place unnecessary reputational or financial risk on the owner or developer (“owner”). These risks are most acute when the owner engages a construction manager on a cost-plus basis. For the purposes of this discussion, we will address the risks and mitigation strategies relating to cost-plus contracts through two distinct and related strategies: (1) implementing a comprehensive third-party due diligence program of bidders and subcontractors; and (2) performing a thorough review of subcontractor procurement. These strategies can also be implemented by the owner engaging a general contractor on a fixed-cost basis, though access to the general contractor’s procurement of subcontractors is likely to be limited. The focus here will be due diligence and procurement review because both occur during the procurement phase of the project. There are other strategies to mitigate both financial and reputational risks which are discussed in other articles in this series.
Third-party due diligence
A comprehensive third-party due diligence program to vet prospective bidders and subcontractors is a vital strategy to mitigate reputational risk. Owners have varied tolerance for reputational risk—some with no thought other than to identify contractors that will finish the job on time and on budget and do little to address the risks. While this may make financial sense to many, it is misguided. First, a well-designed and developed due diligence program is an efficient and cost-effective way to address reputational risk. Second, reputational damage can lead to cost overruns, schedule delays and operational risk. Moreover, contractors and subcontractors without a public record of integrity issues tend to create a construction project that is safer, compliant and more efficient.
In addition to determining subcontractors’ technical ability, financial capability and safety history, a comprehensive third-party due diligence program should include public record searches of the bidder or subcontractor and its principals and a review of the contractors, including key subcontractors, control framework and compliance programs. The public record searches should include safety records, open sources media, government debarment and ineligible lists and criminal records.
Obtaining the compliance polices and program from key subcontractors for review accomplishes two important goals: (1) it identifies firms that may not have a robust compliance program or meet the standards of the owner’s suppliers code of conduct policies; and (2) it signals to the subcontractors that compliance is important to the owner and construction manager.
Under a cost-plus contract, the financial risks of buying subcontracted work fall squarely on the owner, and relying on the construction manager to minimize the owner’s costs is putting the owner in a precarious position. However, owners can minimize this financial risk. First, owners should develop detailed estimates for each scope of work and leverage those estimates to develop a budget. Second, they should perform detailed review of the construction manager’s procurement process; this includes reviewing unit and labor rates and leveling the bids to include allowance work and not just the base bid.
Detailed estimates are an important tool to managing financial risk on any construction project. A proper detailed estimate provides the baseline for specific costs of scopes of work and are integral to developing an accurate budget. Detailed estimates allow the owner and construction manager to properly level bids, identify portions of bids that are inflated and limit subcontractors from engaging in potential anticompetitive behavior. Accurate budgets mitigate risk as they illuminate shadowy areas of the construction process, including anticompetitive behavior, corruption, kickback schemes and inflated costs.
Reviewing labor and unit rates are important for several reasons—including to limit anticompetitive behavior, discussed in more detail here—but our concern here is that it mitigates financial risk. Often in an open-book cost-plus contracting model, the construction manager runs the procurement process, including leveling the bids. Allowances may be included in bids as placeholders for scopes of work that have not been fully designed; changes in logistical requirements; to accelerate work; or other contingencies. Often, allowance work is not included in bid-leveling activities even though analyzing these costs through leveling may reveal a different low bidder. Unit and labor rate reviews should be included as part of the bid-leveling process and used to analyze the cost of allowances among bidders. Even if the results of the review do not reveal a different low bidder, they can be used as a negotiating tool to lower rates—often where contractors look to enhance profit—and drive savings to the overall project.
Leveling bids that include allowances and even potential change orders can be tricky business as there are usually many unknowns relating to allowances, not to mention potential change orders. Developing well-reasoned assumptions and using data analytics to map out the results of the assumptions can provide a tool in comparing bids. The goal is not to pinpoint a number to level to but instead to create a basis of comparison.
Managing procurement risk as an owner is an important tool to limit reputational, financial and regulatory risk. Properly managed procurement of the contractor and its subcontractors can lay the foundation for a compliant, cost-effective and efficient project that limits risks to the owner and contractors.
This article is part of a series to discuss the risk mitigation strategies owners can take in construction and infrastructure development. Previous articles in this series can be found here.