Risk Profile in Turnkey Projects

Revision as of 18:39, 21 September 2015

There has been a transition in the construction industry as a result of innovations in the partnering relationships between the client and the project coalition actors. Today there is a number of different ways to form project coalitions in the industry. The different project structures come with different risks for actors involved in the project. The trend today is use of the integrated project coalition, also called turnkey, characterised by a single contract for both execution and design of the project. This type of contract provides low risk and mission uncertainty for the client. (5.4.5) But this provides more uncertainties for actors such as contractors, designers and consultants.

This type of project management approach requires a thorough risk profile for the project coalition actors. It will always be numerous risks in construction contracts, and without a comprehensive risk profile it could leave the contractor, designer or the consultant dangerously exposed to unexpected responsibilities and risks. But it is important to remember that without risks there will not be innovation, risks and opportunities are related and you need a balance between the two. This wiki-article will look at the leading contractual risk factors and risk profile for the consultants in turnkey contracts in the construction industry.

Turnkey Projects

Definition

A turnkey project, also known as integrated coalitions or single–point responsibility, is a type of project that is constructed as a complete product for a client. (5.4.2) In the turnkey contract the goal of the contractor is to satisfy the clients performance specifications compared to the disigners plans and specifications. This type of contracting is getting more used in the building industry because the client transfer maximum risk to the supplier.

Structure

You can see the relationships under at the figure:

Fig. 1: Turnkey contract structur

As you can see in the figure, the main responsibility is centralized with the turnkey contractor. Normally they guarantee compensation for delays and take full responsibility for overall project cost.(1) In a general contract it is a threeparty arrangement between the client, designer and the contractor. Here the client must relate to two parties and get responsible for design defects(2).

Often, the client hires an independent consultant to advise in the pre-contract stage and sometimes throughout the project so that they make shore that the construction holds the requirements of the project. This third-party can be a project manager, engineer or another type of consultant. This is often a good idea because of the conflict of interest that most often occur when a single contractor is responsible for the overall project on behalf of the client. The constructor wants to complete the work as fast as cheap as possible to achieve their financial goals this might collide with the quality of the finished project.

The turnkey model is most appropriate when there is a large amount of information early in the process, the building is repeated or it is a simple type.

Benefits

One of the main benefits with this type of contracts is the savings in production cost. Because the contractor has responsibility for both design and construction, the building process can start before the design specifications are completed. This way, the contractor saves time and money. It is also more efficient when they are responsible for law related and local neighbour problems.

Turnkey contracts are most off all benefiting the owner of the project. First of all, this type of contracting provides the owner with just one source of responsibility. In contrast, the contractor alone has the responsibility of defects for both design and construction. This means that the owner doesn’t have to determine if a defect is caused by a misstep in design or construction, nevertheless it is not their responsibility. Another positive point for the owner is that the contractor must pay for any additional cost because of defective design or construction. But if the owner authorized the construction plan in the start, then they are responsible of extra costs caused by insufficient plans.

Turnkey contracts will be attractive for owners that do not have to proper technical knowledge. Owners do not need to have these detailed qualifications, that will be the constructor’s job.

Limitations

The construction business is a competitive industry and compared to other sectors there is high risks and low profit. In turnkey contracts tendering is the normal way to get the job. Then there is a fixed price and a packaged deal for the client. So the lowest price is often the winner. A consequent of this is how the constructor price and handle the risks involved in the project. Often the constructions are simple to get the cost-effectiveness at a level so they can achieve an attractive price for the project. Another result can be deficient design, and without detailed checking from a third-part, this can be expensive.

Where there is not a fixed price, the owner often has to negotiate the price after hiring a contractor based on the design. This is a way for the contractor to make sure they don’t waste money on a proposal design. This way the owner may not get the lowest possible price on the project.

For the owner of the project there will be a limitation to the amount of influence on design details. Examples of limitation will be knowledge of delays, defective work, extension of the time schedule. Overall they will have less control over the process.

Further, there are no adequate standard contracts for turnkey. It is a lot of uncertainties for the turnkey contractor and the sub-contactors, and it is a need for a safety net in the contract so that they also have power over variations under the project. A way to solve this could be payment at fixed milestones.

Where there is a lump sum price for the project, the uncertainties are bigger. This is mostly because it is hard to know the precise timeline and costs of a building project. Therefor the contract must be specified carefully.

Since the owner is not part of the construction part and have little verification options, they are exposed in a turnkey. This could result in improper payment and non-conforming work. In the traditional turnkey there is no party that protect the owner’s interests, so they have to be extra aware of liquidity and responsibilities in different situations.

Risk Profile as a tool

Problems facing risks are often hard to understand and clarify because it is not visible or definite. In every project there is a form for risk and various definitions of the term, but they all sum up that risk is an unwanted uncertainty that can harm a project and the actors involved. How it is handled depends on the projects internal and external environment . By making a risk profile the parties involved can manage the risks effectively.

Definition

Risk will be determined differently depending on what industry your project is related to. Marc and Shapira (1987) described risk in technology-driven organizations as “distribution of possible outcomes, their likelihood, and their subjective values”. Stakeholders will have another view at the risks and the outcome of a project compared to the client, the constructor or the consultant.

Risk profiling is an evaluation process of an organizations accept of risk, the level of risk to which they are exposed and the required risk for the organization in a specific project . It is an analytical technique used to plan risk management, and the profile will be specific for an individual company associated with a specific project. This type of analytical techniques is used to define the total risk management situation of the project. For example, the profile will tell the clients, stakeholder or the consultants risk acceptance and enthusiasm according to the project.

It is important to have the risk profile tool separated from the risk assessment tool. The two develop differently and provide different information for the project manager. The purpose of the risk assessment is to give a detailed picture of risks within single processes in a company compared to the risk profile that are risk identification on a higher level.

Structure

As said, there are three aspects in risk profiling that must be evaluated and compared:

Acceptable Risk

This is the level of risk that the organization is willing to take. This will affect the corporation’s decision making and the project. It is important that the firm´s acceptable risk is coupled with the correct definition of risk.

Because of its human dynamic, you can say that risk tolerance is a subjective concept. To quantify risk tolerance you have to figure out the probabilities for occurrences and the impact of it. Too measure the impact and this psychological characteristic, you have to look at the circumstances, values, preferences, attitudes and investment and financial risk of the project.

When a firm knows the risks together with the likelihood of occurring, they can focus their resources towards the risks that lie above the acceptable risk level. This can be visualised as in the figure of probability and impact below:

Fig. 2: Visualization of probability and impact

Another tool for understanding and visualizing risk tolerance is through a utility curve.

Fig. 3: Visualizing through utility curve

Awareness of risk tolerance will give the project managers a better overlook and how they should use their recourses efficiently. By locating the most crucial ones they can be handled and eased to an acceptable level. The result will be better decision-making, shorter length of the project and avoidance of unexpected costs.

It also important to know the acceptable level of risk communicates it throughout the firm so everyone knows how innovation it is acceptable to be. Because it is important to remember that it is a close connection between risk tolerating and innovation.

It is important to remember that risk tolerance is dynamic and that the acceptance of risk will change with time and through the project. Also, when you have bigger firm with portfolio management structure, it is important to remember that lowering the overall risks will not automatically be true for a single project. It is a challenge to find a common risk tolerance for all participants for the whole life cycle of the project. The level of risk tolerance should be set already in the start when the purpose of the project is being clarified.

Capacity of Risk

This is the measure of financial risk the firm can afford to take. This is based on the firm’s investment strategy and how the measured risks for the task required will negatively affect the company’s financial goal.

Required Risk

This is the actual risk the project requires to be done within the budget, schedule and at the requirements of the client. Unlike the risk tolerance level, this is risk the firm has to take to reach the goals for the project. When a client espect more in return then the risk they are willing to take supply, you have to adjust the balance and the risk required will follow.

Benefits

The success of a job comes easier with an in-depth understanding of the companies needs in accordance to their expectation of the outcome of the project. This way companies choose more wisely and avoid dangerous risks. In projects it is impossible to avoid risks, but when you understand them you can benefit from them.

Limitations

There is no accurate way to measure a firms risk capacity and risk tolerance because it is unique for each company and exclusive to every single project.

Very often after a risk profiling, the client see that the risk tolerance and the two financial aspects, required and capacity of risk, are not the same. The result is often not reaching the goal of the task. In these cases adjustments must be done to make a balance between the risks taken and the goal of the task.

In the classic risk profiling you only look at the current situation of the firm in a particular project. With this method the history of the company will not be considered. By looking at a firm’s decision-making over time, their experience in the industry and their overall attitude to risk, it will give a better risk connection.

The use of Risk Profile in Turnkey Projects

Risk and uncertainty is a damaging factor in the construction industry. The construction industry is characterised by complexity, time pressure and a competitive marked. It can be very costly for stakeholders not to account for risk. The chance of failure in the construction industry shows that project coalition actors, especially contractors, need to have a framework for risk analysis and risk profile.

Ling (2005) identified contractual risk factors that are the same globally:

• The nature of the work.
• Combination of the workload and the constructor’s need of the project.
• The level of realistic pricing of the project.
• The amount of competition of the project.

If you look at turnkey in the construction industry there are some main categories of risk factors as well:

• Pricing of the project; owner’s unreasonable expectations.
• The amount and use of subcontractors; inexperience, lac of skilled labour.
• The contractor; poor project management, incompetent team.
• The external risks.
• The internal risks of the different coalition actors.
• The unforeseen site conditions.

When you make a companies risk profile you need to look at the factors above. To be able to establish the level of risk tolerance and risk capacity you have to identify all risk required completing the firm’s task within the project. As explained, the risk tolerance is a psychological characteristic. Knowing the level and amount of risks will shape a company’s risk profile connected to a specific project.

As explained under the section about turnkey contracts, the use of tendering and the competition in the industry forces the contractors to deliver as low price as possible for a project. It is not easy to know the amount of work or the exact timeline of a construction project, and with the risk profile the project manager can make a more likely picture of a worst-case scenario of the project.

Baloi & Price (2003) found that there is a close relationship between the use of virtuous risk management tools and successful projects. This is a logic because risk are defined after the their impact on the objects set for the project. It is important that for example the consultants knows the risk they are taking on and their capacity so that they can price their risk and protect their interests in the contract. But many contactors rely on their own experiences in pervious and similar projects to price the project. When doing it this way, it is important not to avoid innovation in the process.

The process from risk identification till pricing is crucial in a turnkey contract. It is important that the firm has a realistic expectation for the outcome of a project combined with their risk tolerance. The contractor, consultant, owner or sub-contractor need to process the risks identified and construct preventing measures.

There is many companies that offers risk profile generators, such as OGC(www.ogc.gov.uk) or RiskBusiness. This way companies can look at their risk profile over time and see how it changes over a project. Another benefit is the opportunity to compare with similar companies in the industry or standardised risk profiles.

Limitation

Risk tolerance, as explained, is a crucial part of risk profiling. In big and complex project like turnkey, bad channels of communication results in miscommunication of risk acceptance level. A normal outcome of this is delays, overspending the budget and a displeased stakeholder. There are very few communication tools for project managers, and without a communication strategy the risk profiling has little value. Therefor the risk profile is depended on a thorough risk management plan with focus on communication. Without this, the collation actors waste a lot of time and money on risk profiles that are not getting through to the right persons.

Further, a valid risk profile depends on the risk-taking and innovating culture of the workers in the company. It has no effect if the head of the firm has a high acceptance of risk level if the workers are not included and work with the same innovating goal.

Annotated Bibliography