Alliancing in construction

Developed by Gisle Skuggedal

Abstract

In construction projects clients often outsource work. This could be due to that the workload does not justify establishing an in-house capability, or benefits by reducing information asymmetry is outweighed by the cost of internal governance. When work is outsourced there is generally an information asymmetry between the client and the supplier. Where the supplier has the expertise. This information asymmetry may lead to opportunistic behavior by the supplier. Consequently, the client might want to switch supplier. However, the costs of switching supplier are often high and include transaction costs for re-tendering, costs for associated litigation and so on. The switching costs for a supplier is often lower as interim payments are frequently used.

Alliancing is a mean to even out the imbalance in information and switching costs, and in this way minimizing the window for opportunistic behavior. One problem with alliancing is the complex nature of the concept, which makes it hard to define. It is important that alliancing parties has a common understanding of the concept, to avoid a cross-purposed and ineffective discussion. In a meta-study conducted in 2006 by John F.Y. Yeung, Albert P.C. Chan, and Daniel W.M. Chan gather different definitions of alliancing used in articles from scientific journals and conference proceedings, and used Ludwig Wittgenstein’s idea of family resemblance to come up with a definition for alliancing. This definition will be presented in this article. Further the five core elements of alliancing identified in the meta-study, “Formal Contract”, “Real Gain-share/Pain-share”, “Trust”, “Long-term commitment” and “Cooperation and Communication” will be discussed.

In the end the article will briefly presented the concept of relational contracts, which is closely related to alliancing..

Problem of moral hazard

Whenever a client chooses to outsource work the problem of moral hazard will arise. There is no guarantee for the client that the contractor will give a consummate performance once he is hired. The problem of moral hazard arises due to several reasons, one of them is an asymmetry in information between client and contractor. Were the contractor due to his expertise will hold the most information. This gives the contractor the opportunity to behave opportunistically as he can have information that is critical for effective client decision-making. Opportunistic behaviour from the contractor can cause the client to want to switch contractor. However, the switching costs for client is high due to interim payments, transaction costs of retendering, and so on. On the other hand, the contractor has small switching costs compared to the client due to interim payments. Hence there is an imbalance in switching costs.

Alliancing is an attempt to redress the imbalance in switching costs and information, and in this way, minimize the window for opportunistic behaviour. By using alliancing one tries to align the goals of the client and the contractor, and as result create an incentive for sharing of information. The problem of switching costs are addressed using a framework agreement. One of the challenges with alliancing is that is complex concept, which has led to many different definitions of the concept. The discrepancy in the definitions makes in unclear what attributes the concept of alliancing contains. This uncertainty makes room for ineffective and cross-purposed discussion. Hence, it is preferable to have common understanding of the concept. This is hard to achieve with a comprehensive and conclusive definition, that states the necessary and sufficient conditions, as the concept is complex. However, Wittgenstein family-resemblance is a tool that allows us to define complex concepts.

Definition of alliancing in construction

To have thorough understanding of the concept of alliancing, John F.Y. Yeung, Albert P.C. Chan, Daniel W.M. Chan (2006), went through alliancing literature and sorted out the main factors describing the concept of alliancing. These main factors were separated into three groups as illustrated in Fig..

Distinction of alliancing factors (John F.Y. Yeung, Albert P.C. Chan, Daniel W.M. Chan (2006))

The factors which make up the general prerequisites, top management support and adequate resources, where presumed to be generic elements needed in all type of construction projects. Thus, these elements do not contribute to our understanding of alliancing.

From Fig. it is seen that sustainable development was viewed as a desirable outcome of alliancing. An alliancing project can fail. Hence a project is not defined as alliancing based on the outcome. Thus, alliancing will be defined based on the hard and soft elements listed in Fig.. The hard elements refer to contractual and legal features, while the soft refer to elements directly related to relationship and people. Common goal and objective, and agreed problem resolution methods are both viewed as soft elements. Even though, they both indirectly relate to contract clauses. This is due to that both element have a stringer relation to relationship and people.

Having determined the elements that captures the essence of alliancing, the study moves on to using Ludwig Wittgenstein’s idea of family resemblance to establish the relation between these elements and alliancing. As mentioned in the abstract, numerous definitions for alliancing exists. There is a high degree of discrepancy among these definitions as to which elements defines alliancing. Thus, it might seem like the concept cannot be defined. Ludwig Wittgenstein disagrees. He argues that though complex concepts cannot be defined in the traditional way, by stating necessary and sufficient conditions, they can be defined as a complex network of overlapping similarities. John F.Y. Yeung, Albert P.C. Chan, Daniel W.M. Chan (2006) created an alliance sunflower model, on the bases of Wittgenstein’s family resemblance concept, to define construction alliancing. First they searched the website of Google Scholar to find relevant and important literature regarding alliancing. They narrowed it down to 14 relevant pieces of literature. Then the importance of the different elements was determined on the bases of how often they were cited. Higher citing frequency equals high importance, to concept of alliancing. This resulted in five core elements; “Formal Contract”, “Real Gain-share/Pain-share”, “Trust”, “Long-term commitment” and “Cooperation and Communication”. These elements are in the centre of the sunflower illustrated in Fig.. The petals of the sunflower contain peripheral elements. For something to be defined as alliancing it must contain all the core elements and some combination of the petals. Any single petal or combination of petals will do. This makes it possible to create various forms of alliancing projects, dependent of which combination of petals are chosen.

Alliancing sunflower model(John F.Y. Yeung, Albert P.C. Chan, Daniel W.M. Chan (2006))

The five core elements

In this section the five core elements, that must be present for a project to be an alliancing project, will be presented.

Formal contract

One of the key differences that separate alliancing from other methods of establishing collaboration between parties, e.g. [1]., is that alliancing is expressed in contractual form. Through these contracts the parties of an alliance are fused into a virtual corporation with agreed upon profit and loss outcomes that are legally binding. Thus, alliancing is both a relationship management system and a delivery system.

Real gain-share/pain-share

Real gain-share/pain-share can be implemented in an alliance by a target cost contract. The Scottish Futures Trust expressed that the basic principle of these contracts is “that a target cost is agreed upon and then the contractor is paid for the work undertaken on a cost reimbursable basis”. When the project is finalised the final target cost, which is the original target cost with the addition of any costs related to employer changes and employer risk events, is determined. The final target cost is then compared to original target cost. Gains achieved by managing to keep the final target cost below the original target cost, will be shared on a pre-agreed basis. The same goes for losses associated with a final target cost higher than the original. This is the pain share. Fig. illustrates how a typical real gain share/pain-share model works.

Model of real gain-share/pain-share (John F.Y. Yeung, Albert P.C. Chan, Daniel W.M. Chan (2006))

By creating an environment where the employer and contractor share pain and gain, one has achieved an alignment of the contractors and employers’ goals. Both parties are motivated to control costs, as they share the risk of loss and profit through a gain-share/pain-share mechanism. The gain-share/pain-share mechanism can be achieved in several different ways. Fig. illustrates four different paths to achieving gain-share/pain-share.

Methods for achieving gain-share/pain-share

The first example suggests a 50-50 split between the parties, without any caps. This is considered the most just gain-share/pain-share mechanism. It also ensures a strong partnering culture. However, the lack of any cap on the pain-share makes it hard for the employer to estimate what its final payment will be.

The second example proposes a 50-50 split between parties in range of +/-5%. If the costs exceed the target price with more than 5%, the contractor will endure a larger share of pain than the employer. A gain exceeding 5% of the target cost will give the employer a greater share of the profit. Thus, this might seem as an ideal setup from the employers’ perspective. However, this setup reduces the contractors’ motivation to achieve savings greater than 5% as it would increase possibility of starting with a higher target cost.

The third example suggest a compromise between the first two examples. Where the 50-50 split is applied until +/- 10% of the target cost. In this way creating a strong objective alignment of the two parties’ goals. The absolute cap for the employers’ pain-share causes the employer to ease up on the final cost predictions. If the target cost is based on a sufficient analysis, the contractor will not have incentives to seek its increase as a 10% over-spending is highly unlikely.

The fourth example suggest the use of a guaranteed maximum price, GMP. A GMP makes sure that the employer expenses do not exceed the target price. In the example illustrated in Fig.\ref{fig:gspsm}, the employer will in addition keep 100% of the gains exceeding more than 10% of the target price. Even though this can seem like an ideal deal for the employer, it does induce some challenges. The GMP can work as an incentive for the contractor to drive up the target price to minimize its risk of overspending. From the contractors’ perspective, the gains of savings are small compared to the loss experienced if they fail. Thus, the contractors’ incentive for achieving savings are small.

The fourth example illustrated how GMP could be used to cap the clients’ risk. A guaranteed maximum liability, GML, can be used to cap the contractors risk. All the methods mentioned in the examples above are used. Which of them are used dependence on the situation.

Trust

Elements of trust

Trust is needed in an alliance without it, it is impossible to exchange any form of social or economic service. As any exchange requires that a party performing a service, can expect the other party retaliate the service with a service of similar value.

Honest communication is important when seeking an alliance based on trust. Workers in the case study by Malik M.A. Khalfan, Peter McDermott and Will Swan expressed that trust could only be achieved when people where honest.Thus, the people can be certain that the information shared reflects the real situation. However, if reliance between the parties is absent it does not matter if the information communicated is honest. Reliance is of high importance in construction project as they often consist of many specialist trades. Thus, everyone will not have the expertise to comprehend all the information and will therefore have to rely on others. Fig.5 illustrates some of the other elements that make up trust.

Trust is strongly dependent on the relationship between the two parties that make up alliance. The relationship between the parties develops throughout the life-cycle of the project. One party that consistently proves to be reliable will earn the trust of the other party. If the parties have worked together before a level of trust may already be developed. As reported by a case study done by Malik M.A. Khalfan, Peter McDermott and Will Swan, workers learn to trust or not to trust people that they work with. This illustrates how trust is a dynamic that develops throughout the life cycle of the alliance.Hence, trust needs to be ensure during the projects life cycle. This can be achieved by use of teambuilding exercises throughout the span of the project.

How problems are solved within the virtual organization affect the trust between the parties. Along the course of a project problems are bound to happen, the ability of the alliance to solve these problems are vital for the project. Trust is an attribute that makes it easier to solve problem, but problem solving is also an arena that builds trust. It has been seen that positive relations are built when problems are solved at point, instead of being referred to superiors. On senior level, it has been seen that disputes solved without reference to the contract results in increased trust. Jones and Bowie (1998) argues that this introduces a paradox for the virtual organizations that arises with alliancing. As the virtual organizations, contractual basis works against the building of a high trust relationship. The basis for a high trust relationship is relational rather than transactional. Hence, with a high trust relationship it is possible to reduce the transactional costs associated with alliancing.

Long term commitment

Walker et al. looked at commitment as the physical and mental manifestation of trust. By this they mean that the bargain associated with high trust relationship, due to low transaction cost, will motivate the parties to commit with personal pride and a felt obligation to “do the right thing”.

Walker et. al also draws attention to the importance of forming management group, as a true joint management group with a democratic membership to ensure commitment and trust. At the same time discouraging manipulation. Further Walker et al. exemplified this by the management plan of the National Museum of Australia Project. The management plan was based on an alliance concept. Where the core element of the alliance was to achieve a positive outcome for all parties of the alliance, through commitment to a common goal of project realisation. The commitment was made under the assumption that the projects’ success would result in a win-win situation. Not just from the previously agreed upon rewards, but also as the members of the alliance would get a competitive edge on the market from their involvement in a milestone project. This led to project that where finished within the budget and time-limit.

Rowlinson and Cheung (2005) refers to findings that shows that commitment at the level of senior management, has a strong positive influence on the alliance and its culture. Providing support for the view that a committed management strengthens the alliance.

Cooperation and communication

Cooperative arrangements in an alliance motivates the members to work together towards their major goal and objectives for a project. In alliancing cooperation is established through contracts, which are made to increase the workability of the alliance. The parties of the alliance having shared space arrangements and information systems and as well as agreed resolution methods, can further increase and improve the parties’ cooperation and interaction. Walker et al. stated that effective communication is essential for successful relationship building. Walker et al. also pointed out that successful integration of the alliance partners is dependent on communication at a personal level, at a business level, and at an operation level throughout the collaborative procedure. The shared information system mentioned earlier together with an information processing integration makes it possible to meet the requirements for communication at each level.

Relational contract

Relational contracts are, like alliancing, a tool used to manage the dynamic in coalition projects. They differ from other contracts in the sense that they attach great importance to rights and obligations created by laws and social values. Another feature that separates relational contracts from other contracts, are that they put a great emphasis on trust between the members of the coalition.

All transactions are to some extent relational as they involve “deeply embedded interconnected relations”. However, the core elements of relational contracts put a greater significance on co-operation and dependency. There is a special emphasis on sharing knowledge within the coalition to benefit the collective. This is meant to shift the coalitions’ focus from being purely product based to being based on the process and beyond to the business relationship. These connections encourage sharing of knowledge and information. This creates an environment where innovation and value for the parties of the relationship is facilitated. Hence, relational contracts benefit the parties involved by being a cornerstone for an innovative and trustworthy relationship.

Annotated bibliography

The definition of alliancing in construction as a Wittgenstein family-resemblance concept, At www.sciencedirect.com, John F.Y Yeung, Albert P.C. Chan, Daniel W.M. Chan, 2006 A meta-study where alliancing has been defined by use of Wittgenstein family-resemblance.

Managing Construction Projects, Graham M. Winch, 2002, page 132-148 Gives an good introduction to the causes and effect of moral hazard. It also gives an introduction to how one can use alliancing to adress these problems

Relational Contracting - Creating Value Beyond the Project, Barbara Colledge, 2005 The paper gives a good description of realtional contracting. It presents a definition of the concept, where the differences between realtional contract and other contracts is highlighted. It also present the benefits gained from relational contracts.

REVIEW OF SCOTTISH PUBLIC SECTOR PROCUREMENT IN CONSTRUCTION: Guidance on the operation of target cost contracts and pain-share/gain-share mechanisms, Scottish Futures Trust, 2015 The paper presents how one create a gain-share/pain-share mechanism in construction project, with emphasis on target cost contracts. It further discusses different variation of these contracts, and highlights strength and weaknesses with each method.