Issue Identification and Appraisal
Blogs 18 and 19 discussed development of the curves for both the Contractors EPC costs and the Owner’s overheads and lost opportunity cost curves, as shown in figure 1 below. As previous advised this excellent graphic comes from the GPCCAR Module 08-7 and as is based on the US Department of Transportation, Federal Highway Agency’s document “Work Zone Road User Costs Concepts and Applications” figure 15. This blog will develop the final curve the Total Cumulative cost and finalise the chart of the conceptual project. Once completed, the EPC Project curve will be used to determine the ‘Bonus/Incentive’ or ‘Penalty/Disincentive’ against the criteria selection. This week’s problem statement is: How fair is a Bonus/Penalty system and when should it be developed?
Figure 1 – Relationship between project cost and duration
As this is a three-blog posting, each one is examining a different curve on the chart, and finalising with an incentive/disincentive proposal.
- Total Contractor’s Construction Costs
- Cumulative Owners Engineering, Project Overhead and Lost Opportunity Costs
- Total Cumulative Project Costs
There are two alternatives; a) Bonus, or b) Penalty, and these depend on the Contractor’s performance in achieving targets.
Develop the Outcomes for each
The final step in development of the chart is to generate the Total Project costs curve, and is not a difficult task as it is the sum of; 1) the Contractor EPC curve and 2) the Owner’s Cost line, however remember the conceptual project that is being tested;
An Oil and Gas facility Project consisting of 200,000 barrels per day processing plant, a fifty-kilometre pipeline, a near-shore storage tank to hold twenty days’ inventory along with a tanker loading facility. The project is based on a tie-in at the ‘fence-line’ where the feed-stock for the processing facility is delivered, therefor the cost estimate excludes any well-pad facility and transit flowlines. Each project facility is based on an Engineering, Procurement and Construction (EPC) philosophy for design, procure and construct of each portion. Also, included in the estimate along with the EPC portion, are costs for land purchase for the facilities, and all the associated owner’s costs for the Project Management Team (PMT) and offices. Overall Cost Estimate is $2.5B (Billion) with $1.8B being the Contractors portion.
Using the same spreadsheet sum the monthly values of both to provide a total cumulative cost range of values. Figure 2 shows the curve.
Figure 2 – Total Cumulative Project Costs Curve
In summary, the three curves have been developed so all that is required to complete the chart is to put them all on the one chart and then determine the Bonus/Penalty zones.
Determining the Contractor’s optimum cost and duration is based on the agreed schedule and cost in the Contract, there for this case it would be a) $1.8B and b) 42-months.
The Owner’s optimum costs are where the cost curve is the lowest and at what point it occurs, in the model this is a) $3.1B and b) 38-months.
To determine the maximum duration overrun the author felt that it would only be fair to use the normal process of allowing one month for every year of the project, therefore with a 42-month baseline duration the maximum over-run duration should occur between month-45/46, the basis of the analysis is using month-45.
Figure 3 – Schedule vs Time Optimization Model
- Bonus – The determination the ‘Incentive Zone’ is found by trending the data-points from the Contractor’s optimum duration, and the Owner’s optimum duration on the Total Cumulative Cost curve across to the ‘Y-axis’.
- Penalty – The ‘Disincentive Zone’ is determined by using the difference in the other two points on figure 3, the Contractor’s optimum cost vs the higher data-point of the Duration overrun (the lost opportunity costs),
The criteria to be used comes from reviewing the information in figure 3.
The Bonus: The upper value being $3.5B and the lower value being $3.1B, therefor the incentive is $0.4B which needs to be broken down into a $/day basis. To be clear here the incentive would be 100% to the contractor to cover the expenses/inefficiencies associated with acceleration to complete the project quicker, the benefit to the contractor is the shortening of the project duration which in turn would reduce their overheads. The Daily Incentive Cost = Total Incentive value / Number of days, In this case there are 4 months at 30.4375 days per month (the amount of days in a month) which equals 121.75days. Using the $0.4B or $400,000,000 divide the figure by the total amount of days to give a daily figure of $3.285M/day. This is the incentive figure that would be included in the Contract.
The Penalty: In this case is on month-45 intersection with the ‘Owner’s overhead and opportunity’ line equal to $2.4B, and the Contractors optimum cost which is the bid value of $1.8B. The disincentive zone value is equal to $0.6B which also needs to be converted into a daily rate, this time the number of days is 3 months multiplied by 30.4375days/month which equals 91.3125days, giving a daily disincentive rate of $6.571M/day for any delivery after the end of the 42nd month.
Analysis and Comparison of the Alternatives
The problem statement is “How fair is a Bonus/Penalty system and when should it be developed?”
It’s a two-part problem statement – a) How fair is a Bonus/Penalty system? And b) when should it be developed?
To answer point a), there are no hard and fast rules for development of incentives in any contract, but any top tier performing Contractor would always consider options to complete a project ahead of schedule for some form of bonus, while keeping in mind failure to achieve could result in penalties from the Owner. Looking at the conceptual project used to develop and test the above curve, the $0.4B incentive value is to purely cover the expenses and inefficiencies associated with the acceleration, likewise the $0.6B penalty is to cover the lost opportunity costs. Any gains to the contractor would be as a result of saving of overheads. The wording for this type of inclusion in a contract needs the full focus from both Owner and Contractors legal teams to ensure there are no ambiguities and the intent clear, instead of attempting to provide legal clauses for inclusion in a contract, some points for consideration;
- Both ‘Incentive’ and ‘Disincentive’ day rates need inclusion in the appropriate compensation section of the contract, along with any calculation formula to compute the incentive / disincentive costs.
- The scope of work associated with any ‘Incentive’ or ‘Disincentive’ are clearly identified, to ensure that the full intent of the acceleration or lost opportunity is not ambiguous and left to future interpretation.
- Careful attention needs to be given to ensure the contractor completes the full scope of the contract to achieve the full incentive amount and not a partial scope.
The WZ RUC document provides formulas to calculate the incentives based on contractor cost per day but relies on having actual data to compute the values, this is not feasible on large O&G projects due to the large amounts of revenue involved.
Response to point b) it should be as soon as viably possible. Based on the information above, it is clear that this type of Bonus/Penalty scheme could be determined at time of developing the contract. In the Oil and Gas sector many larger projects are usually partnerships between several multi-national companies, therefor any incentive scheme needs the full agreement between all parties prior to implementation. Using the model developed above and adapting it to be project specific, allows an incentive scheme to be developed at the same time as the main contract with or without caveats for its implementation based on a particular set of guidelines. This obtains all Partner/Stakeholder buy-ins ahead of the project commencement and allowing the Project’s managing partner to implement any pre-agreed format at the time the option is exercised, as opposed to waiting internal commercials to delay implementation.
Selection of Preferred Alternative
It’s difficult to pick a preferred alternative here, but believe given the choice, the option of earning a bonus is very attractive alternative, while the distinct probability that the Contractor might have penalties to pay for failure to meet the optimum duration would certainly get the Contractor’s attention from the very first day on the project.
Monitoring Post Evaluation Performance
As could be seen in the first blog in the series, there are many curve options that can be tested, each one provides slightly different answer. There is no “One curve fit’s all approach” here, each project has got slightly different conditions and development of a curve/model to suit those should be paramount if there is any possibility that acceleration of the project is an aspect that all parties embrace – a win win situation with both owner and contractor pleased with the favourable outcome.
- Mallela, J., & Sadasivam, S. (2011). Figure 15 –Work zone road user costs: Concepts and applications : final report. U.S. Department of Transportation, Federal Highway Administration Office of Operations (HOP).
- Guild of Project Controls. (n.d.). 08.7.3 – Cost vs Time Trade Offs (Optimization) – Guild of project controls compendium and reference (CaR) | Project controls – planning, scheduling, cost management and forensic analysis (Planning Planet). Retrieved September 5, 2017 from http://www.planningplanet.com/guild/gpccar/validate-the-time-and-cost-trade-offs
- Paterson, S. J. (2017, September 24). W18_SJP_Cost & Time Trade-off Part 1 – Achieving Guild of Project Controls / AACE Certification BLOG [Web log post]. Retrieved from https://js-pag-cert-2017.com/w18_sjp_cost-time-trade-off-part-1/
- Paterson, S. J. (2017, October 1). W19_SJP_Cost & Time Trade-off Part 2 – Achieving Guild of Project Controls / AACE Certification BLOG [Web log post]. Retrieved from https://js-pag-cert-2017.com/w19_sjp_cost-time-trade-off-part-2/