Getting the right incentives into construction management agreements

Poorly-designed incentives may encourage a contractor to behave in unexpected and unpleasant ways.

And construction management is a form of contract that is especially vulnerable.

The Construction Management Association of America (‘CMAA’) describes two models of construction management:

  • agency, where the construction manager acts as the agent of the owner in managing the various contractors, and
  • at-risk, where the construction management arrangement converts to a more general construction contract arrangement once a price is agreed.[1]

This article is about agency construction management. In an agency construction management arrangement:

  • The construction manager is the agent of the owner.
  • All works contracts are direct with the owner.
  • The construction manager provides project management and related services on behalf of the owner.
  • Remuneration is in the form of time-based payments and reimbursed expenses.
  • The construction manager receives an agreed fee over and above its costs.
  • Incentives may or may not be applied to the fee.

Like any form of contract, construction management has its pros and cons:

  • It makes it easier for owners who may only occasionally execute major projects.
  • It is likely to be less costly in uncertain conditions because the construction manager does not need large risk allowances.
  • Owners are able to be more actively involved, have greater control, and enjoy a more collaborative style of relationship.
  • They tend to be close to cash-flow neutral for the construction manager, and thus an attractive option when capital is constrained.
  • But not only does the owner take all of the cost risk in a cost-reimbursable arrangement, a construction manager has little incentive to find value improvement or cost reduction opportunities for the owner.

A common issue is that owners, while skilled at dealing with technical risk, do not really understand the risk perspective of construction managers.

Owners see their world from the perspective of creation, development and exploitation of assets, while construction managers are in the business of selling services.[2] And owners and contractors may price the same risk differently because it impacts them differently.

Owners make most risk allocation decisions, and often mistakenly believe that they are removing risk from the project when they allocate it to the construction manager.[3] But the more risk the owner pushes onto the construction manager, the more potential there is for conflict, and the more closely the owner will need to watch the construction manager.[4]

Owners are likely to have less information about the progress and details of the project than the construction manager.[5] This can create a ‘moral hazard’ where the construction manager (by being closer to the job and having better information) is able to make choices that favour its own interests over the owner’s.[6]

The moral hazard problem can be dealt with by making the agent financially accountable for the consequences of its actions,[7] but this will only work if the contract incentives encourage the construction manager toward the desired behaviour.

If properly designed, incentives will deal with moral hazard.[8] But if not carefully designed, they can have unexpected effects.

Owners often do not understand how to apply incentives, or the effect incentives will have on their construction managers.[9]

Incentives may at best be ineffective, and at worst, perverse.

If the incentive structure of a contract maximises financial return from a certain set of behaviours, those are rationally the behaviours the construction manager will encourage.

If the benefits from opportunistic behaviour outweigh the reputational, legal and other potential negative consequences, a construction manager has rational grounds to ‘game’ a poorly-designed incentive arrangement.[10]

An owner also needs to think about how the construction manager’s incentives may drive its behaviour towards other contractors. A pain/gain arrangement for project costs may, for instance, create an incentive for the construction manager to disallow contractors’ costs, if this will increase the payment to the construction manager at the end of the project.

Though a lower overall project cost is in both the owner’s and the construction manager’s interest under a target cost arrangement, it is clearly not in the contractors’ interest unless they also have positive incentives to reduce costs.

Here the owner faces the risk that inappropriate incentives for the construction manager may rebound on the owner in the form of disputes with the contractors. And if an incentive scheme only benefits a contractor’s owners or shareholders, it may not translate into actions on the ground from the construction manager’s personnel.

So what to do? Give up on incentives entirely?

Some would argue that incentives are never a good idea. But I believe that well-designed incentives have their place. If incentives are designed to be (or at least seem to be) fair, then the construction manager is more likely to align its interests with the owner’s.

Both owner and construction manager need to work together to develop the incentive regime. And in designing incentives, they should not only consider financial incentives, but work through the behaviour such incentives will drive.

  • [1] The Construction Management Association of America, AN OWNER’S GUIDE TO PROJECT DELIVERY METHODS.
    [2] Merrow, Edward W, Industrial Megaprojects: Concepts, Strategies, and Practices for Success (John Wiley & Sons, 1st ed, 2011).
    [3] Blake Dawson, ‘Scope for Improvement 2011 – Project Risk – Getting the Right Balance and Outcomes’ (2011).
  • [5] Xiang, Pengcheng et al, ‘Construction Project Risk Management Based on the View of Asymmetric Information’ (2012) 138 Journal of construction engineering and management 1303.
  • [6] Bengt Hölmstrom, ‘Moral Hazard and Observability’ [1979] The Bell Journal of Economics 74.
  • [7] Chang, CY, ‘Principal-Agent Model of Risk Allocation in Construction Contracts and Its Critique’ (2013) 140 Journal of Construction Engineering and Management.
  • [8] Schieg, Martin, ‘Strategies for Avoiding Asymmetric Information in Construction Project Management’ (2008) 9 Journal of Business Economics and Management 47.
  • [9] Rose, Timothy and Karen Manley, ‘Motivation toward Financial Incentive Goals on Construction Projects’ (2011) 64 Journal of Business Research 765.
  • [10] TC Berends, Contracting Economics of Large Engineering and Construction Projects (PhD Thesis, University of Delft, 2007) 13.

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