“Small opportunities are often the beginning of great enterprises.” – Demosthenes (384 – 322 BC).
The overwhelming majority of commercial arrangements are underpinned by contracts. The contract is largely used as a tool to allocate risk but the way we often use contracts to manage risk is ineffective for many reasons. First, there is asymmetry of information where parties are unaware of what risks actually exist, what the likelihood of risks are, and their consequences. Secondly, the risk allocation process is often controlled by the buyer and this often results in unfair risk allocation. Thirdly, we become so obsessed by managing risks that we fail to explore opportunities and value creation. In other words, we end up leaving substantial value on the table during negotiations and beyond. This blog explores strategies to improve the way we manage risk and opportunities through collaboration.
Risk and Opportunities Identification
It would be remarkable if a buyer fully comprehends all relevant risks associated with the goods and services they are procuring. It is highly likely an asymmetry of information exists whereby the supplier has a more comprehensive and accurate understanding of the risks associated with their deliverables. Similarly, suppliers may not have a full appreciation of the customer’s environment, constraints, and motivations. Typical commercial negotiations are underpinned by this bilateral asymmetry of information and this results in suboptimal outcomes. There are some strategies that are often used to counteract an imbalance of information such as:
- Contracting for an ‘outcome’ rather than a ‘thing’,
- Relying on price competition to ensure price (not necessarily value) is fair,
- Performing due diligence such as referee checks, customer testimonials, exploring defect rates etc.
Whilst the above strategies may provide some confidence that the goods and services provided are fit for purpose, there are significant limitations where competition is constrained, there is a selection bias in referees/testimonials, and with the failure explore value creation.
Rather than adopt an arms-length commercial approach, a collaborative approach with early engagement is far more likely to capture all relevant risks associated with the contracting function but more importantly, identify opportunities to create value. This can be achieved with buyers and suppliers working together in a joint risk and opportunities workshop to gain a better understanding of the risks and opportunities upfront.
The two stage Early Contractor Involvement (ECI) contract is a very good example of collaborative risk and opportunities management. Under the ECI process, the buyer and suppliers work together early in a preliminary stage to jointly identify risks and opportunities in a collaborative fashion. All options can be explored in this stage, there should be no unnecessary constraints. Once complete, the parties further work together to explore who is best placed to manage the identified risks. This may involve risk transfer or even risk sharing. Insurance brokers may also be invited to participate in these workshops where risks can be allocated to third parties. We need to recognise that this preliminary stage does not have a default risk allocation strategy, a default contract template, or pre-defined remuneration strategy. It is up to buyers and suppliers to jointly work together to determine the most suitable commercial framework well before the head contract is signed. Working together collaboratively eliminates most of the challenges associated with asymmetry of information and ensures the final cost estimates and schedules are realistic.
Fairness in Risk Allocation
Joint management of risk and opportunities will inherently support fairness in the commercial relationship. We mention previously in collaborative contracting blogs that unfair risk allocation can severely erode value:
“Inappropriate allocation of risk resulted in a 14 percent increase in costs to projects. Of this amount, the customer was liable for 78 percent of the cost increase.”
We discussed the downsides of unfair risk allocation in our blog on commercial models but what are the benefits of fair risk allocation? Fair risk allocation eliminates many unwarranted contingency fees or management reserve being added to the supplier’s contract prices. More importantly though, a fair and equitable commercial framework encourages parties to share information, explore continuous improvement and innovation, and focus efforts on pursuing opportunities. A focus on risk transfer does the exact opposite.
Consider a firm fixed-price arms-length contract where the customer allocates as much risk as possible to the supplier. In this situation, the key motivation of the supplier is to spend all their efforts on risk abatement, deliver outcomes only within the strict boundary of the contract, and ignore any deviations from the contractually delivered ‘plan’. If we are serious about benefits realisation, a more considered approach is needed that;
- Encourages joint risk and opportunities management;
- Ensures a risk and reward structure is implemented that is fair and reasonable;
- Encourages parties to work towards delivering enterprise goals (which also includes a vibrant, sustainable, and profitable supply base);
- Focusses efforts on fixing the problem and not the blame; and
- Tolerating prudent risk taking, consistent with the approach of fail fast, fail cheap, fail often, fail safe, and fail smart.
A joint approach to managing risk and opportunity registers with a single of truth is far more likely to foster innovation and value creation. A single source of truth that represents a holistic picture of project risk is also far more valuable to all stakeholders. This can be achieved via a joint liability risk assessment or risk log that explore risk as a probability distribution. The quality of this risk assessment will also be far superior as both buyers and suppliers are involved. A probabilistic analysis can be undertaken to explore most likely, worst case, and best-case scenarios for delivering outcomes. Buyers and suppliers can then adopt a mutually informed negotiation process to reach a commercial agreement but more importantly, all parties can work collaboratively to mitigate risks.
For those that want to explore probabilistic risk assessments further, I have developed a creative commons (free for commercial use) liability risk assessment template which converts three-point estimates for any number of risks into a probability curve and cumulative probability distribution. This tool is based on a PERT Beta distribution using a 10,000 point Monte-Carlo simulation. The tool allows users to derive expected value (p50) and best case/worst case estimates for known risks. This tool provides an understanding of the spread of risks on a project and informs the best commercial model for both buyers and suppliers and can be downloaded from the below link.
Monte Carlo Risk Analysis Tool
Dealing with Uncertainty and Estimation
Managing the known risks is arguably the easy part. Crafting a commercial framework that effectively deals with uncertainty (the unknown unknowns and known unknowns) is far more challenging. The traditional approach of dealing with uncertainty with indemnities and managing change through variations rarely delivers value. The topic of our next blog will explore strategies to craft a commercial relationship that does effectively deal with uncertainty.
Managing risks and opportunities jointly through early industry engagement is far more likely to create value. A shift to collaborative risk and opportunities management though does require a move away from traditional boilerplate contracts and tender evaluation processes. What is needed is a commercial model that explores risks and opportunities at the enterprise level and drive parties to proactively explore these opportunities to realise joint benefits.
 George A. Akerlof ‘The Market for “Lemons”: Quality Uncertainty and the Market Mechanism’ The Quarterly Journal of Economics Vol. 84, No. 3 (1970).
 Roger Quick, ‘Queensland ECI Contract’ ICLR .
 Queensland Government Chief Procurement Office Procurement Guidance Series “Relational Procurement Options – Alliance and Early Contractor Involvement Contracts” (2007) at http://alliancecontractingelectroniclawjournal.com/wp-content/uploads/2017/06/Queensland-Government-Chief-Procurement-Officer-ND-Relational-Procurement-Options-Alliance-and-Early-Conractor-Involvement-Contracts.pdf
 CII Research Report RR210-11 “Contracting to Appropriately Allocate Risk” (2007) summarised in Altman R., Cruz J., Halls, P “One-sided Contracts: Do They Pay Off?” ACCL Vol 11 1 (2017) p 169.
 US Government “Innovative Contract case Studies” (2014), p20.
 Vose D., Risk Analysis: A Quantitative Guide 3rd ed (2008) pp 672-4.
 Respectively referred to as ontological and epistemic uncertainty.