When you’re buying services from a contractor, you want to minimise your risk at the lowest possible cost. If you’re the contractor, you want to minimise your risk while maximising your revenue. This adversarial tension is the core reality of most contracts. What to do?
[Listen to audio version, read by David Hodes]
This is Part 5 of our series on Asset constraint management: Part 1 | Part 2 | Part 3 | Part 4 | Part 5
I define a contractor as anyone who is doing work for an organisation without a permanent employment contract. Thus, contractors could be consultants, professional engineers, IT specialists, lawyers, communications specialists, academics, government lobbyists, as well as every type of trade such as boilermakers, fitters, riggers, scaffolders, drillers and blasters. The usual reason to use contractors is that they either have skill sets their customers don’t or they have capacity which can be used against fluctuating demand, and against which the buyer is loathe to incur a fixed cost for the business.
When two organisations sign a services contract, that contract will primarily be one of two types—a fixed price for a defined scope of work or an estimate based on a schedule of rates for the types of resources and services provided. At the heart of contract negotiations is who carries what risk for what reward. At first sight, there is a direct conflict between the parties, as the owner’s cost is the contractor’s revenue. Every business is trying to maximise its profits now and in the future. Competition plays its part in determining price, but there is inevitably an adversarial stance built into the negotiation between buyer and seller.
Parties at loggerheads
The kinds of games played by professional contract negotiators are quite familiar. Let’s say the buyer wants a fixed price because they want to limit risk in their investment. The sellers will often go in with an unprofitably low bid, hoping (or confident in the belief) that the buyer has not been sufficiently diligent in their planning and will inevitably have to succumb to issuing variation orders for what was not in the original scope. Whereas if the contract is won based on a schedule of rates, there is always the expectation that the seller will drag the work out and will ladle on labour where it is not needed.
“The courts are filled with litigants suing
for damages on contracts gone wrong.”
These are generalisations, the exception being when the time to renegotiate contracts approaches and the sellers are keen to make a favourable impression. But, so long as each of the parties is optimising their benefit—whether minimising cost for the buyer or maximising revenue for the seller—there’s not much room for a breakthrough in results. Indeed, quite the opposite. The courts are filled with litigants suing for damages on contracts gone wrong.
How do we get to a win-win, then? What fundamental shift in thinking needs to occur? The answer is evident when you look at it from the perspective of the owner’s goal. They want their project to make them more money, either by increasing throughput or reducing operating expense. In most cases, the quicker they get that done, the better it is for cash flow: project burn is less and benefits start flowing sooner. Furthermore, they have the management bandwidth available to get onto the next big idea.
Shifting the mindset to win-win
Whatever the contractor can do to make this happen provides a win-win. In the case where throughput is increased—say, reducing the turn-time of heavy maintenance on an airliner, or completing construction of a new mine ahead of time—the business benefit is accounted for readily. Every day saved delivers additional contribution, and the costs incurred in achieving that acceleration can be measured against the benefit provided. The seller can participate in the upside, assuming they don’t compromise the quality of their work in a rush to the finish line. In the case where the goal is less burn, there is a short-term sense of loss for the seller. Why would they want to go faster when that would mean less money in their pockets? We have to think of the long-term benefit of buyer and seller relationships. To quote W Edwards Deming: ‘The result of long-term relationships is better and better quality and lower and lower costs’.
One way in which the idea of creating collaborative rather than adversarial contracts has been given expression is in the concept of ‘alliance contracting’. In its essence, an alliance contract is one where there is complete transparency on costs, and all the participants intentionally engage in a way that addresses both the share of the profits as well as the composition and culture of the leadership team. I believe there are two significant flaws in the model.
“Any project is by definition seasonal, whereas
the organisations engaging in them are perennials.”
First, there is usually a massive imbalance between the parties in how much cash is at risk if the project fails. Think, for example, of the owners investing billions of dollars in a desalination plant against the contractor’s fraction of that investment in performing the labour to get it built. Second, culture formation is a devilishly difficult thing to do. When the partners in the alliance come from organisations with their own strong cultures and ways of working, the project can be over by the time the forming, norming, storming and performing are done. Any project is by definition seasonal, whereas the organisations engaging in them are perennials.
So, if the prevailing paradigm is adversarial contracting, and alliance contracting is not practical because of the imbalance of the financial effects on decisions made collectively, what is a way through? As I quoted Paul Krugman in my recent article ‘productivity isn’t everything, but, in the long run, it is almost everything’, the fact is that Theory of Constraints (TOC) represents the most significant systemic improvement in industrial productivity since the advent of the Toyota Production System.
Thus, let’s look at the implications of this change in productivity from the perspective of both the buyer and seller of the contracting services.
Getting beyond mule-headedness
Imagine, for example, your contract is to haul timber from the Back of Bourke to Gilgandra Downs, and you’ve negotiated a rate based on the volume carried. You’ll use the same kind of donkey cart as your competitors, and you’ll keep doing what you’ve always done to try to make it competitive by starving the poor beasts of costly sustenance and keeping the whips handy for when they inevitably flounder from the burden. It’s just how the industry works. Then along comes some smart aleck to tell you of this innovation of his, called a truck, and you come to learn that you can use the truck to haul an order of magnitude more logs in a fraction of the time and cost.
If you’re in the bid phase of your contract, you get to price so aggressively that your competitors will swear you’ve lost your mind and assume you’ll soon be going broke. But, you win the gig, knowing you’ll secure your profit by the gain you make in productivity. Then, once you’ve won the bid based on the ‘dumb ass’ competitive environment, you get to pocket all that extra margin—at least until your competitors and your customers wise up.
Thus, if you are a contractor labouring under a fixed-price contract, it is beyond reason to not undertake the work required to develop a TOC operating philosophy and combine it with the proven methods of Critical Chain Project Management (CCPM) and Drum Buffer Rope (DBR) production management. It’s your equivalent of the transformation from ‘dumb ass’ power to the productivity leap provided by the internal combustion engine.
The real power of buying the metaphorical truck, however, sits with the owner and buyer of contracting services. It is invariably the case that in hard numbers, the risks and benefits for the owner far outweigh any consequence there may be for the contractor. The organisation with principal risk for the development of a new toll road has far more at stake than the contractor engaged in building it. With this amount of commercial clout, the owner party will usually use the competitive environment to beat their price and risk down to the lowest level the qualified contractor with the biggest appetite for the deal is willing to bear. This is a classic win-lose strategy and leads to endless rounds of claims and counter-claims, often ending up in litigation. Relationships between buyers and sellers become strained, and you spend far more energy arguing performance details than turning that talent to deliver what all parties want—a long-term, win-win relationship.
TOC for the win
By using a constraint-based approach to thinking about and managing contractors—with the logic of the method and the overwhelming evidence of its practical results—I’m convinced you’ll be able to achieve bigger win-wins than you thought reasonable or possible. Furthermore, everyone can savour the feeling that comes with having a fair go. In the words of my ‘Just Work’ manifesto, ‘they are empowered with the requisite authority over the resources required to acquit all of that for which you hold them accountable. You know what you have called for is both reasonable and possible, given the human and material resources you place at their disposal.’
“Everyone can savour the feeling
that comes with having a fair go”
Objectively and rationally sizing the work—and having the owner build and manage a TOC production system capable of synchronising the efforts of disparate workforces—removes bias and mistrust from both sides of the buyer/seller divide. All parties can focus their undivided attention on whatever constraint stops them from maximising the net present value of their assets.
The buyer teams will gain a greater feeling of job security by profoundly understanding the baseload of the work and being able to flex capacity through the use of the contractor component. For the sellers, they develop the knowledge of how to work in this high-performance environment and can gain a share in the spoils of objectively measurable productivity enhancements. And everyone gets to enjoy the deep sense of satisfaction to be gained from the multifaceted achievements of doing meaningful work.
This is Part 5 of our series on Asset constraints management.
Part 1: Asset Constraints Management Capabilities
Part 2: Projecting Projects
Part 3: Producing production
Part 4: Maintaining production
Part 5: Controlling contractors
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What’s next?
The change from standard thinking to Theory of Constraints (TOC) is both profound and exhilarating. To make it both fun and memorable, we use a business simulation we call The Right Stuff Workshop.
We’d love to run it with you. To learn more:
- download the brochure (no email required)
- schedule a call
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[Background image: Men at work on scaffolding, Shutterstock]“A gain at the constraint is a gain for the system as a whole.”
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