Stopping the Race to the Bottom

As Charlie Munger of Berkshire Hathaway once said, ‘If you have a dumb incentive system, you get dumb outcomes’ (here).  And it is hard to argue that the incentive system in construction is working positively, productively and effectively for many people.  This is why we spoke about ‘Stopping the Race to the Bottom’ at our event on 23 October 2024; why are so many clients focussing on cost and compliance in our sector, and what sort of sector is that creating?

Construction is facing transformational challenges; demographic changes, recruitment and retention, and driving carbon out of construction come immediately to mind.  And to have any chance of effectively tackling these challenges, we – construction clients and wider society – need supply chains to invest in quality, performance, productivity, innovation, capacity (jobs) and capability (skills, training & employability).

But construction is one of the most volatile economic sectors (eg insolvencies here and comment here), and in the face of this reality it makes little commercial sense for a supply chain that consists very largely of SMEs (about 98%) to invest in the way that clients need them to.  Not because they don’t want to, but because when you are operating one contract away from failure investment decisions become about survival, rather than long-term development, growth and resilience.  I was speaking to one SME recently that regularly sets aside 5% for bad debt; that’s contingency to ensure you are there next year, rather than investment in new plant that will deliver better quality or other choices that will deliver more effective outcomes for clients.

A sector dominated by a focus on lowest cost and using compliance as an outcome rather than a baseline is one that is constantly feeding dysfunction and volatility.  Clients are too frequently engaging in a situation where they are eating their own tail; a focus on value and outcome isn’t a nice to have, it’s the difference between a sector that can do what they need to do, and one that can’t.

So there is a clear necessity to operate very differently, and turn islands of good practice into business as usual.  Dr Rebecca Rees, Partner & Head of Public Procurement at Trowers & Hamlins, emphasised that clients have the permission to enable value and outcome, with procurement as an enabler, and Patrick Hodgson, Commercial Manager at National Highways, spoke about client practice, making it clear how investment can be used to unlock long-term value and productivity gains by working with the supply chain within a clear but rewarding set of principles and expectations.

Dr Rebecca Rees, Partner and Head of Public Procurement, Trowers and Hamlins

‘If the project starts with lowest cost then at least one party sends the duration of the project trying to recover that position’.  This fundamental client-side decision sets the tone and direction of any project.

Value tends to be developed around, for example, aesthetics, place-making, net zero.  But procurement processes introduce price and capex constraints that are unrelated to the value elements that have been developed at design stage, and break the linkage between design and the budget.  There are different understandings of what clients think procurement is; at one end, it is ensuring there is the right contractor for the right job.  At the other end, it is ‘process we intersperse between desire and delivery’.  But what we don’t do well, in either case, is ensure the translation of client intent into contractually enforceable obligations; consequently the elements that originally underpinned the procurement decision are lost.

Pricing models used for more than 96% of construction projects are based on relative pricing (lowest price = highest score, or pro-rata system).  But this encourages pricing that is lower than competitors rather than a focus on project outcomes and how these might best be acheived; ‘A percentage split between quality and price does not dull that rule’.  Lowest price = highest marks is ultimately is the biggest signal in terms of tone and direction!

Rebecca wrote about the impact of this culture here

And you can find the Trowers and Hamlins White Paper on price evaluation models here

‘As a client, if you don’t know the price you need to find out or employ someone who does’.  How effectively and realistically do you know as a client what prices should look like, both in terms of elements (eg cost of copper pipe, cost per square metre of tiling) as well as overall project cost.  Without this, how do you know what abnormally low looks like, and how can you challenge and ask questions?

There are some changes due in the Procurement Act 2023, eg the change of language from MEAT (Most Economically Advantageous Tender) to MAT (Most Advantageous Tender), but in reality it doesn’t fundamentally change what you can do; since c.2006, clients have been able to procure via value rather than cost, so it remains predominantly a question of client will.

Patrick Hodgson, Commercial Manager, National Highways

Patrick’s presentation brought to life another Charlie Munger quote; ‘You get what you reward for.’  He discussed the key features of an enterprise approach, and talked about the perception of transfer of risk; risk doesn’t disappear off the client’s books in reality, so it is much better to make it visible and ensure it is managed at the right levels.

He talked about procurement models which incentivise and reward suppliers for the delivery of the owner’s defined outcomes and key milestones for a project.  This requires the client to define what they want in quite a sophisticated way rather than default to cost/compliance.  For National Highways, suppliers are incentivised to deliver design and construction solutions against a targeted value, or budget, with projects and teams that deliver within the target and defined outcomes able to realise financial rewards.

Patrick emphasised how much wraps around the actual contract that the contract can’t easily capture, summarised as culture, process and technology.  Nonetheless, these ‘non-contractual’ elements are critical to a high-performing enterprise team;

He was asked about risk transfer.  Even though this is managed in a more collaborative way with Tier 1s, how can NH be confident that it isn’t being passed down in a more traditional, transactional way in areas where the client has less visibility?

He responded that the Tier 1 contractor develops a procurement plan for the project. A key part of this is how any subcontracting arrangements will support the delivery of the project’s targeted value and outcomes. The client has visibility of and approves any subcontracts, and the apportionment of risk between all parties is reviewed by integrated project teams.  The incentives around the delivery of the key outcomes are such that Tier 1’s require effective and high performing supply chains to access rewards; and therefore also require subcontracts which support the creation of high performing teams, capable of the levels of collaboration needed to meet the projects targets.

So what?  What does this all mean for clients?  A CENE Value Theme Group view:

• Remember the First Law of Risk (which owes some credit to the First Law of Thermodynamics); risk cannot destroyed, but it can be transformed from one form to another. And unlike energy, it can certainly be created.  So the client has to be aware of risk, give it visibility, understand where it is sitting and navigate how it is managed in collaboration with other parties.  Pretending that you have passed on risk to a contractor (‘risk transfer’) that pretends they can fully manage it is poor client practice bordering on self-delusion;
• Collaboration is an outcome of how the supply chain is engaged, incentivised and rewarded. Clients can establish effective, collaborative partnerships but they need to ensure they have ‘enterprise’ criteria, not ‘transaction’ criteria.  And if you have to print it on a lanyard, you are probably starting in the wrong place;
• Effective, challenging learning & post-project review processes are vital but far too rare. These need to be done, and done well, so that clients are genuinely learning and improving.  Procurement teams need to be included in PPRs as the procurement stage represents the greatest risk to client intent.  It too often distorts the connection between outcomes and what is actually delivered in practice;
• There was very widespread distrust of Tier 1’s, for example using sub-contractors to win a bid then ditching them once bid is won, or coming back and screwing down pricing. There was consensus that they were driven by the bottom line and lowest price with few exceptions, and engendered hostile, claims-driven working relationships into projects far too often.  Comment in the room included appalling examples of main contractor behaviour – but also great frustration that clients were so distant from these realities and to some extent condoned such behaviour by disinterest and failure to seek insight outside their comfort zone, or to robustly challenge their main contractors.

Conclusion

The CENE Value Theme Group conducted a survey earlier in 2024 that asked clients if they felt they were getting value from their projects.  27% said they were, and 4% said they weren’t.  This may sound like a construction sector that is delivering for clients, but this also means that 65% sat in the middle (‘getting some value’).  However, when asked whether they had the opportunity to bring value to clients, 25% of supply chain respondents answered No, and only 18% answered Yes.  This suggests there is at least a disconnect between what clients feel they are getting and what they have the opportunity to get.  Most of the supply chain are frustrated that they can’t bring their skills and experience to the table, and they can see clients taking decisions that represent poor investment or will cost them much more at the operational stage for the sake of ill-thought through or badly advised decisions at capital stage.  Value and outcome require client structures and practice that close that gap; this benefits clients directly, and helps create a resilient construction sector where decisions about quality, performance, productivity, innovation, capacity and capability are a gateway to long-term collaborative partnerships and reward, rather than a gamble, and one that may risk the farm.  The last comment belongs to Rebecca; ‘We set the rules as clients’.  Enough wilful blindness.

Image supplied by www.barrett.com.au