Contracts and Commercial Practice Lecture 5 Transcript

Slide 1 Welcome to this lecture on the management of commercial risk.

Slide 2 The overall aim of this unit is to provide an overview of the following areas:

1 Commercial Risk in Construction

2 Risk Management Strategy

3 Risk Control Tools and Techniques

4 Time Related Risks

5 Cost Related Risks

6 Quality Related Risks

7 Case Study

Slide 3 We will achieve this aim by tackling the objectives in the following order:

1. You will be able to define Commercial Risk in Construction

2. You will be able to understand the concept of a Risk Management Strategy

3. You will be able to discuss the Risk Control Tools available along with risk control avoidance
techniques, risk transfer techniques, the risk profile in different procurement routes, and shared risk
contracts. We will then move on to supply chain risks, insurances, parent company guarantees, bonds
and collateral warranties.

4. You will be able to explain the types of Time Related Risks

5. You will be able to discuss Cost Related Risks, solvency vetting, retention monies, insolvency,
retention bonds, budgeting, preliminaries, cost monitoring and cost forecasting

6. You will be able to discuss Quality Related Risks, defective works, contractor management issues,
subcontractor performance and disruption to the works.

Overall you will have an appreciation of risk and how to manage the process

Slide 4 Starting with commercial risk in construction:

Slide 5 The first question to be considered is what is commercial risk?

Typically, these would be risks that have the potential to damage the commercial security and
 Contracts and Commercial Practice Lecture 5 Transcript
wellbeing of an organisation. For the purposes of this lecture, the organisation we will be referring to
is a Client, Consultant Contractor (Building Company) or a subcontractor. Each organisation may be
exposed to risks and it is important there are strategies in place to manage this process.

Common commercial risks relating to a Building Company could take many forms.

1. Non-payment from the client. Or Non-payment from the contractor to sub-contractor.

2. Disagreement or dispute over valuation of the works, be it under or over valuation.
3. Disagreement or dispute over value of variations or changes be it under or over valuation.
4. Extension of Time – disagreeing the time allocated or the principle of granting an extension of
time.
5. Discrepancy within the Contract Documents such as drawings, specification and Bill of
Quantities. When different consultants prepare the documents it is common for errors to
occur.

Slide 6 Linked to this is the development of a risk management strategy. It is therefore important a Client,
Consultant Contractor (Building Company) or a subcontractor have strategies in place.

Slide 7 In order to protect itself against commercial risk, it is important for the Client, Consultant Contractor
(Building Company) or a subcontractor to have a risk management strategy. This can come in many
forms and methods, however, generally speaking they are broken down into the following tasks and
activities. This is known as a risk management strategy.

 Risk identification
 Analysis of identified risks
 Evaluation of risks
 Managing the risks

Slide 8 There are further steps in the risk management strategy. These are:

 Review and monitoring the risk

 Communication
 Reporting

These seven stages of a risk management strategy are key to ensuring commercial risks are identified
early and are analysed for awareness and understanding of the team. It is also important that they are
evaluated in order to establish their potential commercial impact on the project and / or company.
 Contracts and Commercial Practice Lecture 5 Transcript
Managing those risks in a proactive manner with regular review and monitoring procedures should
also be employed as good practice. In doing all of the above, it is imperative that good
communication skills are used to ensure that all relevant stakeholders are kept up to date with those
risks and have a full awareness of their potential impact on the project and business alike.

The progress and effectiveness of the risk management strategy should also be reported on a regular
basis to the relevant stakeholders. Clarity of documentation is also important. Record keeping is
critical to an effective risk management strategy.

Slide 9 We are now going to examine some of the risk controls and techniques that can assist in risk control.

Slide 10 Three risk control techniques are on the screen:

1. Risk Avoidance
2. Risk Transfer
3. Risk Absorption

We will now go through each of these in turn.

Slide 11 Avoidance of Commercial Risk

In order to avoid risk, it is important to clarify objectives, to communicate well and to gather as much
information as possible in order that decisions with regards to avoiding the risk can be made.

In carrying out this process it is important to consider whether you have the resources and expertise
to undertake such a project. Consider if it is possible to reject the project or reduce to scope in order
to make it less of a risk and more manageable. Such a contractor may decide to choose to subcontract
elements of their work if they have no have the experience such as M&E.

Slide 12 Transferring the Risk

There are many methods and techniques for transferring risk, these include the following:

• Procurement Route Selection (Traditional versus Design and Build as discussed in lecture 4)

• Sharing the Risk (Pain / Gain, Joint Ventures?)

• Offload risk onto supply chain

• Insurance
 Contracts and Commercial Practice Lecture 5 Transcript
• Parent Company Guarantees

• Bonds

• Collateral Warranties

This risk transfer needs careful planning, thought and consideration. Here it is important to develop a
strategy.

Slide 13 However, we may decide to absorb the risks. If the management of risks cannot be fully removed,
transferred or reduced, we will need to monitor risks, have risk reviews and then it is important to
ensure the team are communicating and updating risk reports. An organisation will review its
strengths and weaknesses. An organisation will make a judgement based on their experience what
risks they are able to absorb or not? Only by experience can an organisation make an assessment.

Slide 14 Risk Absorption refers to risks that cannot be fully removed, transferred or reduced, as the parties to
the contract do not have any control over them.

However, they can still be managed by monitoring the risk, by holding risk reviews and by continued
good communication and updating of risk reports.

Examples of risks that cannot be fully controlled include:

• Exceptionally Adverse Weather (client usually pays)

• Ground Conditions (depending on the procurement method this is risk item. The tender
documents are key. Such as site condition surveys, trial pits and bore hole logs may
indicate ground condition detail. A traditional form of contract the client accepts the risks,
however D&B the contractor take the risk. Therefore the tender documents are key to the
risk factors.
• Local Authority Planning Conditions – again as before this will depend on the
procurement route.
• Political issues – these will depend on the risks stated.
• Economy status– these will depend on the risks stated.

Slide 15 Over the next few slides we will look in more detail at risk transfer techniques. The selection of the
procurement route can have a large impact on commercial risk, two key procurement methods where
 Contracts and Commercial Practice Lecture 5 Transcript
risk is vastly different are:

 Traditional
 Design & Build

The choice of Procurement Route depends upon the Client’s / Contractors attitude to commercial risk

Slide 16 These procurement routes have very different risk profiles. To look at traditional procurement the risk
profile is as follows:

1. The cost risk is split between client and contractor

2. The Client employs a design team therefore design risk lies with the client
3. The Design team produces drawings, the spec and Bills of Quantities. The risk lies with the
client.
4. The Design team designs the building, the client is liable for design defects
5. The defects risk is split between the Contractor and Client.

Here it is important there are detail tender documents.

Slide 17 On the other hand, if you go down the design and build procurement route, the cost risk lies with the
Contractor as the Contractor designs and builds the project. The quality risk also lies with the
Contractor.

Here it is less important for the client there are detail tender documents as the contractor will take on
the risks.

Slide 18 Sharing the risk

With some contracts it is possible to share the risks for example,

 Pain / Gain contracts share risk and reward. The benefits are if the pain/clause is written well
it will motivate the contractor to share the reward. How the clause can also be a disincentive
if the pain/gain does not favour the contractor and favours the client.
 Joint Ventures between clients and contractors. An example may be a large civil engineering
project such as the Channel Tunnel, where the financial risk is too large for one company so it
is sensible to share the risk and reward. The benefits are shared risk and reward however it is
important to have similar company cultures when working together.
 Often Joint ventures between contractors are procured this way. Joint ventures are popular
 Contracts and Commercial Practice Lecture 5 Transcript
for large projects (for example infrastructure or highways).

Have you any experience on Joint Ventures? What were the pros and cons?

Slide 19 A contractor should consider whether he can offload any commercial risks to his supply chain.

This can be done in the following ways:

1. Using “back to back” contracts whereby, all terms and conditions of the main contract are
cascaded down to the supply chain (typically subcontractors). For example when procuring
with a subcontractor a contractor may wish to pass on to the subcontractor the installation
risks.
2. Payment terms that support good cash flow and reserves for the contractor main be
beneficial. For example when procuring with a subcontractor there need to be similar
payment terms so nether the contractor/subcontractor is penalised.
3. Withholding retention money on the supply chain is another way a contractor can offload
some of the commercial risk associated with getting the subcontractors to carry out remedial
works to the defects.
4. Seeking discounts from the supply chain is a method of reducing cost, which can be beneficial
to a contractor. For example when procuring with a supplier regularly it is not uncommon for
a contractor to request a discount from the supplier/subcontractor.

Slide 20 Insurance is another method of risk sharing, key insurances within construction include:

 Public Liability Insurance generally for personal injury and damage to property
 Insurance for the Works which insures work in progress
 Insurance of existing structures used for extensions, refurbishments and the like
 Professional Indemnity Insurance - Covers professional negligence in design and professional
services (QS, Architect, etc.), and for D&B contractors

As a surveyor it is important to collect valid insurance certificates, it is common to withhold payment

 Contracts and Commercial Practice Lecture 5 Transcript
if the insurances are invalid. It is important also the correct level of cover is maintained.

Slide 21 Risks can transferred using a parent company guarantee.

A Parent Company Guarantee is when a larger (parent) company guarantees the work if one of its
smaller subsidiary companies. This is commonly seen in large organisations where the structure of
that organisation has been split into smaller niche companies that specialise in a particular trade.

Slide 22 Obtaining a bond is another route to transfer risks. Bonds are purchased to guarantee the
performance of Contractor.

1. The Bond is purchased from a financial organisation which is then the Bondsman.
2. The Bondsman pays out in the event of non-performance from the Contractor
3. Non-performance is typically breach of contract (for example: the insolvency of a Contractor)
4. The Costs of Bond is typically is priced within the contract sum. Other examples of bonds are
perforamce bonds, tender bonds or advance payment bonds typically 10% of the contract
value. It is important to consider if these bonds are on demand or conditional on a series of
events.

Examples of bonds could be a tender bond, advance payment bond or performance bond.

Slide 23 A collateral warranty is another way for managing risk. A collateral warranty creates a contractual
link, where one was not originally present.

Therefore, in the event of insolvency of Main Contractor, the Employer has a direct link to claim
against the Specialist Subcontractor.

This is an ideal way for offering cover for defects, and we will go through an example next.

Slide 24 We will now go through an example of how a Collateral Warranty works in practice.

A recent example of controversies arising from collateral warranties that you can search for is the
 Contracts and Commercial Practice Lecture 5 Transcript
case of Laing O’Rourke v Parkwood Leisure Limited from 2013.

In terms of a scenario, a collateral warranty can be where an Employer engages a Main Contractor to
build an office block. The office block contains a specialist cladding as part of the envelope of the
building. This cladding is designed, manufactured and installed by a large specialist cladding company,
this company is a subcontractor of the Main Contractor.

Within the Contract there is no contractual link between the Employer and the Cladding specialist, as
he is a subcontractor of the Main Contractor. The concern for the Employer is that if the Main
Contractor becomes insolvent and defects appear in the cladding, there is not an easy way for the
Employer to resolve those defects issues. Therefore with the use of a collateral warranty the
employer has some contractual remedy with the subcontractor.
Slide 25 We will now move on to how time related risks can affect a project.

Slide 26 These time delay risks could be from a number of sources:

 Issues could be delays on site caused by the client. This could be delayed site access, or
delayed design information.
 Or it could be delays on site caused by the contractor. This could be delayed material
deliveries or problems on site such as unforeseen ground conditions.

Slide 27 Delays on Site for Subcontractor include:

 On Site Delays. Such as the could be installation problems such that the design was not
detailed enough for a subcontractor to install.
 Off Site Delays. Such material as lead in problems, or the later ordering/delivery of materials.

Slide 28 Now for you to consider: What risks can a Main Contractor face as a result of delays?

Please jot down some answers to this question and then click next when you are ready to move on.

Slide 29 Some ideas now that you have had time to think about this…

One risk that we covered in lecture 1 is that liquidated damages can be levied against the Main
Contractor, as a genuine pre-estimate of loss but not a penalty. For example, the Main Contractor
may well have issues causing delays, which may therefore have an impact on the completion date.

The other risk is that there may be an overspend on preliminaries. Such as if there is an additional
 Contracts and Commercial Practice Lecture 5 Transcript
week on site this will increased the preliminary costs.

There are also cashflow issues, especially if they receive payment later than intended. Therefore it is
important payments are made on time.

Slide 30 Now for you to consider: What can the Contractor do to protect himself against such delays?

Please jot down some answers to this question, add your thoughts to the discussion forum and
then click next when you are ready to move on.

Slide 31 Some ideas for you to think about how a Contractor can protect himself:

 Write a Delay Notice

 Claim for an Extension of Time
 Write a Loss and Expense Notice
 Claim for Loss and Expense
 Keep good records

It is important a contractor is organised, often a site surveyor will monitor these issues. The site
surveyor will collate these records.

Slide 32 How can the Contractor monitor delay risks?

• Mark up programme in relation to progress. When a tender programme is issued this is what
has been agreed with the client and contractor, at tender. Therefore when a revised
programme is issued a contractor can note the differences. Such that an EOT claim can be
requested.

• Mark up drawings showing progress, as a an example where are a set of tender drawings this
is an agreement with the client and contractor. Therefore when revised drawings are issued,
these are variations that will need to be priced. They may well have time and cost
implications.

• Compare site photographs and videos of the works – these keep an accurate record of
progress.
 Contracts and Commercial Practice Lecture 5 Transcript
Slide 33 How can the Contractor mitigate delay risks?

 Accelerate the works. This will depend if the client instructs the contractor to accelerate.
 Partial Possession. As an example when the site is managed by the contractor the employer
may well need access to a part of the site. Such as a shop floor so the client can trade.
Therefore part of the site may be handed over to the client. It is important if this occurs there
is clarity of who is responsible for insuring what area.
 Overtime working – a contractor may choose to pay a higher labour overtime cost is this
meant avoiding LD’s.

Slide 34 We are going to move now to the cost related risks on a construction project.

Slide 35 Some of these cost related risks are:

• Solvency of Contractor / Client / Subcontractors / Suppliers

• Insolvency of Contractor / Client / Subcontractors / Suppliers
• Retention Money / Retention Bond
• Budgeting
• Cost Monitoring
• Forecasting

It is important in business parties have the ability to budget and pay monies due.

Slide 36 When working with a new company it is possible to check the financial history of a company with
organisations such as Dunn and Bradstreet. It is therefore important to make some checks as to who
you are trading with. The reason why is parties need confidence that it is unlikely a company may
become insolvent and therefore reduce risk.

This is an important function for anyone entering into a contract, as insolvency of the other party
could have serious consequences for the project and the other party.

It is important that stakeholders entering into a contract should be solvent. However, in practice that
does not prevent companies defaulting on contracts as a result of insolvency.

Solvency vetting is therefore an important weapon in the armoury which should be considered
before entering into a contract. Various agencies offer relatively cheap and quick credit and solvency
reports to assist in risk analysis, for example: Dunn & Bradstreet and Experian. This is very easy to do
and advisable to check a company before trading with them. This reduces risk and the report gives
 Contracts and Commercial Practice Lecture 5 Transcript
clarity if a company is solvent or not?

Slide 37 Retention is a sum of money / percentage of contract sum, written into the contract that is withheld
by the client from the contractor. This is commonly withheld to ensure that the contractor does not
make good any defects that he is responsible for.

Retention is typically 3% or 5% of the contract sum.

The first half of retention will be released to the contractor at Practical Completion.

The second half of retention will be released to him when all defects are made good (e.g. End of
Defects Rectification Period)

This is normal practise and is important to ensure the client retains some control over the contractor.

Slide 38 Insolvency of client or contractor in a construction contract can result in lengthy delays, financial
losses and termination of the contract.

Potential warning signs of insolvency might come from: -

• On site rumours
• Contractors inflating applications for payment
• Contractors not paying supply chain
• Materials not being delivered
• Labour on site reduced when work is available to be carried out
• Plant being removed from site

An insolvent contractor/subcontractor will invariable cause problems such as delay. There will be a
delay in re letting the package. Occasionally there is opportunity to save money by renegotiating the
 Contracts and Commercial Practice Lecture 5 Transcript
package with another supplier.

Slide 39 A Retention Bond is typically used instead of Retention Money. A Retention Bond is agreement
between Contractor, Client and Bond Provider. The Bond Provider guarantees to pay the Client
retention money if Contractor fails to complete defects. The benefits for Contractor – he keeps hold
of his cash (retention fund). Benefits for Client – he still has protection that Contractor will complete
defects. This is an alternative to retention and a good compromise to manage the risks.

Slide 40 In a construction contract it is important to have clear budgets. The definition of a Budget is : ‘A sum
of money reserved for a task or activity’. Budgeting is all about planning. Planning enough money is
available.

Client’s and contractor’s set budgets for commercial risks by reviewing these options:

• Provisional Sums
• Prime Cost Sums
• Contingency Sums

We will discuss these further.

Slide 41 The first issue is to think how to budget for preliminaries. A Contractor typically creates a schedule of
Prelims for inclusion in Contract Sum Please see the links below for an explanation:

https://www.designingbuildings.co.uk/wiki/Preliminaries_in_construction

http://www.self-build.co.uk/project-preliminaries-costs

• Each Preliminary item usually has a cost per week ( for example: Site Manager £1000/per
week)
• Some Preliminary items have mobilisation costs ( Eg: Crane for delivery of Site Hut
• Some Preliminary items have removal costs ( Eg: Striking of scaffold )
• The Budget is then typically monitored through the project. As an example if there is an EOT
the preliminaries or prelims will therefore increase accordingly.

Slide 42 It is important to monitor costs throughout the project via a monthly Cost Value Reconciliation
(CVRs). Typically carried out monthly, CVRs compares value of the works against cost of the works.
This shows a snapshot of financial position of the project. It also assists Directors of contracting
 Contracts and Commercial Practice Lecture 5 Transcript
companies in making financial decisions.

The cost/value analysis carried out for construction works is, in its most simple terms, the profit and
loss statement for the project, whereby the contracting organisation calculates the amount of work
done to date and the amount of cost incurred to date. The two are then compared, with the
difference being the amount of profit or loss made at that point in time. This is then investigated and
explained as necessary, taking each of the common analysis levels in turn.

The production of a comparison of cost to date versus value to date, and a comparison of the final
cost and value, are some of the most important aspects of commercial management, and the
culmination of many of the other activities detailed within this guidance note. The calculation is
sometimes simply known as the ‘cost value’: an abbreviation of ‘cost/value comparison’ (CVC) or
‘cost/value reconciliation’ (CVR). Different contracting organisations also have their own names for it.
In this guidance note, for consistency, the calculation is referred to as the CVR.

Slide 43 We also need to be able to predict and think about future costs, also known as a Project Status
Report. Cost to Complete is a forensic analysis of the current, in-progress job status of an ongoing
construction project, combined with a detailed evaluation of the remaining work and budget to
complete it.

Cost to Complete services consist of an inspection to verify current status and existing conditions of
construction projects where work has already begun. Cost to Complete services provide an estimation
of time, funds and materials required to complete a construction project.

Forecasting is looking ahead and allowing for risks and potential cost over run

For example : A Cost to Complete Exercise by a Contractor

It allows for:

• Cost to date, Known Costs to come

• Unknown costs to come (Recoverable or Non Recoverable?)
• So we need to think through what might happen and the cost implications.

Slide 44 We now need to think through the quality related risks.

 Contracts and Commercial Practice Lecture 5 Transcript
Slide 45 These quality related risks could be:

• Defective Works which can arise when the work was not carried out in a 'good and
workmanlike manner' often because good practice or a particular design was not followed.
Sometimes, wrong materials have been used – matters which would usually be the
responsibility of the building contractor and its supply chain.

Alternatively, the designer could be at fault, because a particular design is not working in the
manner that it should.

• Contractor’s Management issues are linked to managing client’s expectations on timeframe,

quality and cost of the project. The Contractor must also take care to manage staff working
on the project and that could also include dealing with issues arising from sub-contractor’s
performance.

• Disruption to the Works – such as weather or delayed material deliveries.

Slide 46 Now that you are aware of what defective works are, can you jot down a few
ideas on what these defective works can result in? Share your thoughts on the
discussion forum.

Slide 47 Now that you have had time to consider this, here are some ideas.

Defective works can result in:

• Additional costs

• Delays to the works

• Disruption on site or

• Loss of reputation for the Contractor

Therefore, it is important to mitigate and reduce the risks.

 Contracts and Commercial Practice Lecture 5 Transcript
Slide 48 There could be risks of managing the contractor.

• These include Incorrect Setting Out

• Issuing “out of date” drawings to subcontractors
• Poor co-ordination of resources or calling in subcontractor’s to site too early

So it is important to plan a site effectively.

Slide 49 There are potential risks with Subcontractor’s performance. These could be:

• Poor quality of workmanship

• Non-attendance on site
• Under resourced work force on site
• In effective management
• Poor communication

Slide 50 Works can be disrupted. Such as

• Out of Sequence Working. This often happens with subcontractors working in multiple
locations at the same time instead of working in sequence. This causes issues with
forecasting. Finishing 95% of a location and then moving to the next location is also typical.
The third important issue is starting too many subcontractors at the same time in the same
location
• Return visits required if work could not be completed in a specific time frame
Multiple work faces
• Trade congestion.

Therefore it is important to programme works accordingly.

Slide 51 In this next section, you will be looking at your case study which you will upload on to the course page
for peer review.
 Contracts and Commercial Practice Lecture 5 Transcript
Slide 52 Your case study is as follows:

A Contractor asks you to advise on the commercial risks related to the refurbishment of a 200 year
old listed building in a city centre.

The building is currently a large office, which consists of many small rooms. The Contractor’s work is
to strip out parts of the building, and refit the inside to form an open plan accommodation.

Discuss the project and list out the potential commercial risks and how they can be offset and
managed.

Consider a risk management strategy, risk control tools, techniques. Consider also time, cost and
quality risks a contractor may face.

Please upload your responses under the section ‘case study submission’ on the course pages.

Good luck!