In this article, I am going to dive into the risk and reward plan negotiations in IPD contracts, one of the things that sets Integrated Project Delivery (IPD) apart from other construction delivery models.
How do we set up a risk and reward plan?
There are several steps to consider and various levers owners can employ to achieve the right Risk Reward plan for their project. As each project is unique, we need to consider different plans. There is also a recommended standard plan. For construction professionals new to IPD, I recommend starting with a simple plan, and then modifying as needed on future projects.
Strengthen the team spirit and foster collaboration
From my experiences with over 20 different project negotiations, I found that the following approach works best when developing a risk and reward plan.
Let’s start with a baseline and assume that we've got our contract value. The design and construction teams have estimated all of their costs. The project owner has a set design and is ready to negotiate the final deal, signing up all involved parties for the risk and reward plan. The costs, contingency amount, and profit are calculated.
Let’s further assume that our team has agreed to put 100% of their profit at risk in exchange for guaranteed costs and a share of savings.
The next question is how much the team should be rewarded for excellent performance on the project, specifically focusing on cost savings. We can explore incentives based on key performance indicators, such as safety, RFI, and submittal turnaround, but a risk-reward plan based on the overall financial outcome of the project is my preferred solution. From my experience, it works best to strengthen the team spirit and foster collaboration.
Image: Jason Goodman via Unsplash
Contingency and shared savings
First, I look at the contingency percentage. For example, if a team is looking for a 5 or 6 percent contingency, which is a fairly large contingency, I’d suggest the shared savings % be lower.
If they have agreed on a smaller contingency, say 3 percent, the team is taking more risk. They're putting their profit at risk faster, which means that the owner may be willing to give a larger percentage of any shared savings.
I also look at the design status or the design stage. If the project is in schematic design, I recommend a slightly higher contingency and, at the same time, offer larger shared savings for the team. I believe the team has the most ability to affect the outcome of the cost of a project in the first 20 to 30 percent of the schematic design phase.
Costs can also be reduced in the design development phase when the focus is on optimising the design so that the team doesn’t lose their contingency once the project moves into the construction phase. Once construction has commenced, the team has very little control over reducing the costs.
In other words, earlier in the design of the project, I can share more of the savings. If I'm setting it later, after the design is established and the trades have been bid out, I'm going to share less in the savings, meaning the Shared Savings percentage decreases. Shared Savings are another lever owners can use to negotiate the Risk Reward plan.
The smaller the contingency, the larger the Shared Savings
Less contingency means the owner can share more of the savings. For example, if we have a 3% contingency, I recommend distributing 80% of the Shared Savings. If the contingency is larger, I’d propose sharing 20% of any savings. My intention is for the team to be aggressive with their numbers. I want them to have a contingency that protects their profit and the team from an overrun.
The reason behind this is I have already taken some of the contingency back, so if I reduce a contingency from 5 to 3 percent, the 2 percent goes back into the owner contingency. Therefore, as the owner, I'm willing to split more of any savings on the remaining three percent.
If we look at the profit in IPD delivery models, the owner is paying all additional costs. Therefore, the team must budget accurate numbers. At the same time, we want them to do everything they can not to spend the contingency. The solution is to offer them shared savings. The smaller the band of contingency, the more shared savings the owner will usually give.
The Advantages of IPD Contracts
Hurdles and caps
A more advanced approach to Risk Reward plans is hurdles and caps. Some Risk Reward plans will be set up with a 5 percent contingency. Owners may not want to share any savings on the first 2 percent, which is there to protect their profit, and they are not going to split it, if not necessary, because it is a healthy contingency.
But they are willing to split 80 percent of the last 3 percent. In this case, the first 2 percent of savings go back to the owner, from the next 3 percent of savings, the team receives 80%.
The second concept is a cap. I usually like to have a cap on shared savings to protect me from either an error or somebody who is purposely estimating high. For example, we have agreed to share 50 percent of any unused contingency with the team until the team has made 50% additional profit. Most teams will agree to this because they believe their estimates and don’t think this scenario is likely. On more than one occasion, this cap has protected me from paying a huge shared savings check caused by extremely poor estimating by one of the partners.
A win-win situation for everyone
If they've made 50% additional profit, then all additional savings on the project go back to the owner. I have seen shared savings capped between 50 and 100 percent enhanced profit. In the 20 IPD projects I worked on, I always recommended having a cap. Two of them have exceeded the cap and that money went back to the owner. And in both cases, it was because of an egregious estimating error; it wasn't the team excelling and producing that much savings.
Therefore, I highly recommend having a cap on Shared Savings on any Risk Reward plan. It's fairly easy to negotiate with the team while they are calculating their numbers. They never assume that they're going to be 10 or 15 percent under budget. So if the owner offers a reasonable cap, the team is usually comfortable with the deal, creating a win-win situation for everyone.
In summary, the Risk Reward plan is what binds the team together. If the team goes over budget, they're losing their profit, and the owner is paying more than expected. Nobody wins.
On the other hand, everybody wins when the team doesn’t use all of the contingency and the owner shares the savings. Plus, the owner has a project that finishes on budget, which is the most important thing.
In one project, I wrote a $500,000 bonus check to the project team, and $500,000 flowed back to my company. In that case, we reinvested most of our 500,000 in the project to increase the quality. At the end of the day, the team received a $500,000 bonus on top of their profit, and the owner got $500,000 in enhanced value, while the project stayed within budget.
Want to take your construction project to the next level?
The introductory online course to integrated project delivery, designed by the Integrated Project Delivery Alliance (IPDA) and LeanIPD, is for intermediate-level construction professionals who want to deliver complex projects on time, on budget, and with the original intended scope and value proposition.
For those who want to dive deeper, the advanced online course delivers the specifics of Integrated Project Delivery and teaches project owners how to set up and manage their construction projects with IPD. From aligning incentives through shared risk-reward structures to implementing target value design and understanding change orders in an IPD framework, this course will provide the skills to take construction projects to the next level.
Feature image: Cytonn Photography via Unsplash
Further reading
Profit at Risk with an IPD Framework
The Cost Structure of IPD Projects
James is an expert in the set-up and structure of large, complex capital projects using Lean and Integrated Project Delivery to drive highly reliable results.
He has negotiated IPD contracts and delivered over $650M in complex healthcare projects as an Owner's Representative with multiparty contracts, aligned team incentives and collaborative delivery models.
