In a traditional construction contract, whether it's lump sum, guaranteed maximum price, CM at risk or design bill, the general contractor in the major trades usually has their profit held. Even if they go over budget, they are not putting their profit at risk.
In this article, I am going to explain what it means to put profit at risk within an integrated project delivery (IPD) framework.
What does profit at risk mean?
In general, one can argue that in most projects, if there is the risk of going over budget, the profit is always at risk. The difference in an integrated project delivery format is that putting profit at risk is a more transparent way of doing it.
Within our IPD cost structure, there are the cost and overhead of all the design and construction partners, the contingency, and the profit.
In an IPD framework, each partner calculates their profit. An audit will make sure that these figures are realistic and correct.
For example, for construction contractors, it is usually a percentage of the cost of the work. General contractors mostly calculate 1.5 to 5 percent on typical construction projects, overhead would be outside of that and in addition to profit. Trade partners usually estimate 4 to 10 percent profit. All of this depends on the complexity of the work, the market conditions and how much competition there is for a specific project.
In an IPD contract, the profit of every member of the team is converted to a lump sum. For example, 5 percent of a million dollars is $50,000. When the team agrees on the overall contract value, the $50,000 becomes a lump sum profit amount.
If the project comes in under budget, this partner will get their full $50,000 plus any amount of shared savings.
Now what if the project goes over budget?
Imagine a pie chart with each slice representing the profit of one of the partners in the IPD contract. Each partner has their profit at risk, combining to cover the overall profit pool or the incentive compensation layer in some contracts. The combined profit number is what the team agrees to put at risk.
If the project goes over budget, they will lose all of their profit, and the owner will continue to pay overhead and cost of work. In some cases overhead will stop being paid but the cost of work is always guaranteed in IPD contracts.
The profit pool always sits above the contingency when the contingency is exceeded. Cost overruns will get paid for by reducing the profit of the team, meaning if the project costs increase, the profit pie will shrink.
In a profit-at-risk model, everyone is responsible
One of the unique things about profit at risk is that it doesn't matter who goes over budget on the project.
If one of the trades for example goes significantly over budget, this cost overrun will impact every other team member proportionally.
In traditional projects, people often try to blame others by issuing a bunch of letters and documentation to shield themselves and not take responsibility. In IPD contracts it doesn’t matter whose fault it is and everybody is impacted by the cost overrun, which truly pulls the team members together to resolve problems when they arise.
Whereas in a traditional delivery model, when costs run over, an error becomes obvious, or there is a problem in the design or constructability, none of the trades wants to do anything until they find out whose fault it was. No one will proceed to solve the problem.
In these cases, the project owner is often left frustrated, wondering why they have to manage this situation after they've hired all of these experts.
With the risk-reward pool and shared savings plan, the profit pie increases no matter who was responsible for the savings and every partner receives a bigger profit proportionately. Consequently, if the cost starts to go over, then this pie gets proportionately smaller.
How do you split the pie?
One of the most popular questions with the profit-at-risk model is how to split the pie. In my experience, it's fairly simple math most of the time.
In our previous example, the general contractor calculated 5 percent profit ($50,000) of a million-dollar contract. This is the sum this contractor would put in the pool.
If the overall profit is $500,000 from all of the different parties, then this contractor would get 10 percent, which is $50,000 of the $500,000 pool. In other words, they would have a 10 percent share of the risk and reward plan.
That 10 percent would also mean that in case there's $1 of cost overrun, this firm would pay 10 cents of that, meaning they'll pay 10 percent of the cost overruns out of their profit until it's exhausted. Of any shared savings, this firm will typically get 10 percent.
The larger the piece of the pool one partner has, the more profit they have in risk relation to their peers. They have more to gain and more to lose. Overall, a fair model for all involved parties.
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.
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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.