Contractual Obligations in Business - Coursework Example

One of the most fundamental components of a mutual engagement for the purpose of conducting business is that of contractual obligations. It is vitalfor two entities [be it individuals, institutions, organizations or businesses] to come to a consensus with regards to the scope and ramifications of this engagement. This consensus generally involves logistic, fiscal and economic, legal and ethical considerations. In terms of the economic component of contractual arrangements, there are many inherent problems. The Agency Model and its integral component—the agency relationship serves as one of the most prolific examples of the inherent difficulties with regards to arriving at a mutually agreeable contract. First and foremost an agency relationship is one which is established when a principal (the owner) hires an agent (the contractor) to act on the principals behalf and to advance the principals goals (Macleod 2002, p. 220). Such relationships permeate the construction industry, just as they do everyday life. The contractor, as it undertakes the design or construction of a new facility; is an agent of the owner. Subcontractors are agents of the contractor when hired to help meet the contractors obligations. The individual engineer employee, expected to provide designs that will satisfy the owner/contractor agreement, is an agent of the design contractor employer. Conflicts of interest inevitably exist in agency relationships. Solutions to the resulting problems are an increasing area of study in economics in recent years (Charreaux 2002, p. 251). Considered in a construction context, this growing body of knowledge offers guidelines for design of contracts to maximize alignment of contractors with owners objectives. Before examining the economists perspective of the owner/contractor relationship, two points are worth noting. First, the economic concept of agency should not be confused with the agency concept of contract law, in which a principal and agent agree that the agent can and will act on the principals behalf in dealing with a third party (Sweet 1994). As long as the agent acts within its authorized scope, a third party can negotiate and form a contract with the principal through the agent. While issues of legal agency may accompany economic agency examples, they are not central to the notions expressed in this paper. Secondly, economic assumptions that lead to the principal-agent model may seem extreme characterizations of industry or individual behavior, but they are consistent with accepted economic approaches and yield predictions that are consistent with observed behavior. Assumptions are admittedly abstractions from reality, but are made for analytical simplicity in that they make otherwise overwhelmingly complex problems surmountable. Theory based on assumptions is accepted if the results are useful for the purpose at hand. As an analogy, consider a surveyor laying out a building foundation. Implicitly, the earth is assumed flat as elevations are set with a level. Errors from the earths curvature, although non-zero, are insignificant compared with the cost and time of calculating curvature effects. In a similar manner, economic theories survive not by withstanding assaults on the assumptions that underpin them but by providing useful predictions of how people and institutions adjust to changing circumstances (McCormick 1993). Assumption of Self-interested Behavior A basic building block in the study of economic organizations is that individuals and firms do only what they perceive to be in their self-interests. Further, parties are assumed to be amoral in that maneuvering, taking shortcuts, breaking agreements, and taking any actions that offer personal gain are expected. This leads to useful predictions that often hold up even if the assumption is relaxed. Company incentive plans appear designed so that individual employees find it in their best interests to advance the companys goals, in spite of the fact that many employees would not stray the instant the incentives were removed. Likewise, banks have guards, vaults, and audits because they would otherwise be robbed, a result unaffected by the fact that many honest people would not rob an unguarded bank (Milgrom & Roberts 1992). It is analytically useful to assume that the parties to the construction contract will focus purely on advancing their own interests. This leads most quickly to effective contracting strategies. Further, this assumption does not rule out seemingly unselfish behavior. Honoring agreements, keeping ones word, and doing more than is required by contract are not necessarily inconsistent with this model. The notion of self-interests is broad, and can include concerns for reputation, when its loss might translate to lost business. A seller that values repeat business with satisfied clients has a long-term incentive not to take short-term gains at the expense of the customer and to the detriment of the seller/customer relationship (Hart 2002, p. 180). As an illustration, a contractor might accept responsibility for and correct an error that was primarily the fault of the owner if gain in terms of client relationship and future work could be realized. Differing Owner and Contractor Objectives The assumption of self-interested behavior relates to the conduct of the owner and contractor because of their conflicting objectives. Some objectives were common to the owner and contractor. There was general agreement over the desirability of the following objectives: complete project within budget, complete project within schedule, maintain a high level of quality, execute the project safely, without lost time accidents, minimize claims and litigation (Kay 1996, pp. 138-145). Owners, however, frequently listed internal objectives not shared by the contractor, such as: meet return on investment goal for project, minimize plant operating and maintenance costs, minimize plant downtime and outages, achieve high product quality, achieve product throughput capacity goals, provide design flexibility to meet future needs, minimize disruptions to existing operations, avoid negative impact on environment and community, reduce project cycle time, exceed internal customers expectations (Karake-Shalhoub 2002, p. 105). Frequently cited contractor objectives, not shared by owners, were: achieve profit and other financial goals, satisfy client and generate repeat business, manage cash flow, limit long term liability, develop employees and create satisfaction, optimize employment level, contractor organization (Macho-Stadler & Pérez-Castrillon 1997, pp. 18-21). The conflicts between the second and third sets of objectives generate many of the problems in contracting for construction services. The owner usually desires to obtain maximum quality, functionality, and capacity at minimum cost. The contractor, while hoping to develop a satisfied client, must in the long-run achieve financial goals that are advanced by expending the minimum resources required to meet a minimum scope of work. These objectives are naturally in conflict. When accompanied by owner inability to observe all aspects of contractor performance, this conflict can produce serious problems for the owner. The owners challenge of steering the contractor toward the owners goals is known as the principal-agent problem within agency theory. Moral Hazard Important aspects of the contract, even if they can all be specified, may not be observable to the owner. Assurances may have been made as to the quality and experience of an engineering contractors staff, but the owner can not control the contractors selection process as it staffs the project. An owner with a time and expense contract may worry that the contractor will assign inexperienced designers to its project, while using more capable employees on other fixed-price contracts. Owner and contractor objectives are not perfectly aligned, and it is difficult for the owner to determine the quality of the contractors assigned personnel. Opportunistic behavior by the engineering contractor is possible, and it behooves the owner to put in place counteracting mechanisms that make such behavior less likely (Macho-Stadler & Pérez-Castrillo 1997, p. 35). The potential for such self-interested behavior after contract execution is referred to as moral hazard, a term originally generated in study of the insurance industry. If the contractor (agent) is acting on behalf of the owner (principal) and has interests that differ from the owners, and if some aspects of the contractors performance are not completely specified or observable, then the possibility of self interested behavior by the contractor at the expense of the owner exists. The nature of the capital project process, where large investments are committed in advance of important performance by others, intensifies the moral hazard potential (Macho-Stadler & Pérez-Castrillo 1997, 52). Responses to the Moral Hazard Problem Most responses to the moral hazard problem attack two of the necessary conditions for its existence - difficulties on the part of the principal in determining whether the terms of the contract have been followed and in enforcing the contract, and divergent interests between the agent and principal. From these conditions arise the two primary control mechanisms, monitoring and creating incentives. Performance Monitoring as a Solution One technique to prevent or detect inappropriate behavior on the part of an agent is monitoring and verification by the principal. Employees are sometimes required to punch a time clock so that they can be penalized if they arrive late or leave early. If adequate motivation does not already exist to induce conscientious work habits, the fear of the reprimand, pay reduction or dismissal that accompanies poor attendance usually tips the employees decision toward compliance. Similarly, an owner may place an engineer in the contractors office to monitor level of effort, quality of staff, and contractor effectiveness. These measurements of performance inform the owner whether the contractor is meeting contract requirements and providing accurate information, and discourage opportunistic behavior by making it less feasible (Kennerley & Neely 2002, p. 150). However, direct monitoring consumes owner resources and burdens the owners decision to contract out work as opposed to self-performing. To this extent, monitoring costs limit the owners ability to contract with the market for project services. Reducing these costs, or finding less expensive sources of information, broadens the owners contracting options in addition to reducing expenses. Two alternate information sources encountered in the interviews were the construction services market and independent benchmarking consultants. Reducing the Need for Monitoring Moral hazard problems arise because two conditions exist together: measurement or enforcement difficulties, and objectives that are not aligned. If the owner and contractor can devise a contract that naturally motivates the contractor in the direction of the owners interest, the potential for moral hazard is less and the need for monitoring is reduced. In cases where there is an insufficiency of internal staff to coordinate the project, the responsibility for developing a contract that would delineate coordination and cooperation between the architect, engineer, and construction manager may rest with the owner’s project manager. Their objectives therefore became more aligned with those of owner. The need for oversight by the owner was thus reduced (Ahrens & Chapman 2002, p. 248). Performance Incentives as a Solution Incentive contracts are an attempt to align the interests of the contractor with those of the owner by basing compensation, to some degree, on results that are important to the owner. In basing pay on performance, however, the owner also transfers risk to the contractor. The output of a contractor is typically a function of factors within its control (such as level of effort, quality of assigned personnel, and management attention) and outside its control (such as weather, supplier problems, and owners technology). The performance variation resulting from outside factors introduces randomness to the contractors output, and therefore to its income. Contractors may charge a premium to bear this risk, so the owners challenge in designing incentives becomes one of balancing the gain in contractor performance against the added cost of risk bearing (Baker, Jensen & Murphy 1988). Risk Aversion Economists characterize an agents attitude toward risk using the concept of risk aversion. In the case of construction, risk aversion would prompt a contractor to charge a higher price to perform work subject to random income variation, even if the contractor expects the average deviation to be zero in the long run. A risk averse contractor would prefer to have a smaller certain income than a slightly larger income on average that is subject to unpredictable and uncontrollable variations (Culp 2001, p. 120). To illustrate, consider a compensation plan with the only variability being the random element outside the agents control. Suppose a small subcontractor, understanding the requirements of a job, is willing to accept it for $2000/week. However, the contractor advises that, depending on the timing of payments from the owner, the compensation may fluctuate. The subcontractors pay will average $2000/week each month, but may vary randomly week to week. One week it may be $1500, and the next week it may be $2500. The subcontractor, concerned with cash flow implications, may decide that average payment will have to be higher, say $2250/week, to compensate for the risk of erratic payment schedule. The S250/week cost to carry the risk of fluctuating payments, even though the average of the payments is the same, is a function of risk aversion. If the contractor is not as sensitive as the subcontractor to the cash flow impact, isolating the subcontractor from the variation is a lower cost solution. Individuals and firms have varying degrees of aversion to financial risk, and are assumed by economic theory to rationally consider that aversion during contracting choices. Factors outside a contractors control which affect its performance introduce compensation risk which can add cost and which dilutes incentive effect. Balancing risk costs against incentive effects is a major consideration in incentive contract design (Culp 2001, p. 156). Principles for Incentive Pay Design Milgrom & Roberts (1992) have developed a mathematical model of the principals and agents behavior under an incentive contract, and suggest principles for incentive contract design, paraphrased here for the owner/contractor relationship. The optimum incentive intensity, or magnitude of the incentive pay component relative to the fixed component, depends on four factors: the incremental profit to the owner of additional effort on the part of the contractor, the contractors degree of risk aversion, the precision with which the owner can measure the contractors performance, and the responsiveness of the contractors performance to incentives. Incentive Intensity versus Contractors Degree of Risk version All other factors equal, more risk averse contractors should be provided with less intense incentives. Performance motivating incentives are more expensive with more risk averse contractors, so the level of incentives at which risk bearing costs overtake performance improvements is lower. No direct indicators of contractors degrees of risk aversion were observed during these interviews, but there is some empirical evidence of risk aversion and how it varies across contractors from a study of subcontractors in the Japanese automobile manufacturing industry. Kawasaki and McMillan (1987) studied the degree of subcontractors risk aversion and the trade-off between risk sharing and moral hazard in contracts between auto parts suppliers and auto manufacturers. The prevalent contract for the supply of parts to Japanese automobile manufacturers sets total subcontractor compensation as p = b + a(c - b) where (p) represents the price paid to subcontractor, (c) the subcontractors actual cost,(b) the target price, and (a) the sharing parameter. This equation is of the form used by Stukhart (1984) to describe the contractors fee. In its general form, the equation describes a pure cost-reimbursable contract when a = 1 and a lump sum contract when a = 0. The equation is also similar to the compensation schemes in the Environmental Compliance and Corporate Headquarters projects that were subjects of interviews. All designated portions of under runs as potential bonus payments to contractors. In the Japanese automobile industry study, multiple contracts were analyzed across five subcontractor size categories using a mathematical model that included degree of risk aversion and risk sharing. Among the conclusions from the study were that all of the subcontractors were risk averse, and that their degree of risk aversion increased with decreasing subcontractor firm size. This suggests that, all other things equal, contracts with smaller subcontractors should be less dependent on incentives that shift risk from the owner to the contractor. Other patterns in the contracts were that the price paid to the subcontractor adjusted more to changes in the subcontractors actual costs the more risk averse the subcontractor was, the larger the potential fluctuation of costs was, and the less severe the potential for moral hazard. Risk is inherent to capital projects and must be borne by the owner or by the contractor. The efficient allocation of risk between the parties is determined by the contractors attitude toward risk compared to the owners, as well as the relative ability of the parties to control the risk. Incentive Intensity versus Degree of Contractor Control The smaller the performance measure component that is outside the control of the contractor, the stronger will be the incentive effect. Alternatively, the more in control is the contractor of the performance that is measured, the more responsive will be its pay to its performance, and the stronger will be the influence of incentives. This implies that owners can bolster the power of incentives by structuring projects to put contractors more in control of their performance. This should lead to a contractor choosing a higher level of performance, such as choice of personnel assigned to project, the amount of management attention from the home office, the hours worked by site personnel, or other decisions not explicitly covered by contract. The more directly a contractors performance determines incentives, the higher the return to the contractor on its marginal effort, leading to better performance. Incentive Intensity versus Contractor Responsiveness to Incentives Incentives should be most intense when contractors are most able to respond to them. Generally, responsiveness is increased by more contractor control and discretion over the choice of work methods and resources used for the project. A contractor facing strong financial incentives who has broad discretion over execution strategy may find innovative ways to improve performance and increase profit. Incentive Compensation Effect on Other Performance Areas Care must be taken in design of incentive plans for areas that are a basis of incentive payment. The natural response of a contractor is to expend effort where the marginal return is greatest, potentially leaving areas of neglect. A project may be completed within budget, on time, and with excellent safety statistics, triggering a bonus, but generate an environmental incident that leaves the owner with neighbor problems long after the project is completed. Incentives have the potential to weaken efforts in other areas. Besides the solution of attempting broad, all-inclusive incentives, two potential solutions are subjectively determined incentives and partial reliance on contractor concerns over reputation in the marketplace. Ratchet Effect Often it is difficult to determine appropriate performance levels on which to base incentives. From the owners standpoint, each project may be unique, with variables such as scope, schedule constraints, and technical difficulty. The owner may wish to associate average compensation with average performance, and to tie maximum compensation to aggressive but achievable targets. What constitutes acceptable performance, and what constitutes outstanding performance, is difficult to determine. There are basically two options for the owner (Chrystal & Lipsey 1997, p. 335). Performance levels can be based on comparison to what other similar contractors achieve on similar projects, using the owners prior experience, benchmarking, or other information sources, or performance can be based on this contractors past performance on similar work. In long-term relationships or cases of repeat projects, past performance may offer more reliable information. Reinforced by the continuous improvement philosophy common in manufacturing, owners may set performance targets in multi-period relationships based on contractor performance better than ever accomplished in the past. Last years excellent performance becomes this years expectation. Like a high jump competition, each performance better than the last triggers a request for better still. This continuous raising of the performance standard, referred to as the ratchet effect (Weitzman 1960), can be unproductive. In the short term, outstanding performance increases incentives and therefore profits. But the contractor in a continuing relationship may reason that outstanding performance also raises all subsequent targets and decreases long-term incentives and profits. Effectively, the contractor has a long-term incentive to hold down performance level. The Lincoln Electric Company is known for its extensive use of performance incentives with employees, particularly piece rate pay schemes (Lienert 1995). Each job is rated according to the skill, effort, and responsibility levels required for its satisfactory performance. The base wage level for each job is set using wage rates prevailing for comparable jobs in local industry. Then, based on time and motion studies, compensation per unit of output is set at a level such that an employee of average productivity is compensated at the base rate. Employees are allowed to challenge the base productivity level if they believe it unfair. Lincolns agreement with its employees that it will not raise piece rate targets unless new equipment or work processes are introduced that increase efficiency, as validated by a time and motion study, illustrates one possible solution to the ratchet effect problem. After having examined the complex nature of contracts as they relate to the economics, it is evident why many individuals, corporations, organizations and agencies fail to achieve a true meeting of the minds. This is made evident by the fact that both parties have varying interests and will act to protect those interests. In protecting those interests, it is prudent that the notion of risk assessment and damage mitigation be examined. In so doing, one’s best interest is protected and the true integrity of a business relationship is maintained. This relationship is one of mutual benefit. In cases where one party benefits more, this can lead to contention. In arriving at a clear and concise contractual agreement, much of this contention is prevented. It just makes perfect sense and in a great degree contracts serve as the basis for any functional business relationship. References Ahrens, T., & Chapman, C. 2002, ‘Loosely Coupled Performance Measurement Systems’ in Business Performance Measurement: Theory and Practice, ed. A. Neely, Cambridge University Press, England. Charreaux, G. 2002, ‘Positive Agency Theory: Place and Contributions’ in The Economics of Contracts: Theories and Applications, eds. E. Brousseau & J. Glachant, Cambridge University Press, England. Chrystal, K. A., & Lipsey, R. G. 1997. Economics for Business and Management. Oxford University Press, England. Culp, C. L. 2001. The Risk Management Process: Business Strategy and Tactics. Wiley, New York. Hart, O. 2002. ‘Norms and the Theory of the Firm. In The Economics of Contracts: Theories and Applications’, eds. E, Brousseau & J. Glachant, Cambridge University Press, England. Karake-Shalhoub, Z. 2002. Trust and Loyalty in Electronic Commerce: An Agency Theory Perspective, Quorum Books, Westport, CT. Kawasaki, S., & McMillan, J. 1987 ‘The Design of Contracts: Evidence from Japanese Subcontracting.’ Journal of the Japanese and International Economies, vol. 1, 327-349. Kay, J. (1996). The Business of Economics. Oxford University Press, England. Lienert, A. 1995, ‘Case Study: a Dinosaur of a Different Color’ Management Review, Feb, 1995, pp. 24-29. Macho-Stadler, I., & Pérez-Castrillo, J. D. 1997. An Introduction to the Economics of Information: Incentives and Contracts, Oxford University Press, England. Macleod, W. B. 2002. ‘Complexity and Contract. In The Economics of Contracts: Theories and Applications’ , eds. E, Brousseau & J. Glachant, Cambridge University Press, England. McCormick, R. E. 1993. Managerial Economics, Englewood Cliffs, N.J, Prentice Hall. Milgrom, P. & Roberts, J. 1992. Economics, Organization, and Management. Englewood Cliffs, N.J., Prentice Hall. Stukhart, G. 1984, ‘Contractual Incentives’, Journal of Construction Engineering and Management, vol. 110, no. 1, pp. 34-42. Sweet, J. 1994. Legal Aspects of Architecture, Engineering and the Construction Process. West Publishing, St. Paul, MN. Read More