16 Feb Procurement Tip: The Dangerous Practice of Transferring Risk
Today’s procurement tip is on the dangerous practice of transferring risk. The idea that a buyer can transfer risk to a vendor has become very popular. Buyers love the idea that, no matter what, their project will be completed with no schedule delays or change orders, and if anything does happen, the vendor will take care of everything. I admit, the idea is very enticing! The only issue with it is that it is not possible and attempting to do it, does not lead to high-performance outcome that Buyers believe they will get.
The most recent form of this can be seen in public private partnerships (P3) or Vested contracts where risk sharing is encouraged. The concept of sharing or transferring risk has time and time again has shown to lead to contractual disputes, increase costs, and eventual project failure. In this article we will explain why it’s not possible to transfer risk, the negative effects of attempting to do it, and correct way to handle and mitigate risk.
Understanding the Underlying Reason Risk Cannot Be Transferred
To understand why risk cannot be transferred, we first must understand what causes risk. There are many different risks that could occur on a project, but there is one main cause for all risk—a lack of information. Every risk is caused due to someone not knowing. For example:
- Bad weather is only a risk because we do not have enough information to predict when it will rain, when a hurricane will go through an area, when a blizzard will occur and shut everything down.
- Site Conditions are only a risk due to not knowing what/where things are buried, what is behind the walls of a 50-year-old office building, when the internet or network will shut down, etc.
- People only cause issues because they don’t know how certain changes will affect the project, what is expected of them, how they fit into the project, etc.
- Getting approvals are only a risk because it is not known how an inspector interprets the code or requirement and you don’t know how long it will take for the government to inspect and approve the work or design.
- Communication and coordination are common risks, because if the right information doesn’t get to the right people, then those people do not know what is happening and will then cause risk to the project.
The list could go on, but at the root of each risk is that someone didn’t know or didn’t have the information. If this is correct it would mean that the majority of risks on projects should not be caused by the vendor, it would be caused by the buyer and their stakeholders as they are not the experts on projects and have the least amount of information. This has been confirmed and validated through multiple studies researching risk (http://journal.cibw117.org/index.php/japiv/article/view/124). The studies find that 90% of all risk is caused by the buyer and their stakeholders. Most of the remaining 10% of risk is caused by unforeseen conditions and missing information at the beginning of a project. Almost none of the remaining risk is caused due to the contractors or vendors.
Since the majority of risks are caused either by the client and their stakeholders or unforeseen conditions, it makes transferring risk impossible.
You only have risk when someone lacks information. Meaning you cannot transfer risk from a person who is not an expert to an expert. This is because the expert does not have the risk that a non-expert creates on a project. For example, there could be a risk that some of the project stakeholders unknowingly do things in the wrong order—this is not something that the expert vendor would do—thus, they will never have this risk and can never be given this risk.
One of the major components of transferring risk is the client believes that they can make the vendor financially accountable for all the risks that occur. However, since the vendor is not causing any of the risks and does not have control over the people and things causing the risks, it will be impossible to make the vendor financially accountable for a risk if it occurs.
Attempting to Transfer Risk Leads to Poor Risk Mitigation
I have observed that when buyers try to transfer risk the following things also occur:
- Vendors charge more for working with buyers who want to transfer risk.
- Vendors will not pay for the cost of risks.
- Vendors are less skilled and less capable of knowing what to do to prevent risk.
- More risks tend to occur.
- Vendors become more reactive than proactive.
- Litigation and Disputes are more likely to occur.
Two things occur when vendors find out a buyer is trying to transfer risk. The first is usually the expert vendors will not bid on the project. Experts do not accept accountability for things that they cannot control. Thus, a buyer is more likely to attract and hire a vendor that has less expertise when they try to transfer risk on a project. Second, the vendors that will bid on the project will increase their cost to cover the risk. This increase in cost is usually referred to as contingency. This in itself is waste. The vendors are now having to include a cost into their proposal which may or may not occur. Meaning if the risk doesn’t happen, the client is now paying the vendor for something that didn’t happen and if it does happen, the vendor will still charge the client more if it exceeds the contingency that they have set aside for it. With the buffer of contingency, vendors are now more likely to rely on their contingency to account for risk rather than plan, mitigate and track risk as it occurs. The vendor and stakeholders become more reactive to risk instead of proactive. This means more risks will occur and the cost of the project will increase.
As the cost of the project increases this leads to the next issue, no accountability. When projects are not documented well, then it is impossible to identify who is causing the risk, which means no one can be held accountable for it. When there is no transparency and costs increase, this usually leads to disputes and eventually litigation, which will cause the vendor to lose more money and the buyer to pay more to get the project completed.
How to Properly Prevent and Mitigate Risk
The best way to mitigate risk is to hire the vendor with the most expertise, as the only way to mitigate risk is through information and transparency. An expert vendor will know what to do to minimize the most amount of risk, and will simplify the project to ensure the buyer and their stakeholders know what they need to know to stop them from causing risk to the project.
The best way to attract an expert vendor is to have a project where the vendor is responsible to identify actions and steps to minimize risks from happening. If a risk occurs, the vendor is responsible for identifying how to mitigate it, but they are not responsible for any financial impacts of the risk.
After a buyer hires and expert vendor they can require the vendor to do two things to minimize risk on the project:
- Pre-plan the entire project before they begin, ensuring they have a detailed schedule, a plan that includes actions to prevent any known risks (missing information, people they do not control, or unforeseen conditions), and a clear way to track their progress and show their performance at every step in the project. Ensure they have a way to document every risk that occurs and identify who is accountable for the risk.
- Require the vendor to simplify their plan and create transparency, ensuring the buyer and all stakeholders understand the plan and accept it. Make it the vendor’s responsibility that everyone on the project knows the risks that could occur before the project begins. They will ensure the plan is simple enough for everyone to accept and agree to. At every step of the project, they will ensure that all parties understand what is happening and what they are accountable for.
A Proven Solution to Mitigate Risk
The question always arises, why would a client agree to hire a vendor who does not take any accountability for project risk? The answer is that based on the logic and supported through thousands of project tests. When buyers hire experts who don’t take accountability, the project costs go down. Not only do clients now receive lower initial costs due to the exclusion of contingency, but they also only pay for the risk that occurs. Additionally, when there is proper project management and transparency, the risk caused by client stakeholders (which is 90% of risk that occur) is severely minimized. This is expected, as once client stakeholders know their risk causing activities, know they will be held responsible for the cost if they occur and are assisted by the vendor to prevent it from happening, most risk will simply go away.
The Best Value Approach (BVA) is a procurement and project management process are structured around the principles mentioned in this article. In contrast to most approach which attempt to transfer and share risk, the BVA focuses on identifying and utilizes experts to mitigate risk. The results speak for themselves as they lower project cost and eliminate risk.
To learn more about the Best Value Approach see:
- Free membership for latest tips and news: https://pbsrg.com/membership/
- For latest books, events, and licensed partners: https://pbsrg.com/resources/
- Latest BVA journal publications: www.cibw117.org/
- Annual Best Value Conference in January: https://bestvalueconference.ksm-inc.com/
- Latest presentations and videos: https://www.youtube.com/channel/UCxBi26nXLDTqG4ZRV6p0iiQ