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The Importance of Contracts in Project Delivery Systems

Question:

Define Risk in Contacts. How can we mitigate risks in contracts. Recommend efficient strategies to mitigate risk in different contracts.

Contract is one of the essential tools for the project delivery system that aids to effectively manage obligations. It helps all the parties engaged in the business to reduce their effort and time significantly (Kendrick, 2015). Additionally contacts help the parties, who are indulged in business to create and amend their strategies as well as the procedures to perform the business smoothly. Using the contracts for business quantity, price and equilibrium quantity can also be chalked out by the management of the firm (Love & Trowbridge, 2017). Now, when it comes to smooth operation of a business, then contracts are the cornerstone that brings in transparency and maintain the quality requirements. According to the Harrel, (2017) it is important to remember that contracts expose the firms to the unique risks, which are beyond the scope of typical control framework.   Managing this risks and proper assessment of the risk is highly important in order to attain the best deals. Though there are high amount risk is associated with the contracts, however, if it can be managed properly, then aids the firm to have higher profitability as well as better scope of income with ultimate transparency in the business (Klijn & Koppenjan, 2016). There are various ways to assess the risk associated with the contract and numerous ways have been discovered to mitigate them. Simple steps or initiation can lead the contract as a tool that enlarges the business and make it more lucrative in front of the prospective customers (Wellin, 2016). This essay is meant t analyse the ways to mitigate risks in contracts at first place and then it will discuss the reason for rising those risks. Besides this, the essay will discuss efficient strategies to mitigate risk in different contracts and to conclude it will provide some recommendations to reduce the scope of risks in contracts in the business.

Contracts are one of the most useful things that aid the business to become more competent and transparent. However, it has been seen that it possess adequate amount of risks if handled improperly. These risks can lead the joint venture or the whole operating to breakdown that makes it highly important to mitigate the risks in contracts (Liu et al., 2016). There are various ways to mitigate the risks in contracts, which are risk assessment, transferring risk, risk buffering and many others. Details regarding these risk management mechanisms are as follows:

Risks Associated with Contracts

In order to mitigate the risk associated with a contract, risk assessment is one of the best tools. It helps to understand the key business and legal risk associated with the parties involved in the contracts and highlights the areas that need focus. With the involvement of the stakeholders, risk assessment guide to identify the areas of high risk in the contracts and reduce the same with proper actions (Lin, 2016). Risk assessment not only includes the financial aspects, moreover, it considers the financial aspects to find out the likelihood of occurrence of the risk. Besides this, risk assessment considers various things to trace the probable occurrence of the risk in contract are as follows (El-Sayegh & Mansour, 2015):

  • Expanses and the possibility or revenue generation in case of the contracts
  • Type of the authority (for instance, foreign subsidiaries, business units, individual firm and others) who are engaged into the contract
  • Functional area of the party who are engaged in the contract

Depending upon the number of hands the contract flows, risk assessment categories the contracts and aid the firm to reduce the scope of risk to a great extent; however, the level of benefit that a firm can gain from the risk assessment largely depends upon the factor that how well the particular brand utilize the tool.

Once the contractual risk assessment is done, then the next step to minimise the risk is to implement the risk transfer procedure. It aids to determine and dismembers the risk to different parties (Ahmad et al., 2016).  Various indemnification clauses make the risk transferring procedure, which are as follow:

It is a mechanism that allows shifting the probable cost of risk from one party to another.  In the case of any physical or monetary loss indemnification clause allows to pay to the third part as outcome of the injury (Lobo, Newhouse & Bergstrom, 2017). Using this mechanism, risk associated with the contract can be altered to the third party thus by reduces the scope of loss.

It is another beneficial strategy to reduce the risk associated with the contract because it provides a exposure cap to the contracting parties in case of any claim is made. Limitation to the liability reduces the risk exposure by 90% and thus reduces the overall risk level associated with the contract.

This is another risk mitigating clause in case of contracts that helps the firms indulged in the contract to sue the third party for the loss incurred due to the failure of the contract. Thus, by reducing the scope of uncertainty it helps to subrogation of the risk associated with the contract (Soderblom, Samuelsson & Martensson, 2016).

Strategies to Mitigate Risk in Contracts

Risk buffering is an effective mechanism to reduce the scope of contract risks because this simple framework aids the firm indulged in the contract to keep some buffer stock so as to make them potent for absorbing any undesired shocks (Olson & Wu, 2015). Whether it is cost overrun or the lack of time and material, if the buffer stock is there, then it can aid the contract to operate smoothly; however, it is important to keep in mind that, risk buffering gives the contract price to rise and lead the project completion time to increase (Mishra et al., 2016). Whatever it is, risk buffering will certainly aid the contract to run smoothly without any scarcity and even if there is some amount of scarcity, then it would the reserve stock will absorb the same.

Uncertainty is one of the main reasons for the rise in contractual risk and whenever there is contract, and then there will be some amount of uncertainty too. Depending upon the level of uncertainty, the burden of the risk can be shared among the parities indulged in the contract (Grote, 2015).  Thus, if the uncertainty of the contracts can be reduced, then it would mitigate the risk associated with the contract too. One of the best ways to reduce the uncertainty associated with the contract is to enhance the organisational flexibility and bring in the risk control mechanism (Kerzner & Kerzner, 2017).

Till now most of the ideas that can be used to mitigate the risk in contract are theoretical, however, in order to utilise them in practical, there are professional tools or software that do the task. These tools are programmed in such a way that it can address the central issue of the contractual risk and focus on the factors to negotiate on the management process in order to enhance transparency (Yildiz et al., 2014). Professional tools are beneficial to reduce the communicational gap among the parties indulged in the contract and open up the path to enhance the linkage among the external stakeholders as well as the third parties. The process of contract negotiation become inherently collaborative with the use of the professional tools and it not only gives enough amount of transparency, moreover aids the firm to chalk out their incurred cost, profitability and liabilities. Back and forth exchanges in case of the contracts get largely reduced by utilizing professional tools and thus it reduces the scope of miss approvals (Neale, Weir & McGee, 2016). On the other hand it keep limelight on the five stages of the contract life cycle, thus providing enough scope to mature the contract and prove it to be fruitful for all the parties indulged in the contract.

Reducing Uncertainty in Contracts

Contracts are one of the essential tools for the growth of every business irrespective of their variety. Contracts aid the firm from introducing new subsidiary firm to establishing partnership and in addition, it guides the firms to secure licenses to enhance their business around the various places beyond their place of origin (Edsparr & Fisher, 2014). However, it is true that contracts are highly associated with the risks and it can bring the firm to the shutdown point leading to complete loss of all the effort. On the other hand, if the contracts can be managed properly, then it would provide great amount of protection from the risk and liability. Depending upon the contract type, risk burden varies widely and the share of the burden falls relying on the amount of uncertainty the respective parties are facing. For instance, there are three broad categories of contract, which are namely Fixed-Price contract (FP), secondly Time and Material (T&M) contracts and lastly Cost Reimbursable (CR) or Cost Plus (CP) contracts (Jorgensen, Mohagheghi & Grimstad, 2017).


Now, in the case of FP contracts, seller has highest amount of uncertainty in the amount of profit making due to the fact that seller does not know how much profit he or she can earn at the beginning. On the other hand buyer has full information about the payout that reduces the amount of uncertainty that the party is going to have. Thus, the risk in contract in the case of FP contracts shifts from buyer to the seller (Biais, Heider & Hoerova, 2016). According to the same source, when it comes to the CP contracts, then the buyer do not have idea regarding the amount of payout during the time of contract and this enhances the level of liability to the exorbitant level. On the other hand, seller has proper information regarding the payout for the contract that reduces the uncertainty level. Thus, the burden of risk in the FP contract lies over the buyer with a higher magnitude compared to the seller. T&M is the mediating form of contract that sets between the previously mentioned contracts varieties. According to the Shokoohyar & Katok, (2017) level of uncertainty remains same for both the parties and the risk of this type of contract is divided between both the parties. During the initiation of the project none of the party has proper information regarding the cost of the project. In the case of buyer he doesn’t have any idea about the material cost and on the other hand the supplier does not have idea regarding the labour cost. Thus the risk of this type of contract is shared both by both the parties.

Professional Tools for Managing Contractual Risks

Well, though there are risks in case of the contracts, however, it can be reduced to a great extent using the proper mechanism. Moving forward, this essay will highlight various efficient strategy recommendations to mitigate the risk related to the contracts.

Contracts are efficient tool that can lead a business or collaboration to the zenith of success; however, if it is mishandled, then it can come down as the bane on the whole project.  Thus, whenever parties are engaging themselves in the contract, then it is highly important to follow some basic rules, in order to reduce the scope of risks in contract. Some of the recommendations for this purpose are as followed:

  • Fundamental of managing risks in contract lies in the in-depth knowledge about the contract. Thus, the first and foremost thing in order to reduce the risk in contract is to properly know the clauses and proper understanding regarding the same and then indulging into the contract.
  • Secondly, it has often been seen that firms, irrespective of the size and magnitude of business are indulged into the variety of contracts with different parties. Over the time they forget to review them and this gives the stimuli in to the risk in contract. Thus it is highly important to review the contracts in a periodical manner in order to reduce the scope of contracts.
  • Proper assessment of the suppliers and measuring the value addition of the contracts are subject to periodical reviewing. Thus it would be better for the firm to perform survey and organise interviews with the parties indulged into the contract in order to mitigate the scope of risks in contracts.
  • Contracts are considered as one of the influential tool for pricing strategy of the firms. Thus proper monitoring of the pricing adjustment and amend the same in order to stick with the contract is essential for mitigating the risk associated with the contracts.
  • It would be better for the firms to bring in risk control mechanism so that in case of any unwanted fluctuation in the contract couldn’t hamper the flow of operation. Using tools like early warning system and risk control mechanism, firms can avoid the scope of risk appearance in case of the contract.
  • Surveying and risk assessment frameworks are cost worthy, however, they need huge amount of investment too during the initial stages. Thus it would be better for the firms to allocate necessary amount of fund in order t reduce the scope of cost overrun.

Conclusion:

The essay has analyzed the risks in contracts and it has tried to find out how the risks related to the contract can be minimized. The analysis has found that there are various reasons that can give rise in the contractual risks. Among many, one of the main reasons for the rise of contractual risk is lack of transparency in the contracts. The report has found that, lack of transparency in the contract can lead to bad planning as well as result in complicated pricing strategy. These things ultimately cause overrunning costs, miscommunication among the parties indulged in the contract and lead to loss of revenue. Besides this, the report has found that, lack of timely reviewing of the contracts makes the contract a financial burden for most of the firm. The report has found that contracts act as the financial burden to the small firms compared to the large firms due to the fact that they are in their growth stage. Moving forward, it can be said that the essay has provided various ways to mitigate the risks in contract. As an effective mechanism to reduce the scope of risk in the case of contract, is to adhere with the risk management guidelines. Besides this, it has also been found that timely reviewing and proper knowledge about the contract can be proved to be beneficial for the firms to reduce the scope of risk in the contract. In addition, risk transfer is another effective mechanism to reduce the scope of risks in contracts. The essay has provided some effective recommendations, if implied these can lead to a transparent contract, which is associated with minimal amount of risk. To conclude, it can be said that contracts are effective and essential tool for every business; thus, if they can be used properly, it can help the business to reach the zenith of success and act as the buffer for any supply or demand side shock. In addition it can provide the business sustainability and fuel to indulge in more business activities.

Differences in Risk Burden Between Contract Types

References:

Ahmad, A. U. F., Mahbob, I. B., & Ayub, M. (2016). The nature of retakaful: risk sharing or transferring risks?. Chapters, 171-191.

Biais, B., Heider, F., & Hoerova, M. (2016). Risk?Sharing or Risk?Taking? Counterparty Risk, Incentives, and Margins. The Journal of Finance, 71(4), 1669-1698.

Edsparr, P., & Fisher, P. (2014). 5 Tail risks and contract design from a financial stability perspective. Developments in Macro-Finance Yield Curve Modelling, 121.

El-Sayegh, S. M., & Mansour, M. H. (2015). Risk assessment and allocation in highway construction projects in the UAE. Journal of Management in Engineering, 31(6), 04015004.

Grote, G. (2015). Promoting safety by increasing uncertainty–Implications for risk management. Safety science, 71, 71-79.

Harrell, A. C. (2016). The importance of contract law: A historical perspective. Okla. City UL Rev., 41, 1.

Jørgensen, M., Mohagheghi, P., & Grimstad, S. (2017). Direct and indirect connections between type of contract and software project outcome. International Journal of Project Management, 35(8), 1573-1586.

Kendrick, T. (2015). Identifying and managing project risk: essential tools for failure-proofing your project. AMACOM Div American Mgmt Assn.

Kerzner, H., & Kerzner, H. R. (2017). Project management a systems approach to planning, scheduling, and controlling. John Wiley & Sons.

Klijn, E. H., & Koppenjan, J. (2016). The impact of contract characteristics on the performance of public–private partnerships (PPPs). Public Money & Management, 36(6), 455-462.

Lin, C. (2016, July). The risk management under conditions of contract for EPC in overseas projects. In Logistics, Informatics and Service Sciences (LISS), 2016 International Conference on (pp. 1-5). IEEE.

Liu, B., Dong, S., Wu, D., & Xu, H. (2016). Contract Risk Aversion of the Simulation Model of the Coordination between the Supply and Demand on Both Side. International Journal of Simulation--Systems, Science & Technology, 17(5).

Lobo, M. J., Newhouse, S., & Bergstrom, W. R. (2017). Case Study: Excavation Adjacent to High Pressure Natural Gas Transmission Pipelines—A Risk Management Approach. In Geo-Risk 2017 (pp. 184-193).

Love, T., & Trowbridge, T. (2017). Beyond Illustrations—The Importance of Contract Language. Journal of Financial Service Professionals, 71(4), 67-79.

Mishra, D., Sharma, R. R. K., Kumar, S., & Dubey, R. (2016). Bridging and buffering: Strategies for mitigating supply risk and improving supply chain performance. International Journal of Production Economics, 180, 183-197.

Neale, T., Weir, J. K., & McGee, T. K. (2016). Knowing wildfire risk: scientific interactions with risk mitigation policy and practice in Victoria, Australia. Geoforum, 72, 16-25.

Olson, D. L., & Wu, D. D. (2015). Enterprise risk management(Vol. 3). World Scientific Publishing Company.

Shokoohyar, S., Qi, A., & Katok, E. (2017). Project Management under Risk-Sharing Contracts.

Söderblom, A., Samuelsson, M., & Mårtensson, P. (2016). Opening the black box: triggers for shifts in business angels’ risk mitigation strategies within investments. Venture Capital, 18(3), 211-236.

Wellin, M. (2016). Managing the psychological contract: Using the personal deal to increase business performance. CRC Press.

Yildiz, A. E., Dikmen, I., Birgonul, M. T., Ercoskun, K., & Alten, S. (2014). A knowledge-based risk mapping tool for cost estimation of international construction projects. Automation in Construction, 43, 144-155.

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