W16_LUCKY_Decision to put up contractor claim or not to put up contractor claim using Decision Tree

W16_LUCKY_Decision to put up contractor claim or not to put up contractor claim using Decision Tree

1.      Problem Recognition

A friend of mine who is a contractor has approached me for advice. He has essentially completed the construction of the block of flats under a fixed price contract. There have been budget costs overrun, unfortunately. Although, not losing money overall, the overrun has substantially reduced his profit.

2.      Problem Definition

My friend believes that the cost overrun was caused by delays attributable to the owner in the form of late deliveries of owner-furnished materials, slow reviews of submittals, etc.

Will submitting a claim be the best?

I would like to solve it using the Decision Tree Tool and Technique.

a.      Assumptions

Key assumptions include:

·         The preliminary estimate of delay costs, both direct and indirect, is USD1 million

·         The owner is generally unreceptive to claims for indirect costs on change orders

·         There is no provision for the use of arbitration for dispute resolution

·         The contract does not have damages for delay clause, as none of the delays were for force majeure

·         It will cost $20,000 to prepare the claim

 

3.      Feasible Alternatives

Feasible alternatives include:

1.      Do not submit the claim

2.      Submit the claim and owner request a negotiation

o   This option has 50 per cent probability

o   If it goes well, chances of recovering the amount are as follows

§  $750,000 – 10%

§  $500,000 – 50%

§  $250,000 – 40%

3.      Submit the claim and owner rejects it. Two choices available

o   Leave off

o   Request arbitration (Estimated cost $20,000)

§  30 per cent probability

o   If it goes to arbitration, chances of recovering the amount are as follows

§  $750,000 – 10%

§  $500,000 – 50%

§  $250,000 – 40%

4.      Owner rejects arbitration. Two choices available

o   Leave off

o   Pursue legal action (Estimated cost to file suit: $50,000)

§  70 per cent probability

o   It could result in out-of-court settlement, chances of recovering lower amount are as follows

§  $500,000 – 20%

§  $250,000 – 50%

§  $100,000 – 30%

o   Time to file suit and claim estimated to be 1 year

§  Time-value –of-money at 12 percent per year

5.      Owner not receptive to out-of-court settlement

o   Legal cost increase by $100,000 to bring case to trial

o   It could result in chances of recovering amount are as follows

§  $500,000 – 40%

§  $250,000 – 40%

§             $0 – 20%

o   Time to pursue trail to final judgment estimated to be 5 years

§  Time-value-of-money at 12 percent per year

 

4.      Development of outcomes  for each alternative

There are three decision points:

1.      The decision to submit or not to submit

2.      If claim is rejected, whether to pursue arbitration or not to pursue arbitration

3.      If arbitration is rejected, whether to pursue legal action or not to pursue legal action

There are three intermediate event nodes towards the ultimate outcomes as follows:

X – From which my friend can choose to negotiate or reject claim

Y – From which my friend can either agree to arbitrate or reject arbitration

Z – From which my friend can either go for trial or settle out-of-court

The following calculations results:

Step One –

Determining the expected value, E_v

·         Outcome A: Don’t submit option - E_v = $0

·         Outcome B: Claim submitted, negotiation results

E_v = $1,000,000 (0%) +$750,000 (0.1) + $500,000(0.5) + $250,000(0.4) = $425, 000

·         Outcome C: Leave off option - E_v =  $0

·         Outcome D: Seek arbitration , E_v  = $425, 000

·         Outcome E: Arbitration rejected, E_v = $0

·         Outcome F: Possible legal action, at time of award, with 90 per cent probability

E_v = $500,000 (0.2) + $250,000(0.5) + $100,000(0.3) = $255, 000

Calculating the present value of the outcome at Node Z –

PV = $255,000 – (P/F, 12%, 1 yr.) = $228,000

·         Outcome G: Going to court,  with 10 per cent probability

E_v = $500,000 (0.4) + $250,000(0.4) + $0(0.2) = $300, 000

Calculating the present value of the outcome at Node Z –

PV = $300,000 – (P/F, 12%, 5 yr.) = $170,000

4.      Selection Criteria

The selection criterion is to use the most favorable net expected value at the original decision node and tracking it back through the tree to determine the most favorable decision.

 

5.      Analysis and Comparison of the alternatives

 

Step Two –

Working backwards through the paths:

 

Node Z: Assuming the legal fee is paid in year 3 although spread across the 5-year period, the present value,  PV = $100,000 – (P/F, 12%, 3 yr.) = $71,000

Thus, net expected value at node Z = $170,000 - $71,000 = $99,000

Combining expected value of out-of-court settlement with going to court expected value gives a net expected value (present value) as follows

E_v = $99,000 (0.1) + $228,000(0.9)  = $215, 000

At decision Node 3, since filing suit for legal action cost $50,000, the net value of that option at Node 3 is $165,100 (i.e. $215,000 - $50,000)

Node Y: Option of acceptance or rejection of arbitration, the expected value is

E_v = ($425,000-$40,000) (0.3) + $165,100(0.7) = $231, 070

At decision Node 2, the expected value will also be $231, 070 since it only compared to the leave off option.

Node X: Option to negotiate or not, the expected value is

E_v = $425,000 (0.5) + $231,070(0.5) = $328, 035

Subtracting the cost of preparing the claim, the net expected value is $308,035 (i.e. $328,035 - $20,000) comparing to the option of not submitting a claim (expected value of $0).

 

6.      Selection of preferred alternative

It appears that submitting a claim would provide a positive return of $308,035 compared to not doing so. This is the advice I would give my friend, although, I would stress to him that the expected value is not assured but just a better chance of getting an award than losing money. Besides, he needs to note that the expected value is far less than the $1m estimate at the onset. Additionally, I would remind him of the consequences of taking this decision which includes alienation of the client, loss of future opportunities, bad publicity in the market place, and valuable staff time taken away from other more important tasks for his company.

7.      Performance monitoring and post evaluation of results

Time value of money could be applied to the outcomes and costs just like with those associated with legal actions. For a better decision, it may be useful to calculate the net outcome for each potential final event and the probability of occurrence. This will be examined in a subsequent blog.

 

 

 

Reference

1.      Sullivan, W., Wicks, E., Koelling, P., Kumar, p., & Kumar, N. (2012).Chapter 12 Probabilistic Risk Analysis (pp. 528 - 533). Engineering economy (15^th edition). England: Pearson Education Limited.

2.       Brassard, M. & Ritter D. (2010). Chapter 24 Tree Diagram (pp.200 – 209). The Memory Jogger 2 (2^nd edition). USA:GOAL/QPC

3.      Giammalvo, P. (2012, October 22). Integrated portfolio (asset), program (operations) and project management methodology course (cost engineering) slides (An AACE methodology course). Lagos, Nigeria: Lonadek