W17_LUCKY_Fine Tuning the
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.
In a previous blog, it has
been determined that submitting a claim appears to yield a positive return. But
what decisions should be taken in what sequence to assure this positive return?
I would like to solve it
using the Decision Tree Tool and Technique once again.
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, Ev
·
Outcome
A: Don’t submit option - Ev
= $0
·
Outcome
B: Claim submitted, negotiation results
Ev = $1,000,000
(0%) +$750,000 (0.1) + $500,000(0.5) + $250,000(0.4) = $425, 000
·
Outcome
C: Leave off option - Ev
= $0
·
Outcome
D: Seek arbitration , Ev =
$425, 000
·
Outcome
E: Arbitration rejected, Ev
= $0
·
Outcome
F: Possible legal action, at time of award, with 90 per cent probability
Ev
= $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
Ev
= $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 and
using the following formulas:
Net outcome = (Expected value) – (Present Value of
costs)
Percent Probability = sequential product of individual
probabilities of occurrence
·
Net Outcome
A: Zero; percent probability = zero
·
Net
Outcome B: $425,000 - $20,000 = $405,000; percent probability = 50%
·
Net
Outcome C: Zero; percent probability = (50%)(0%) = 0%
·
Net
Outcome D: $425,000 - $20,000-$40,000 =
$365,000; percent probability = (50%)(30%) = 15%
·
Net
Outcome E: Zero; percent probability = (50%)(70%)(0%) = 0%
·
Net
Outcome F: $228,000 - $20,000-$50,000 =
$158,000; percent probability = (50%)(70%)(90%) = 31%
·
Net
Outcome G: $170,000 - $20,000-$50,000 -$71,000 = $29,000; percent probability =
(50%)(70%)(10%) = 4%
6.
Selection of preferred alternative
In this case the resultant
advice that I would give my friend will be: (1) pursue the claim; (2) if the
claim is rejected, seek arbitration; and (3) if arbitration is rejected, take
legal action hoping for out-of-court settlement. The odds for winning the case
are very slim (4%) for an outcome of $29,000.
The best option would be to
pursue the claim hoping for a negotiated resolution with 50% probability of
achieving the expected value of $405,000 otherwise back off with a loss of only
$20,000, the cost of preparing the claim
7.
Performance monitoring and post evaluation of results
The precautions against
seared relationship with the client, bad reputation in the market place and loss
of valuable time are worthy of mention to my friend for serious consideration.
Perhaps an improved relationship with the client would eliminate this type of
incident in the future.
Reference
1.
Sullivan,
W., Wicks, E., Koelling, P., Kumar, p., & Kumar, N. (2012).Chapter 12
Probabilistic Risk Analysis (pp. 528 - 533). Engineering economy (15th edition). England: Pearson Education Limited.
2.
Brassard, M. & Ritter D.
(2010). Chapter 24 Tree Diagram (pp.200 – 209). The Memory Jogger 2 (2nd 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
Also awesome, Lucky!!!
ReplyDeleteAnother good treatment indicating you know and understand how to use this tool/technique under different or real life circumstances.....
Just keep doing what you committed to do in the beginning each week and you should be in good shape by the time we meet face to face...
BR,
Dr. PDG, Jakarta