Projects as a Form of Production

How Production Theory Links to Project Management

In the previous post the idea that a project might be considered as an internal, temporary micro-market post was considered. An economic approach emphasises both the market for projects and projects as markets, and leads to a different approach to the analysis of projects. This different approach is quite well suited to the growing importance of the economic role of projects in the modern economy.

This post is concerned with another aspect of the economics of projects. The starting point is the idea of a project as a form of production, in the economic sense of combining a number of factors or resources to create output. Here, a representative firm selects the technology to use, organises and manages the production process to maximise efficiency and deliver output.

The economic theory of production that developed after the mid-18^th century was one of the main topics of classical political economy, firstly by the French physiocrats and their theory of agricultural rents and revenue, and later by Adam Smith and his analysis of the emerging factory system and profit. After the marginal revolution in economics in the second half of the 19^th century, production theory adopted Alfred Marshall’s framework of optimal allocation of scarce resources.

In the neoclassical theory of production, the starting point is a set of physical technological possibilities represented by a production function. The output of a production process is determined by the choice of technology and the flow of inputs used, the flows of capital services, labour services, and services from land, energy and raw materials. The task of a firm and its managers is to combine all these into a flow of output. 

This economic model of the firm as a black box, turning inputs into outputs, left many unanswered questions. Production processes vary widely within and between industries, and across regions and countries. Industry concentration and structure, and the regulation of market power, have become increasingly important. The data we get from the SIC (System of Industrial Classification) comes with many qualifications.

During the 20^th century answering these questions led to substantial new sub-fields in organisational and industry economics, investigating the boundaries and management of firms and industries. The single topic that attracted most theoretical research, however, was the choice and application of technology, as this had long been recognised as the driver of productivity and economic growth. Technology, in turn, is embodied in the capital used as a resource in the production process.

Many aspects of project management seem to be about resource allocation and delivery of a product (i.e. the project), the economic-orientated set of activities found in a production model. Although a wide range of management tools and methods are used in the course of a project, over the conception to handover cycle, the emphasis is actually on the way that the production process is managed. Thus the central role given to work breakdown structures, schedules and risk management. Further, the generic nature of project management supports this view. There is specific knowledge required for delivering construction projects, for example, but the broader set of PM skills are not industry specific and are about getting the various processes needed for a particular project right.

Also, many decisions in PM are often about the technology to be used. The substitutability of capital (how much equipment) and labour (how many workers) is apparent in any office and on every construction site. Economic theory gives technology the key role in determining efficiency, with management of the production process determining the level of efficiency. Thus a link between PM and the economic theory of production is found. These are both process-based and concerned with production technology choices.

Do Projects Have Internal Markets?

Projects As Micro-Markets

Can an individual project contain within it an internal, though temporary market? The definition of a market found in a standard economics text is “any arrangement in which the interaction of buyers and sellers determines the price and quantity of goods and services exchanged”. By this criteria the act of procurement, which is purchasing goods and services, is indeed a market transaction.

A market for a single project is created by the client as they go through the procurement process, regardless of the particular system or method of procurement followed. The client is the buyer of a bundle of goods and services from the contractor/s bidding or negotiating for the project, and their interaction on the scope (quantity) and price of the project is resolved when the agreement or contract is exchanged. In particular, the extent of market power held, gained or lost by participants as the procurement process goes through the stages of pre-bid, tender, final bid and negotiation, or some variation of those stages, is an important factor.

A distinction can be made between the market for a project, typically one of many similar types of projects, and the market for the supply of the bundle of goods and services required to deliver that specific project. Such a market is created by a project manager or lead contractor as they organize the work and subcontract the various specialized tasks. This could be called a micro-market, and it establishes within the project an internal market.

If procurement of a project creates an identifiable, though temporary, micro-market for goods and services, what are the distinctive characteristics of such a market? Clearly it is not like a conventional market described in a textbook. The characteristics of markets are the number of buyers and sellers, the distinctiveness and substitutability of products, forms of competition, barriers to entry and concentration ratio, and the information and mobility of customers. These market characteristics do not, however, neatly carry over to industries with extensive subcontracting, such as building and construction, for three reasons.

The first reason is there is only one buyer, and in such a market with a single buyer it is possible to gain market power through bargaining with potential suppliers. Bargaining power is found in the bilateral negotiations over terms and conditions of supply between trading partners. In a bargaining framework buyer power is the ability to extract surplus from a supplier, typically through individually negotiated discounts. However, because this bargaining power cannot be exercised when suppliers are competitive, it is a countervailing power and thus its use is constrained by circumstances.

Buyer power is the bargaining strength a buyer has with suppliers with whom it trades, where its bargaining strength depends on its ability to credibly threaten to impose an opportunity cost if it is not granted a concession. The traditional economic treatment of bargaining power uses the concept of outside options available to buyers and sellers. The Australian Competition and Consumer Commission describes these as “the outside option is the best option that either the seller or buyer can achieve if they walk away from the negotiations.” Strong outside options for a buyer, or weak outside options for a seller, will be a major source of buyer power in a bilateral bargaining framework.

The second reason is that subcontractors are typically not engaged in a single transaction, as in the market-based trades of instant exchange and settlement envisaged in economics textbooks. The relationship between a large corporation and its subcontractors is typically more durable and intensive than a market relationship. This idea of ‘relational contracting’ has firms developing long-term ties with contractors, often with a degree of mutual understanding and trust that are not typical of market transactions. Instead of using the market, the firm will rely on a trusted supplier, especially when their relationship involves shared knowledge and learning.

Third, there are ‘hybrid’ concepts, where relations between a head contractor and the subcontractors are stable and continuous over fairly long periods of time and only infrequently established through competitive bidding. A form of-integration that largely makes the concept of relational exchange redundant. The hybrid concept does not survive the reality of contractual obligations, however. While there may be relational aspects to the organization of production/projects between firms, the legal distinction between firms, markets and other arrangements remains real, and the legal status of the firm has not been undermined. Conceptual boundaries are not contractual boundaries, and this distinction should not be ignored.

A different approach to these long-term or continuous relationships is the idea that a project creates an internal, temporary, micro-market for the goods and services supplied by subcontractors. This temporary micro-market, or internal project market, comes into formal existence after the procurement process has been completed, a contract signed and the project become a defined, deliverable building or structure (although there seems to be no good reason why this idea could not be applied to any type of project, such as software or equipment development).

In fact, all this takes us back to Ronald Coase’s original 1937 paper ‘The nature of the firm’. Coase was the first to argue that markets and firms are alternative governance structures for economic transactions. Importantly, the firm is a distinct legal entity, a ‘legal person’ that enters into written or unwritten contracts. He argued the firm is an organisation, rather than just a production function, and separated the market from the firm with the ‘price mechanism’ on one hand and its ‘supersession’ on the other.

For Coase the alternative to the firm was the coordination of self-employed individual producers by the market, each being his or her ‘own master’. In the case of subcontracting, this extended organization still coordinates production, but within the temporary market created by the project. Like any other type of market this internal, temporary micro-market created by a project will have a range of characteristics and dynamics.

The basic proposition behind this line of reasoning is the idea that project procurement is a mechanism for creating an internal market. If this is the case, we can utilise the elements of industry structure, competitive analysis and so on, that have traditionally been applied at the firm level, to better understand projects and their governance.

Delusion and Deception in Project Selection

Two Basic Methods for Prevention and Avoidance

It is well known that the future is uncertain, where uncertainty is an unmeasurable or truly unknown outcome, often unique. This can be clearly seen on large infrastructure projects, which often bring into focus the issues around project selection. A remarkable number of these projects are unsuccessful, by exceeding their time and cost estimates, or inefficient because their returns and/or benefits are well below forecasts.

Major infrastructure projects are typically selected under conditions of uncertainty, not risk. Risk is identifiable and measurable, uncertainty is not. There are three main reasons:

1. Costs and benefits are many years into the future, and the estimates depend on the assumptions and type of model used;
2. These projects are often large enough to change their economic environment, hence generate unintended consequences, with the Oresund Bridge between Sweden and Denmark the prime example; and
3.  Stakeholder action creates a dynamic context, with the possibility of escalation of commitment driven by earlier decisions.

In their 2009 paper ‘Delusion and deception in large infrastructure projects’ Flyvbjerg, Garbuto and Lovallo argued project planners are often far too optimistic in their estimates (delusion) or ‘strategically misrepresent’ their project to approving and funding organisations (deception). Clearly, one path to better project selection that would address these issues is better information about the proposed project.

One source of such information can be found in the performance of previous similar projects. Although it seems obvious, this has only recently become common practice by some experienced private sector clients’ when considering major projects, as the example of IPA shows.

Independent Project Analysis was established by Edward Merrow in 1987, after a stint at RAND where he did the first published study on megaprojects, those costing over US$1 billion. The company provides a project research capability for heavy industry and the process and extraction industries. Their database in 2011 had 318 megaprojects, of about 11,000 projects in total, from industries like oil and gas, petroleum, minerals and metals, chemicals, and power, LNG and pipelines. In his book on megaprojects Merrow found that the best examples of project-definition work reduce both project timelines and costs by roughly 20 percent.

Depending on the project, between 2,000 and 5,000 data points are collected over the initiation, development and delivery stages. From this database companies can compare their project with other, similar projects, across a wide range of performance indicators. The data gives estimates on approval, design and documentation, and delivery times for the type of project, and allows for factors like location, access and complexity in costs.

In his 2011 book Industrial Megaprojects Merrow advocates a process he calls front-end loading, the “period prior to sanction of the project”. There are three stages. In summary, the first evaluates the business case, the second is scope selection and development, and the third is detailed design. His argument is that there need to be gates between these stages that prevent less viable projects from getting to authorisation. If there is a problem in the private sector with project selection, even with the managerial structures, capital budgeting and corporate finance constraints found in profit-driven companies, then the problem in the public sector can be reasonably expected to be much worse.

A significant reason for poor decisions on project selection is unwarranted optimism about outcomes, called the planning fallacy by Kahneman and Tversky, or the tendency to underestimate the time needed for a task, even with the experience of similar tasks over-running. Thus, we have a general tendency to underestimate the time, costs, and risks of future actions and overestimate benefits of those same actions.

In their ‘Delusion and deception’ paper’ Flyvbjerg, Garbuto and Lovallo proposed a solution to optimism bias they called Reference Class Forecasting. This works the same way as the IPA database, but their database was mainly composed of public infrastructure projects, many in the transport sector. RFC involves three steps:

1. Identification of a relevant reference class of past, similar projects;
2. Establishing a probability distribution for the reference class;   
3. Comparing the specific project with the reference class distribution.

In decision-making under uncertainty errors of judgment are often systematic and predictable rather than random, manifesting bias rather than confusion. RFC may limit bias just by following a procedure and by gathering relevant data for a panel of projects to be used in the comparisons. RFC may also prevent excessively large projects being preferred to more welfare-efficient projects when the political benefits are large compared to more effective projects.

To deliver better results in on-time and on-budget delivery, Merrow argues project developers or sponsors should spend 3 to 5 percent of the cost of the project on early-stage engineering and design. This is because the design process will often raise challenges that can to be resolved before construction starts, saving time and money.

If more realistic, and therefore more accurate, time and cost estimates were given for major infrastructure projects before they are approved, and during the design and development stages, there would be fewer recriminations about project performance and less incentive to find scapegoats on completion, which is typically over budget and schedule. There would be fewer of the common accusations of poor productivity, management failures or poor planning, thus lessening the atmosphere of acrimony that often surrounds major projects in their latter stages. This would also encourage more transparency about the project’s performance, in both the delivery and operational stages, particularly by public officials.

Merrow argues the owner’s job is to select the right project and the contractor’s job is to deliver the project as specified, on time and on budget. In his view contractual relationships are more tactics than strategy, and cannot address any fundamental weaknesses in the client’s management of the project, in particular the client ultimately has to own the design. This crucial point is now widely recognised by the private sector clients/owners of large engineering projects that Merrow studies.

For example, both Shell and BP established project academies in 2005 because they understood that significant risk transfer from clients to contractors is structurally impossible on the oil and gas projects they undertake. In the public sector, the UK Cabinet Office started a Major Projects Leadership Academy with the aim of reducing reliance on consultants, and in Australia a similar Leadership Academy was announced in 2013, and six MBA-type courses on procurement developed with government departments are now running at Australian universities.

A great deal is already known about the requirements for large infrastructure to be successful, based on the performance of projects over the last two decades and the many studies and reports that have been done on those projects. Better use of data from previous projects in the evaluation and definition stages of new projects would be a transformative innovation in procurement management, and a more empirical approach by clients in collecting and using data is necessary if better decisions are to be made.

 

Flyvbjerg, B., Garbuto, M. and Lovallo, D. 2009. Delusion and deception in large infrastructure projects: Two models for explaining and preventing executive disaster, California Management Review.

Kahneman, D. and Tversky, A. 1979. Intuitive prediction: biases and corrective procedures. TIMS Studies in Management Science.

Merrow. E.W. 2011. Industrial Megaprojects: Concepts, Strategies and Practices for Success, Hoboken, N.J.: Wiley.