Subcontractor defaults on construction projects can be catastrophic, which makes selecting the right team of trade partners crucial. However, in a world where contractors make decisions both within the context of what they know about subcontractor candidates (hard data) and within the boundaries and limitations of their perceptions, worldview, and other biases, we see time and time again that, despite any empirical evidence to the contrary, our decision-making processes are strongly influenced by the human factor.
Psychologist Daniel Kahneman, noted for his groundbreaking work applying psychological insights to economic theory, says whatever else it produces, an organization is a factory that manufactures judgments and decisions. He also says that one of the major biases in risky decision-making is optimism. Therein lies the challenge in the chaotic and complex construction business, specifically, in the subcontractor selection process.
When contractors make "gut feel" decisions about subcontractor awards, they walk the proverbial tightrope of default risk. It's not that they don't have guidelines to follow or best practices to lead the way, it's simply that, when it comes down to selecting whom to work with, business is not actually about business—it's about people. And people can and will be swayed from facts and data, by their thoughts and feelings … their biases.
So, how do we do it right? How do we use the industry best practices and overcome the biases affecting our subcontractor selection process while not completely abandoning the human element? Ultimately, how do we unbiasedly select the ideal trade partners who help us drive successful projects?
Build a Strong Case before Applying the Human Element
Industry prequalification and subcontractor selection best practices exist to benefit and protect contractors. They help make a case for why a subcontractor should or shouldn't be awarded a project in an organized, methodical manner and allow us to proactively address inherent risks. The first step in risk reduction is being mindful of deviations from what you know to be best practices, lest you begin down the proverbial rabbit hole of project risk. Let's start by briefly outlining some industry best practices for subcontractor selection.
Financial strength. Consider data points such as financial statements (audited preferred), with ratio calculations and year-over-year comparisons to reveal trends, credit, and payment history. Are there any liens or past due accounts? What are their banking relationships like? Pull a Dun & Bradstreet report, and look into their surety bonding. Do they have any legal issues to be concerned about?
Operational strength. Consider both their depth and current capacity. Look at their organizational structure, corporate culture, insurance limits and coverage, risk management, years in business, supply chain, etc. Find out their historical annual anticipated current year volume and projections for the next year. What's the largest project they've performed in recent years, their current work in progress, pipeline, backlog, projects out-to-bid, and available man power? What's their geographic strength, market segment, scope of work, level of complexity, and skilled man power for this project's unique features of work? Do they have current union/nonunion affiliations, regulatory or licensure requirements, etc.?
Safety practices. Do they have a full-time safety manager, appropriate support staff, and a formalized safety program? Look up their Occupational Safety and Health Administration (OSHA) 300 records, alcohol/drug testing, OSHA 30-hour trained personnel, and safety goals. Do they have 100 percent fall protection compliance? Does their safety culture align with yours?
Quality practices. Do they have a corporate quality-management program and a field quality-management program in place? What are their preconstruction considerations? Will they engage in preinstallation meetings? Do they build functional mock-ups and perform third-party testing and design reviews? Do they request progress inspections and have punch-list practices? Do they have commissioning, warranty management, and water intrusion protocols? Does their quality culture align with yours?
Reputation and track record. Touchpoints such as postbid/preaward interviews are important to establish. Externally, running reference checks and listening to the rumor mill are essential for picking up anything you may have missed. Lastly, your most valuable internal resource is postperformance reviews from past projects with that subcontractor.
When Subcontractor Bias Steers Us Wrong
Now that we have a framework for best practices, let's walk through the project life cycle from subcontractor selection through failure to perform and remedy of default in an exploration of how our decision-making bias can affect overall project success.
Phase 1: Bid Phase
Unrealistic Optimism + Denial of Risk. The bid is screaming low, and you're looking for a reason that, despite the red flags in their prequalification package, this sub's the right pick. You may be thinking: "I've never had a subcontractor default in the X years I've been building," or "They've been in business for 50 years! They're solid," or "They're too big to fail," or maybe even "We can control the risk!"
If your company experiences a subcontractor default only once per $100 million of work, we (as humans) have a tendency toward unrealistic optimism and round "rarely" to "never." All of a sudden, we're in denial and making risky decisions due to unrealistic optimism.
Phase 2: Subcontractor Selection and Award
Incentives, Goals, and Authority. The bids are in, but none of the bidders have all of the desired criteria. What do you sacrifice to make the job "go"? A good risk manager would pay attention to all the information, but oftentimes there is no perfect choice. In an imperfect world, what happens when there are tradeoffs between low price and safety, for example? We must examine our incentives and goals. How crucial is price (is the prime contract a hard bid or negotiated)? How important is an experience modifier rating of 0.85 verses 0.70? Maybe the project is extremely complex and requires intricate quality control? Examine your incentives and goals in conjunction with an authority matrix to ensure alignment will support solid decisions.
Anchoring + Satisficing. We generally assume the goal of decision-makers is to choose among risky alternatives in order to achieve the ideal outcome. However, optimization involves choosing an alternative that exceeds some criterion or target. While it's true that we want to find the best combination prices and performance characteristics, there is the tendency to award (anchor with) the first subcontractor that provides a bid that meets the (1) minimum performance standards and/or (2) matches budget/estimate in order to get on with the project (satisficing).
When the decision is made quickly, having anchored or satisficed, we settle for "good enough" and often miss out on the optimal outcome. This is the equivalent of someone saying, "Would you like a scoop of vanilla ice cream or.…" and before you hear the rest, you say, "Yes!" Since you like vanilla ice cream, this seems like a win. What you didn't wait to hear was the rest of the question, "Would you like a scoop of vanilla ice cream or three scoops of vanilla ice cream?" You have just satisficed yourself out of two extra scoops of your favorite ice cream.
Phase 3: Operations and Subcontractor Performance
Belief in a Causal Basis of Events. Your project was going well; however, now your subcontractor begins to display warning signs of distress. Never fear, you think, we will get them through! We will control their performance with a risk plan. Confidence is good, but here's where you may overestimate your ability to control events. Ask yourself how much control do you really have over subcontractor performance.
While some events may be manageable (e.g., loss of a key individual, cash flow issue, workflow issue, etc.), believing everything is manageable is likely an overestimation of your influence. A belief in causal basis of events lures us into a false sense of security by suggesting that if we caused the failure, surely we can cause the remedy!
In subcontractor default, we often see contractors attempt to manage or supplement a failing subcontractor for longer than is practical or profitable rather than terminate them and onboard a new one. In this game, you have to know when to hold 'em, know when to show 'em, know when to walk away, and know when to hire a new subcontractor.
Phase 4: Subcontractor Default
Prospect Theory. As humans, our perception of a situation is directly affected by how it is presented to us. If I told you that you have a 20 percent chance of failure on a project, you are now thinking about failure itself, and 20 percent may seem risky. But, if I said you have an 80 percent chance of success, well now you're thinking about success, and 80 percent looks rosy! Same odds, different presentation, different perception.
So, when we're replacing that defaulted subcontractor and all the replacement bids result in savings, the decision-maker is likely to be risk-averse. Since they narrowly escaped a catastrophic loss, and they stand to save money anyway, why take an unnecessary risk? However, if the replacement bids all came in high, and they are going to lose money anyways, decision-makers tend to become risk-seeking.
Project teams will do anything to preserve budget and schedule, but they don't always seem incentivized to take a chance on the upside. The same project manager that is unwilling to lose a guaranteed bonus for a shot at high rewards becomes risk-seeking when faced with decisions that guarantee losses. In the end, we dislike losing more than we like winning! This concept affects our decisions in an imbalanced manner.
Phase 5: Project Close-out and Looking Toward the Next Project
Success-Induced Bias. When we have a positive experience, we tend to give ourselves credit for executing our intentions, see history as a causal chain of events, or update our expectations for future performance and confidence. In fact, decision-makers are likely to be biased by recalling their own (recent) experiences in their memories. They attribute their successes to their abilities and their failures to their luck.
Coming off of a successful construction project, we will remember our own contributions best and will give ourselves credit for executing our good intentions. Success makes us confident, which can cause us to underestimate risk and influence other (less successful) decision-makers. As a result, successful managers, who are by intention trying to be risk-averse, could actually wind up being risk-seeking simply as a result of past successes, which in reality have no bearing on future outcomes.
Engineer a Better Approach to Decision-Making under Risk
How can we do a better job of choosing the right subcontractor for the job? How can we be sure to look at the whole picture and ensure that it includes a balance of best practices and human decision-making? We must examine our entire process and most specifically how our biases influence that process and our view of the situation, which flavors our decisions and determines the ultimate outcome.
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