As a tool to allow people to prepare for the resolution of unexpected issues and conflicts that may arise between parties, a contract penalty clause is widely used as a featured risk mitigation tool in procurement management. To mitigate cost risks – especially for a delay in delivery – a contract penalty clause is defined in the contract.
If utilized, the clause brings additional costs to the contractor as they will be liable for an additional sum to be payable to the client. For the client, the amount recovered will offset some, but not all of their costs– it will not cover the lost time, reputational damage, loss of potential new business opportunities, and so on. No matter how much money the client gets back, it won’t provide him with the benefits that on-time delivery would have.
The penalty clause can raise the price of the contract. When a client adds a penalty clause, the contractor will often add to their risk contingency for the project, increasing the total contract price. However, without the penalty clause, the client will be unable to as easily enforce a penalty on the contractor.
Unlikely in team sports, where one side usually benefits from a penalty decision, if a penalty clause is invoked it can ultimately also be detrimental to the client. Ideally, the contractor should be your partner in business life, not your opponent.
So are there alternatives to the contract penalty clause?
We need sustainable relations with our contractors and make them our solution partners. To do this, as an alternative to a penalty clause, mutual trust, risk management, and reward clauses can be used.
There has to be mutual trust between parties, with each party putting part of their reputation on the line. The contractor needs to feel the risks such as reputation loss in the sector or the potential for losing new opportunities with you.
Risk Management Clause
Risk Management is one of the most effective tools in our expertise as project management professionals, hence we need to employ it in the execution of contract administration as well.
The first step to mitigate the risks is to build the contract on clear, concise, and achievable outcomes. The foreseeable risks should be defined in the contract and the related and detailed risk response plans should be annexed to the contract. In this way, if there is any risk of a delay in schedule, the risk response plans can be referred to, this can help to ensure the contract is on track, instead of focusing on the penalty fee.
In addition to the well-defined incentives that are in reimbursable (cost plus fee) contracts, reward-type clauses can include promises to the contractor, such as:
- increasing work-shares in the next contract,
- new contracts in the future,
- priority in future bidding,
- royalty payment from sales.
While many contracts are delayed inevitably, nowadays, we need to be more innovative in our contract clauses!
Eren Akdur, MBA, MSc., PMP, PMI-RMP, is the current Vice President for the PMI Turkey Chapter, a Program Manager at Roketsan Inc. and has more than 17 years of experience in project management for the defense industry. He is a part-time project management instructor for the MBA Program at Bilkent University, and also teaches fundamentals of project management to junior project managers. Eren writes about procurement management and contracts.