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The impact of principal–agent relationship and contracttype on communication between project owner andmanager
Abstract
Communication structures between project owners and projectmanagers are influenced by the principal–agent relationship betweenthe parties and the contract type chosen. Empirical researchresults on project owner–manager communication practices are mappedagainst the contractual communication requirements in projects.This identifies possible risk factors for projects, based on aconflict between ‘best’ communication for a project and suggestedcommunication through the chosen contract type. The paper providesrecommendations for risk-minimizing owner–manager communication, aswell as contributions to project theory by showing the differencesof principal–agent theory and transaction costs economics inminimizing costs for governing projects.
1. Introduction
Responsibility for project success in firms lies typically withproject owners, who hold the business case [1], ensure theproject’s alignment with the firm’s strategy, and acceptaccountability to the firm’s senior management for the investmentin the project [2]. Owners provide the financial resources,monitor the project and accept forecasts, plans, milestones as wellas project completion [3], [4], [5]. However, theresponsibility for day-to-day management of the project isdelegated from the project owner to the project manager, whomanages the project towards the agreed uponobjectives [3], [6].
This delegation establishes a principal–agent relationshipbetween owner and manager, where the principal (owner) depends onthe agent (project manager) to undertake a task on the principal’sbehalf. During task execution the owner does not have access to thesame information as the manager, and does not know why the projectmanager makes the choices they do on their behalf, and whether theyare making the best selections on their behalf [7], [8].This information asymmetry creates the potential for mistrust.
The following paper addresses this communication issue from aprincipal–agent theory and transaction economics perspective. Theresults of a worldwide study on communication between projectowners and managers are assessed against communication implied bythe contract type chosen for a project. The research question istherefore:
How do project owner and manager communicate in theirprincipal–agent relationship, and how is their communicationimpacted by the type of contract chosen for the project?
The results are interpreted in the framework of principal–agenttheory for communication structures and transaction costs economics(TCE) for contract selection.
2. Principal–agent theory in project owner–managerrelations
Literature suggests a cooperative, collaborative context for theparties working in a project. However, many owners create a cultureof inflexibility and control in their projects [9]. Why dothey do this? Principal–agenttheory [7], [8] potentially explains this bysuggesting that owners do this out of fear that the project managerwill seek to maximize their own utility out of the project not thatof the owner, and the only way to stop this is by using rigidcommunication structures.
Jensen [8] defines an agency relationship as acontract under which one party, the principal, engages another, theagent, to perform some service on their behalf which involvesdelegating some decision making authority to the agent. If the aimof both parties is to maximize their economic position, then thereis good reason to believe that the agent will not always act in thebest interests of the principal. Delegation of decision makingauthority from principal to agent is therefore problematicbecause:
•
The interest of principal and agent will typically diverge ifboth are utility maximizers.
•
The principal cannot perfectly and costlessly monitor theactions of the agent.
•
The principal cannot perfectly and costlessly monitor andacquire the information available to or possessed by theagent [8], [10].
Moe [11] summarizes the tension between the principaland agent as:
1.
The adverse selection problem. During the project, themanager (as agent) knows more about the project than the owner (asprincipal). The manager knows more about the substantive projectissues as well as their own personal traits such as honesty anddiligence. So, the owner cannot be totally certain about why themanager makes the decisions they do, and whether they are makingthe right choices on the owner’s behalf.
2.
The moral hazard problem. The project manager has theirown interests. They will do what is best for themselves and only dowhat is best for the owner if their interests are aligned.
Agency theory suggests solving this problem by realignment ofthe two parties, interests through contracts, designed so that theactions regarded as most appropriate by the principal yield thehighest payoff for the agent [7]. Contract selection, however,is influenced by more factors than just the payoff for the agent.Contracts are selected to minimize the overall cost for governingprojects, and are therefore done from a TCE perspective, which willbe explained below.
3. TCE and contract selection
Projects are transactions which are subject to the make or buydecision, because they can be executed within a firm’s hierarchy orbought in the market. According to Williamson [12] themake or buy decision is based on the combined ramifications of:
•The degree of asset specificity as the main influential factor.This is the extent to which the object of the transaction isspecific (or unique) to the individual transaction and cannot beredeployed in future transactions.
10. Conclusions
The paper suggested a certain level of communication to handlethe information imbalance of principal and agent in projects. Atthe equilibrium of information needs and mutual provision of therequired information the overall administrative costs related toproject communication are lowest. Investments in communicationshould be up to that level.
The contracting strategy chosen for a project was identified toset the framework for the owner–manager communication duringproject implementation. Fixed-price and cost-plus contracts wereidentified as having adverse effects on owner–managercommunication. A possible mitigation strategy was developed thatensures a constant and trust-building communication between theparties.
It was shown that TCE takes primarily a pre-contract perspectiveof projects and principal–agent theory a post-contract perspective.TCE guides the make or buy decisions and thereby the selection ofcontract type. Principal–agent theory, among others, explains theinterpersonal issues of project owner and manager primarily duringthe project execution stage. These issues need to be resolvedthrough communication.
Future research on this subject should use empirical evidence ofthe differences in administrative costs arising from the twotheories. That allows investigating the differences of TCE andprincipal–agent theory in projects in order to develop acomprehensive definition of the administrative costs inprojects.