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Microsoft Word - Merck agency theory instructional case final publish.docx Resolving agency issues in client-contractor relationships 1 Resolving agency issues in client-contractor relationships: The Merck Innovation Center Christine Unterhitzenberger, Lancaster University and Dietmar Möller, Merck KGaA ABSTRACT The management of relationships has been acknowledged as a crucial element of project success. However, agency related issues such as goal conflict, information asymmetry or opportunistic behavior can make this a real challenge. Steven and Mark – program managers for One Global Headquarters at Merck – developed their own way on how to deal with this challenge in a complex and uncertain environment. This case study will provide unique insights into their approach and motivation. KEYWORDS: project management, agency theory, project success, principal agent relationship Fig.1 Merck Innovation Center and Emmanuel-Merck-Platz in Darmstadt, Germany (reproduced with permission from Esch (2018)) Resolving agency issues in client-contractor relationships 2 A FACELIFT FOR A 350-YEAR-OLD COMPANY In 2015, after several large acquisitions transformed its businesses, Merck KGaA1 underwent a re-branding into the single brand Merck. Merck is a diversified pharmaceutical, life sciences and chemicals group founded in 1668 and ever since headquartered in Darmstadt, Germany. The company employs approximately 52,000 people around the world, with 11,000 in North America and about the same number in Germany (Merck, 2019). The company invested US$ 565m in Capex world-wide in 2015, including a large number of construction projects (Merck, 2016). The new brand was designed to position the organization as an innovative science and technology company as prior analysis suggested that its culture had to undergo a transformative change. It was also recognized that architecture, in particular at the headquarters, conveys a strong message to customers, partners, the community, and employees and that the architecture needs to represent the transformative change as well. On this basis, the program One Global Headquarters (OGHQ) was initiated in 2014 with the aim of completion by 2018, when the company celebrated its 350-year anniversary. The program consisted of about 90 interdependent construction projects of various sizes, shapes and forms at the headquarters in Darmstadt with a total investment of more than US$ 200m. The program was led by two internal managers – Steven and Mark – who mainly focused on strategy and governance issues and were supported by a program management team of internal and external experts to oversee the high number of projects. External experts were hired in all cases, in which internal resources were considered inadequate or insufficient to stay in control of architectural quality, schedule and budget, all of which were non-negotiable. At the heart of the program was the development of the Innovation Center and the adjacent Employee Restaurant (Figure 1 and 2), which was described by its architects Henn as follows (Henn, 2019): “The Innovation Center will be used to cooperate temporarily in interdisciplinary teams and to communicate both internally and externally. While the newly developed public square (…) orientates the company towards the city, the Innovation Center opens it to the interior. There are three levels which are set back from one another so that they are to a large extent visually linked. Levels can be changed using arched ramps. These connections, like the bridges joining the segments at individual levels, are highly frequented meeting places where the direct exchange of information among knowledge holders is encouraged. In passing, building users can be inspired by the work of their colleagues and prompted to engage in discussions. Different demands on the workplaces – concentration, communication, cooperation – find spatial expression in a flowing transition. Team communication takes place in the spacious internal area on each floor. Single-person office cells along the façade provide space for activities requiring concentration and intensive thought. The company restaurant is connected to the Innovation Center on several levels. It will assume essential functions on the currently decentralized staff canteens, some of 1 Founded in 1668 in Darmstadt, Germany, Merck is the world's oldest pharmaceutical and chemical company. In the 19th century, the success of its export business to the United States led to the establishment of an office in New York in 1887, which gave rise to the establishment of a separate entity four years later. In 1917, during World War I it was expropriated. Ever since, there are two different, unaffiliated companies that use the name MERCK. Globally, except in the United States and Canada, Merck KGaA, and its affiliates are named simply “Merck”. In the United States and Canada, Merck KGaA uses its firm name "Merck KGaA, Darmstadt, Germany," and its businesses operate under "EMD Serono" in biopharma, "MilliporeSigma" in life science and "EMD Performance Materials" in the materials business. The other company, Merck & Co., Inc., Kenilworth, NJ, US holds the rights in the trademark MERCK in the United States and Canada. All references to the name Merck in this case study refer exclusively to the former. Resolving agency issues in client-contractor relationships 3 which are to be decommissioned. The restaurant will become a meeting place for numerous employees from the various parts of the site.” Fig. 2 Typical floor space in the Merck Innovation Center (reproduced with permission from Esch (2018)) EUROPE’S LEADING CONSTRUCTION MARKET The context for this case study is Europe’s leading construction market with the continent’s largest building stock: Germany. The construction sector in general is one of the largest contributors to the world economy and a key industry in most countries. A recent global survey found that the productivity of the sector has by far trailed that of almost all other industrial sectors over the past decades, thus offering huge opportunities for improvement (Barbosa et al, 2017). While it was found that low productivity performance in construction is not uniformly distributed, with big variations between countries and subsectors, there are still common reasons for it. Among those reasons stands the observation, that “Construction is highly fragmented. Contracts have mismatches in risk allocation and rewards, and often inexperienced owners and buyers find it hard to navigate in an opaque marketplace. The result is poor project management and execution, insufficient skills, inadequate design processes, and underinvestment in skills development, R&D, and innovation.” (Barbosa et al, 2017, p. 8) The study concludes that market failures and external factors compromise how the industry functions and result in low productivity of firms of all sizes. Overall, low labor productivity, as Resolving agency issues in client-contractor relationships 4 well as poor project management can be directly linked to project failures in terms of cost overruns and delays that are often observed in construction projects. The German construction sector is a good representation of this situation. The above- mentioned study finds it to be almost average-ranking in terms of both construction labor productivity and its growth. In 2018 the industry’s added value contributed US$ 178bn or 5.3% to the German economy (Statistisches Bundesamt, 2019). During the past decade, after a cyclical downturn of the industry, many large national construction firms, whose core competence was the efficient execution of large turn-key construction projects, left the market and their place was taken by medium-sized, often family owned, companies specializing in particular trades such as concrete works, façade-works or interior fit out. Architects typically work in small- to medium-sized specialized practices and subcontract engineering design work to specialized engineering firms. Deliverables, their quality and, to some extent, the fees of architects and engineers are regulated by national legislation. It has been widely argued that contractors, like all other partners in a project, should become fully involved as early as possible in order to participate in the evolution of the final design by contributing their knowledge and expertise and become an integrated network partner. However, many public and private clients defer the final investment decision by means of their corporate governance until basic design is completed and cost estimates by the consultants become firmer. Hence, only after the final investment decision is made by the client, the architect and engineers start to prepare the tendering documents for all trades and procurement packages in order to avoid sunk costs in case the final investment decision is negative. Various different procurement models are available, whereas the traditional competitive tendering is still prevalent. More innovative methods like open book contracts are in its infancy in Germany and many clients and contractors do not know how to accommodate them in their corporate governance and are not familiar with the required changes in behavior and attitude. Many spectacular project failures both in the public as well as in the private sector have been credited to an adversarial and fragmented project environment based on suboptimal contractual arrangements that often resulted in claims and litigation. Major customers and powerful players of the German construction industry have recognized the necessity of better collaboration and better contracts with their initiative TeamBuilding under the slogan “For a Better Collaboration in the Construction Industry”, which was started in 2017 (Initiative Teambuilding, 2019). ONE GLOBAL HEADQUARTERS – THE MAIN ACTORS As previously mentioned, the OGHQ program was led by Steven and Mark. Steven is a program and project manager with more than 30 years’ experience. He is a chemical engineer with a PhD by training, however moved into the management of major projects within Merck several times during the past 20 years. Since then he has been responsible for R&D, construction and organizational projects ranging from tens to several hundred million US$ with the OGHQ program being the largest and most important so far. His background gives him a very good understanding of the client’s organization as well as project governance. Mark is a qualified architect and joined Merck only shortly before the program by direct initiative of Merck’s CEO. He has a long career in the construction industry with vast experience as architectural lead for a major contractor in Germany. This gives him specific expertise in architecture as well as in the nuances of the German construction market. He likes to stress the need for a good start in any project and compares it to a 100m sprint that Resolving agency issues in client-contractor relationships 5 is always lost, if the runner doesn´t get a good start. This theme became a proverb in the program. Steven and Mark are supported by a team of internal and external experts. Within the program, Claire is the project manager for the Innovation Center and Employee Restaurant. Claire is a qualified architect, who worked as an independent architect before joining Merck 20 years ago. She has been trusted with major and important construction projects since. Based upon her track record, Steven had lobbied hard to have her assigned to the program. Other key players were Peter, the architect’s project leader who had the overall responsibility for the design of the buildings as well as the construction management, and John, the structural engineer, who had to find ways to make Peter’s ambitious design feasible and affordable while also complying with building regulations. John heads the Berlin office of his structural engineering company, which is one of the best in the country with a vast experience in challenging designs. Peter led many ambitious construction projects for large corporate clients in Germany and China and is supported by Paul, a civil engineer by training, who successfully acted as a construction manager for various projects. Worth mentioning here are also Frank, who is Merck´s procurement manager for the program with an engineering background, and Lilian, a civil engineer and quantity surveyor, who is part of a team of external specialists from the project management consultancy Drees & Sommer. She and her team were specifically hired for the program to complement all required competences of the program management team. CONCRETE AND STEEL WORKS – BACKGROUND Considering the general environment outlined earlier, Steven and Mark were faced with a dilemma: they either follow the traditional way of procurement through competitive tendering, which is likely to create the basis for an adversarial environment with all its negative consequences, or they use more innovative forms like open book contracts, which are difficult to accommodate within Merck’s corporate governance and the industry isn’t very familiar with them either. However, they did not want to adopt an only partially suitable solution and decided to explore new collaborative ways of selecting contractors. They were conscious of some of the issues often present in client-contractor relationships like goal conflict, information asymmetry, trust or opportunistic behavior and tried to identify ways to overcome these. They assumed that these issues contribute to the adversarial environment and hence,