PrepTest 103, Section 1, Question 23
Construction contractors working on the cutting edge of(88 more words not shown)
Which one of the following,(14 more words not shown)
- AClients are much(33 more words not shown)
- BOn long-term contracts,(21 more words not shown)
- COn any sizable(24 more words not shown)
- DClients billed under(27 more words not shown)
- EThe practice of(27 more words not shown)
Reading the argument
If spending more makes me earn more, why would I keep the bill down?
That's the incentive in a percentage-profit contract. Suppose I get my costs paid plus 10 percent. Spending $100 gives me $10 profit; spending $200 gives me $20. With a fixed-profit contract, by contrast, my costs are reimbursed but my profit stays at the agreed amount. Raising the cost doesn't raise that fixed profit.
Yet the percentage contracts exceed their original estimates less often. The incentive alone makes me expect the opposite. What keeps it from producing the expected result?
Maybe the clients recognize the incentive too.
If I know my contractor earns more whenever the bill grows, I may check every expense. Did you need that material? Why did you hire the more expensive supplier? Extra scrutiny could discourage waste or catch it before it builds up. A fixed-profit client might feel less need to check so closely.
What we’re looking for
That's my prediction for resolving the apparent paradox: a difference in oversight could outweigh the difference in incentives. We need to explain why overruns are more common with fixed profits, not just why construction sometimes costs more than expected.
Working the answers
- A
This concerns when clients are willing to choose fixed-profit contracts, depending on whether a project might be abandoned. It doesn't tell us why projects under those contracts more often exceed their estimates. Choosing a type of agreement and going over budget after choosing it are different matters. No connection to the observed overrun difference is supplied.
- B
Underestimating inflation could explain some overruns on long projects. But the comparison here is between percentage profits and fixed profits, not long and short projects. Without a reason the inflation problem affects the fixed-profit group more, it doesn't explain the difference we're trying to resolve.
- C
Regular billing lets clients detect rising costs early under either arrangement. That shared opportunity doesn't explain why the outcomes differ. We'd need to know whether clients actually use it differently, or whether it has different effects in the two groups. C gives the opportunity to check, not the contrasting behavior.
- DCorrect
Clients review bills for waste only when the contractor's profit varies with the cost—that is, under the percentage-profit arrangement. This is the extra scrutiny we predicted.
The incentive to spend more is still there. But those are also the contractors whose expenses get examined for waste. Fixed-profit contractors face no corresponding review under this answer. That difference can help explain why percentage contracts less often exceed estimates, despite the incentive pointing the other way.
- E
Watch which group starts with exaggerated estimates. It's the fixed-profit group, which is also the group with more overruns. Giving that group a higher starting estimate would make exceeding it harder, not easier.
Suppose the work is expected to cost five units, but the estimate is inflated to seven. An actual cost of six now stays below the estimate. That helps explain fewer reported overruns for the fixed-profit group—the opposite of the stated result. E can sound attractive because it explains how estimates affect overruns, but it pushes this particular comparison the wrong way.
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