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Federal Highway Administration Research and Technology
Coordinating, Developing, and Delivering Highway Transportation Innovations

This report is an archived publication and may contain dated technical, contact, and link information
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Publication Number:  FHWA-HRT-14-034    Date:  August 2014
Publication Number: FHWA-HRT-14-034
Date: August 2014


Executive Summary

State transportation departments rely on private industry construction contractors to build, rehabilitate, and replace their infrastructure assets. The Federal Highway Administration (FHWA) is interested in providing guidance that State transportation departments can use to select contractors that can complete projects cost-effectively. One potential method to help select qualified contractors is to use a performance-based contractor prequalification process. FHWA commissioned this study to evaluate the wisdom of expanding the use of this process. This report presents the results of this study, which examined relevant literature, evaluated the benefits and costs of performance bonds and performance-based contractor prequalification, and recommended a model performance-based prequalification approach.

The literature review assessed current performance-based prequalification program components, adjusting bidding and bonding capacity, and barriers to implementation. Several conclusions regarding current prequalification practices emerged from this review:

The study team conducted three outreach efforts to obtain feedback from the major parties involved in the use of construction contract performance bonds. Representative State transportation departments and their contractors completed surveys tailored to each group, while the Surety and Fidelity Association of America (SFAA) and several surety industry representatives participated in interviews. Following are conclusions on contractor and State transportation department views of the potential benefits and the structure of performance-based contractor prequalification:

Contractors believe that where only performance bonds are used, a marginal contractor has an unfair advantage over a well-qualified contractor. While State transportation departments expressed numerous positive views about the use of performance-based contractor prequalification, they also would be uncomfortable eliminating performance bonds.

The SFAA provided surety information from filings made to State regulators, and several surety companies provided additional anecdotal input. Their conclusions include the following:

The study team conducted case studies with five State transportation departments: Iowa, Oklahoma, Utah, Virginia, and Washington. Each of these State transportation departments has varying forms of performance-based prequalification, ranging from simple reference checks to project performance evaluations. None of them indicated any knowledge of a surety becoming involved in a project before a State transportation department requested that involvement. They were not comfortable eliminating performance bonds completely, but several would consider raising the minimum project value that requires a performance bond. Additionally, all case study State transportation departments continue to use performance-based prequalification and a few are even further developing their systems.

A benefit-cost analysis of performance bonds was conducted, based on information from the literature review and data collected from the outreach efforts and the case studies. The financial benefits of performance bonds occur after a default claim is filed and consist of default cost avoidance, schedule delay costs, and re-bid costs. Because the default rate in the highway industry is less than 1 percent, this indicates that default is an infrequent and an unpredictable occurrence. The benefit-cost analysis was to determine, from a strictly financial standpoint, whether performance bonds could be eliminated. Due to the sensitivity of the analysis to the assumptions, multiple iterations of the analysis were conducted. These analyses show that if the default rate is held constant at 0.69 percent (the highest default rate of State transportation departments in the outreach effort), projects over approximately $10 million have a net benefit from performance bonds; projects between $100,000 and $1 million have a net cost for performance bonds; and projects less than $100,000 and between $1 million and $10 million vary between net cost and net benefit. However, when the default rate is lowered to 0.46 percent (the average default rate of the State transportation departments in the outreach effort) there is a net cost for performance bonds on all projects.

As indicated, State transportation departments are not willing to eliminate performance bonds, even though few of them have experienced a default. This is the performance bond paradox-the unwillingness to eliminate performance bonds, even though the risk of default is low. State transportation departments saw value in the detailed financial analysis performed by the sureties and in the agency’s option to contact a surety if a contractor’s performance was unacceptable and did not improve. Rather than eliminate performance bonds, it is recommended that the minimum contract value that requires a performance bond be raised to between $1 million and $10 million, based on the benefit-cost analysis. Currently, the minimum contract value that requires a performance bond varies from State to State, between $0 and $300,000. The five case study States could have saved between $1.2 million and $7.9 million over 5 years if the minimum project size that requires a performance bond had been raised to $1 million; they could have saved between $6.5 million and $26 million over 5 years if the minimum project size that requires a performance bond had been raised to $10 million.

While there is the ability to achieve considerable premium savings by raising the performance bond threshold, there remains a risk, albeit small, that a State transportation department will still experience a default. A State transportation department can further reduce the likelihood of default through the implementation of performance-based prequalification because it will help screen out poorer performing contractors. If a default does occur, the State transportation department still can recover funds from the contractor to offset the cost of default. Any unrecovered costs would be borne by the State transportation department, but as the above analysis indicates, large savings in bond premiums can significantly offset these costs.

A performance-based prequalification system provides many benefits, but quantitative data about these benefits does not exist because the benefits are simply qualitative, such as improved contractor relationships, or the State transportation department simply does not collect the data to measure the benefits. Consequently, it is not possible to calculate a benefit-cost ratio. However, based on the outreach efforts and the case study, the overall areas that benefit from performance-based prequalification are the following: project quality, project timeliness, number of claims, and contractor and State transportation department relationships. The costs associated with operating a performance-based prequalification system range between $104,000 and $416,000 per year. This is negligible, compared to the costs of performance bonds.

Based on the project research and analysis, the study developed a performance-based prequalification model. The model combines elements of the processes used by the Florida Department of Transportation (FDOT), Ohio Department of Transportation (ODOT, presented as ODOT-OH for the purposes of this report), and the Ontario Ministry of Transportation (MTO), and it borrows concepts and terminology from each. The model accounts for a contractor’s financial capacity, rewards good performance, and encourages the improvement for marginal performance by prequalifying a contractor, based on a bidding capacity that is determined by rating prior performance. It consists of a two-tier process that is applicable to design-bid-build projects and an optional third tier for alternative project delivery methods, such as design-build (DB), construction manager/general contractor (CMGC), and public-private partnerships. It also can be used for design-bid-build (DBB) projects, where a State transportation department wishes to do a performance evaluation. A summary of the tiers follows:


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