Procurement: Target price contracts

01 Introduction

Construction is a high-risk activity and much effort has been focused over the years on eliminating this risk. Studies, such as Improving Public Services Through Better Construction by the National Audit Office, suggest that many of these initiatives, which are often focused on transferring rather than managing risk, reduce contractors’ motivation and performance.

Even so, many clients continue to transfer risk to contractors through design-and-build contracts, arguably giving contractors greater control over projects. The latest RICS Contracts in Use survey indicates design-and-build procurement accounts for more than 43% of the market.

As risk transfer to the contractor does not necessarily improve the project outcome, there are many initiatives focused on business improvement, particularly on enabling participants to collaborate effectively. These include:

• The development of information exchange standards and processes to help project teams to promote effective, information-enabled collaborative working

• Financial arrangements such as insurance liabilities. Single project insurance policies, covering all project risks, are intended in part to help eliminate sources of unproductive and risk-averse working practice by project participants motivated by the need to manage their design-related insurance liabilities on an individual basis

• Contractual arrangements, including standard partnering contracts such as PPC2000 and the recently launched JCT Constructing Excellence contract.

Procurement policy is especially important for public sector clients, who must set high standards as employers, be accountable to the public and deliver best value.

02 NEC contracts and co-operative working

The NEC exemplifies many aspects of co-operative working. The target cost options allow public sector clients to provide off-the-shelf incentives, and back this up with systems that allow for performance payments within a framework of accountability.

The NEC promotes many aspects of co-operative working, including:

• Focusing the whole team on delivery
• Equal sharing of risk
• Managing risk rather than transferring it
• Continually assessing cost, time and quality.

Focusing the team on achieving these goals is important if the full benefits of the NEC are to be secured. However, a number of ways of circumventing its processes have emerged, through contract amendments or variable commitment to sound administrative practice.

03 Target contracts

The most widely used variants of the NEC are options C and D, both target contracts. The main difference between a target contract and a conventional contract is the mechanism for sharing risk and opportunity. While the client retains the cost and time risk linked to contractual changes, the financial effects of cost overruns can be shared between the client, contractor and supply chain. This is often termed the gain/pain share mechanism.

Target contracts are best used on well-defined projects, where the contractor has a motivation to reduce costs, rather than on projects that are loosely defined, as changes in project definition are likely to change the value of the target price.

Using this approach, equitable risk transfer is often adopted to encourage positive behaviour. That said, as contractual share of risk and gain/pain mechanism are set by the client, it can modulate its exposure to risk.

Used effectively, target contract options should give the incentive to deliver a project on time and to budget. However, if costs fall out of control, the contractor may seek to increase the target via compensation events. In this case, a greater burden of cost overrun risk may transfer to the client than intended.

As such, effective administration by the project manager and contractor is vital.

04 How a target cost contract works

Under a target contract, a contractor is reimbursed for the cost of the works, including those of subcontractors, some elements of establishing the site and the fee for the items listed in the contract as actual or defined costs. These include management costs, overheads and profit.

The contractor is contractually committed to meeting the target cost, which comprises the cost of the works described in the works information, activity schedule or bill of quantity, plus a fixed percentage fee.

The target cost and the contractor’s reimbursement are not linked until the end of the project, when the gain/pain share mechanism is applied. What the contractor recovers through regular payments is the actual cost incurred, along with the percentage fee.

While the contractor is paid in accordance with a combination of lump-sum and actual costs incurred, the incentive mechanism and commitment to deliver the project on time are fixed. However, should any allowable compensation events occur that result in a change to cost or programme, the target will be adjusted by the actual cost incurred or by a lump sum, depending on how the contractor and project manager agree them.

After the project is completed, payments made to the contractor are compared to the revised target cost. Depending on the outcome, the gain/pain share mechanism agreed in the contract will come in to play.

Typically, the gain share involves splitting the amount of money saved, that is, the difference between the target cost and the actual expenditure, between the client, contractor and possibly some subcontractors.

If the project’s costs exceed the target cost, the pain option is exercised. This could involve the contractor taking 100% of the liability and, as such, suffering the loss. Alternatively, the client may shoulder part of the loss.

The contractor would ideally meet the target cost, in which case it would receive full remuneration. Savings against the target would be shared with the client. The worst outcome for the client is the contractor being paid more than the revised target cost.

The difference between the target cost and the actual cost is, of course, fundamental to the incentive model. However, the lack of a direct link during construction means there is a risk that the project team could lose sight of its target and incentive. Therefore:

• The target cost should be realistic, based on a fully set of works information. Target cost contracts are sometimes misunderstood as being incentivised develop-and-construct approaches, where a project team is encouraged to work from an outline concept to deliver a solution focused on a client’s needs. Unfortunately, a project let without well-defined works information resulting from incomplete design development is highly likely to require substantial changes and result in compensation events and amendments to the target cost. In reality, the documentation required to support the contract will be as detailed as a lump-sum contract.

• It should be set at a level that acts as an incentive. Too low, and the contractor will recover costs by other means. Too high, and inefficient working may be rewarded.

• It should be based on a detailed programme. The target cost mechanism cannot be properly administered without considering the impact of compensation events. Without this, it is not possible to assess the responsibility for delay.

• The client must understand that it is not a lump-sum contract and should co-operate with the project manager in administering the contract. Failing to comply with timescales can lead to a client creating liabilities for itself under the NEC.

• It is important for the contractor to keep track of costs incurred relative to the adjusted cost, so its own commercial position is protected. In some cases, where subcontractors are also incentivised, this may involve the project manager and contractor in the audit of material supply invoices and labour returns, to confirm levels of expenditure.

05 Effective management and maintenance of incentives on target cost contracts

Target contracts operate by encouraging good purchasing and contract management so long as the incentive is understood by the contractor and the target remains visible.

Given the administrative demands of the NEC contract, there is a risk that the link between target and actual cost entitlements could be lost, and the client could be exposed to a significant transfer of cost risk. This exposure can be managed by the gain/pain mechanism.

There are a number of characteristics of target contracts that clients and their project managers need to manage to maintain the incentive. These include:

• Management of the information flow. The NEC workflow is extensive and complex, so a management system should be in place to support the project manager and contractor in meeting timescales and updating reports. On projects worth more than £10m, web-based extranet systems designed to support the NEC workflow are invaluable.

• Dealing with the learning curve. The cultural changes associated with incentivised contracts and the NEC are substantial. Many parties may not fully appreciate the benefits to innovation or project management.

• Use of the contract. On a JCT-based project the contract stays in the drawer unless there is a problem; under NEC the opposite applies. If the contract is not referred to regularly, problems are likely to build up.

• Rebalancing risk transfer. Some of the compensation events under NEC can expose the client to risk. Examples include the prevention event, which transfers risk of many remote events to the employer. A common but less equitable amendment deals with the impacts of poor project management performance linked to the issue of notices.

• Effective use of the contract’s risk management provisions.

• Maintaining the programme. Assessment of the programme in real time is an essential element of the NEC philosophy. It is essential that the programme is kept up to date. Under the target cost option, adjustments should be based on a pre-assessment of the impact of specific compensation events. Under a typical post-hoc assessment extension of time, the pressure is to recover all the delay costs, even if some result from aspects of the contractor’s management. In practice, programme impacts are often managed imperfectly under NEC with, for example, a series of compensation events being grouped together for assessment. However, as long as the assessment is kept up to date, the contractor and client will understand their position.

Other challenges include:

• Managing alternative financial motivations, such as:

Chasing turnover. As contractors are compensated, in part, by a fee, there may be pressure to increase recovery through defined costs during the contract rather than secure gain share at the close.

Optimism with regard to cost recovery. Owing to the disconnect between the contractor’s costs and their entitlement under the adjusted target cost, it is essential contractors appreciate what their entitlement is likely to be and what their costs are.

Assessing compensation events in advance. The NEC gives the option for the target cost to be amended by means of agreed quotations, addressing both future cost and programme. Many clients and project managers do not feel comfortable agreeing these impacts in advance as the contractor may on some occasions secure an upside. Early assessment does, however, facilitate good decision-making. A degree of risk sharing is also built into the assessment.

If impacts are assessed retrospectively once costs are known, they are more likely to be awarded on the basis of cost and time rather than as a target.

Where the employer has a well-defined scheme that presents opportunities for cost saving via effective procurement and management, a co-operative approach based on risk sharing may be an incentive. The employer must appreciate, however, that the project has to be sufficiently well defined to enable a realistic target to be set and that the contractor and project manager must understand the relationship between target and actual costs.

06 Case study

The case study is based on a commercial project using NEC2 with both the main contractor and some subcontractor packages being subject to target cost incentives. The employer adopted a target cost approach to achieve a balance between risk transfer and demand on in-house administration.

The agreed gain/pain share was based on a combination of fixed-sum preliminaries, overheads and profits. It rewarded early completion and provided some cushion for cost overruns. The gains would be divided 50:25:25, between the client, main contractor and subcontractors respectively.

The target cost was established using a well-developed design produced after a two-stage procurement process. In stage one, specialist contractors competed on overhead, profit, preliminaries and schedules of rates.

In stage two, the specialist either agreed a lump sum or, where there were genuine opportunities for performance improvement, a target cost approach was adopted.

The target cost was settled from quotations and guaranteed lump-sum payments for preliminaries, overheads and profits.

The actual cost was assessed through guaranteed payment and audited costs. There was no pain share mechanism, which meant the only allowable upward increase in costs came from the assessment of compensation events. These could trigger an increase in the value of the target costs related to the value of the work, together with an uplift for overhead, profit and preliminaries related to duration.

In practice, not all subcontractors were able to buy into the opportunities represented by the gain share. Reasons included:

• Wondering why it was needed. Guaranteed preliminaries helped to gain their confidence
• In the late stages of design, cost-saving opportunities related to buying power only
• Contractors’ control of their own costs. Some specialists were ineffective in controlling costs and accounting and could not track target and actual costs accurately.

The administration processes used on the contract took some time to settle down, emphasising the need for a familiarity with procedures. The compensation system also came under pressure owing to the volume of changes required. That said, specialists quickly understood the importance of the process, although it was difficult to agree “upfront” adjustments to the target costs.

In the final analysis, the project was a considerable success, delivered below budget and ahead of programme. Most specialists did well out of the project, although some lost control of their own administration and costs.

Some specialists introduced real innovation in their procurement and management to secure maximum savings and to maintain control over their own costs.

In general, cost control was heavily incentivised and the project was sufficiently well defined for the inducement to make an impact, even though there continued to be significant commercial issues affecting the project throughout. Whether in less positive circumstances the target cost mechanism could have provided the right balance of control and motivation is difficult to conclude, but on this project it played a part.

07 Advantages

 

• Provides contractors and subcontractors with an incentive to improve performance and enables the client to secure a share of the benefits of a well-managed project
• Encourages active and equitable risk sharing, based on a clearly defined allocation of risk agreed at the outset of the project.
• Can incorporate lump-sum and prime-cost subcontracts under a single target price
• Target costs provide incentive for the timely administration of change control mechanisms
• Provides an accountable mechanism to enable public sector clients to use incentives.
• Provides an incentive for the effective management of prime cost contracts.

08 Disadvantages

• Requires contractor to share savings derived from improved performance with the client and other members of the supply chain
• Client and contractor must share gain and pain if the full benefits are to be secured. The client may have greater exposure to cost risk
• Potential for failure on insufficiently defined projects owing to misunderstandings of the operation of the incentive mechanism
• Complex target price, gain/pain share and change controls may not be understood by all
• Separation of target and actual costs before completion creates the potential for loss of control
• Relies on administration best practice and a competent project manager.