62
ECONOMICS
ANALYSIS . .FACTS FORECAST
Procurement Target price contracts
In today’s overheated market, clients need all the help they can get to deliver good-value, low-risk
projects. Some clients are turning to collaborative working – and contracts such as the NEC – to
provide an extra incentive. Simon Rawlinson of Davis Langdon examines the issues
01 Introduction
Construction is a high-risk activity and design-and-build procurement accounts covering all project risks, are intended in
much effort has been focused over the years for more than 43% of the market. part to help eliminate sources of
on eliminating this risk. Studies, such as As risk transfer to the contractor does not unproductive and risk-averse working
Improving Public Services Through Better necessarily improve the project outcome, practice by project participants motivated
Construction by the National Audit Office, there are many initiatives focused on by the need to manage their design-related
suggest that many of these initiatives, business improvement, particularly on insurance liabilities on an individual basis
which are often focused on transferring enabling participants to collaborate ■ Contractual arrangements, including
rather than managing risk, reduce effectively. These include: standard partnering contracts such as
contractors’ motivation and performance. ■ The development of information exchange PPC2000 and the recently launched
Even so, many clients continue to transfer standards and processes to help JCT Constructing Excellence contract.
risk to contractors through design-and-build project teams to promote effective, Procurement policy is especially important
contracts, arguably giving contractors information-enabled collaborative working for public sector clients, who must set high
greater control over projects. The latest ■ Financial arrangements such as insurance standards as employers, be accountable to
RICS Contracts in Use survey indicates liabilities. Single project insurance policies, the public and deliver best value.
02 NEC contracts and co-operative working
The NEC exemplifies many aspects of The NEC promotes many aspects of Focusing the team on achieving these goals
co-operative working. The target cost co-operative working, including: is important if the full benefits of the NEC are
options allow public sector clients to provide ■ Focusing the whole team on delivery to be secured. However, a number of ways of
off-the-shelf incentives, and back this up with ■ Equal sharing of risk circumventing its processes have emerged,
systems that allow for performance payments ■ Managing risk rather than transferring it through contract amendments or variable
within a framework of accountability. ■ Continually assessing cost, time and quality. commitment to sound administrative practice.
03 Target contracts
The most widely used variants of the NEC are Target contracts are best used on client, it can modulate its exposure to risk.
options C and D, both target contracts. The well-defined projects, where the contractor Used effectively, target contract options
main difference between a target contract has a motivation to reduce costs, rather than should give the incentive to deliver a project
and a conventional contract is the mechanism on projects that are loosely defined, as on time and to budget. However, if costs fall
for sharing risk and opportunity. While the changes in project definition are likely to out of control, the contractor may seek to
client retains the cost and time risk linked to change the value of the target price. increase the target via compensation events.
contractual changes, the financial effects Using this approach, equitable risk transfer In this case, a greater burden of cost overrun
of cost overruns can be shared between the is often adopted to encourage positive risk may transfer to the client than intended.
client, contractor and supply chain. This is behaviour. That said, as contractual share of As such, effective administration by the
often termed the gain/pain share mechanism. risk and gain/pain mechanism are set by the project manager and contractor is vital.
BUILDING MAGAZINE 14.09.2007
economics.procurement 63
04 How a target cost contract works
Under a target contract, a contractor is with a combination of lump-sum and actual the pain option is exercised. This could involve
reimbursed for the cost of the works, including costs incurred, the incentive mechanism and the contractor taking 100% of the liability
those of subcontractors, some elements commitment to deliver the project on time and, as such, suffering the loss. Alternatively,
of establishing the site and the fee for the are fixed. However, should any allowable the client may shoulder part of the loss.
items listed in the contract as actual or compensation events occur that result in a The contractor would ideally meet the target
defined costs. These include management change to cost or programme, the target will cost, in which case it would receive full
costs, overheads and profit. be adjusted by the actual cost incurred or by remuneration. Savings against the target
The contractor is contractually committed a lump sum, depending on how the contractor would be shared with the client. The worst
to meeting the target cost, which comprises and project manager agree them. outcome for the client is the contractor being
the cost of the works described in the works After the project is completed, payments paid more than the revised target cost.
information, activity schedule or bill of made to the contractor are compared to the The difference between the target cost and
quantity, plus a fixed percentage fee. revised target cost. Depending on the the actual cost is, of course, fundamental to
The target cost and the contractor’s outcome, the gain/pain share mechanism the incentive model. However, the lack of
reimbursement are not linked until the end agreed in the contract will come in to play. a direct link during construction means there
of the project, when the gain/pain share Typically, the gain share involves splitting is a risk that the project team could lose sight
mechanism is applied. What the contractor the amount of money saved, that is, the of its target and incentive. Therefore:
recovers through regular payments is the difference between the target cost and the ■ The target cost should be realistic, based on
actual cost incurred, along with the actual expenditure, between the client, a fully set of works information. Target cost
percentage fee. contractor and possibly some subcontractors. contracts are sometimes misunderstood as
While the contractor is paid in accordance If the project’s costs exceed the target cost, 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
A target price contract has helped control costs on the £4.2bn Heathrow Terminal 5 expenditure.
BUILDING MAGAZINE 14.09.2007
64 economics.procurement
05 Effective management and maintenance of incentives on target cost contracts
Target contracts operate by encouraging events being grouped together for programme. Many clients and project
good purchasing and contract management assessment. However, as long as the managers do not feel comfortable agreeing
so long as the incentive is understood by the assessment is kept up to date, the contractor these impacts in advance as the contractor
contractor and the target remains visible. and client will understand their position. may on some occasions secure an upside.
Given the administrative demands of the Other challenges include: Early assessment does, however, facilitate
NEC contract, there is a risk that the link ■ Managing alternative financial good decision-making. A degree of risk
between target and actual cost entitlements motivations, such as: sharing is also built into the assessment.
could be lost, and the client could be ● Chasing turnover. As contractors are If impacts are assessed retrospectively once
exposed to a significant transfer of cost risk. compensated, in part, by a fee, there may costs are known, they are more likely to
This exposure can be managed by the be pressure to increase recovery through be awarded on the basis of cost and time
gain/pain mechanism. defined costs during the contract rather rather than as a target.
There are a number of characteristics of than secure gain share at the close. Where the employer has a well-defined
target contracts that clients and their project ● Optimism with regard to cost recovery. scheme that presents opportunities for
managers need to manage to maintain the Owing to the disconnect between the cost saving via effective procurement and
incentive. These include: contractor’s costs and their entitlement management, a co-operative approach based
■ Management of the information flow. The under the adjusted target cost, it is essential on risk sharing may be an incentive. The
NEC workflow is extensive and complex, so contractors appreciate what their entitlement employer must appreciate, however, that the
a management system should be in place to is likely to be and what their costs are. project has to be sufficiently well defined
support the project manager and contractor ● Assessing compensation events in advance. to enable a realistic target to be set and that
in meeting timescales and updating reports. The NEC gives the option for the target cost the contractor and project manager must
On projects worth more than £10m, to be amended by means of agreed understand the relationship between target
web-based extranet systems designed to quotations, addressing both future cost and and actual costs.
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 The high-speed rail link to St Pancras also benefited from a target price contract
BUILDING MAGAZINE 14.09.2007
economics.procurement 65
06 Case study
The case study is based on a commercial preliminaries, overheads and profits. procedures. The compensation system also
project using NEC2 with both the main The actual cost was assessed through came under pressure owing to the volume
contractor and some subcontractor packages guaranteed payment and audited costs. of changes required. That said, specialists
being subject to target cost incentives. The There was no pain share mechanism, which quickly understood the importance of the
employer adopted a target cost approach to meant the only allowable upward increase process, although it was difficult to agree
achieve a balance between risk transfer and in costs came from the assessment of “upfront” adjustments to the target costs.
demand on in-house administration. compensation events. These could trigger an In the final analysis, the project was a
The agreed gain/pain share was based on increase in the value of the target costs considerable success, delivered below budget
a combination of fixed-sum preliminaries, related to the value of the work, together with and ahead of programme. Most specialists did
overheads and profits. It rewarded early an uplift for overhead, profit and preliminaries well out of the project, although some lost
completion and provided some cushion for related to duration. control of their own administration and costs.
cost overruns. The gains would be divided In practice, not all subcontractors were able Some specialists introduced real innovation
50:25:25, between the client, main to buy into the opportunities represented by in their procurement and management to
contractor and subcontractors respectively. the gain share. Reasons included: secure maximum savings and to maintain
The target cost was established using a ■ Wondering why it was needed. Guaranteed control over their own costs.
well-developed design produced after a preliminaries helped to gain their confidence In general, cost control was heavily
two-stage procurement process. In stage one, ■ In the late stages of design, cost-saving incentivised and the project was sufficiently
specialist contractors competed on overhead, opportunities related to buying power only well defined for the inducement to make an
profit, preliminaries and schedules of rates. ■ Contractors’ control of their own costs. impact, even though there continued to be
In stage two, the specialist either agreed Some specialists were ineffective in significant commercial issues affecting the
a lump sum or, where there were genuine controlling costs and accounting and could project throughout. Whether in less positive
opportunities for performance improvement, not track target and actual costs accurately. circumstances the target cost mechanism
a target cost approach was adopted. The administration processes used on the could have provided the right balance of
The target cost was settled from quotations contract took some time to settle down, control and motivation is difficult to conclude,
and guaranteed lump-sum payments for emphasising the need for a familiarity with but on this project it played a part.
07 Advantages 08 Disadvantages
■ Provides contractors and subcontractors ■ Requires contractor to share savings
with an incentive to improve performance derived from improved performance with the
and enables the client to secure a share of client and other members of the supply chain
the benefits of a well-managed project ■ Client and contractor must share gain and
■ Encourages active and equitable risk pain if the full benefits are to be secured. The
sharing, based on a clearly defined allocation client may have greater exposure to cost risk
of risk agreed at the outset of the project. ■ Potential for failure on insufficiently
■ Can incorporate lump-sum and prime-cost defined projects owing to misunderstandings
subcontracts under a single target price of the operation of the incentive mechanism
■ Target costs provide incentive for ■ Complex target price, gain/pain share and
the timely administration of change change controls may not be understood by all
control mechanisms ■ Separation of target and actual costs
■ Provides an accountable mechanism to before completion creates the potential
enable public sector clients to use incentives. for loss of control
■ Provides an incentive for the effective ■ Relies on administration best practice and
management of prime cost contracts. a competent project manager.
Coming up … Data toolkit
21 Sep The tracker; Building’s extensive database of cost data
Country focus: Hungary is an essential resource for anyone in the
28 Sep Specialist cost business of procuring buildings. Gain
update instant access to this valuable information
5 Oct Cost model at www.building.co.uk/datatoolkit
BUILDING MAGAZINE 14.09.2007