Monday, 22 May 2017

Incentives and Target Cost Contracts

Delivering Complex Projects

Target cost contracts (TCCs) are not a new idea, they have been widely used in manufacturing for many years, and are not new in construction either, although the history is much shorter. Masterman called them “An incentive-based procurement strategy” that rewards a contractor for savings. A common version is a ‘cost plus incentive fee’ agreement that uses incentives for the contractor to reduce construction cost. They are well known in the United Kingdom, where a 2012 Cabinet Office report described them as a “cost-led procurement model” that could produce a 15-20 per cent cost saving for public sector construction projects. These contracts have also been used in the United States, Australia, New Zealand and Hong Kong.

Under a TCC, the actual cost of completing the project is compared to a target cost previously agreed. If the actual cost exceeds the target cost, some of the cost overrun will be borne by the contractor (known as the ‘painshare’) and the remainder by the client in accordance with an agreed formula. Conversely, if the actual cost is lower than the target cost, then the contractor will share the savings with the client (known as the ‘gainshare’).

These contracts require the scope of work to be well-defined and therefore would only be considered on major projects, due to the significant up-front investment needed by both client and contractor/s in detailed planning, because the cost has to be agreed before commencement and there are penalties for cost over-runs. Therefore, both client and contractor/s and suppliers have to be prepared to make a credible commitment  if an incentive contract is to succeed. While there are many variants of a TCC, they have to include:

  • A target cost, the best estimate of the total costs of performing the required scope of work;
  • A target fee, the amount of fee payable without adjustment if actual costs ultimately equal the target cost;
  • A painshare/gainshare formula to allocate excess costs (overruns) or cost savings (underruns) in relation to the target cost agreed between the client and the contractor.

When actual costs exceed the target cost, the contractor receives their actual costs plus target fee, less its proportion of the overrun (determined by the share formula). When actual costs are less than the target the contractor is paid costs, plus target fee, plus a proportion of the under-run. For example, a 50/50 cost-sharing ratio means the client will pay 50 per cent and the contractor 50 per cent of costs in excess of the target cost. Conversely, if costs turn out less than target cost, the client and the contractor share the savings in the same ratio.

The distinguishing feature of these contracts is the painshare/gainshare mechanism, which is intended to align the interests of contractors and clients. Claims under a TCC can be difficult to manage if there are doubts about the effects of what Greenhalgh and Squires called ‘certain situations’ on the target cost. These include both cost reductions due to contractor input (through early design work for example) and cost increases due to client design changes. The challenge is to carefully prepare a TCC to preserve the incentives and remove the doubts about changes to the target cost. Although the published research is generally supportive of TCC, there has been some debate about how the benefits are spread between clients, who Hughes, Williams and Zhaomin argue gain most, and contractors, with Erikisson and Pessämaa suggesting a reduction in disputes, earlier involvement and shorter construction time benefit contractors.

There is also wide scope for variations in a TCC. For example, different share ratios may apply depending on the extent of the cost overrun or underrun, or whether fixed or variable costs are the type of costs incurred or saved. There may be a buffer above and below the target cost before the pain/gainshare mechanism applies. A price ceiling may be specified, above which one party (generally the contractor) bears 100 per cent of the cost risk, or a price floor, below which one party (generally the client) retains 100 per cent of cost savings. Obviously, negotiating and agreeing on the operation of a TCC is not a simple task.

While incentives might be an effective way to reduce cost, improve project delivery and increase productivity, the actual operation of a painshare/gainshare mechanism is not straightforward. The sharing formula can vary from simple to complex systems of benefit and risk sharing, and can involve more than one supplier. Gil details the development of the commercial agreement and incentive scheme through three stages on BAA’s Terminal 5 project, as the client and contractors identified problems with the earlier versions and finally found a workable solution. The three aspects of the T5 Agreement detailed by Gil were the design (reimbursable cost plus agreed margin), the ‘ring-fenced profit’ (an agreed lump sum amount against an agreed estimate of resources for a defined scope of work), and compensation for design changes (but not for ‘design evolution’). Gil’s paper includes both positive and negative comments on the agreement from a range of suppliers, and the wide range of issues covered clearly shows how challenging this form of contracting can be.

The agreement and the painshare/gainshare mechanism is between the client and the contractor and typically does not include designers, subcontractors and other suppliers. This is a weakness in these contracts, as the contractor can attempt to shift risks further down the supply chain to maximise their profit. With TCCs it would be possible to include subcontractors and suppliers in the agreement, and potentially contractor and subcontractor employees in the gain share agreement. Rose and Manly criticise TCCs for only giving incentives to the client and contractor, yet to deliver a gain under a TCC collaboration between the client, contractor, consultants, sub-contractors, designers, suppliers and manufacturers is complex. How do TCCs motivate other stakeholders outside the contract if they do not receive any shares of the gain? By the third version of the T5 project TCC, Tier 1 contractors were sharing gain and pain with Tier 2 suppliers.

This could be an effective productivity incentive that would work through the entire supply chain if incorporated into the project’s contracts and industrial relations agreements. Rather than the client sharing the gain from improved performance, this share could be used to provide an incentive through the supply chain, and thus allow subcontractors and employees to benefit. It seems obvious that if subcontractors and suppliers, and their employees, were included in the gain share agreement they would have an incentive to increase their productivity. The client benefits would be in the project’s quality and completion time, with associated reductions in disputes and defects.

The big issue with TCCs is the up-front costs of incentive contracts, where the work has to be estimated in detail in advance for target costs to be set. This requires significant investment in project preparation by both the client and contractor, and the method of approving changes in scope can add to the management costs. Logically, it would only be realistic to use these contracts on complex projects which are management intensive anyway. Not all major projects are complex, and few require the management resources of a T5, however if a large project is divided into a number of sub-projects it might facilitate the use of TCCs by allowing accurate (as possible) estimates for those sub-projects. Clearly, cost visibility, transparency and open book accounting are essential for successful implementation and operation of a TCC, and there will be some contractors and suppliers who prefer more traditional forms of procurement.

It should be noted that a TCC exists in a broader context of other contractual mechanisms also aimed at contractor performance. These may include liquidated damages for extended delays or performance shortfalls, warranty obligations for defective supplies, indemnities for loss caused by contractor default, stop payment rights and other rights such as step in rights and termination rights typically included in a construction contract.

While TCCs have been used in manufacturing for decades, their use in construction is more recent. The first case studies came out around 2000, with those and later research finding TCCs are not a panacea. Sometimes they work well, sometimes they don’t, much like everything else in building and construction. Nevertheless, the argument that TCCs are appropriate for complex projects that cannot be fully specified at the outset is solidly based on the outcomes of the projects studied, and is supported by successful projects like T5, a rare megaproject that came in on time and within cost in 2008.

Cabinet Office, (2012). Government Construction Strategy: Final Report to Government by the Procurement / Lean Client Task Group, London, p. 6.
Erikisson, P.E. and Pessämaa, O. (2007). Modelling procurement effects on cooperation, Construction Management and Economics, 25:8, 893-901.
Gil, N. (2009). Developing Cooperative project client-supplier relationships: How much to expect from relational contracts, California Management Review, Winter, 144-169. 
Greenhalgh, B. and Squires, G. (2011). Introduction to Building Procurement, Oxford: Spon Press.
Hughes, D., Williams, T. and Zhaomin, R. (2012). Is incentivisation significant in ensuring successful partnered projects. Engineering, Construction and Architectural Management, 19(3), 306 –319.
Masterman, J.W.E. (2002). Introduction to Building Procurement Systems, 2nd Ed. London: Spon Press, p. 106.
Rose, T. and Manley, K. (2010). Client recommendations for financial incentives on construction projects. Engineering, Construction and Architectural Management, 17(3), 252 –267.