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.

Improving Project Preparation

Building Client Capabilities

Understandably, clients tend to under-invest in project preparation during the initiation phase as they seek to minimise design, development and feasibility study costs. However, because many projects are put to tender with incomplete documentation and before their cost has been estimated accurately, tenderers have to add a significant risk premium to their bids. Project costs cannot be accurately estimated without detailed design and specifications, and high cost bids for a project allow the later diversion of funds. On the other hand, incomplete design can lead to estimates below project costs, with consequent claims and disputes obscuring the eventual recipients of funds. Contractors’ claims for reimbursement can lead to significant cost increases, and an unscrupulous contractor will also cheat on materials, compromise on quality, and deliver below the specification, resulting in poor quality assets with high maintenance costs.

Therefore, the first reason clients should invest in the development of some internal PM capabilities is because the quality of design and documentation before tendering reduces contractor risk and thus total project cost. Whether these documents are being prepared internally or externally, this task is one of design management. If the interaction between designers, consultants and contractors is managed by the client project team, they take responsibility for the project’s overall design and development at the earliest stages. Separating the design stage from tendering will also improve opportunities for consultation.

The second reason clients should invest in the development of internal capabilities is because they are, in reality, holding the eventual risk of their projects when they complete and become operational. The ability to manage that risk with their own client team on major projects, responsible for the process of project shaping and front-end definition, is an opportunity to add a great deal of value for the client. Even when consultants and contractors work to the best of their abilities, their firms have separate interests from the client.

The key factor is the extent of the specifications. On some major projects there may be a limit to how much design can be completed upfront, as this develops over time and the project details are refined and defined. It is unreasonable to expect a complex project to be fully specified at tender, and in most cases this would not be possible. It may also be advantageous to look for innovative ideas or design options, so for these projects an incremental approach would be followed to allow contractors and suppliers the opportunity for input during the development of the design. This also has the advantage of reducing uncertainty from poor tender documentation, thus lowering risk and cost for tenderers.

The client PM and project team should be responsible for overseeing the design and documentation of the project, ensuring the most appropriate construction options are chosen. Despite the proliferation of contracts used in the building and construction industry most major projects are delivered using either the traditional design-bid-build or Design and Build (D&B) and Design and Construct (D&C) contracts. The trend has been toward D&B and D&C contracts for major projects, and these account for a larger share of work done than number of projects. There is some support for design and construct procurement of buildings and social infrastructure from school PPPs in Australia and hospital PFIs in the UK. This may be due to the buildability issues found in complex buildings with many services, like hospitals, or the emphasis on maintenance costs with schools. However,  the problems found in D&C projects of design changes by the client and conflict of interest between design team members and the contractor are common.

Nevertheless, Ed Merrow argues for traditional construction procurement for the types of projects in his database. This is when consultants are appointed to manage the design, and a competitive tender is held for one or more contractors to execute the works on site against a complete design. Using evidence from the 11,000 private sector resource, industrial and engineering projects in his database, Merrow believes the best form of project delivery is what he calls ‘mixed’, with engineering design contractors hired on a reimbursable contract, and construction contractors hired on a separate fixed price contract. The evidence from the database suggests this is the most effective form of project organization, and represents traditional procurement with consultants appointed to do the design, and a competitive tender run for one or more contractors based on the finished design.

The approach advocated here combines elements of both the D&C and traditional procurement strategies. By engaging the PM and project team early, before detailed design work commences, the integration of design development with construction options retains the advantage of a D&C contract, as the PM manages the consultants as they develop the design solutions. However, the loss of control and the premium that is paid for management of a D&C contract is avoided.

Pre-Modern Building Procurement

 A Short History of Building Procurement: Part 1

This short history describes the evolution of procurement in the building and construction industry, from the early modern system of production in the 17^th and 18^th centuries to the emergence of the general contractor and the professions with modern methods of procurement in the 19^th century. Procurement here is the commissioning or purchasing of buildings and structures, and any associated supplies and services required, by a client that pays for the work. A historical overview is useful because there is a surprising, and often not well-recognized, continuity in the methods used and problems found.

The process of designing and delivering buildings is as old as civilization. However, the procurement of projects has not attracted as much attention as the buildings and structures themselves, or the organisation of the work, because in the distant past this was done by imperial edict for essential granaries, armories, pyramids or temples. Procurement itself dates back to a red clay tablet found in Syria, dated from between 2400 and 2800 B.C. This earliest procurement order was for “50 jars of fragrant smooth oil for 600 small weight in grain” (Coe 1989: 87).

The earliest records on construction procurement are from Rome in the middle of the first millennium before the present era (around 500 BC). What is significant about the history of procurement is the continuity they show, in how the basic characteristics of the methods used have been around since then. Straub (1952) quotes Plutarch on construction where ‘artists’ submit estimates and drawings and “they select the one who, at the lowest price, promises the best and quickest execution”. It appears to have been common to divide large projects into work packages, with the Long Walls of Athens broken into 10 and the Roman Coliseum into four separate contracts (Morris 2013: 14, again based on Plutarch).

Along with continuity of procurement methods, issues around client and contractor performance are also familiar. The stereotypes of capricious and poorly informed clients and duplicitous contractors have a long history. For example, Marshall Vauban was a military engineer and builder of fortifications for the French monarchy who insisted suppliers should be selected on quality, not just on price. In a letter from 1685 (cited by Callender 2003) to his Minister he complained of delays due to budget cuts and argued:

Breaking of contracts, failures to honour verbal agreements and new adjudications, only serve to attract those firms which do not know which way to turn, rogues and ignoramuses, and to make those with the knowledge and capability of directing firms, beat hasty retreats.

I would add that they delay and inflate considerably the cost of these works, which are the worst since these cuts and the cheapness sought are imaginary. For the contractor is ruined … He does not pay the merchants who supply the materials, pays badly his employees, cheats on those he can, has only the worst, and since he is cheaper than the others, uses the poorest materials, quibbles about everything and is always crying for mercy … go back to plain dealing; pay the price for the works and do not deny an honest salary to a constructor who fulfils his duties; that will always be the best deal you can find.

This history of procurement is about its development in England, and in particular in London where capital (often made through the expansion of trade) was concentrated and many of the major projects of the time were built. These developments are relevant to many countries today because, more than any other nation, England has shaped our modern language, laws, institutions, and governance over the past half-millennium. While ideas like competitive tendering, enforceable contracts, subcontracting and measurement of costs with a bill of quantities are now widespread and common, this was not the case 200 years ago. In other countries, especially the US and elsewhere in Europe, the details of their history of procurement are different, but the modern system established in England and the UK at the turn of the 18^th century is the foundation on which they are built.

Early Procurement Methods

Through the Early Modern period in Europe, until the end of the 17^th century, the usual way of getting building work done was to employ craftsmen directly. If the client did not supervise the work himself, an agent would be appointed, and craftsmen were employed at daily wage rates set by medieval craft guilds that guaranteed quality. The trades and guilds were based on the materials used, such as wood and stone, and had an apprentice-journeyman-master structure that set standards of fairness enforced by the courts run by their Companies (Knoop and Jones 1933). This had been the normal way of building for centuries, although even then there were different methods of employment and payment.

While the common system was direct employment at day rates, sometimes work was done under a system known as ‘measure and value’, where work done in the different trades was valued based on an agreed set of prices and wages rates. Master craftsmen would make an agreement (in effect but not in form a contract) for building, and employ other craftsmen and labourers to do the work, called task work. The payment was still usually on a measure and value basis not for an agreed price, although there was some lump sum work. As use of this method of ‘contracting’ increased the direct labour system declined, with wages and prices still regulated by the guilds. Measuring was usually done on completion and had its own issues, mainly with delay, disputed work and associated litigation.

A third way of contracting was known as in grosso (by the great), meaning for an agreed, fixed sum. Harvey found examplnes from the 15^th century where what today would be called a lump sum contract was used to deliver projects. An important difference was that they involved separate agreements with the various tradesmen, however in this case the price was agreed in advance instead of work getting valued when done. This form of contracting was strongly opposed by many clients and craftsmen, who felt that the in grosso formula would produce poor quality and high prices, and sureties were often demanded to guarantee completion if the contractor did not complete the work as agreed. The method of contracting ‘by the great’ led to the end of regulated prices and undermined guilds.

There are also early examples of fixed-price contracts, typically with the separate tradesmen involved on a particular project. These were quite rare. It was not unknown, however, for a single person to carry out a complete project through subcontracts or direct employment, and this led eventually to the modern contracting system. Harvey (1975) describes the building of the jail in York in 1377 using a fixed price and a contractor with agreed stage payments.

Christopher Wren, in a 1681 letter to the Bishop of Oxford, explained that there were three ways of getting a job done and the problems with each one: working by the day, by measure, and by the great. His preference was to work by measure, although good measurers were hard to find, and he argued that contractors employed by the great who were not familiar with the tasks “doe often injure themselves, and … shuffle and sligh the worke to save themselves” (McKellar 1999: 86). In the building of St Paul’s after the Great Fire of London during the 1670s, responsible for both supervision of the work as well as the design, Wren employed different sets of craftsmen under these three different types of contracts to do the work, but most of the work used the method of separate contracts with different trades, a form of contracting by the great. This spread the risk and became the most common form used in the late 1700s.

By the end of the 17^th century some procurement was being done through a building agreement, usually for speculative property developments, between the client or developer and the builder. These were legally binding documents that specified the structure or structures, their size and materials, payments and any financial penalties incurred after the agreed time. McKellar (1999: 83) describes these as “fairly comprehensive and sophisticated”. They contained arbitration clauses, and resort to the courts only happened when arbitration failed. The main problem was quality control, and common phrases like ‘well made’ or ‘good work’ made disputes over quality common.

The role of property developers and speculative builders at this time is an important element in the development of the building industry. Some of these were lords (Bedford, Southampton, St.Albans) but many were not (Babon, Cubitt, Bond). Literate and, essential for estimating, numerate master craftsmen became master builders. Usually bricklayers or carpenters, these men would build for the speculative market and employ or contract with tradesmen. They used surveyors to mark out building sites and measure completed work to settle contracts. There was a wave of house building in the mid-seventeenth century, documented by Summerson, led by ambitious craftsmen and opportunistic developers who were not deterred or prevented from building by royal decrees or church interests, unlike the other European capitals:

London is above all a metropolis of merchandise. The basis of its building industry is the trade cycle rather than the ambitions and policies of rulers and administrators. The land speculator and adventuring builder have contributed more to the character of the Georgian city than the minister of the Crown … or the monarch (Summerson 2003: 9)

At this time the industry was clearly undergoing changes. For many years, even centuries before, building had been done by independent craftsmen belonging to guilds, or Companies, who usually worked directly for a client. The end of the 1700s, however, was the time of transition from these old, established ways to what eventually became known as the ‘modern system’ of contract labour and measuring to determine costs. This was not some linear, steady progress, but an overlapping of the old procurement methods with the new system, as both continued to be widely used. As McKellar observed:

The guild system had broken down well before the late seventeenth century and certainly in London any remaining vestiges of power that the Companies had were annihilated by the legislation following the Fire which allowed ‘foreigners’ from outside the city to work within its boundaries. The building industry might still be organized around separate trades, however the relationships between these different crafts and the methods of contracting were undergoing a profound transformation. (1999: 71).

Importantly, as part of this transition to an industry with more of the characteristics seen today, the different construction professions began to form, as experienced tradesmen started to specialize in various aspects of building and construction and professional architects appeared. Morris (2013: 15) describes the emergence of the roles of architect, engineer, surveyor and contractor during the rebuilding of London after the Great Fire of 1666 under Christopher Wren and Robert Hooke. A hundred years later, toward the end of the 18^th century, the general contractor had arrived as a new type of firm, responsible for organising the building process and employing craftsmen to undertake work directly or as subcontractors. 

This is part 1 of a three part series, the following parts are on The Great Transition and The Modern System. A pdf of the full document is here.