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.
