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.

Lean Construction as Production Theory

The Theory of Lean Construction

Radosavljevic and Bennett’s theory of construction management (CM, discussed in this post) as a series of interactions between teams under internal and external constraints is a different approach to CM. Indeed, outside the lean construction (LC) movement there has been limited interest in a, or any, theory of production as applied to the construction industry. That said, LC can be also be thought of as a philosophy, as can be seen in many of the publications its founder Lauri Koskela. His Editorial in a 2008 Special Issue of Building Research and Information on theories of the built environment that did not include CM is a good example.

In the evolution of Koskela’s ideas since the 1992 publication of his “Application of the New Production Philosophy to Construction”, production theory developed into the Transformation-Flow-Value (TFV) theory. This is a theory that draws on the management literature and history as its base, with the roots of LC in lean production pioneered in the Toyota Production System clear. Koskela and his colleagues argued that:

What is needed is a production theory and related tools that fully integrate the transformation, flow and value concepts. As a first step toward such integration we can conceptualise production simultaneously from these three points of view … however, the ultimate goal should be to create a unified conception of production instead. (Koskela et al. 2002: 214).

The TFV theory combines three points of view and is built on the insight that there are three fundamental phenomena in production that should be managed simultaneously. The ideas of LC started with site operations but have been progressively applied to the supply chain, design and cost management and project delivery. These elements are brought together in the Lean Project Delivery System (LPDS, Ballard et al. 2002), below.

For the construction industry, the ideas and methods of LC offer an alternative to mainstream management theories. There are three reasons, apart from the usefulness of conceptualising production processes in a discipline traditionally preoccupied with practical matters. First, LC was, prior to Radosavljevic and Bennett, the only theory of production to have been developed specifically for the construction industry. Therefore, it provides insights into the range of processes that are involved, based on theory, that lead to propositions that can be tested by application to building and construction projects. The many case studies that have been published at the LC conferences over the years are all tests of the theory and practice of LC. These tests now add to a substantial body of evidence for the effectiveness of LC in a wide range of settings.

Second, the Lean Project Delivery System is an integrated approach to managing all the participants and stages of a project, from initiation to operation. Other approaches, such as value management, design management and indeed project management, typically only cover certain stages or a specific stage in the progress from conception to operation of a building, facility or structure. The LPDS is a framework starting from the project life-cycle, not adding bits on to achieve a comprehensive looking project plan.

Thirdly, drawing on LC theory and the LPDS as an application of that theory, the way building and construction projects are managed can be reconceptualised using the tools and techniques of lean construction. From the new management methods that LC engenders (for example, the activity definition model and set based design), efficiency and productivity gains that have proved to be so elusive under traditional project management in the construction industry might be realised.

These efficiency and productivity gains are also what Radosavljevic and Bennett are seeking. Their book puts forward a coherent model of CM and contains an abundance of propositions (25) that are intended as guidance in decision making, that one assumes would also improve performance. It is notable that they present the Japanese construction industry as the most advanced in terms of their theory (in providing a total service), and that LC is founded on the Toyota production system and the development of lean production in Japan. Lean is all about management, as Womack, Jones and Roos (1990) keep reminding us, and has now become the dominant manufacturing philosophy.

While the underlying vision of LC is an industrialised process of delivering construction projects, what LC is focused on is managing processes to deliver better outcomes. Clearly there is some relationship between these two theories of CM and LC.

Ballard, G., Tommelein, I., Koskela, L. and Howell, G. 2002, Lean construction tools and techniques, in Best, R. and de Valence, G. (eds.) Building in Value: Design and Construction, Oxford, Butterworth-Heinemann, 227-255.

Koskela, L. 1992. Application of the new production philosophy to construction, Technical Report No. 72, Center for Integrated Facilities Engineering, Dept.  of Civil Engineering, Stanford University, CA, September 1992

Koskela, L. 2000. An exploration towards a production theory and its application to construction, Espoo, VTT Building Technology. VTT Publication 408.

Koskela, L., Howell, G., Ballard, G. and Tommelein, I. 2002. The foundations of lean construction, in Best, R. and de Valence, G. (eds.) Building in Value: Design and Construction, Oxford, Butterworth-Heinemann, 211-225

Koskela, L. 2008. Is a theory of the built environment needed? Building Research and Information, 36 (3), 211-15.

Radosavljevic, M. and Bennett, J. 2012. Construction Management Strategies: A Theory of Construction Management, Oxford, Wiley-Blackwell.

Womack, J.P., Jones, D.T. and Roos, D. 1990. The machine that changed the world: Based on the Massachusetts Institute of Technology 5-million dollar 5-year study on the Future of the Automobile, Rawson Associates, Toronto, Collier Macmillan.