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.

Project Characteristics and Classifications

Categories and Typologies

There are a few obvious ways to categorise projects. The industry a project lies within is one, and by function is another, although categories such as these often overlap (e.g. shipbuilding or information technology). Distinctions are made using a variety of characteristics between hard and soft projects, major and minor projects, public and private sector projects, routine and transformative projects, and so on. While there is no agreed definitive list, these characteristics typically include factors such as size or cost, familiarity and complexity, scheduled time, outcome or product, parent organisation type or status, and the contracts and delivery methods used. There are many factors that can be taken into account, and categories help resolve this diversity by creating frameworks to structure a lot of loosely connected data.

The way we see and understand an industry typically starts with the data we get from the national accounts and other collections done by national statistics agencies. For building and construction, government statistics are typically collected by sector and then divided into building or structure type, shown in a generalised form in Table 1. Projects within a defined market are then grouped together to establish sector size and importance, detached housing for example, or commercial developments. Because the data on industry activity and output is presented in these classifications, analysis of trends and forecasts of construction work are also usually found in this format. (Informal building is included here because it is an important part of the industry, but this sector is not included in industry statistics.)

Table 1. Building and construction

Sector	Type
Residential building	Detached housing, medium and high density dwellings, alterations and additions etc.
Non-residential building	Private - Retail, commercial, industrial, hotels etc.
	Public and social - Education, health, community etc.
Engineering construction	Bridges, ports, rail, electricity, roads, water and sewerage, dams, telecommunications etc.
Informal building	Owner builders, DIY, cooperatives, communes, etc. Picked up in sales of equipment, materials and components.

 

Common typologies used to categorise building and construction projects are based on the procurement system or contract used, financing method, size, complexity or some other characteristic of the project. Examples are Masterman’s exhaustive set of lists of construction project and client characteristics, which can be used to classify projects, and Flygberg et al., who argue there is a separate and distinct set of megaprojects and the characteristics of these projects (apart from size) make them a focus of research in their own right. Many project management researchers identify “complexity dimensions” and/or levels of risk for projects to create frameworks for classification. There is a very large literature on this, and with the diversity of projects it is not surprising there is a wide range of views on categories and typology. However, this is not just an abstract question. The way we understand the industry is framed by the categories we use to structure that understanding.

The question being asked here is whether it might be possible to develop a classification system for building and construction projects that is independent of the characteristics and factors identified above, such as size or building type. A different set of categories might illuminate the industry in a different sort of way. To do this requires identifying a number of characteristics that are common to projects in general, and construction projects in particular. There is no shortage of candidates: organization forms, technology, environment, information density, decision making and technical or organisational complexity could all be considered.

When looking for common characteristics across projects there are some obvious places to start. The first would be the main project management (PM) systems, such as PMBOK and PRINCE. These detail PM tasks, planning methods, and control tools and techniques. Other systems like Morris and Pinto’s APMBOK include topics such as technology management, economics and finance, people skills, and the social and environmental context. These PM systems are generally organised around the competencies needed to deliver projects, but emphasise different competencies. They help in identifying common project characteristics by eliminating the need to include PM methods and techniques in the search, partly because they are so comprehensively covered by these frameworks but also because their application varies greatly across different types of project.

The stages a project goes through is another candidate. All projects have stages, and while there are many variations on the details, there is broad agreement on the sequence of initiation, development, execution and finalisation. Again, because this has been already comprehensively covered it does not offer much opportunity for a new approach. Stages also create a sequential structure, which is not what is being sought here. This means we have to move the search for common characteristics to a higher level of generality.

In his well-known Handbook of Project Management (now in its fourth edition) Rodney Turner states “There is no agreement about how to classify projects, but I have found it useful to classify them against three parameters”:

• By the position of the project in the life cycle of the product produced by the facility, or in the strategic development of the parent organisation;
• By the type of industry or technology of the project or the parent organisation;
• By the size of the project.

Within each of Turner’s three categories there are sub-categories. The two life cycle categories are new product development and technological development. In industry sector or technology, the three categories are organisational change, engineering and information technology and by size, projects can be small to medium, large or major. This is a good representative example of the functional approach to project classification, where the type of project is primarily defined by its role. This functional approach is often found in construction management books, which tend to follow the format of construction statistics with their division of the industry into sectors and project categories based on their physical structures.

In a later typology Turner used the level of difference between projects to get four project types ranging from the familiar to the completely unknown. These two approaches are complementary, in that they expand the detail of the classification system

• Runners: These are very familiar projects, done repeatedly. They almost count as batch processing. Routine processes can be used;
• Repeaters: The organisation has done projects quite similar to these in the past. The majority of elements of the project are very similar to things done in the past and there is knowledge in the organisation about how they should be managed;
• Strangers: The organisation has never done a project like this before, but there are many familiar elements;
• Aliens: The organisation has never done anything like this before. These projects are high risk.

Using familiarity as a key point of distinction between projects seems like a useful insight, although it then leads to questions about where a project lies on the known/unknown spectrum, and why. One approach that tackled these issues is Shenhar and Dvir’s novelty, technology, complexity, and pace (NTCP) “diamond” framework. This is an interesting system of project classification, intended mainly for technology projects. It creates cobweb diagrams of a project based on four dimensions, defined as:

• Novelty: How intensely new are crucial aspects of the project?
• Technology: Where does the project exist on the scale from low-tech to super-high-tech?
• Complexity: How complicated are the product, the process and the project, on a scale from a simple component to an array that combines many components.
• Pace: How urgent is the work? Is the timing normal, fast, time-critical or blitz?

Project profiles are determined by the level of each of the four dimensions, and the combination of the four levels on each dimension gives the set of 16 characteristics a project can be mapped against. A project has a specific profile, with associated specific planning and execution needs. This is a flexible approach that identifies project characteristics, and Shenhar and Dvir argue knowing these characteristics should lead to better project management and outcomes, and they link specific management decisions (such as design freeze point, PM structure or the timing of reviews) to each of the four dimensions. This line of argument, that understanding project characteristics leads to better management decisions, underpins many project typology and classification systems.

 

Using the NTCP framework gives a visual representation of a project, and can easily be applied to building and construction. Many building projects would fit into a small central diamond of low-tech, derivative projects with regular timing that are component based. An engineering project like a refinery would be represented by a larger, still symmetrical, diamond of a medium-tech, platform with competitive timing and on-site assembly. Disaster recovery projects need to be fast and are often low-tech, logistics centres and fabrication plants are high-tech and so on. While helpful this framework does not, in itself, provide any great new insight into construction projects.

To adapt all these ideas about project typologies, and the many others in the literature not mentioned here, to the construction industry is not straightforward. If a characteristics approach is taken to classifying projects, the question then moves to become one of definition: what are the specific characteristics, how are they identified, and where are the boundaries between them? Most importantly, what is the purpose of a typology or classification system?

Flyvbjerg, B., Bruzelius, N. and Rothengatter, W. 2003. Megaprojects and Risk: An Anatomy of Ambition, Cambridge University Press, Cambridge.
Masterman, J.W.E. 2002. Introduction to Building Procurement Systems, 2^nd ed., Spon, London. 

Turner, J.R. 2014. The Handbook of Project-Based Management, 4^th ed., McGraw-Hill, New York. 

Shenhar, A. and Dvir, D. 2005. Reinventing Project Management –The Diamond Approach to Successful Growth and Innovation, Harvard Business School Press, Boston, MA.