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.

Corruption Legislation in Australia

SUBMISSION TO THE SENATE STANDING COMMITTEE ON EDUCATION AND EMPLOYMENT

INQUIRY INTO FAIR WORK AMENDMENT (CORRUPTING BENEFITS) BILL 2017

Introduction

The Final Report of the Royal Commission into Trade Union Governance and Corruption by Justice Dyson Heydon found evidence of blackmail, theft, intimidation and death threats, use of motorcycle gangs and other criminal groups as hired muscle, interference in union elections and illegal agreements with employers. The Final Report highlighted poor union record keeping, false invoicing and destruction of documents, union ‘rubber stamp’ committees which failed to enforce rules, payment of large sums by employers to unions for dubious ‘training’ schemes and ‘services’, and influence peddling in the Labor Party through inflation of union membership figures. The sums of money involved were also significant, with many officials benefiting from their positions through fraud or theft from the union or through arrangements with employers for work on properties owned by officials.

Based on that evidence over 40 people, unions and companies were referred to various authorities for possible prosecution, including police and public prosecutors, the Australian Securities and Investments Commission (ASIC) and the Fair Work Commission. Some of the large private companies caught up in the inquiry were Thiess, John Holland, ACI, Downer EDI, Cbus, Winslow Constructors and Mirvac. Companies were found to have made payments to unions to get onto tender lists The Final Report, released in December 2015, had 79 recommendations, over half concerned with the regulation of unions (24) and union officials (14). The first recommendation was “Commonwealth and State governments give consideration to adopting a national approach to the registration, deregistration and regulation of employee and employer organisations, with a single regulator overseeing all such organisations throughout Australia.” This Registered Organisations Commission would have investigative powers similar to ASIC, and focus on financial compliance with new rules on management and disclosure.

This submission supports the proposed amendments to legislation by the Australian Government on registered organisations.

  

Background

Before the Heydon Royal Commission there were two previous Royal Commissions into the building and construction industry, both also led by judges. Roger Gyles headed the Royal Commission into Productivity in the Building Industry in NSW (1991-1992) and Terence Cole the Royal Commission into the Building and Construction Industry for the Commonwealth Government (2001-03). Both concluded the fundamental problem was a lack of respect for the rule of law, a phrase found repeatedly throughout both final reports, and this was a problem on both the employer and union sides. Cole said “Culturally, first, there needs to be recognition by all participants that the rule of law applies within the industry” and Gyles suggested those who break the law should be punished.

Gyles also said “Observance of the law and law enforcement in general play very little part in the industry. The law of the jungle prevails. The culture is pragmatic and unprincipled. The ethos is to catch and to kill your own … Once it becomes acceptable to break, bend, evade or ignore the law and ethical responsibilities, there is no shortage of ways and means to do so.” Gyles found illegal activities "range from physical violence and a threat of physical violence at one end to petty pilfering of building materials at the other. In between there is a great variety of illegal activities, essentially economic in nature or effect, from collusive arrangements involving giant corporations and industry associations to labour-only subcontractors paying small amounts of graft to project managers. Those involved range from managing directors of large corporations to labourers on site. No sector of the industry has been immune.”

Ten years after Gyles the same problems were still prevalent. In his final report Commissioner Cole envisaged an industry where “disputes are resolved in accordance with legislated or agreed dispute resolution mechanisms rather than by the application of industrial and commercial pressure. The rule of the law must replace industrial might.” His view was “These findings demonstrate an industry which departs from the standards of commercial and industrial conduct exhibited in the rest of the Australian economy. They mark the industry as singular. They indicate an urgent need for structural and cultural reform. At the heart of the findings is lawlessness. It is exhibited in many ways.” The final report proposed an Australian Building and Construction Commission to monitor illegal behaviour by unions.

It is worth asking if the recommendations of the Gyles and Cole Commissions, the other State efforts and their codes of conduct, had all been implemented and followed through, would a third Royal Commission have been necessary? While the recommendations from Gyles and Cole did become legislation, and Heydon’s are in process, perhaps the real underlying issue that should be addressed is why the building and construction industry operates the way it does. None of these Royal Commissions produced a vision of a different industry, apart from a law abiding one, and made no recommendations on the direction that strategic development of the industry might take.

The three Commissioners agreed the problem is a culture of lawlessness, and the three inquiries found widespread illegal behaviour by both union officials and contractor managers. Their recommendations, in various ways, focused on increased regulation and enforcement through legislative action. In this they had “well developed and precise views”. However, while necessary, increased regulation does not address the issue of why the building and construction industry has such a culture and the causal factors at work in creating this culture.

Construction has a reputation for corruption and collusion, and is ranked by Transparency International as the world’s most corrupt industry, mainly due to issues in developing countries. But this is also a problem across countries in the OECD, not just for Australia, because many countries have found entrenched anti-competitive practices and criminal involvement in the industry. For example, the 2015 Charbonneau Commission in Canada into awarding of public contracts in Montreal concluded corruption and collusion are "far more widespread than originally believed" and organised crime had “infiltrated” the industry. The Commission revealed complex webs of collusion with sophisticated mechanisms’ for extracting funds from public construction projects. Politicians, high level public officials, consultants, and contractors were all involved.

Project Preparation and Procurement

The current approach to procurement of building and construction projects by both public and private clients facilitates corrupt payments by allowing the increase in project costs they cause to be hidden in tender bid prices or claims for reimbursement. This is primarily due to clients’ under-investing in project preparation in the initiation phase, as they seek to minimise the design costs of a feasibility study. Because many projects are then put to tender with incomplete documentation, their cost cannot be estimated accurately and tenderers have to add a significant risk premium to their bids.

Project costs cannot be accurately estimated without detailed design and engineering specifications, and high cost estimates 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.

Failures in project preparation opens up opportunities for corruption during the later stages of a project. For example, inadequate project preparation may lead to subsequent implementation delays and work changes that can be manipulated to benefit individuals or companies. The preparation stage is likely to facilitate corruption during construction when failures at this stage are opportunistic or deliberate. Incomplete design inevitably requires adjustments after the work has started, although many are due to unexpected events and circumstances. However, starting without a complete plan opens the door to post-contract negotiation and opportunistic behaviour.

To improve project preparation both public and private sector clients would have to take more responsibility for project initiation and definition, and employ larger and more capable client teams to manage their projects’ procurement and delivery strategies. The cost of a client project management team is not an added extra to the project, and the task is essential if the scope for collusive and corrupt behaviour in the building and construction industry is to be reduced.