Target cost and cost reimbursable contracts: construction share tips
14 February 2011
In his final article on target cost and cost-reimbursable contracts, Ian Heaphy looks at pain/gain mechanisms and how they can help develop partnering behaviours
The pain/gain mechanism forms the key driver in aligning the objectives of the contractor and employer to work together as a team to reduce cost and make savings. There is no right or wrong pain/gain mechanism and there are a myriad different approaches available.
Most are based on a percentage split of overspend or savings between the contractor and employer, and are often ‘banded’ based on the percentage of overspend or savings made compared to the target cost.
The simplest allocation is a straight 50:50 split of all over/underspend. This is often seen as the most equitable because both parties share the risk equally which helps develop partnering behaviours. It is also less likely to encourage the contractor to drive up the target cost value or chase compensation events.
However, there is no cap on the pain share to the employer and therefore they cannot accurately predict what the final payment will be. It may also be argued that there is less incentive for the contractor to mitigate cost, but in reality the potential of paying half the cost of overspend should provide this.
The simple 50:50 model is often altered to include a sliding scale of percentages whereby the employer allocates increasing amounts of pain/gain share between the parties. There can be a number of different versions of this model.
The most common option is for the employer to split the first 10% of any over/underspend equally but then to alter the allocation above and below this percentage. Normally, the employer will increase the pain share percentage in the bands above 110% to give the contractor a greater share of the overspend. Similarly, the employer will decrease the percentage gain share to the contractor below 90% of the target cost (commonly a 75:25 split).
Changing the split
However, some employers have reversed this approach and have increased their exposure to pain share in the increasing overspend brackets (i.e. over 110%) and decreased their percentage of any underspend (i.e. below 90%). The rationale here is that larger employers may be better able to carry the financial risk of overspend against the target cost and so would rather carry this risk than allocate it to the contractor who will seek to make provisions for it somewhere in their target cost. Similarly, increasing the percentage gain share to the contractor will motivate them to mitigate cost and create gain share as they will receive increasing benefit as greater savings are made.
The sliding scale is often extended to provide a cap on the employer’s potential pain/gain share payments. The employer will, at a certain level (normally above 120% and below 80%), allocate 100% percent of overspend and 0% of underspend to the contractor. This reduces the financial exposure to the employer and increases the financial risk to the contractor.
This model allows the employer to introduce a limit to their exposure in terms of overspend and is commonly selected. There is less potential for the contractor to over-recover gain share under such a mechanism and there is a greater incentive for them to mitigate costs due to the pain share cap. The employer will also be better able to predict what the final payment will be, subject to any changes.
On the downside, the contractor may seek to increase their target cost or maximise changes to avoid hitting the pain share cap.
Another issue is that the contractor may not be motivated to make savings below the 90% level as they get a reduced return, and certainly not below the 80% level where they get no return. In fact, the contractor may actually try to increase costs to ensure that no savings occur below the gain share threshold.
The choice of model clearly has to take into account the potential behaviours it will drive in the parties. The employer needs to review a number of factors before choosing a model:
- experience of the parties
- method of setting the target cost – negotiated, competitively tendered, etc
- accuracy of the scope of works and therefore the target cost
- potential for variations.
As different models alter the financial risk allocation between the parties, some employers leave the model blank at tender stage and ask for the contractors to propose differing models and associated fees as part of their commercial offer.
Out-turn cost forecasting
The forecasting of the final out-turn cost of a project can prove to be an issue under target cost and cost-reimbursable contracts. The reality of such arrangements (and perhaps true of all contracts, at least from the contractor’s perspective) is that the actual cost of the project will not be known until it is completed, and often not until several months later when all accounts in the supply chain have been settled.
Unlike fixed price contracts (where the employer has a running final account based on the original contract value, plus or minus agreed variations), under a target cost/cost-reimbursable contract the contractor is paid on actual cost which can vary greatly during construction.
Difficulties can arise when forecasting costs still to be settled such as accruals and liabilities for materials received or work undertaken, but not yet invoiced. Tougher still is forecasting the cost of work not yet ordered or agreed, or the final value of disputed variations or claims. This is further complicated by the need to reconcile the costs expended to date compared to the value of work done, e.g. a project is 50% complete in terms of physical progress but 75% of the costs have been incurred. Does this mean that the project will overspend or is it simply that the more expensive elements have been completed, and in fact the project should have expended 85% of the costs by this stage and so a gain share should be predicted?
To deal with these issues it is recommended that some form of earned value analysis is undertaken, overlaying progress of the physical works with the costs incurred. This will allow the value of work done to be compared to the cost to determine current, and forecast future, financial performance.
A failure to accurately forecast the out-turn cost of a project can often cause major difficulties to an employer – they can suddenly find that a project they thought they were going to make savings on suddenly turns to a loss simply because the contractor has spent more than they had envisaged. I have been party to difficult meetings where an employer has had to go back to their board for more funding and, when questioned as to what has changed or what the additional scope or risk event was that has occurred to create the need for the additional monies, the response was “Nothing, it’s just cost more than we thought.”
A straight 50:50 split of all over/underspend… is often seen as the most equitable because both parties share the risk equally which helps develop partnering behaviours
In my experience, target cost contracts are increasing in use globally as they create a greater alignment of parties’ objectives to reduce costs and create savings.
They can provide a better mechanism than traditional fixed-price or remeasureable contracts for dealing with risk and provide greater flexibility to the employer. They also help create partnering behaviours due to the need for openness and transparency of costs, which also helps in reducing the potential for claims and disputes.
However, it is essential that employers understand that they will carry a much greater financial risk, post-contract, than they would under a fixed-price or remeasurement arrangement. If the contractor is efficient, works well and makes savings the employer will share in this. However, if the contractor is inefficient and performs badly then (subject to the limited grounds for disallowed costs) the employer will have to share in any resulting overspend.
Employers also need to ensure that the target cost is set at a competitive level so as to provide the incentive for the contractor to be efficient or to seek value for money in the supply chain. The incentivisation mechanism must be designed to drive the right behaviours in the contractor and not to drive them to create claims or to inflate costs to increase overhead and profit recovery.
Overall, I believe that target cost contracts can be a valuable addition to the more traditional fixed price and remeasurable approaches. If used correctly they can often offer a better method for procuring complex or high risk construction works or projects where the parties want to encourage collaborative working; however, users need to understand the issues in order to secure the benefits they offer.
Ian Heaphy is a Partner with EC Harris