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TARGET COST CONTRACTS

By

Roger Knowles

CONTENTS

New Approach

Standard Target Cost Contracts

Reference to Target Cost in the Contract

When Should the Target Be Fixed

Calculating the Target Cost

Adjusting the Target Cost

Fee

Gain Share/Pain Share

TARGET COST CONTRACTS

New Approach

Traditionally contracts for construction work have been placed on the basis of a lump sum being paid to the contractor for carrying out the work. This sum will usually be adjusted for employer changes and all employers risk items provided for in the contract for such matters as design errors. The culture is for the work to be undertaken by the contractor who submits the lowest price. In recent times this method of procurement has fallen into disrepute in respect of public sector work where best value has been the preferred procurement route with lowest price falling by the wayside.

It is now commonplace in the public sector where best value applies for procurement systems to provide for payment to the contractor based upon its recorded costs. To ensure that costs are not allowed to get out of hand a target for these costs is fixed at the outset. The target is adjusted to take account of any employer changes and other price risks allocated to the employer under the terms of the contract. To ensure that there are incentives in place so that costs are kept to a minimum it is usual for the target cost to be linked to a gain share /pain share mechanism which is fixed at the outset. The recorded costs are compared with the target cost and any saving shared between the contractor and employer in a pre-agreed manner. In like manner any over expenditure compared with the target is shared.

Standard Target Cost Contracts

The following contracts are standard target cost contracts:

1. Public Sector Partnering Contracts

• Option 2 – Term Maintenance

• Option 5 - Authority Design

• Option 6 - Contractor Design

2. ICE Conditions of Contract Target Cost Version

3. PPC 2000 Standard Form for Project Partnering

This contract provides for a Price Framework which leaves the parties to devise their own payment mechanism. It is commonplace for a cost reimbursable with target cost to be used. There is provision for including an Agreed Maximum Price in the Form of Commencement Agreement.

4. New Engineering Contract

• Option C - Target Contract With Activity Schedule

• Option D - Target Contract With Bill of Quantities contract

Subcontracts

5.1 Public Sector Partnering Contract

• Option 8 – Subcontract Target Cost With Cost Reimbursable

5.2 SPC 2000 Standard Form of Specialist Contract for Use with PPC 2000

Reference to Target Cost in the Contract

1. Public Sector Partnering Contract

Option 2 Term Maintenance provides in clause 23.1 for the calculation of the Target Cost by measuring and valuing the work in accordance with the Schedule of Rates referred to in the Appendix.

Options 5 Authority Design and Option 6 Contractor Design; in clause 18.0 it states that the Target Cost is indicated in the Articles of Agreement. There is no method provided as to how the Target is to be calculated.

Option 6 Subcontract: In clause 21.0 it stipulates that the Target Cost is stated in the Articles of Agreement. There is no indication as to how the Target is to be calculated.

2. ICE Target Cost Version

The Target Cost and the Fee are given in the Appendix Part 2 to the Form of Tender.

3. ECC Contract

The Target Cost is referred to as the total of Prices which are included in the Data submitted by the Contractor with his tender.

4. PPC 2000

Partnering Documents referred to in the contract include a Price Framework. The Guide states in section 5.4 that at the date of the Project Partnering Agreement the Price Framework should include the agreed amount payable for the Constructor’s services, agreed profit, central office overheads and site overheads. This document when agreed will provide a mechanism which will enable these sums to be calculated. It is usual for the Constructor’s costs to form the basis for the sums to be paid. In the definition section reference is made to an Agreed Maximum Price which is the price payable to the Constructor pursuant to the Price Framework. There is no specific guidance as to how it is intended to operate and how the Agreed Maximum Price is to be calculated. This will be a matter for the parties to agree before the contract is entered into. It is commonplace however for the parties to agree a Target Price to be included in the Price Framework as the Agreed Maximum Price.

The Agreed Maximum Price is stated in the Commencement Agreement.

5. SPC 2000 Standard Form of Specialist Contract for Use with PPC 2000

Payment will be in accordance with the Specialist Payment Terms to be agreed by the parties. The parties may agree that a Target Cost will form the basis of the Specialist Payment Terms

When Should the Target Be Fixed

There is no hard and fast rule as to when the target should be fixed. The following provide examples:

1. Some clients opt to introduce an element of competition into the process. It is therefore common for contractors to be requested to indicate the Target Cost as part of the tender submission. This is regarded by many as being contrary to the spirit of partnering as it can lead to a lowest price selection policy.

2. A variation on this method is for the contractor to be requested to submit with the tender the amount to be included in the Target Cost for overheads and profit.

3. On most partnering contracts it is customary for the Target Price to be fixed after tenders have been received but before the contract is signed. Some contracts such as the PPC 2000 include a provision for the Target Cost referred to as the Agreed Maximum Price to be included in the Pre Possession Agreement.

4. On most contracts it is usual for a value engineering process to be undertaken. It can take the form of a fairly major exercise during the early design stage and be ongoing during the remainder of the design and construction phase. If the Target Cost is fixed before the first major value engineering exercise has been undertaken it is less challenging for the contractor to achieve a cost for the project within the Target Cost. The reason being that during the first major value engineering phase a significant amount of cost may be taken out which would benefit the contractor if the Target Cost has already been fixed.

Calculating the Target Cost

There are several methods of calculating the Target Cost and include the following:

1. Measured quantities multiplied by unit rates

2. Cost per unit eg bed space

3. Employing an elemental cost analysis technique

4. Floor area multiplied by cost per square metre

Often a building block approach is employed comprising:

1. Unit cost

2. Sum included for risk

3. Overheads

4. Profit

Unit Costs

The unit costs may be calculated using a schedule of rates for work which is inclusive of labour, materials and plant. Measured quantities for the work are then applied to the rates to arrive at the unit costs. Where the target is fixed at a stage when little design work has been undertaken a more basic approach is often used by employing the floor area of the building and applying a rate per square metre for the labour, plant and materials. It is sometimes convenient to calculate the areas of the various elements such as cladding and roofs of the building and apply a separate rate per square metre for each element in respect of the cost of labour, plant and materials to provide a total cost for each element. These costs should always be inclusive of what are often referred to as site preliminaries such as the cost of site accommodation.

Where a large part of the work is to be designed and constructed by subcontractors the unit costs are often built up using quotations received from the subcontractors who will be undertaking the work.

Risk Allowance

The contract should be very clear as to how the risks are to be shared between the parties. This is often achieved by using a risk register. In building up the target price a sum should be included in respect of the risks which are to be borne by the contractor. For example it is usual in times of relatively low inflation for the target price to include for inflation. On many contracts the contractor is required to include in the target price the estimated cost of any ground conditions which may be encountered whether they are foreseeable or otherwise. A financial provision should be included in the target price for this type of risk. Where the extent to which ground conditions are anticipated to be unfavourable is unknown before work commences it is better for a provisional sum to be included in the target price which can be adjusted at a later date to take account of the contractor’s actual costs. It should however always be made clear at the outset as to which of the parties bears the risk.

Head Office Overheads

The head office overheads are usually provided for separately in the build-up of the target price. It needs to be made clear at the outset which costs are included under this heading and which are site costs. For example quantity surveyors may be site based and included in the unit costs whereas the commercial director and chief quantity surveyor may be head office based and form part of the head office overheads. It is usual for the head office overhead element to be calculated by the addition of a percent to the total of the unit costs

Profit

The profit is the reward paid to the contractor for satisfactorily completing the work. It is usually calculated by adding a percentage to the total of the unit costs, risk and overheads. Normally profit is the major element of the Fee.

Adjusting the Target Cost

The contract will usually provide details as to how the Target Cost is to be adjusted. The following are examples

1. Public Sector Partnering Contract Option 6 Contractor Design

Clause 18.0 lists the following events which give rise to an adjustment to the Target Cost

1. Any act, omission or default by the Authority or others employed or engaged by the Authority

2. Any matter outside the control or responsibility of the Contractor or others employed or engaged by the Contractor

3. Where the Contractor suspends the work due to a failure on the part of the Employer to make payment in accordance with the terms of the contract.

4. Variations to the works.

2. PPC 2000

Clause 18 under a heading of risk management provides sixteen delaying events which may give rise to the contractor having an entitlement to an extension of time. Clause 18.6 makes provision for there to be an adjustment to the Agreed Maximum Price in respect of ten of these events which cause additional cost. Briefly these ten events are:

• Delay by the client

• Discovery of antiquities

• Changes in legislation

• Opening up the works for testing

• Failure on the part of the client to allow access

• Suspension of the work due to non payment

• Terrorism affecting the project

• Breach of the partnering contract by the client

• Delay by any specialist appointed by the client

• Any other event stated in the Commencement Agreement

A change by way of additions, omissions or variations to all or any part of the project in accordance with clause 17 may result in an adjustment to the Agreed Maximum Price.

3. ICE Target Cost Version

Provision is made in the following clauses for the adjustment of the Target Cost

• Clause 6 Late issue if instructions by the Engineer

• Clause 12 Unforeseen adverse physical conditions or artificial obstructions

• Clause 13 Delay or disruption resulting from the Engineers instructions except where due to the contractor’s errors

• Clause 31 Additional cost resulting from providing facilities for contractors employed by the employer

• Clause 36 Additional costs relating to tests and samples not provided for in the contract or due to the contractor errors

• Clause 40 Suspension of the work in accordance with the Engineers instructions

• Clause 42 Late provision of the site by the employer

• Clause 51 Variations to the works

• Clause 58 Expenditure of PC and Provisional Sums

4. ECC Contract

The ECC contract provides for the Prices for the work to be adjusted in the lights of any of the compensation events which are listed in clause 60. The seventeen compensation events provided in this clause comprise:

• Changes to the works information

• Late possession of the site

• Late provision by the employer of plant, materials or other matters required by the contract

• An instruction to change the conduct of any or all work

• The employer fails to work within the periods or other conditions stated in the works information

• The project manager or supervisor does not reply to communications from the contractor within the period stated in the schedule of contract data

• Project manager’s instruction for dealing with an object of value or historical interest found on the site

• Project manager or supervisor changes a decision which he has previously communicated to the contractor

• Project manager unreasonably withholds an approval

• The supervisor instructs the contractor to search and no defect is found

• The supervisor does not carry out a test promptly

• Discovery of unexpected physical conditions

• Adverse weather which occurs less frequently than once in ten years

• Employer’s risk event

• Employer uses part of the works before both completion and completion date

• Employer does not provide materials facilities and samples for test as stated in the works information

• Changes in legislation.

5. Subcontracts

The PSPC Subcontract and SPC 2000 Standard Form of Specialist Contract provide for adjustment of the Target Cost for reasons similar to those in the main contract. In addition the Target Cost may be adjusted to take account of any additional cost which results from defaults by the contractor/constructor.

Fee

The payment process usually involves payment of the contractor/constructor’s cost plus a Fee. It is normal for the contract to define what the fee is intended to cover and whether and how the fee should be adjusted. The fee in all cases is intended to include the contractor’s profit.

• The PSPC main contract and subcontract provides for the Fee to be stated in the Appendix Part 3.

It is specifically stated that any costs which are not included in the Schedule of Cost are deemed to be included in the Contractor’s Fee. These contracts state that the Fee will not be adjusted.

• The ECC contract provides for a Fee percentage to be stated in Part two of the Contract Data

• The ICE Target Cost Version provides for a Fee percentage to be stated in the Form of Tender Appendix Part 2. Part 3 stipulates that the fee will include the following costs;

Legal and company secretariat

Senior management

Human resources

Finance, commercial, accounts, purchasing

Health and safety environmental and quality assurance

Administration

IT

• In PPC2000 any fee arrangement will be specifically included in the Price Framework

The lump sum fee is payable monthly in the PSPC contract and subcontract apportioned on a time basis in relation to the contract or subcontract period. In the case of the ECC and ICE Target Contract Version the fee becomes payable as a percentage addition to the costs which have been included in the payment certificate. In the case of PPC 2000 the matter of payment of the fee will be dealt with in the Price Framework.

Costs

There is no industry standard as to what constitutes payable costs it is a matter of what is either included in the contract or agreed by the parties. The standard contracts deal with this matter in the following manner:

1. Public Sector Partnering Contract

A definition of costs and what are allowed is set out in a Schedule of Costs

Clause 12 in this Schedule states that any costs which are not included in the schedule are deemed to be part of the Fee.

Disallowed Costs are listed in clause 14

• Costs the Contract Administrator considers to be excessive

• Costs of carrying out the work which does not comply with the contract

• Costs of replacing work which does not comply with the contract

• Cost which result from the inefficient use of labour

• Sums paid to subcontractors due to acts omissions or default of the contractor.

2. PPC2000

It will be for the parties to agree what constitutes cost and for it to be included in the Price Framework.

3. ICE Target Cost Version

Cost are defined in the definition section as the charges and costs attributable to the carrying out of the works and all expenditure incurred or to be incurred by the contractor whether on or off the site but not including any items included in the fee.

Disallowed Costs

Costs associated with:

• Repair, amendment, reconstruction, rectification and making good defects.

• Negligence

• Which cannot be reasonably be justified by the contractor’s accounts and records

• Plant, materials, equipment and resources not used in carrying out or providing the works

.

4. ECC Contract

Actual Cost is defined as the payments due to subcontractors for work which is subcontracted and the cost components in the Schedule of Actual Cost for work which are not subcontracted

Disallowed Costs

• Correcting defects

• Plant and materials not used in providing the works after allowing for reasonable wastage

• Equipment and people not used to provide the works or not taken away when requested by the Project Manager

Subcontracts

The SPC2000 Standard Form of Specialist Contract and the PSPC subcontract deal with cost in a similar manner to the main contract.

Gain Share /Pain Share

Gain Share occurs where the total costs and contractor’s fee for the project are less than the adjusted target cost. Any saving or gain share is shared between the employer and contractor usually on a pre-agreed percentage basis. The contract will normally state when the gain share/pain share is to be paid.

Pain Share occurs where the total costs and contractor’s fee for the project are greater than the adjusted target price. The pain share is usually shared between the employer and the contractor normally on a pre-agreed percentage basis. It is not uncommon for the employer to take no share of the pain which is then fully carried by the contractor.

The standard forms of Target Cost contract deal with pain share/ gain share in the following manner:

1. Public Sector Partnering Contract

The calculation of a gain share or pain share is set out in clause 20 which provides for the contractor’s costs and fee to be deducted from the adjusted target cost to give a positive or negative balance. Gain share and pain share percentages are stated in Appendix Part 3 as being applied to the balance. Payment by employer to contractor or contractor to employer will be provided for only in the Final Certificate

2. PPC 2000

Clause 13 makes reference to the Core Group seeking to agree incentives. Any incentives which may take the form of a pain share/gain share arrangement will be agreed and set out in the Price Framework

3. ICE Target Cost Version

The term gain share/pain share is not used in this contract. Clause 61(5) sets out the method of calculating a contractors share relating to differential percentage bands and share percentages set out in Appendix Part 2 to the Form of Tender.

The contractor’s share will be calculated and included in any certificate issued after the date of substantial completion. The share may be positive or negative. In the latter case the negative share will be deducted for money due to the contractor

4. ECC Contract

The contract data sets out the percentages to be used in calculating the contractor’s share. There is provision for certifying and paying the contractor’s share or a payment from the contractor to the employer on a monthly basis in accordance with clause 53. These payment are finally adjusted after completion of the works

5. Subcontract

The PSPC Subcontract deals with pain share/gain share in a similar manner to the main contract. Where the SPC 2000 Standard Form of Specialist Contract is used it will be a matter for the parties to agree what to include in the Price Framework for incentives.

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