Infra.Law
Pain and Gain
By Francis Ho
Complex developments, which may encompass challenging ground conditions, logistical hurdles or undefined scopes, demand a problem-solving culture. Subjecting such projects to a fixed-price arrangement, which places many key risks squarely on the contractor, can be a recipe for disputes and financial failure.
A cost-reimbursable regime – where the contractor is paid for the actual cost of the works, plus overheads and profit – would relieve contractor apprehensions. From a client's perspective, however, this model is typically only suitable for simple, repetitive work or for projects where budget is not a primary constraint. Target cost agreements offer a potential compromise. This variant on cost-reimbursement forgoes the notion of an absolute price. Instead, the parties set a target cost and a pain/gain share formula that financially incentivises them to deliver the project at or below this figure. The result is a commercial structure that compels the parties to work co-operatively for the good of the project. A key question is whether target cost is suitable where development finance is required. Even with pain/gain sharing, a contract with open-ended costs may offer little comfort to funders. For this reason, target cost is occasionally used with a guaranteed maximum price (GMP) to cap the employer’s financial exposure. This effectively transforms the arrangement into something akin to a fixed-price contract but satisfies a funder’s need for certainty on their maximum outlay. Of course, the introduction of such a ceiling can cause the collaborative mindset that the contract seeks to foster to evaporate. The cost-reimbursable aspects of the JCT’s new Target Cost Contract (TCC) are derived from its Prime Cost Contract while the remainder is based on the popular Design and Build Contract (DB). Instead of a contract sum, the contractor is paid the Allowable Cost plus the Contract Fee. The former constitutes the actual cost of the works but excludes costs arising from the contractor’s breach of contract or those which cannot be reasonably substantiated. The Contract Fee, which covers the contractor’s overheads and profit, can be a fixed amount or a percentage of the Allowable Cost.
To this, the JCT has added a pain/gain share mechanism, the Difference Share. Should the final Allowable Cost be lower or higher than the Target Cost, the resulting saving or overrun is shared between the parties according to the pre-agreed Difference Share. This is assessed and applied to each interim payment and the final payment. The Target Cost itself can be adjusted – for instance, due to changes and loss and expense – as can the Contract Fee (where it is a fixed amount). Many would have preferred the concept of "disallowable cost" to have been incorporated. While the TCC lists a limited number of exclusions from the Allowable Cost, a defined list of disallowable costs would have removed ambiguity. This omission perhaps illustrates the contrasting philosophies of the JCT and its primary competitor, the NEC. The NEC Engineering and Construction Contract, which offers the best-known examples of target cost pricing through Options C and D, adopts a highly process-driven approach, underpinned by meticulous programme management and strict notice procedures. That can be resource intensive. The JCT’s lighter touch may arise from the TCC’s roots in the DB, where the contractor’s assumption of fixed-price risk is balanced with wider discretion, reducing the need for rigorous project management. This may mean, however, that the TCC’s terms lack sufficient direction to mitigate poor attitudes or inexperience, particularly where parties are transitioning from a fixed-price mindset. Regardless, the launch of the TCC represents one of the most exciting contract developments in years. As the basis for some of the UK’s current infrastructure megaprojects, target cost is of increasing interest to the real estate sector as a means of balancing risk transfer with budget predictability. Previously, property developments using this model would typically amend the DB contract. With the launch of the TCC, the JCT has done the hard work.
A version of this article first appeared in Building magazine.
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