June 14, 2021
Due to inherent problems with the traditional Lump Sum Contract and Cost-Plus Contract procurement method in terms of project cost and risk, Target Cost Contracts (TCC) are increasingly becoming the contractual model of choice for large scale projects.
This article will explore the perceived benefits of adopting the TCC based procurement strategy when accompanied by the gain-share/pain-share arrangement, and why it could be implemented in your next project to increase value for money and improve overall project performance for the principal.
Lump Sum Contracts and Cost-Plus Contracts
Traditional lump-sum contracts are the recognised agreement of choice in the construction industry for most small projects, projects with a well-defined scope and where the risk of different site conditions is minimal due to the reduced design and contract administration costs.
In lump-sum contracts the risk is assigned entirely to the contractor who must take care of (and importantly price) all possible unforeseen contingencies. The contractor will assess the risks involved in delivering the project requirements and will include a ‘risk value’ to offset the perceived level of risk, usually resulting in an increased contract price. While there is a lower risk placed on the principal, typically contractors are not required to provide a detailed breakdown of costs. Rather, the payment of the total contract price is linked to the contractor completing all the work. This means it can result in a high cost for the principal or a poor project outcome as the contractor will try to increase profit margin, or will use cheaper materials to stay within budget.
Similarly with cost-plus contracts, the parties agree on a price for the actual cost of the project to which it is the responsibility of the contractor to complete the project within the budget and within the set time frame. However, the principal must also cover overhead costs and an agreed profit. In this case, it benefits the contractor as there is no risk of loss arising from changing prices or wrong estimates as all agreed costs are recoverable. Additionally, the principal benefits in terms of quality as the contractor is likely to use the best labour.
However, it is likely the principal will pay much more than expected due to the uncertainty in final contract price and there is the risk contractors may take advantage to increase their profits (e.g. contractor will deliberately incur higher prime cost).
Target Cost Contracts
Conversely, TCC contracts work by setting a fixed target cost based on given parameters at the outset of the project. Any savings or overruns between the target cost and the actual cost at completion date is split between the contracting parties in accordance with the pre-determined share ratio.
The TCC procurement strategy generates a plethora of benefits throughout the whole delivery process, including:
- inclusion of a gain-share/pain-share arrangement serving as a cost incentive mechanism;
- ability to monitor the project progression in a real time format;
- aligning individual goals of various contracting parties with the overall project objectives;
- achieving better value for money by monitoring work completed against target cost and payment claim; and
- more satisfactory overall project performance in terms of time, cost and dispute occurrence.
The theory of the pain share/gain share mechanism is that by implementing an incentivisation agreement contractors will work efficiently and achieve cost saving, which in turn aligns the financial interests of the contractor and the principal and can produce a better project outcome. Hence, TCC produces a desirable ‘win-win’ situation for both the principal and contractor.
TCC is a relatively untested model within the Australian construction industry, however, our team at Lamont Project and Construction Lawyers have the knowledge and experience to assist with all TCC questions and any contractual issues with railway projects you may be encountering. If you would like to discuss any matters raised in the article as it relates to your specific circumstances, please do not hesitate to contact us.