How practitioners set share fractions in target cost contracts

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Abstract

Research into target cost contracts has been undertaken at The University of Birmingham to understand the choice of share profiles used in practice. The use of target cost contracts is increasing and the research has shown that share profiles which vary with the extent of over or under run are more common today than constant share profiles. Seven examples of share profiles used in practice are described and the reasons for their choice are explained. These choices are then discussed in the context of key factors considered when choosing a contract strategy. The use of utility theory proposed by others for determining the share profile is briefly considered and the authors believe it is both insufficiently pragmatic and unable to deal with the complex interactions of the factors which should govern the choice of share profile.

Introduction

This paper is the result of research into target cost (TC) contracts (also known as cost-plus-incentive-fee (CPIF) contracts in America) and other innovative incentive mechanisms which has been undertaken in the School of Civil Engineering at The University of Birmingham. The second author is a principal author of CIRIA Report 85, target and cost-reimbursable contracts [1], which, although published in 1982, is still regarded by many in the UK as a seminal work. The purpose of the current research is to update the knowledge in that report and other published works, particularly with regard to:

  • •

    the increasing use of TC contracts as the contractual framework that underpins a partnering relationship;

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    the publication of new forms of contract, such as the NEC Engineering and Construction contract [2], which includes target cost options; and

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    how information technology has affected the administration of TC contracts.

This paper covers an area which was only briefly considered in the CIRIA Report: how different sharing fractions are set for cost over or under runs and how these fractions vary with the degree of cost over or under run compared with the target. The authors have termed this a share profile, governing the extent to which risks between the employer and contractor are shared.

The research methodology was a series of semi-structured interviews with practitioners. Some of these were conducted while the construction contract was in progress and some after. In some of the contracts, one of the authors has been involved in the decision making process.

Section snippets

Literature review

Al-Subhi Al-Harbi in a paper previously published in this journal — “Sharing fractions in cost-plus-incentive-fee contracts” [3] — gave an extensive literature review on risk studies, albeit with a strong North American bias. He identified a lack of literature giving guidance on the setting of share fractions in TC/CPIF.

The references in this paper include European literature on general risk allocation [4], [5], [6], [7], [8] which should help practitioners follow the evolution of thinking on

Towards practice

In a cost reimbursable contract, the contractor is reimbursed his actual costs1 plus a fee. The fee covers anything not covered in the definition of actual costs, such as off-site overheads and profit. This fee can either be fixed or a percentage of actual costs. The latter is illustrated in Fig. 1. Using this figure, to work out the total paid by the employer, you first determine the

Practice

Fig. 3 shows a share profile used in practice.2 It was for a term repair and maintenance contract on a city water network, where the contractor had tendered on a schedule of rates basis. The items in the schedule would be called off as required by the employer. At the contractor's suggestion, it was converted to this format with the target — built up

Conceptual overview

The choice of a share profile is the culmination of a series of decisions made in the context of selecting an appropriate contract strategy. During the research the authors found it useful to develop a working description of the purpose of contract strategy as follows:

“the alignment of the motivations of the parties so as to maximise the likelihood of project objectives being achieved, taking account of the constraints and risks that act on the project and the strengths and weaknesses of the

Use of utility theory as means of setting the share profile

Al-Subhi Al-Harbi [3] in his paper ‘Sharing fractions in cost-plus-incentive-fee contracts’ suggested using utility theory as a means of setting the share fraction in TC contracts. The authors have two problems with this approach:

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    Weitzman in his paper ‘Efficient incentive contracts’ [19] states that “while the basic theoretical issues (of utility theory) are well understood, results are at a rather higher level of abstraction, somewhat removed from the realm of practical application”. After

Conclusion

Having given the background to the research and explained how a share profile is illustrated, various share profiles were presented all of which are based on those used in practice. Sufficient background to the projects was given so that the reader could understand the reasons for the particular share profile being used. These reasons appear, initially, to be contract or project specific.

However, some common themes emerged in the course of the research. These themes were highlighted in the

Acknowledgements

The authors would like to acknowledge the time given by practitioners and the financial support given by the following companies which has allowed this research to progress. The sponsoring companies are, with largest contribution first: London Underground Limited; National Power plc; Anglian Water Services Ltd and UKAEA.

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