Cost plus incentive fee contracting — experiences and structuring

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Abstract

In this paper the contractual relationship between owner and Engineering Contractor during the development and implementation of capital investment projects is considered. The described Cost Plus Incentive Fee contract type provides a mechanism for allocating project cost risk to the owner, being the party best placed to bear the cost risk consequences and providing a performance incentive for the Engineering Contractor, being the party best placed to manage the cost risk. The results of an analysis of eight case studies involving major capital investment projects from the oil and chemicals industry are presented and a quantitative methodology for structuring incentive schemes is described and illustrated.

Introduction

During the last decades many owners in the oil and chemicals industry have reduced their (hands-on) involvement in the management of capital investment projects for the realisation of new or modified manufacturing facilities. Most of the Engineering, Procurement and Construction Management (EPCM) work for the implementation of projects is currently carried out by Engineering Contractors (ECs). Increasingly, ECs are also involved in project development which for the purpose of this paper is defined as the stage(s) leading up to final evaluation/approval of a project, prior to project implementation. Although owners have reduced their in-house engineering and project management resources their interest in effective project management remains. Consequently, the way in which the owner — EC relationship is managed has become increasingly important and selection of the EPCM contract type must be an integrated part of establishing the overall project execution strategy. In this way the EPCM contract becomes a management tool, rather than merely the terms and conditions of EC payment. When the type of EPCM contract is selected the ability of contract parties to bear the consequences of the cost risk and the ability of contract parties to manage this risk has to be taken into account [1]. However, in most cases the owner is best placed to bear the cost risk consequences, whilst (with most of the EPCM work carried out by the EC) the EC is best placed to manage the cost risk.

Incentive contracts for EPCM aim to overcome this problem. This type of contract has received considerable attention, particularly in the economics literature. However, relatively little has been published in terms of practical experiences. This paper aims to make a contribution towards filling this gap. The general principles and objectives are described of a Cost Plus Incentive Fee (CPIF) contract for EPCM where the cost risk of the project is born by the owner, the EC’s profit is at risk but there is no risk of loss for the EC. The results of an analysis of eight case studies involving major capital investment projects from the oil and chemicals industry are discussed. Finally, a quantitative methodology for structuring the incentive scheme of this type of contract is presented.

Section snippets

Contracting for project development and implementation

Project development work carried out by an EC often includes not only basic design engineering but also the compilation of a cost estimate, a schedule and other information required for project implementation. This work is mostly done on the basis of a reimbursable type contract, due to the inherent uncertainty regarding the project scope. After completion of the development work the owner has the option to negotiate an EPCM contract with the ‘development EC’, or to put the EPCM work out for

Contract types for project implementation

Various contract types are in use for project implementation. With a Lump Sum/Fixed Price (LSFP) contract, the EC is paid a specified fixed contract sum for the entire scope of work. The cost risk is born by the EC. Included in the contract sum is the premium which the owner has to pay for the EC carrying the cost risk. Regarding project objectives other than cost (e.g., technical requirements, safety, etc.) there is no inherent (financial) performance incentive for the EC under a (plain) LSFP

Cost plus incentive fee contracts

With the CPIF contracts described in this article the owner pays all costs associated with the project including the EPCM (man-hour) costs. With respect to the EPCM man-hours this includes salaries of EC personnel and costs associated with overheads, legal obligations, travel, etc. but excludes EC profit. Generally, purchase orders for materials/equipment and construction contracts are placed after competitive tendering on a LSFP basis. Costs must be properly incurred and directly related to

Case studies

Eight case study projects from the oil and chemicals industry, have been analysed. The projects were implemented during 1993/98 with TIC per project ranging from approx. US $50 – 2000 mln. (present value November 1998).

As shown in Fig. 2, on average there was an actual cost underrun of 2.8% of the (final) target cost. The latter includes approved scope changes which on average constituted some 4.5% of the (initial) target cost, with the largest scope growth occurring on those projects of a

Structuring the incentive scheme

As indicated in Eq. (1), the available incentive fee IF is a function of (actual) project cost c. Subject to a systematic cost estimating methodology and the availability of reliable, statistical data, anticipated project cost can be described by a probability density function f(c). Given an incentive fee function IF(c) and probability density function f(c), the anticipated value of the incentive fee can subsequently be calculated by multiplying IF(c) and f(c) and performing an integration for

Conclusion

The grown involvement of ECs in the development and implementation of capital investment projects has made the contractual arrangement between owner and EC, increasingly important. CPIF contracts for EPCM provide a mechanism for allocating project cost risk to the owner, who is the party best placed to bear the cost risk consequences, whilst at the same time it provides a performance incentive to the EC who is the party best placed to manage the cost risk. In order to be effective, the

Kees Berends is a project consultant with Shell International Chemicals B.V. and has been working as a Project Engineer, Project Manager and Contracts Manager at various locations of the Royal Dutch/Shell Group. He holds a Master’s degree in mechanical engineering from the Technical University Eindoven, The Netherlands and an MBA from Henley Management College, UK.

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Kees Berends is a project consultant with Shell International Chemicals B.V. and has been working as a Project Engineer, Project Manager and Contracts Manager at various locations of the Royal Dutch/Shell Group. He holds a Master’s degree in mechanical engineering from the Technical University Eindoven, The Netherlands and an MBA from Henley Management College, UK.

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