Legally Bound

Jordan ...  the main criticism of TCCs is that they don’t offer anything new.

Jordan ... the main criticism of TCCs is that they don’t offer anything new.

Do target cost contracts hit the mark?

STUART JORDAN examines the pros and cons of target cost contracts, and indicates that they may possibly provide a way forward in contract conditions where there are real unknowns.

January 2019

We return this month to the topic of “Things We Don’t Do Much in the Middle East” by examining target cost contracts (TCCs). This is a construction contract pricing model which (its supporters say) offers both a collaborative approach and strong risk management.

It is always worth looking at ideas that promise to move our industry beyond the “zero sum game” of contract negotiation, where risks are simply allocated to one party or the other and the contract is priced accordingly.

In our quest for something else, we have previously examined partnering and alliancing models to see whether the fabled “win-win” can be achieved through modern, non-adversarial team working. The Gulf’s construction industry has remained sceptical about a lot of this; a view which I often share. We should, therefore, consider whether TCCs are similarly strange beings or something which could be of practical help.

In a TCC, the parties record in the contract an agreed target cost for completion of works. During the build, the works are valued and paid for on the basis of actual allowable cost, plus the agreed profit, overhead and risk contingency components – in the same way as a cost-reimbursable contract. The difference is only in the manipulation of the final outturn cost.

In the simplest TCC arrangement, if the outturn cost exceeds the target cost, the contractor will only be entitled to receive 50 per cent of the difference – and if the outturn cost is less than the target cost, the contractor receives an additional 50 per cent of the difference effectively as a bonus.

Most TCCs have both a “painshare” and “gainshare” element like this but parties usually agree to more complex sharing provisions, such as unequal pain and gain, or graduating bands, such as “50 per cent of the first 10 per cent of overrun, then 75 per cent above that”. To tweak the incentives, owners might also look to limit their exposure with a “guaranteed maximum price” cap.

Importantly, there remain risks which are not shared: Variations and legitimate money claims for delay and disruption due to agreed owner-risk events should increase the target cost as well as the actual cost. Equally, the contractor’s own inefficiencies are not “allowable cost”. This model can still be used where there are provisional sums. Where there is an instruction to expend a provisional sum, the target cost should be adjusted to match the difference between the provisional and actual cost.

Also, a target cost formula can be added to a remeasurement contract such as the Fidic Red Book. In this model, the contractor is paid during the build according to the actual quantities of work done (as remeasured) and calculated according to the agreed rates and prices. In terms of cost control before application of the formula, this is a more managed model than the fully cost-reimbursable basis described above.

There are several published versions of TCCs used internationally. The Institution of Chemical Engineers (IChemE) Burgundy Book (aimed as process engineering projects) and the NEC/3 Options C (reimbursable with target cost) and D (remeasurement with target cost) are the best known.

The real benefit of TCCs is that the owner and contractor are both incentivised on managing cost overrun because they both have a material stake in the outcome. At the same time, it has to be acknowledged, they each have less of an incentive than they would if they held all of that risk alone. And that is the main criticism of TCCs – that they don’t offer anything new; they just offer half of the advantages and half of the disadvantages of the other models. Contracting, therefore, remains a zero sum game, just with lower stakes.

TCCs have a place in the market, in my view. Some projects are too big and complex to be priced with accuracy. Some employ novel engineering solutions, or are to be built in difficult and unpredictable conditions. Owners and contractors have other tools available to them in the preconstruction phase to understand and mitigate risk. If that leads to a reasonable lump sum solution, then that’s fine. If it doesn’t and the parties are left to gamble on real unknowns, a TCC might be the way forward.

A word of caution though: the $19-billion Crossrail project in London used TCCs for the big tunnelling contracts and is a long way over budget. A third cash injection (worth $1.8 billion) was just announced. I should add quickly that the reasons for this are not yet known and might have been for owner-risk events which would have arisen in a fully lump sum project. We can, however, say that TCCs do not necessarily bring happy outcomes. 

* Stuart Jordan is a partner in the Global Projects group of Baker Botts, a leading international law firm. Jordan’s practice focuses on the oil, gas, power, transport, petrochemical, nuclear and construction industries. He has extensive experience in the Middle East, Russia and the UK.

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