International Journal of Project Management 20 (2002) 5966

www.elsevier.com/locate/ijproman

How practitioners set share fractions in target cost contracts

Jon Broome, John Perry *
Management Group, School of Civil Engineering, The University of Birmingham, Birmingham B15 2TT, UK

Abstract Research into target cost contracts has been undertaken at The University of Birmingham to understand the choice of share proles used in practice. The use of target cost contracts is increasing and the research has shown that share proles which vary with the extent of over or under run are more common today than constant share proles. Seven examples of share proles 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 prole is briey considered and the authors believe it is both insuciently pragmatic and unable to deal with the complex interactions of the factors which should govern the choice of share prole. # 2001 Elsevier Science Ltd and IPMA. All rights reserved.
Keywords: Contract strategy; Target cost contract; Incentive contract; Utility theory

1. 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; . the publication of new forms of contract, such as the NEC Engineering and Construction contract [2], which includes target cost options; and . how information technology has aected the administration of TC contracts.

This paper covers an area which was only briey considered in the CIRIA Report: how dierent 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 prole, 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. 2. 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 identied 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 [48] which should help practitioners follow the evolution of thinking on risk allocation, although they do not address the specics of

* Corresponding author. Tel.: +44-121-414-5154; fax:+44-121414-3675. E-mail address: j.g.perry@bham.ac.uk (J. Perry).

0263-7863/01/$20.00 # 2001 Elsevier Science Ltd and IPMA. All rights reserved. PII: S0263-7863(00)00035-1

60

J. Broome, J. Perry / International Journal of Project Management 20 (2002) 5966

target cost contracts. While there is European literature on Target cost contracts [1,913] which mentions or gives some guidance on the setting of share fractions, none of the references address the issue in any detail. Consequently, the authors consider it worthwhile to approach the topic from the other direction that of practice. 3. 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 denition of actual costs, such as o-site overheads and prot. This fee can either be xed or a percentage of actual costs. The latter is illustrated in Fig. 1. Using this gure, to work out the total paid by the employer, you rst determine the actual costs incurred by the contractor, and then go up from the horizontal axis, adding on the appropriate fee, before going horizontally back to the vertical axis to gain the answer. In a TC contract, a target price is introduced. The target is the fulcrum around which the incentive mechanism operates [9]. Any cost under or over run against this target is split in pre-agreed, specied proportions. This is illustrated in Fig. 2. with a 50:50 split, i.e. the share line bisects the angle between the actual cost plus fee line and the horizontal target line. It is this share line which now determines the total paid by the employer, as illustrated by the thick dotted line in Fig. 2. This can be expressed algebraically as: Total paid out by employer actual costs fee target cost actual costs contractor's share There is now a motivation for both parties to work together to minimise actual costs: for the employer to minimise the total sum paid out and for the contractor to maximise his prot above that included in the fee. 4. Practice Fig. 3 shows a share prole 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 o as required by the employer. At the
1 The authors have, for convenience, adopted the terminology of the NEC Engineering and Construction Contract [2]. 2 The reader should note that all the gures for share proles are for illustrative purposes and are not drawn to exact scales and dimensions.

contractor's suggestion, it was converted to this format with the target built up using the tendered schedule of rates being reconciled with the contrator's actual costs on a three monthly basis. The contractor realised that, if the employer prioritised his maintenance schedule, there was an opportunity to save time in travelling between, and setting up at, dierent locations which would result in cost savings. The contractor also realised that without a share of the savings, the employer had no motivation to prioritise his maintenance schedule. One of the reasons why the employer accepted this arrangement was that his nancial committment would not be more than that under a schedule of rates payment mechanism. A variation on this theme is given in Fig. 4. This share prole was used for a large construction project

Fig. 1. Cost-reimbursable contract with percentage fee.

Fig. 2. Target cost contract with 50:50 share prole.

Fig. 3. Share prole with capped employer commitment.

J. Broome, J. Perry / International Journal of Project Management 20 (2002) 5966

61

($100+million) by an employer with no repeat order business and a budget constraint, hence the cap at 110% of the target. To balance this, a large share of any savings made (75%) would be given to the contractor if actual costs plus fee came in below 90% of the target. The contract was put out to tender with the employer stating a minimum level of performance that the asset had to meet, but with the contractor being selected on the best proposal oered for the stated target. The contractor was predominantly responsible for the scope design and the detailed design. Once the contract was awarded, the intention was that any projected savings in actual cost plus fee compared with the target would be re-invested in the project, again in order to get the best asset possible for the xed budget. This re-investment would be in the form of a scope change which would increase the target, thus allowing the contractor another opportunity to earn a share of any savings. This, in combination with the contractor having control over both scope and detailed design and, therefore, having plentiful opportunity to decrease costs as the project progressed, accounts for the relatively low contractor's share in the 90110% range of the target. However, a danger of using a cap on the employer's commitment is that once it is perceived that actual costs plus fee will exceed the cap, then the employer's motivation to work with the contractor to reduce actual costs is substantially reduced. This is because the employer will pay out the same amount, regardless of how much the actual costs plus fee exceeds the cap. For this reason, one relatively large employer with repeat order business for the same sort of work introduced a progressive cap on framework contracts, whereby the contractor progressively takes a greater share of any overrun until, at above +30% of the target, he takes 100% of any further cost over run. As the work is of a familiar type and the contractor is party to setting the target, it is unlikely that this point would be reached. This prole is illustrated in Fig. 5. Another reason for having a progressive cap was to avoid the

contractors including excessive risk contingency in the target: risk which the employer, in terms of his ability to absorb nancially, is better placed to take. The contractor still has the incentive to manage the risk, both because of the eects of the share prole and his desire for repeat order business. The latter reason is also why the contractor is allocated a comparatively small share of any savings. So far, all the contracts illustrated have had a relatively small chance of large cost overruns and/or a xed cost constraint. However, one area identied as suitable for the use of TC contracts by the CIRIA Report [1] was in high risk projects with a high likelihood of cost escalation. The share prole for a relatively risky project is shown in Fig. 6. Here the project was the breaking out and replacement of a concrete slab above an underground railway station and below a road junction situated in the nancial centre of a capital city. The works were subject to numerous constraints and risks hours of working, noise and vibration levels, trac management (a temporary bridge over the site had to be constructed), a restricted time window (which if exceeded would lead to widespread and bad press coverage) and many telecommunications cables servicing large nancial institutions. The design of the new work was developed with the input of a contractor who was paid on a time fee basis.

Fig. 5. Share prole with progressive cap.

Fig. 4. Share prole with capped employer commitment and any savings re-invested in the project.

Fig. 6. Share prole for medium risk project and nancially strong client.

62

J. Broome, J. Perry / International Journal of Project Management 20 (2002) 5966

This was so that buildability and risk issues could be addressed. The target was subsequently developed with the contractor on an open book basis, where the employer was able to see the estimates of potential subcontractors, calculations of productivities, type and amounts of resources etc. This places an extra burden on the employer in terms of the time taken to evaluate the contractor's tender compared with a straight comparison of lowest cost under a competitive tendering regime. However, the employer's condence in the contractor's proposals is greatly increased. Both the contractor and employer took the view that if actual costs plus fee were outside the band of 10% of the target, then both their estimates for the known work (including risks within the target) would have been seriously wrong. If a signicant cost under run occurred, it was, therefore, felt unreasonable for the contractor to make excessive prots, so the contractor was allocated a low share of savings below 90% of the target. On the over run side, the employer was a large one (spending over $1 billion on infrastructure and its maintenance per year), whereas the contractor had a turnover of around $50 million per annum. The employer was, therefore, better able to absorb any over run due to nancial strength. On another contract, the purpose of the works was to install a sewerage pipeline out to sea. Conventionally, this involved digging a trench from a ship, laying the pipe in the trench and then backlling it. At the time, directional drilling was a relatively new technology: indeed there were only two contractors within Europe who oered this service and both were in demand. The same level of performance could be achieved for potentially a quarter of the cost of doing it conventionally. However, the technology was not mature, so there was a high risk of equipment breakdowns occurring and, because of the demand and risks associated with the work type, the contractors were used to working on a cost reimbursable basis. Despite the technological risk being more in the contractor's control, they were in a strong position to charge a high premium for taking this risk. The employer, however, did not wish to pay a large premium for risk which may not occur, and recognised that they were in a stronger position nancially to take the risk of a cost overrun than the contractor, especially as, by their standards, it was a relativelly small contract. The share prole adopted is shown in Fig. 7. A comparatively small percentage share of any over run is allocated to the contractor, but enough, the employer hoped, to motivate the contractor to minimise any over run. The thinking behind the large share of any savings below the target being allocated to the contractor was that it gave him the opportunity to make a comparatively large prot if no breakdowns occurred. This would lead to a competitive tender target with the contractor making more eort to prevent equipment break downs once the contract was awarded.

The CIRIA Report [1] identied the use of a neutral or target band to indicate the degree of condence in the target and to impose limits on the fee. A neutral band is where, if the actual costs plus fee fall within the band, then the contractor is reimbursed these costs plus Fee only, with no deduction or addition from the application of the share formula. A share prole with a neutral band is illustrated in Fig. 8. This share prole was used for the purchase of two relatively low technology buildings and, therefore, low risk projects. An outline design was developed by the employer's internal designers and the contractor selected on a number of factors including their tendered fee percentage, but not a tendered target. This was specied by the employer as he had good historical data on the cost of similar buildings. Once the contract was entered into, the internal designers were responsible for the detailed design, but the parties value engineered together and the contractor contributed his ideas on buildability. The reasons for the share prole are:
. The neutral band reected the degree of condence that the employer had in the out turn costs if procured by a traditional procurement route. . As the scope design was complete and it was a low complexity building, the potential for large savings in cost was limited, so the contractor was given a

Fig. 7. Share prole for risky project, nancially strong client and risk-averse contractor.

Fig. 8. Share prole with neutral band.

J. Broome, J. Perry / International Journal of Project Management 20 (2002) 5966

63

large share of any savings below the neutral band in order to motivate him to commit sucient management resources to produce cost savings. . The employer was constrained by a xed budget, so he capped his nancial commitment at 10% above the target (although the target could still be adjusted upwards for additional work). Neutral bands could also be appropriate where the two parties cannot agree what the likely actual costs of elements of the work are and the band then covers the dierence. The nal example is illustrated in Fig. 9. It was used for each of about ten civil engineering contracts on a very large construction project ($2 billion plus). A major risk to the employer was that if one work package was late, then the opening of the whole asset would be delayed and the employer would be getting no return on his investment. Each contract package was substantially designed prior to tender on a competitive basis with the target price being a major factor in the selection of the contractor. However, as suggested by the CIRIA Report [1], contractors were also asked to provide detailed programmes with method statements and resources, expected productivities, risk allowances, etc., in order to assess the likelihood of achieving both the cost and time targets. The share prole was decided upon for the following reasons: As there was a high degree of condence that the nal actual costs plus fee would be in the vicinity of the target, a share of 25% was allocated to the contractor if the actual cost plus fee was between 90 and 120% of the target. This was deemed sucient to motivate the contractor. For savings of more than 10% of the target, the contractor was allocated a 50% share in order to motivate him to strive for large savings. If the target was exceeded by more than 20%, then it was recognised that something had gone seriously wrong with a contract, and on contract packages this large in some cases over $150 million the contractor may well be unable to bear a signicant loss. If allocated this

loss, then the contractor would then probably become adversarial and, in extreme circumstances, bankrupt. Neither scenario would aid the timely opening of the whole project. For these reasons a comparatively small percentage (10%) was allocated to the contractor for over runs exceeding 20% of the target. This would eliminate any further contribution to prots and osite overheads- typically between 8 and 10% in the civil engineering sector so the contractor would be comparitively neutral about actual costs if this sharing fraction was reached. However, the damages for delay would still motivate the contractor to spend money in order to reduce time, which was of great importance to the employer. 5. Conceptual overview The choice of a share prole 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 parties to it''. The words in italics represent the principal issues which need to be considered when developing a contract strategy. They were used as prompts during the interviews in order to explore the extent to which they inuenced both the selection of a target cost contract and the subsequent choice of share prole. A framework of concepts related to these key issues is given below to inform the discussion of the share proles used in practice.
. Alignment of motivations/project objectives: project objectives for each of the parties should reect the business objectives. For a contractor, the main business objective is ultimately prot. For an employer, the project objectives should be an optimum combination of time, cost and performance/quality which contributes to their business objectives. The minimum cost objective is normally relevant when discussing TC contracts as they provide a joint motivation to minimise costs (the employer's objective) in order for the contractor to maximise his prot. This aspect has been noted in various research reports up to the mid-eighties [1,14]. This factor, in combination with the openness that open book accounting3 engenders, was given by interviewees within the research as one of

Fig. 9. Share prole for multi-contract project.

64

J. Broome, J. Perry / International Journal of Project Management 20 (2002) 5966

the principal reasons for the decision to use a TC contract. It was the reason for the contractor proposing the prole illustrated in Fig. 3 and for the proles below the target cost in Figs. 57 and 9. In Fig. 9, however, the employer also had a strong time objective for each contract package it must not delay the opening of the project and, therefore, adjusted the prole for a cost overrun situation so that the contractor would be more motivated to spend money to nish on time. In the examples illustrated in Figs. 4 and 8, the employers' objective was to obtain the best facility available a quality objective within their budgetary constraint, so any savings were reinvested in the project. . Constraints: can be time, e.g., latest project completion date or access, or physical, e.g. noise levels or access. In TC terms, the constraint is normally cost. For instance, a xed budget available for that project. If this point is reached, the employer's risk aversion may suddenly increase. This is evident in the examples illustrated by Figs. 3, 4, 8 and to a lesser extent 5, where the employer's exposure to any cost over run is limited by allocating all of it to the contractor above a certain percentage of the target. . Risks: should be identied and analysed before the appropriate response is determined. The classic responses are avoid, reduce, transfer, retain or insure [15]. If they are included in the target, then they are shared. This was the predominant reason for using a TC contract in the examples illustrated by Figs. 6 and 7. The share proles partially reect the degree of risk thought to be present. Stuckhart stated, `risk' is the possible exposure to economic loss or gain'' [16]. A risk in the ``gain'' sense could, for example, be the potential for cost savings to be achieved on the target through the use of value management techniques or through integrating processes. The former is the type of scenario advocated by Trench for the use of target cost contracts for the design and construction of oce buildings [12]. It is evidenced by the examples illustrated by Figs. 4 and 8 and to a lesser extent Figs. 5 and 9 where the gains would be more from value engineering. The examples illustrated by Fig. 5 and especially Fig. 3 anticipate gains from process improvement. However, in these examples it should be noted that shares of any savings allocated to the contractor vary considerably. . Strengths and weakness of the parties: can, for instance, relate to the work breakdown structure and who takes responsibility for dierent parts of
The contractor's accounts of actual costs are open to full inspection by the employer.
3

the work. In the TC contract context, the strengths and weaknesses of the parties relate to two points:  ability to manage an aspect of the project process or specic risks. A principal reason for employing a contractor is his ability to manage construction and its associated risks;  the relative nancial strengths of the parties to the contract. In the UK civil engineering and building industries, prot on turnover probably averages around 2%. If one considers that the average contractor in these sectors turns their capital invested over six or seven times per annum [17], then a 1% change in their prot on turnover leads to a 6 or 7% change in their return on investment. Bearing this in mind, it is not surprising that contractors are risk averse and would imply that the sharing fraction for a project dominated by neutral risks that is risk which each party has a similar degree of inuence over or uncontrollable risks which are included in the target should be weighted heavily towards the Employer. As Ashley et al. [18] stated: ``with contractors and designers under capitalised relative to the size of risk they face, the costs . . ., of accepting such risks would be higher than to the owner, who is typically less risk averse''. Hence, neutral risks are usually excluded from the target. The latter reason is very evident in the share proles used for cost over runs illustrated in Figs. 6, 7 and 9. It is also the reason for the employer taking a high percentage of any initial overrun in Fig. 5. Lastly, the strength of an employer might be the ability to give repeat order business to the contractor, i.e. a constant prot stream of a reasonably certain level, in which case contractors may be willing to accept lower rewards on any individual contract in exchange for increased certainty of prot in the longer term, i.e. a lower share of savings on a target cost contract. This is evident in the example illustrated in Fig. 5. 6. Use of utility theory as means of setting the share prole 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:
. Weitzman in his paper `Ecient incentive contracts' [19] states that ``while the basic theoretical issues (of utility theory) are well understood,

J. Broome, J. Perry / International Journal of Project Management 20 (2002) 5966

65

results are at a rather higher level of abstraction, somewhat removed from the realm of practical application''. After giving an example, he summarises by saying ``this conclusion accords with common sense''. ``Common sense'', as described in this paper, requires consideration of the factors aecting contract strategy (as discussed in the section titled `Conceptual overview' of this paper). The interaction of these factors and the practical issues involved do not seem amenable to solution by mathematical theory. . Utility theory assumes a constant level of risk aversion for each party, whatever the size of a cost over run. Consequently, it assumes a constant sharing fraction however large the potential over (or under) run. While constant share fractions have been observed in practice, variable fractions for varying levels of cost over and under run appear to be far more common. Considering that utility theory has been in existence for at least 20 years, the authors of this paper suggest that if the theory had a practical application, then it would be in common use or, at the very least, its successful application would have been reported. Despite reading papers suggesting its application in the construction environment [3], defence contracting [19], labour contracts [20], investment banking [21], and general business [22,23], the authors of this paper have not yet come across a paper reporting its use in practice and, therefore, deduce that it has little or no practical application. Ward and Chapman, in a paper titled `Choosing contractor payment terms' [24] would appear to agree with these authors' scepticism. 7. Conclusion Having given the background to the research and explained how a share prole is illustrated, various share proles were presented all of which are based on those used in practice. Sucient background to the projects was given so that the reader could understand the reasons for the particular share prole being used. These reasons appear, initially, to be contract or project specic. However, some common themes emerged in the course of the research. These themes were highlighted in the `Conceptual overview' section of this paper, where the authors proposed a working denition of the purpose of contract strategy: ``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 parties to it''. Each of the matters in italics were highlighted as being relevant when setting the share proles illustrated in the paper.

It is the intention of the authors of this paper to write a further paper providing more analysis and guidance on setting share proles. The treatment of risks within target contracts and their interaction with the choice of share prole also needs further consideration. This will draw upon share proles included in this paper and others encountered within the research and will also develop the fundamental analysis of target contracts published elsewhere by Perry and Barnes [25]. In the meantime, each of the share proles illustrated could be used as a `template' when practitioners encounter a contract with similar circumstances. Alternatively, the denition of the purpose of contract strategy can be used to develop a share prole more suited to the particular circumstances of the contract. Positive feedback has been received in this respect from industrial sponsors and through the authors' consultancy experience. In terms of being of use to practitioners, the authors consider this approach to be of far more use than utility theory. Acknowledgements The authors would like to acknowledge the time given by practitioners and the nancial support given by the following companies which has allowed this research to progress. The sponsoring companies are, with largest contribution rst: London Underground Limited; National Power plc; Anglian Water Services Ltd and UKAEA. References
[1] CIRIA Report R85. Target and cost reimbursable contracts. (1) Perry JG, Thompson PA. Part A: a study of their use and implications; (2) Perry JG, Thompson PA, Wright M. Part B: management and nancial implications; (3) Perry JG, Thompson PA, Wright M. Part C: preparation of contract conditions. London (UK): Construction Industry Research and Information Association, 1982. [2] Institution of Civil Engineers. The NEC engineering and construction contract. (1) Option C: target contract with activity schedule; (2) Option D: target contract with bills of quantities. London (UK): Thomas Telford Ltd, November 1995. [3] Al-Subhi Al-Harbi KM. Sharing fractions in cost-plus-incentivefee contracts. International Journal of Project Management 1998;16(2):7380. [4] Barnes M. How to allocate risks in construction contracts. The International Journal of Project Management 1983;1(1):248. [5] Abrahamson MW. Risk management. The International Construction Law Report 1983;1(3):24163. [6] Hayes RW, Perry JG. Risk and its management in construction projects. Proceedings of the Institution of Civil Engineers 1985;1(77):479521. [7] Ward SC, Chapman CB, Curtis B. On allocation of risk in construction projects. International Journal of Project Management 1991;9(3):1407. [8] Perry JG. The New Engineering Contract: principles of design and risk allocation. Journal of Engineering, Construction and Architectural Management 1995;2(3):197208.

66

J. Broome, J. Perry / International Journal of Project Management 20 (2002) 5966 [18] Ashley DB, Levitt RE, Logher RD. Allocating risk and incentive in construction. Journal of the Construction Division, ASCE, 1990;106:297305. [19] Weitzman ML. Ecient incentive contracts. The Quarterly Journal of Economics, June 1980. [20] Fabel O. Implicit contracts with eort incentives. Zeitschrift fur Nationalokonomie, Spring 1990. [21] Baron DP, Holmstrom B. The investment banking contract for new issues under asymmetric information: delegation and incentive problem. The Journal of Finance 1980;XXXV(5). [22] Demski JS, Sappington D. Optimal incentive contracts with multiple agents. Journal of Economic Theory 1984;33:15271. [23] Sappington D. Incentive contracting with asymmetric and imperfect precontractual knowledge. Journal of Economic Theory 1984;34:5270. [24] Ward S, Chapman C. Choosing contractor payment terms. International Journal of Project Management 1994;12(4):21621. [25] Perry JG, Barnes M. Target cost contracts: an analysis of the interplay between fee, target, share and price. Journal of Engineering, Construction and Management 2000;7(2):2028.

[9] Blyth AH. Design of incentive contracts: basic principles. Aeronautical Journal 1969;73:11924. [10] Walker D. The inuence of incentive provisions on project management. Aeronautical Journal 1969;73:1258. [11] Herten HJ, Peeters WAR. Incentive contracting as a project management tool. Project Managment 1986;4(1):349. [12] Trench D. On Target: a design and management cost procurement system. London (UK): Thomas Telford Ltd, 1991. [13] Roseneld Y, Geltner D. Cost-plus and incentive contracting: some false benets and inherent drawbacks. Construction Management and Economics 1991;9:48192. [14] Schneider M. Draft 3 of PhD thesis on Cost reimbursable contracts, 1986/1987. [15] Hillson D. Take no risks with risk. Project The Magazine of the Association for Project Management 1999;12(1). [16] Stuckhart G. Contractual Incentives. Journal of Construction Engineering and Management, ASCE 1985;110(1):3442 [17] Potts K. Major Construction Works: Contractual and Financial Management. Harlow (UK): Longman Scientic and Technical, 1995.