The current market conditions will substantially enable owners to call the shots when it comes to contracting strategy. Stipulated price is the most potent motivator of performance and the reason why Revay has seen resurgence in stipulated price and design-build delivery strategies of late.
Design-build increases the likelihood of construction within the owner's budget, chiefly because contractors are best placed to provide prices and information regarding construction methods and design-build affords the contractor the opportunity to conduct value engineering and constructability analysis from project inception. But design-build is only suitable for owners who have sufficient nerve to refrain from meticulous supervision and for projects wherein change will be limited.
The Construction Industry Institute has collated data regarding the incidence of change in design-build contracts for industrial, residential and commercial sectors and concludes that, on average, the additional cost attributable to change equates to 9% of the original price. This is, perhaps, still too high to realize the full potential of the design-build strategy.
Nevertheless, design-build has proved to be a quick and cost effective mode of project delivery and is appropriate for organized and trusting clients provided a comprehensive project brief is available at the outset. Data gathered by the Design-Build Institute of America indicates that this delivery approach is gaining in popularity; in 1993 the contribution of design-build on American non-residential construction was negligible; today it accounts for some 40% of American nonresidential construction.
In the absence of a stipulated price, owners must look to other mechanisms to motivate performance. A well worn, but often ill thought out, example of this is target cost contracting. Many owners in the Prairie Provinces are still clinging to target cost contracting, even in the face of a "buyer's market", while others remain saddled with target cost contracts that were negotiated in a "seller's market". Target cost contracts are intended to motivate performance by enabling the contractor to share in any cost savings measured as the delta between actual cost and the target. They also serve to encourage timely performance by allocating to it liability for a share in any cost over runs.
The potential to share in savings (or conversely the potential to shoulder some of the cost over run) is realized through a mechanism, known as the "pain:gain share". The pain:gain share makes for relatively strong motivation only when certain conditions are met. However, in certain circumstances a target cost contract does not, of itself, provide any incentive to minimize cost, rather it does the exact opposite. If the gain share is low, the contractor's strategy will be to maximize fee rather than benefit from any potential gain share. This issue is important because owners tend to adopt the policy of awarding to the bidder who provides the lowest target.
The typical compensation components in a target cost contract are:
- Actual costs - these are reimbursed on a monthly basis as work proceeds.
- Fee - which can be either a lump sum or a percentage of the aggregate actual costs; the fee may be payable on the basis of milestones or at monthly intervals; and
- Payout or deduction on the basis of the pain:gain share - generally the amount is calculated on the basis of a percentage split that remains constant irrespective of the magnitude of saving or cost over run, although schemes involving a complex graduated scale of percentages determined by the magnitude of saving or cost over run are not uncommon.
Under all fee arrangements, if the contractor reduces the target while increasing the fee, for any pain:gain share percentage, the price payable will increase, irrespective of the aggregate actual costs. If the contractor's share of the potential savings is low, it will be motivated to increase the fee at the expense of the target. The corollary is: owners choosing between competing bids where target and fees are comparable should opt for the bidder who provides the lowest fee. Alternatively and more typically, the owner will be faced with competing bids in which targets and fees differ wildly. In such a situation, the price differential method should be employed to evaluate the competing bids.
Target cost contracting focuses on one particular outcome factor i.e. final cost. This serves to distract all parties from non-cost objectives. As such, target cost contracts are susceptible to driving behaviors that are detrimental to the project. Success is more likely if the contractor is constrained to adopt the behaviors that coincide with successful projects.
This may be done by means of an incentive scheme predicated on a mix of key performance indicators ("KPIs") embracing outcome factors and critical input factors. Input factors are those that relate to intermediate processes, procedures, actions or techniques. Figure 1 identifies some examples of useful input factors that concern cost and schedule. There are, of course, many others that concern safety and quality.
Input Factors - Cost and Schedule
- Are changes recorded to individual cost codes.
- Is rework recorded to separate cost codes.
- What is the response time of the materials management reporting system(s).
- To what degree are planning and supervision activities tied.
- Does the contractor's team have the capability of simulating "what-if" scenarios?
Does the team do this as a matter of routine.
- To what extent and how often does the contractor benchmark.
- How accessible is cost and schedule information to site personnel? What is
the extent of systematic input from site personnel.
- What methods does the contractor use for tracking materials price, use and
Figure 1: Input Factors Relating to Cost and Schedule
In a cost reimbursable arrangement, the motivation comes by way of tying compensation to performance as measured against the KPIs. The reason for doing so is twofold - KPIs respond to our psychological imperatives and they provide a practicable management tool. The knack is to distill from nebulous ideals performance indicators that are measurable and effective and to administer the scheme appropriately. Incentive schemes of this ilk are currently being used in several provinces in Canada for designers and contractors alike and with considerable success.
For stipulated price contracts of all guises, the owner's KPIs will centre on matters other than cost. Of particular use to the owner will be liquidated damages, particularly when applied to interim milestones. However, Revay would like to warn against liquidated damage overkill. Liquidated damages are extraordinarily strong motivators and should be used sparingly, otherwise the contractor will focus on liquidated damage avoidance to the detriment of all else.
In Part 2, this paper will deal with the following
6. See Oyetunji, A. and Anderson, S., Project Delivery and Contract Strategy, 165-12 (Austin, TX: Construction Industry Institute Research Report, 2001); Sanvido, V. and Konchar, M., Project Delivery Systems: CM at Risk, Design- Build, Design-Bid-Build, 133-11 (Austin, TX: Construction Industry Institute Research Report, 1998); Wardani, M., Messner, J. and Horman, M., Comparing Procurement Methods for Design-Build Projects, 132-3 J. Constr. Engrg. and Mgmt., pp. 230-238 (March 2006).
7. See www.dbia.org/about/designbuild/
8. Any reader who would like a copy of the analysis that supports these contentions and/or an explanation of the price differential method is encouraged to contact Sue England at firstname.lastname@example.org.