The Target Cost Contracting - Essay Example

The Target Cost contracting INTRODUCTION The Target Cost contracting or also known as a Stipulated Sum contract is the type of contact where the contractor would come up with a fixed price or total cost of the work that he is going to perform. This is the negotiated price the owner/developer will pay regardless of the contractor's actual cost of construction. For example, if the contract is valued at $100,000 and the contractor completes the project for $60,000, the $40,000 represents the contractor's profit. Conversely, if the contractor's cost is $130,000, the contractor is obligated, by contract, to complete the project for $100,000 and fund the difference out of his own pocket. Use of a target cost contract places all of the financial risk of construction on the contractor. The target cost contracts are relatively straightforward agreements in which the contract value is fixed, and the owner/developer knows what his cost will be. ( Haug 2002) The second type of agreement is known as a Guaranteed Maximum price or GMP contract. This agreement should not be confused with “cost plus”, another contract type where the contractor includes charges to the owner/developer in labor (charging should only include field personnel, while home office personnel should not be reimbursable cost and should be covered by the contractor’s fee), materials ( evidence that a competitive bid process was followed on major material purchases), subcontractor costs ( work subcontracted to others should be covered by subcontracts), equipment rental (a lucrative sideline to many contractors where equipment purchased long ago and carried on the books at zero cost are being rented out at new equipment rates). The GMP contract is offered or bided exactly the same as target contract; it is in this sense that the contractor assumes the same risk because he has to put on certain expense and risk that he cannot charge to the project; but a split risk in a sense that in case total budget exceeds, funding the difference incurred without the overcharge in labor, materials, etc. will not come out from the contractors own pocket, though from the perspective of the owner/developer, whatever saving is earned, less cost, will also go to him. Under this form of contract, the contractor is reimbursed its actual cost of the work plus a preset, guaranteed fee/profit up to an agreed guaranteed maximum price. If the actual cost exceeds, the owner/developer pays the contractor the same fee agreed upon and nothing more. So then, the owner/developer is protected by a guaranteed cost price on the contract and shares the same risk though receiving the additional benefit that, should the actual cost of the work plus the contractor's fee come in under the guaranteed maximum price, the savings accrue to the owner/developer. Under the target cost (TC) contract, the contractor in trying to minimize this risk will typically include a substantial contingency to protect the project from going over budget. If the project progresses well, the contractor makes his profit plus whatever contingency he did not use. However, if the contractor did not plan well and construction costs exceed the budget, then the contractor will have to use his contingency and/or profit. The worst case scenario is that the contractor's costs go over the agreed stipulated sum and the contractor must finish the project out of his own funds. Should this scenario occur the contractor may cut corners in order to finish the project or, worse, not be able to finish the project, leaving the owner/developer to find a new contractor and infuse additional funds to finish construction Since the contractor accepts the greater risk and plans for that risk, the owner/developer on the other hand will also not have an opportunity to gain any contract savings once the document is signed. Under the GMP contract, the contractor who is by virtue responsible for cost overruns (exceeds time limit or fixed budget) will then be at risk in case there is failure on the part of owner/developer. Risk in terms of home office cost, and especially if the owner/developer inserts additional scope of work within the base project. Claims and Disputes of any Construction Contract Definition    A "Claim" is a demand or assertion by one of the parties seeking, as a matter of right, adjustment or interpretation of contract terms, payment of money, and extension of time or other relief with respect to the terms of the contract. The term "Claim" also includes other disputes and matters in question between owner and contractor arising out of or relating to the contract. Claims must be made by written notice. The responsibility to substantiate claims shall rest with the party making the claim. (FindLaw 2008) Areas of Dispute in Construction Contracts Contract terms and conditions are very vital in preventing and resolving disputes in construction contracts by providing comprehensive coverage of all the items of work, duties and responsibilities of the contracting parties, and conflict resolution mechanisms related to all contingencies. However, in most contracts, a few clauses are regarded as dispute-prone. Disputes may arise due to numerous reasons including unfair contract clauses allocating disproportionate risks on parties, ambiguity in contract clauses leading to varied interpretations and applications, discrepancies and inconsistencies among various documents, and conflicting interests of owners and contractors in the contracts. A survey was conducted of 72 clauses in some government construction contracts which led to the identification of 17 potential dispute prone-clauses. The study revealed that dispute-prone clauses can be grouped in one of the four factor dimensions, namely, owners’ powers, contractors’ default, payment to contractors, and deviations and discrepancies. (Chandrashekhar, et. al. 2002) Reduction of disputes and claims In order to reduce disputes and claims in construction contracts, there must be additional contract provisions for risk allocation. These provisions can appear in numerous areas in addition to the total construction price. Typically, these provisions assign responsibility for covering the costs of possible or unforeseen occurrences The language used for specifying the risk assignments in these areas must conform to legal requirements and past interpretations which may vary in different jurisdictions or over time. Without using standard legal language, contract provisions may be unenforceable. Unfortunately, standard legal language for this purpose may be difficult to understand. As a result, project managers often have difficulty in interpreting their particular responsibilities. Competent legal counsel is required to advise the different parties to an agreement about their respective responsibilities. Quality of work and collaboration in both TC & GMP From the conventional TC and GMP, modifications and fine-tuning is done on both the TC contract and the GMP contracts to alleviate its relentless effects to both the contractor and the owner/developer to ensue fair play among them or collaboration. Unlike the “conventional” TC contract the “modified” pain/gain sharing fashion initiated to give an opportunity to owner/developer to gain contract savings by sharing some risk in case target contract exceeds. This shared ratio formula is agreed upon at the start of the contract. This means that whatever extra payments or savings is gained, it is calculated in relation to the ratio that has been agreed upon. In the case of the GMP contract, “modification” is set primarily to address the impact of project delay and anticipations to add-on scope of work from the base contract, though other features may also include stipulations to reach a compromise agreement to share the gains purportedly obtained by the owner/developer (in percentage, like 75-25 or 50-50). The administrator plays an active role throughout the entire process either in the TC or the GMP “modifications” since savings are shared. Transparency in managing cost is well regulated and documented because every purchase order and invoice received from the contractor is submitted to the owner as backup. When the administration is properly set-up and organized, the quality of work and collaboration between contractor and owner/developer is apparent, cost and time is manageable since cut measures for processing is timely. Risk allocation Depending on who takes the responsibility of administering the project or how the project will be administered to balance the dynamics of collaboration and depending on how to distribute a fare share of the contractor and the owner/developer does not lie on the cost to each party separately. The goal of an optimal allocation of risk is to minimize the total cost of risk on a project. Thus, it might sometimes seem as if one party is bearing more of the risk costs than the other party. However, if both contractors and owners take a long-term view and take into consideration the benefit of consistently applying an optimal method to themselves and to the rest of their industry, allocation reduces everyone's cost and increases the efficiency of all parties involved. When risks are understood and their consequences are measured, decisions can be made to allocate risks in a manner that minimizes costs, promotes project goals, and ultimately aligns the construction team (agency, contractor, and consultant) with the needs and objectives of the project. A contract therefore in a modified TC or GMP is a vehicle of a risk allocation. The objectives of risk allocation can vary depending on unique project goals, but three fundamental tenets of sound risk allocation should always be followed: First is allocate risks to the party best able to manage them...the party assuming the risk should be able to best evaluate, control, bear the cost of, and benefit from its assumption. This will ultimately result in the lowest overall price because contractors will not be forced to include contingencies for possible financial losses or take gambles in an extremely competitive bidding environment. Secondly is allocating the risk in alignment with project goals...risks should be allocated in a manner that maximizes the probability of project success. The definition of a clear and concise set of project objectives is essential to project success and these objectives must be understood to properly allocate project risks. : Project objectives directly determine optimum risk allocation strategies, or when project risk allocation is justified in deviating from traditional industry standards. In addition, project objectives can affect the procurement methods and contracting strategies. The objectives should be understood early in the project process and referred to for any important design, procurement, contracting, or construction management decision. Thirdly is sharing risk when appropriate to accomplish project goals...define risk allocation as the process of identifying risks and determining how (to what extent) they should be shared. In reality, no risk is truly shared; instead, exposure to the risk is split among the parties. Risk sharing is clearly the defining point at which the task is transferred from one party to the other. Ex. the agency is allocated the risk of delay while the contractor is allocated the risk of additional costs. Communication among parties is a key to any sharing of risk allocation. Risk sharing provisions should be written with the principle of risk management and alignment of project objectives. (Osgood 2004) Above is a chart showing the risk allocation for the different kinds of construction contracts: fixed price (Lump Sum or uppermost), reimbursable (Cost Plus percentage or lowermost), or modified (those in-between Cost plus and Lump sum). Risk allocation depends on the people involved in the project because different parties have different abilities to manage or tolerate different types of risks. This means that the premium charge is less for the one who takes the bigger risk. Interest of the parties should be defined at the outset as project goals, which includes proper scheduling, overall budget and scope of the objective to save money on the total project We also take note in the graph that the optimum distribution of risk between the contractor and owner lays at the center of the diagram which is the cost-plus incentive. From the cost-plus incentive toward the lump sum, there is an increase in the risk for the contractor, so it belongs to the TC modified contract, TC being the conventional. Likewise, from the cost-plus incentive downward to cost-plus percentage, there is an increase in the risk for the owner so that it belongs to the modified GMP contract. This somehow can tip both parties which contract leaning are they going to approach. Graph below showing TC: (Osgood 2004) In a TC (Haug 2002), when the contractor accepts the greater risk, plans for that risk by including a substantial contingency because of the risk that he has to undertake. However any deviation to lessen that risk will amount to a risk factor for the owner/developer and thus should alters the measure of risk factor for the contractor. Graph (Osgood 2004) below showing GMP: The graph represents the range of drawing how much percentage premium the contractor can get for sharing some risk in the modified GMP contract. The downside also needs stating. GMP contracts require more work on the owner's part to administer. The main effort involves defining what cost is. And if you are not interested in collecting discounts, obtaining credits for small tools, establishing realistic labor rates, monitoring rentals, and are not really prepared to act as a partner with your contractor in the project. You have to have a strong administrator experienced in general contracting. Contractors also resent inexperienced owners questioning their decisions. Advice Pre-qualification and selection of competent contractor Most owner/developer pre-qualifies bidders, but primarily on the basis of financial stability. In contrast, a more comprehensive use of pre-qualification requires further random selection. In pre-qualifying a competent contractor, his ability to get performance bonds and the consideration of the contractor's past performance is enough at this stage. Contractors who have satisfactorily passed pre-qualification are then invited to submit an expression of interest on the target project. Pre-qualification processes on selected contractors In this pre-qualification stage the amount of information provided by the contractors varies depending upon the size and complexity of the projects they will bid on. Success on pre-qualification should include several steps in order to shortlist to 2 contractors. From the randomly selected contractors, essential information at this point is probing further the contractor’s capability to provide: Warranty coverage after completion of the project. Performance bond and the consideration of the contractor's past performance is not enough at this stage. Performance bond only apply after work is being completed or provides assurance that the materials and workmanship of the contractor will be good during the project completion and project acceptance. Warranty coverage after the completion of the project will necessitate correcting failures from material or workmanship that may have escaped notice during construction and guarantees a higher concern for quality performance. Another process requires the tenderer to answer a confidential questionnaire to be submitted along with a complete set of audited financial statements and details concerning assets, liabilities and equity and affidavit of financial condition. This questionnaire asks information regarded the preceding company details submitted. This must be submitted 10 days prior to the date bids are to be opened. After the questionnaire and qualifications have been assessed, 2 contractors are chosen. Awarding of Contract A frequently cited cause of contract problems is that the contractor is selected largely based on the lower bidder. Lower bidders, however, do not necessarily mean a more competent contractor to absorb greater risk, since it can also mean cutting corners and hiring low-quality personnel. Thus, when the 2 best contractors are chosen, they are given three months to further develop their technical and financial proposals which will finally be assessed by an assessment panel chaired by the client’s senior management to finalize the contract award. The bidders are required to list specific cost qualifications including the base constructions costs, preliminaries, head office overheads, profits, commercial and technical risks to be borne by the contractor, shared commercial and technical risks, entrusted works and attendance on designated contracts. Awarding the contract does not however mean that there is no room for negotiation on the intricate issues. Issues to discuss on a pre-contract meeting Technical Issues Areas of concern would largely depend on the choice of the owner/developer and his preference on the structure of the contract that he wishes to enter into. In a Design/Build Contract since the contractor is responsible for Architectural and Engineering Plans, issues of discussing does not only lie on an agreement between rights and obligations of both parties, but should also include areas of concern in the architecture and engineering concepts including ground survey. This is unlike the Build Only Contract where owner/developer produces his Architect, Engineer or other Consultant, who is or is identified as such in the Contract Documents. Issues of agreement among various technical personalities that is directly involved in the project must explicitly clarify all areas of concern. Rules of engagement must be discussed on how the course of the work on the project would be directed. The “who” and the “how” must be settled to warrant smooth administration of the project. There must also be an agreement between the various technical personalities who are directly involved in the administration of the project and the owner of the project. Risk allocation must be thoroughly discussed by all parties to determine optimum distribution between the contractor and owner/developer. The establishment of Project Cost must then be instigated. Master Plan involving all technical issues is drawn. Financial Issues Financing a construction project presents a myriad of issues especially if owner’s lender or financial institution in involve. In fact, it requires the owner to negotiate separate contracts with two parties that have differing, and possibly conflicting objectives. The owner's task is to negotiate the terms of both agreements so that the owner is not at odds with either or both the lender and the contractor during the construction process. Identifying areas of potential conflict between the contractor and the lender, and addressing those areas during the negotiation of the construction contract and the loan documents, is the key to avoiding possible disruption or delay. The construction contract and the loan documents are often negotiated and finalized separately from each other (in some cases, the lender will review and approve the construction contract as part of the underwriting process). However, having a list of the relevant issues when dealing with both sides is helpful in keeping the negotiating point’s straight and keeping both agreements on track. Other issues to discuss are the payment scheme the owner, owner’s lender and the contractor will agree upon, in either a fixed cost scheme (TC) or reimbursable (GMP). It also involves further discussion on sharing scheme in terms of percentage of savings incurred after the project completion. We have noted that under the TC kind of contract the owner and contractor enter into a pain/gain sharing scheme while in the GMP the owner and contractor negotiate the percentages that each party will share in agreed savings or overruns. The following diagram shows the financial formation of the Target Cost. (Wong 2006) After all this have been taken into account, both parties have to agree on measures to take on the occasion that a dispute or a claim might ensue either from delinquencies of owner or contractor. These measures are legal procedures that may be taken by either of the parties in case such a problem would occur. Post Contract Considerations Record Keeping and Audit Rights. To facilitate audit’s by Owner and Owner’s Lenders, Contractor shall at all times implement and maintain such cost control systems and daily record keeping procedures as may be necessary to attain proper fiscal management and detailed financial records for all costs related to the work and as are otherwise reasonably satisfactory to Owner and Owner’s Lenders. Records to be maintained by the Contractor shall include the following: (a) payroll records, wages, salaries, taxes, (b) all correspondence, minutes of meetings, daily logs including schedule status reports, memoranda and other similar data, (c) items such as bids, proposals, estimating work sheets, quotes, cost recaps, tabulations, receipts, submittals, tax returns, etc.. and (d) all other data relating to or arising out of the work like materials ordered and payment for supply contracts and the payment of sundry materials and any other similar supporting documentation reasonably required by the Owner or Owner’s Lender. Also included in this stage is the keeping of accounts of the actual costs of the works done. Both parties must agree to the contractor’s opening or establishing a bank account where all payments from the client under the project are made and all outgoing payments to subcontractors and suppliers are also made. Transaction records are verified by the client regularly and checks on the following documents: payment receipts against the bank statements. Contract Variations. The contractor or the client may initiate a variation in contract which can be in the form of a value engineering proposal. They are required to state the reasons for and the benefits of the proposal, the cost estimate and any program benefits to the project. If this variation in required, then an appropriate instruction is issued. With this variation comes a revision in target cost which must be agreed upon by both parties after determining its impacts and consequences. If the variation is only minor, no adjustment is made to the target cost. The final target cost should not be adjusted to reflect initiatives, innovations, economies, procurement benefits, etc. which are beneficial to the project as a whole. This enables the best reflection of cost savings at the final project outcome since the gain/pain share formula is not adjusted. Compliance Certification. The contractor is responsible for certifying his compliance with the requirements of the contract and must identify and carry out any alterations or remedial work necessary due to errors and omissions or by discrepancies during the self-certification of the works. The cost of these alterations is charged as actual costs forming part of the final total cost. Upon inspection of the work, if the client identifies items that need remedial ramification work, the contractor has to carry these out. Cost of this work is not part of the total final cost. These are called disallowed costs. Contract Administration and Supervision. To best administer and supervise for TC contracting, the client monitors the contractor’s letting of subcontracts and supply contracts through the following policies. The client approves the contractor’s subcontract letting procedures, the terms of the subcontracts and the tender list for major subcontracts and supply contracts. The client participates in the selection and consent to subcontracts and supply contracts and prohibits single subcontract tenders unless fully justified by the contractor. The supervision of works in progress by the client is important to any construction project. The contractor is required to submit inspection and test plans for each part of the works, to identify holding points (a stage in the construction process where work cannot proceed without a notification and successful inspection by the site supervisory staff) and witness points (a stage in the construction process where the site supervisory staff must witness any physical tests and confirm that the results are correctly recorded);. Progress Monitoring. At six-month intervals, the client will assess the performance of the contractor and the associated subcontractors through the predetermined criteria and marking scheme. The performance reports will be feedback to the parties concerned, and the assessment results should be taken into account in the pre-qualification of contractors for future projects. The contractor also is required to submit monthly reports to the client containing the following commercial and financial information: (a) list of sub-contracts and supply agreements awarded up to the end of each reporting period, (b) forecast of procurement activities for the next 3 months, (c) summary of actual cost relating to the works completed, (d) forecast of costs to complete the works including any revisions to the cash flow forecast, (e) report on the status of items in the risk register which is a section of the progress report to reflect the effect of work progress to anticipate target cost and (f) identify measures to be taken to mitigate risk on activities in the next three reporting periods, (g) report on the status of value engineering proposals and (h) report on the status of claims, if any. (Wong 2006) References: Abdou, OA 1996, ‘Managing construction risks’, Journal of Architectural Engineering, ASCE, vol. 2, no. 1, pp 3-10. 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