Jacob Austin (00:00:17) - Hi all. Austin here, owner of QS.Zone. And welcome to Episode 23 of The Subcontractors Blueprint, the show where subcontractors will learn how to ensure profitability, improve cashflow and grow their business. Today's episode, number 23 is going to be about target cost and actual cost contracts. Now what are they for a start. And what's the difference between these two different commonly used kinds of contracts. So starting with actual cost contracts which are also known as cost plus contracts, these are a type of procurement agreement where the contractor is reimbursed for their actual costs incurred for performing the work, and they also get alongside that an agreed fee. That kind of contract suits situations where there's a lot of uncertainty, where projects are particularly complex, or you're using innovative methods, and it's perhaps more difficult for you to come up with a fixed price or a fixed program due to one of those factors. Whereas a target cost contract is a type of contract used to share the risk of cost overruns and share the benefit of cost shortfalls in some instances between two parties in the contract.
Jacob Austin (00:01:32) - And what happens is a benchmark price is set at the start of the job, then the contractor is paid its actual costs for carrying out the work. Then, as the job unfolds, if the costs are coming in lower than the target cost, sometimes the opportunity is given to the client to reinvest some of that shortfall, meaning that they can get more value from the initial budget that they set for the job, and the idea being that the gains are shared between the contractor and the client or the subcontractor and the contractor. And then there is usually an arrangement for the overspend. So conversely, if your costs are coming in above the target cost, then there are various different ways of splitting these. Once you get past that target cost. And sometimes there's multiple bands and multiple layers of different pain share scenarios. So perhaps for the first say, 5% of cost overrun, the client may pick up the tab for that. Then for, say, the next 10%, it might be split on a 50:50 basis, but then beyond that, the cost burden might fall fully to the contractor or fully to the subcontractor person carrying out the work.
Jacob Austin (00:02:40) - So these kind of arrangements have become commonplace in a lot of government procurement. And what you're seeing is a lot of framework projects and a lot of large scale, say, civil engineering projects are falling under these kind of contract arrangements. I personally think these contracts are shit. I like the idea of frameworks. I'm all for it. I'm all for repeat working. So that, say, a team that's been working on a project continues onto another project of a similar nature. They carry on the learning that they've started on the first project. They take it through into the second project, it all becomes more efficient. You start developing synergies that you know you can achieve based on the first project. You start looking at where things went wrong and how you can improve them, so that for the next project and any follow on projects afterwards, you're starting from a solid cost base, you benefiting from the learning and over time you're ending up more efficient, hopefully faster, hopefully more cost effective, and hopefully everybody wins.
Jacob Austin (00:03:40) - And sadly, I just don't think that is the case. I think these arrangements are so sloppy, particularly the cost plus contracts they're lacking in any target. There's no incentive for the contractor to perform similarly with a subcontractor on a target cost arrangement, there's no incentive for them to perform the job takes as long as it takes. The costs are whatever they are, the fee gets added to it and the contractor wins and it's all over the place. See all the motorway roadworks that everybody sits in? You can't seem to go on the M1 without being stopped or slowed down somewhere. And why do you never see anybody doing any work? Because it all happens at night. You can drive through miles and miles and miles of roadwork, and all you see is the abandoned excavators, dumpers, plant and accommodation scattered around, not a body in sight. And crucially, the public pays for it. All of the workers that work at night are paid a premium antisocial hours and it's like a bullshit snowball. As soon as one little bit of work is done out of hours, you lose time by swapping people back to a day shift.
Jacob Austin (00:04:44) - So then the next shift gets done. Out of hours and out of laziness and ease, people are allowed to rack up bills of God knows how much money, because there's no incentive for them to get the method right and find a safe way for things to be done during the day. And perhaps you might be for carrying out some work at night if it meant that roads could stay open. But what you seem to find is that they don't. In a lot of instances, lanes are narrowed because the bulk of the work is being carried out at one side of the road. So then all of those lovely 50 mile an hour speed limits and the average. Cameras are put in place and thousands of people's mourning spirited, ruined by tailbacks, more traffic and a far longer commute than they needed. And it doesn't just apply to roads. We've got the HS2 project, a shining example of how not to procure a project. Once you get over the will, we won't. We build it. It was raging on for donkey's years before we actually put a bucket in the ground.
Jacob Austin (00:05:42) - Now the job is underway. The budget has run wild. In 2010, the initial investment was estimated to be around 33 billion. By 2019, that had climbed to 71 billion. Now there is talk of it being well over 100 billion. These are absolutely colossal numbers for cost overrun. And because most of the procurement is being done on an actual cost basis or cost plus basis, the contractor actually makes more money if the costs go over because their fee is greater, they've got no incentive. They're actually de-incentivised from saving money. So the government has effectively handed over a set of blank checks to all of these contractors and said, go fucking nuts and give me a railway at the end. Is there any wonder why it's overbudget? Unsurprisingly, a recent government report has actually discovered that cost plus contracts don't give good value for money, and that that is the reason for the overspend on HS2. And of course, being the government. This has been done by some kind of committee of Ex-cabinet members and public officials, no doubt copying for a lovely salary off the back of it.
Jacob Austin (00:06:51) - But it's hardly a Sherlock Holmes mystery. I could have told you for free. No doubt, off the back of the report, there will be a spate of public procurement on a competitive tender basis, but I'll be shocked if that goes to plan as well, because the whole industry, well, certainly some very large sections of it, have just got used to cost plus contracting. And that means the ability to price work competitively and arrive at a firm number has disappeared, as has that ability to make something stick, that need to innovate, to be able to make a tender price work or find a different method, hone and refine the costs. Consider 3 or 4 different ways of working. Look for real value engineering methods. All of these things aren't necessary, if somebody hands you a blank cheque and says, pay yourself at the end of the job. And I think a big shock to the system will come if the day comes where competitive tendering is the norm once again. So what does all of this mean for you as the subcontractor? Well, certain packages are placed on a target cost basis and some on an actual cost basis.
Jacob Austin (00:07:56) - And the typical contracts that are used for these are the JCT Prime cost contract and the NEC option E contract. The terminology is slightly different in both, but essentially they're the same sort of principle. There's a fee which includes your overhead and profit, and it can also include for certain elements of the management such as contracts, managers, quantity surveyors, people that are involved in the job but they aren't there directly doing work on site every day. And they might visit for chunks of a time, chunks of a day, but they're not there the full time. Now, you want to pay attention to those kinds of people, because the definitions of the contract only allow you to charge for people that spend a full day on site. And now you might think, given everything that I've said previously about the blank cheque, cost overruns and contract sums running wild, that if you get an option contract, that it's fill your boots time. And perhaps there's an element of truth in that. But subcontractor beware disallowed cost and in some cases adjustments with work which hasn't been carried out efficiently can come back to bite you.
Jacob Austin (00:09:02) - So as the subcontractor, you're not exactly guaranteed to make the fee that you set out with at the start of the project. If there is any duplication between the fee and what you include on your cost ledger, of course that will be disallowed. So it's important for you to understand what is part of the fee. There are also early warnings, or more specifically, if you fail to submit an early warning, which then turns into a compensation event if the contractor is able to find that. Had you submitted an early warning, the compensation event might have gone away, then the costs that you've incurred because of that early warning or lack of early warning could be disallowed. There's also the matter of excessive waste or the excessive ordering of materials. Then the efficiencies aspect comes in as well. And this is there to prevent, say, the over resourcing of a project. There's also the element of reworks. So if you've done something defective say and then you're going back in to complete it or remedying it or make it good or whatever the cost incurred with that putting right can be disallowed as well.
Jacob Austin (00:10:05) - You also are required to keep adequate records. If you don't have records of what your staff are doing, and in some instances, if they're inconsistent or the records are incomplete, then you may well be challenged and disallowed those costs as well. You also have to be prepared that there is a hell of a lot of administration required to run an actual cost contract. This is far from a situation where you just get paid your cost and you add on a percentage. And what I mean by that is you have to justify what your cost is. And that means tipping out your invoices, tipping out your payroll, costing system, tipping out the record sheets for your labor on site so that the person assessing your costs can tell what the man was doing, and check that he's gainfully employed on the site for the time that you say he is. So that might mean downloading and printing and collating in hardcopy. Leverage file after leverage file of invoices along with time sheets, goods delivery notes, and the applications for any sub subcontractors you might have.
Jacob Austin (00:11:06) - I have also seen requests for these to be embedded as PDFs into a larger document, such as an Excel spreadsheet, and so that means by the end of the job, you've got thousands of lines of a spreadsheet that you've had to go and upload and embed individual copies of each of these documents. And it can be a real administrative headache. And you have to bear that in mind when you're quoting for your fee, because it's highly likely that the person who collects all of that information for you is not somebody that's working on site delivering physical work. So it's just a word of warning to make sure that you've covered off that time. It does go beyond the typical overhead for administering a normal project, and it's a way you could quite easily lose out without even thinking about it. Now moving on to target cost contracts. All of the same issues apply. The actual costs are collated and assessed in exactly the same fashion. But what you've also got is this situation where you're running a normal valuation alongside the actual cost situation.
Jacob Austin (00:12:09) - So that administrative burden has increased again. Now, having done a few of these target cost contracts in my lifetime, I actually think these are the worst of all worlds. You start off with a tender price, and you adjust that tender price for variations in the same way that you would under any other contract. So additional work enhances the target, less work reduces the target. And what you have to do is hope that you got the tender right, because somebody's going to trawl through your actual cost, strike out the bits they don't like, and then mark you against the benchmark that you set that target. And if it's wrong within 5 or 10%, either way you lose out. You don't get any ability to make extra money beyond the gain share mechanism on the contract. And if your costs overrun, you're holding the baby. So on the one hand, because the gain share stops at whatever percentage and you don't want to come across as a shyster or a rip off merchant and be left with a massive pot that you're splitting 50:50 with your contractor or client at the end of the job.
Jacob Austin (00:13:12) - So you're encouraged by that to price the job fairly keenly. But at the same time, if you do price it keenly, and things go awry, then the support of the client, the contractor runs out fairly swiftly. So the one bit of advice I can give you on this is that you think about the risks in the contract really clearly. you make your exclusions as clearly and explicitly as you can, and you make sure where you're left holding risks, that you have a budget for these in the contract. That is one of the quite unique and refreshing things about the NEC contract, as it's quite common for there to be risk sums they're allowed for within the contract. And again, when you price compensation events, you can price those risk sums. And again you can pro-rata the sums that you've already started with or as and when you see additional risks being introduced by a change, you can introduce a new risk for that as well. And another thing that you can do if and when it gets to a point where the risk allowances are getting too much and the project manager is starting to feel like there's an unreasonable level of risk, or certainly the allowances for it, then you can start discussing that assumptions get made on compensation events, and the project manager instructs these assumptions on his instruction.
Jacob Austin (00:14:28) - And then what that means is, if the risk that is tied to those assumptions comes off at a later date, then you can reprice the change, or you can price a new change that represents the change due to that assumption. So say you're pricing an additional bit of steel frame. And as part of your compensation event, you price in some weather risk for days when it's too windy for you to get the crane out. Now, if the project manager isn't happy with that risk, or the contractor isn't happy with that risk, they can instruct you to include an assumption which might say, assume there is no days where the wind speed is above x and you're unable to lift with a crane obviously associated with that compensation event. And what that does is it shifts the risk back to the contractor. It would be wise for them. To how the budget for that. But then when on day two of lifting that steel, you get winded off, then you're entitled to a second compensation event to capture that event happening.
Jacob Austin (00:15:27) - But going back to the arrangement as a whole, let's say that the pain share and gain share are 5% either side of your target price. If your actual costs come in quite a bit lower than your target price, then you only make 2.5%. Assuming that you're splitting the gain share 5050 with the contractor, and you might only be reimbursed for costs that go up to 5% over the target. And in that instance, usually the fee is ringfenced. So that would mean that you've diluted your profit percentage by 5%. And also if you go any further over that, it's likely that you don't get any further money. So you're carrying the can for that overspend. And not only that, to add insult to injury, if your costs are going in at, say, 115%, you can still also within those costs have disallowed goals that you don't get reimbursed. So you're forced into this situation where you've got a really tight margin of error. So how you treat these risk sums when you're pricing the job and when you're pricing the compensation events, is really key to maintaining a good target price and maintaining your ability to get a healthy margin out of the job.
Jacob Austin (00:16:38) - Okay, I hope that gives you some useful pointers on actual costs and target cost jobs. If you are working on one of these types of contracts, it's highly likely that you're working under the NEC4 suite of contracts. And I did do episode number seven on NEC4, which I think would be of good use to you when you're operating one of these contracts.
My mission with this podcast is to help the million SME subcontractors working within our industry. If you've taken away some value from today's episode, I'd love it if you'd share the show and pass on that value to somebody else who would benefit from hearing it.
And thanks for tuning into today's show. If you like what you've heard and you want to learn more, please do find us at www.QS.Zone That's the letters Q S dot zone (Z O N E) where you can subscribe to our training and support system for like minded subcontractors. In there you'll find templates, how to videos, interviews and more. And it's less than the price of a cup of coffee per day and you can cancel any time.
We're also on all of your favourite socials @QS.Zone. Thanks again! I've been Jacob Austin and you've been awesome.
