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Target Cost and the Risk Revolution?

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The Joint Contracts Tribunal’s (“JCT”) next edition arrives next year and alongside it, a new family of target cost contracts.  This is Indicative of a shift in the market which we are experiencing within the industry moving away from fixed price / lump sum contracting.  This article discusses that shift and changes in attitudes to risk in the industry.

Traditionally, clients have sought fixed prices or lump sums for work from contractors.  Essentially, selling the risk/reward to the contractor.  The contractor makes risk allowances in its pricing, if things work out better for the contractor than that allowance, it keeps the savings, if things work out worse it is forced to swallow the loss.

Are they truly fixed price though?  The contract can also choose to allow certain other things to be a client’s risk and for the contractor to be paid if those risks occur.  The more modern standard forms of contracts list these out, calling them Relevant Matters under JCT, and Compensation Events for the NEC folks.  While there is a fixed price, if none of these issues arise, the price can be adjusted if they do.

A prime example of a shift in the market concerns the use of price variation clauses, fluctuation provisions or inflation indices, which allow for adjustments to the price as the cost of materials changes.  For years, most contracts we saw did not include any adjustments, letting contractors take on the risk on the basis that they were best placed to deal with it by managing their own supply chains.  That was fine in a period of relative stability and market foresight.  Well, that all went out the window with COVID and other international issues, which led to spikes in the cost of materials, in excess of 20%.  On fixed-price contracts without these provisions, this led to significant increases in tender prices, the 20% already incurred and a further 20/30% risk allowance for further increases.  Unsurprisingly, clients were more willing to consider the inclusion of adjustments for materials costs in those scenarios to avoid that higher sticker price, especially when it was generally thought prices had peaked.  In that scenario, the client now has the risk / reward with respect to material costs, prices go up client pays more, prices go down client keeps the saving.

What I am getting at here, is that when it comes to risks in a contract, you have a general option which fixes the risk/reward in general times, such as a fixed-price contract.  There is also the option to deal with specific risks in a specific manner.

What are the alternatives to fixed-price contracting?  Well, on the opposite extreme is cost-plus contracting, where the contractor opens its books, and the client pays the costs of carrying out the works plus an allowance for profit.  The client has the risk/reward as if things go well, they will not pay the risk allowances the contractor would have made under a fixed contract, but if things go badly, then they pay for that.  This remains a rare beast, used for emergency works or where there too much uncertainty to fix a cost.

The balance is in target cost contracting.  This is an approach which still fixes a price, meaning the contractor still makes risk allowance and gives a set price when it tenders.  However, rather than pay on the basis of that fixed price (such as a Bill of Quantities) the contractor again opens its books and the client pays the costs of carrying out the works plus an allowance for profit – up to a point.  The parties set brackets around the tender price, and if the cost of the works is less than that target, the client will pay the contractor part of the saving, if the cost of the works is more than that target, the contractor will pay the client part of the overspend.  In this manner, the risk/reward is split between the parties, with both always incentivised to minimise the cost of the project.  Accordingly, collaboration and value engineering are very much encouraged, which is a great benefit for those riskier projects with more uncertainty to be dealt with.

This type of contracting is not new, but with the popularity of JCT forms of contract it is good to see its introduction, which will hopefully lead to a higher level of co-operation and less adversarial behaviour across the industry.

If you have a query about this article or would like to discuss a JCT-related matter, please contact our JCT experts here.

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