In the ever-evolving landscape of construction, where efficiency, cost control, and superior quality are paramount; incentivised target cost (“ITC”) construction contracts have emerged as a sophisticated and strategic approach to pricing construction projects. This article explores incentivised target cost contracts as a pricing model, exploring their benefits, risks, and the opportunity they provide clients in construction project management.

ITC – what are they?
As part of the NSW Government Action Plan: A 10 Point Commitment to the Construction Sector, the NSW Government committed to working towards procuring and managing contracts in a more collaborative way, including by moving away from a reliance on fixed price, lump sum procurement methods, and being open to collaborative contracting models. The ITC form of contract involves complete transparency and extensive collaboration between the contractor and the client, and interface contractor(s) involved in any dependent projects. The target cost is based on shared risk allocation and includes:

• lump sum components (including management fee and preliminaries) where there is more scope certainty and/or the contractor is best placed to manage the risk; and
• Actual (or reimbursable) cost components (including contingencies) where there is less scope certainty and/or the client is best placed to manage the risk.

The target cost excludes costs which are unknown at the time of procurement and may include project specific risks such as unknown specified utilities, latent defects, site conditions such as contamination, or additional packages to be incorporated into the contract later. These costs are usually determined by the client and paid on an actual basis.

ITC contracts also include contract incentives such as:

• Gain share/pain share mechanism where the contract price differs to the target cost.
• Early completion payments if completion dates are paramount to the client, e.g. to facilitate another project. Many clients have tended to take the view that liquidated damages incentivise contractors to complete early or on time. However, as many projects leveraging early completion payments have proved, liquidated damages merely function as the bayonet to an already wounded contractor from a programming perspective whilst early completion payments encourage contractors to strategise towards finding program efficiencies that enable them to accelerate completion.
• Payment for meeting key performance indicators (stretch non-cost benchmarks) e.g. customer service outcomes.
• Liquidated damages and delay indemnity to cover the client’s potential costs associated with poor performance or delay (including knock-on effects on other projects).

When is it appropriate to utilize an ITC pricing model?
ITC contracts are appropriate in the following circumstances:

• Client wants to align reimbursement and performance in a transparent and collaborative way, but with some allocation of risk to the contractor;
• Projects with complex interfaces, many stakeholders and non-standard deliverables;
• There is some uncertainty on technical inputs and risks at time of award; and
• Greenfield or brownfield projects where the risk cannot be efficiently transferred to the contractor.

Benefits of ITC pricing model

• Risk mitigation and collaboration: These contracts encourage a collaborative risk-sharing approach. By distributing risk among project stakeholders, including clients, contractors, and suppliers, according to the rudimentary principles of which party is best able to control the risk, the incentivised target cost model fosters a shared commitment to project success.
• Performance excellence: The incentive structure in these contracts promotes a focus on performance excellence. Contractors are motivated to surpass minimum standards, delivering higher-quality outcomes that align with the client’s expectations.
• Open book pricing means transparent cost control: Setting a target cost establishes a transparent baseline for project expenses. This transparency, coupled with the incentive structure, encourages rigorous scrutiny of costs, leading to the identification of efficiencies and opportunities for cost savings throughout the construction process.
• Flexibility and Adaptability: Incentivised target cost contracts offer flexibility in project execution. As construction projects are dynamic, the model allows stakeholders to adapt to changing circumstances without the constraints often associated with fixed-price contracts.
• Win/Win: The commercial model aligns reimbursement and performance with a focus on delivering project objectives and win/win outcomes.

Risks associated with ITC pricing model

• Complex implementation: Implementing incentivized target cost construction contracts requires a nuanced understanding of project dynamics, cost structures, and collaborative frameworks. Successfully negotiating and structuring incentives demand a high level of expertise from all parties involved.
• Balancing incentives and penalties: Striking the right balance between incentives and penalties is critical. Overemphasis on penalties may stifle collaboration, while excessive incentives can undermine cost control efforts. Achieving equilibrium is a delicate yet vital aspect of implementing these contracts successfully.
• Legal framework and compliance: Establishing clear contractual frameworks that detail the terms of incentives, penalties, and project expectations is paramount. Legal expertise is crucial to drafting contracts that protect the interests of all parties and ensure enforceability.
• Less cost certainty than fixed price contracts: Project cost is unknown at the outset (creating difficulty to budget for), and limited cost certainty. However, this needs to be considered in the context that one of the reasons ITC contracts are considered appropriate in the first place is that there are a lot of unknown risks at the outset making it inappropriate to utilize a fixed cost contract.
• Relies heavily on mutual desire to mitigate risks quickly and inexpensively: There is a risk that if certain risks are out of control, there may be little incentive for the contractor to have the job done quickly and inexpensively as theoretically they are financially compensated more if the issue is poorly managed. This is where the gainshare/painshare mechanism may prove useful.
• Scope creep: Clients believe that a contractor may deliberately incur higher cost in order to increase profit. Whilst possible, this depends on the business and project strategy of each contractor. A win on one contract may lead to them losing further contracts due to losing client trust.

ITC construction contracts represent a progressive and strategic shift in the construction industry, emphasizing collaboration, performance excellence, and value for money decision-making. As construction projects become more complex and dynamic, these contracts provide a strategic framework for aligning stakeholder interests and achieving successful outcomes. By fostering a culture of shared responsibility and accountability, ITC construction contracts are poised to redefine project management in the construction sector, ensuring that projects are not only delivered within budget but also to the highest standards of quality.

Our legal team is ready to support you in planning and drafting the pricing model in your infrastructure contracts using the appropriate methodology to achieve optimal results for your project. For further guidance, please reach out to our team who are well placed to assist.

References:

• NSW Government Action Plan: A 10 Point Commitment to the Construction Sector
• INSW, Framework for Establishing Effective Project Procurement for the NSW Infrastructure Program
• INSW NSW Construction Leadership Group, Procurement Methods Guidelines