Performance incentives in contracts

1 The use of incentives in construction contracts
2 Types of incentives in contracts
3 Performance of whom or what?
4 Types of performance
5 Types of incentive contracts
- 5.1 Fixed price contracting
- 5.2 Cost reimbursable contracting
6 Related articles on Designing Buildings

[edit] The use of incentives in construction contracts

The use of performance incentives in contracting consist of essentially two aspects 'first aligning the objectives of both parties through the use of performance measures and second, linking them to payment' (Construction contract incentive schemes: lessons from experience, London Construction Industry Research and Information Association; Richmond-Coggan 2001).

Sometimes referred to directly as performance incentive contracting, incentive contracting or indeed performance contracting, as general terms used to describe often a number of different types of contract form which encourage contractors to achieve specific goals, often relating to time, budget or quality, (which might also be referred to generally as the contractor's performance).

[edit] Types of incentives in contracts

There is some argument to say that most contracts in themselves, should act as performance incentives, through payment arrangements, extensions of time, recommendations, letters of appreciation and references. However, these types of contracts offer more specifically incentives in the form of rewards or penalties to the contractor based on their performance.

The paper Incentives in Construction Contracts: Should we pay for Performance? (W.Hughes, I. Yohannes and JB Hillig 2007) points out that although incentives are commonly used as tools in construction projects there efficacy is often assumed but not often questioned or researched. It goes on to describe the drive in the UK around this time for 'value for money', whilst at the same time there being no formally accepted definition or general consensus of what is meant by value. Performance assessment is inherently impacted by the interpretation of value.

[edit] Performance of whom or what?

In simple terms construction contracts are generally evaluated in terms of the project team, including the contractor, carrying out their tasks under the contract. But there is inherently a performance crossover with that of the building itself. That is to say performance might increasingly incorporate and be defined in terms of the various aspects of the buildings performance, which can, especially innovation projects be less clear

in terms of material and product choices made through the procurement process and through which supply chains.

It may be further defined in terms of the handover process of a building over an above simple completion to occupation, highlighted by initiatives such Soft Landings. Finally the post completion performance of the building in terms of its operational success, during the first year or two through to a number of years. Whilst there can be some difficulty in capturing as well as incentivising many of these aspects contractually, they are demands that are increasingly being asked of projects.

[edit] Types of performance

Performance most commonly relates to the traditional procurement method triangle of time, cost or quality. As such incentive contracts usually relate primarily to cost such as fixed price or cost plus contracts. Whilst performance in terms of cost are commonly key, these may also move beyond pure capital cost or expenditure considerations (CapEx) of a programme and project to include the operational costs some years ahead, after completion or operational expenditure (OpEx). These wider costs considerations are normally referred to as economic indicators.

If a project has a particular deadline of key importance, the focus maybe on the delivery time for the scheme and as such supported by the use of schedule incentive contracts. The final element of quality will often need further definition as it could cover a broader spectrum of what might be called performance incentives as described below, or more often than not included along with the former performance aspects in what is sometimes called multiple incentive contracts.

There are increasingly indicators of performance (both in terms of the contractor and the building) that could be interpreted as measures of quality but usually expand beyond traditional remits, this might be referred to as sustainable procurement, covering economic, social and environmental performance. Many of these performance parameters or indicators of performance will need clear and careful definition and allocation of responsibility, as they may lie with design or engineering aspects of a project but also crossover into contractor responsibilities and sometimes the building users.

Other more broad ranging such as social or environmental performance, may also be included and could be defined both in terms of the contractor carrying out their tasks but also in the crossover with the building. Such as performance defined in terms of material choices and supply chains, the handover process as well as the post completion performance of the building in terms of operations during the first year or two.

The indicators used to assess performance will normally be defined within the contract or within a document referenced by the contract, these are often called Key Performance Indicators. The indicators and targets are designed to be motivate the contractor to achieve those specific goals and or surpass these with benefits. Key performance indicators should be aligned with what is called SMART which is:

Specific, that is that they should be specific to a particular goal or task in the project or programme.
Measurable, so that success of failure can be assessed, quantified and evidenced.
Attainable, in that it should be agreed prior to project commencement that they are achievable.
Realistic, similar to the two above the indicators need to be practically applicable to the project.
Timely, in that they need to be realistically woven into the programme of the project with appropriate deadlines.

The types of topics that might increasingly be covered through the use of indicators might cover;

The indoicators that might be used to measure these might be

Number of and time to rectify defects
Rework rate
Downtime percentage
Incident rate
Number of accidents
Working hours
Specific package costs
Inspection pass rate
Safety meeting attendance
Site waste by volume

In general or traditionally there are two main types of incentive contracts; fixed-price contracting and cost-reimbursable contracting, there are however a wide variety of variations to these two basic forms which might be considered within this category cost plus contract, cost-plus award contract, share in savings contract, schedule incentives, multiple incentives, specific performance incentives contracting, schedule incentive contracting, Multiple incentive contracting,

In general or traditionally there are two main types or categories of incentive contracts; fixed-price contracting and cost-reimbursable contracting, there are however a wide variety of variations to these two basic forms which might be considered within this category.

[edit] Types of incentive contracts

[edit] Fixed price contracting

Fixed price or lump sum (as well as stipulated sum) contracts are sometimes 'firm price' contracts, although even between these terms there can be some differences.

Lump sum or fixed price contracts, agree a price before the works begin. If the actual cost of the works exceeds the agreed price, then the contractor must bear the additional expense. If on the other hand the cost of the works is less than the agreed price, the contractor will benefit from the savings.

This is unlike a guaranteed maximum price contract, where the contractor bears any additional costs above the guaranteed maximum price, but if the cost is lower than the guaranteed maximum price, then savings may go to the client, to the contractor or are shared. An extension of this is the target cost contract, where there is a ‘pain / gain’ agreement allowing the client and contractor to share both additional costs and savings.

However, lump sum contracts tend not to be fixed at all, but allow the price to change under certain circumstances:

Variations: These are changes in the nature of the works. Most contracts will contain provision for the architect or contract administrator to issue instructions to vary the design, quantities, quality, sequence or working conditions.
Relevant events: A relevant event may be caused by the client (for example failure to supply goods or instructions), or may be a neutral event (such as exceptionally adverse weather) and may result in a claim for loss and expense by the contractor.
Provisional sums: An allowance for a specific element of the works that is not defined in enough detail for tenderers to price.
Fluctuations: A mechanism for dealing with inflation on projects that may last for several years, where the contractor tenders based on current prices and then the contract makes provisions for the contractor to be reimbursed for price changes over the duration of the project.
Payments to nominated sub-contractors or nominated suppliers.
Statutory fees.
Payments relating to opening-up and testing the works.

A truly 'fixed' price contract would not necessarily be in the interests of the client as it would require that the contractor pricerisks over which they may have no control, and which might not arise.

[edit] Cost reimbursable contracting

A cost reimbursable contract (sometimes called a cost plus contract) is one in which the contractor is reimbursed the actual costs they incur in carrying out the works, plus an additional fee. Option E of the NEC3 Engineering and Construction Contract (ECC) is an example of a cost reimbursable contract.

A cost reimbursable contract might be used where the nature or scope of the work to be carried out cannot be properly defined at the outset, and the risks associated with the works are high, such as, emergency work (for example, urgent alteration or repair work, or if there has been a building failure or a fire requiring immediate reconstruction or replacement of a building so that the client can continue to operate their business). Tendering may proceed based on an outline specification, any drawings and an estimate of costs.

This is a high risk form of contracting for the client as the final cost is not known when the contract is entered into (i.e. there is no contract sum).

The costs for which the contractor is entitled to be reimbursed must be set out very clearly in the contract. This is a complex procedure that needs to be carefully considered, as whilst some direct costs may be relatively straight forward to determine, whilst other ‘shared’ costs, might not.

Direct costs that are clearly attributable to a single project could include: