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Contents

Section 1 Target Costs and Open Book

Section 2 Different Contract Approaches

Section 3 The Principles of Open Book 

 

Description:  This module will enable you to apply the principles of open book cost management to differentiate between recoverable and non-recoverable costs for a construction project, whilst outlining the key stages for agreeing the completion of final accounts and analyzing costs received.

Author:  David Lowe, Value by Design Ltd


Section 1  Target Costs and Open Book




Aims and Objectives

At the end of this section you should be able to:
  • Explain the Open Book and Target Cost methodology.
  • Discuss the confidentiality issues surrounding open book cost management.


Open Book 

Open book is a defined mechanism and process to reimburse ‘actual costs’ to the Contractor. It utilizes ledger evidence, audit trail, justification and judgement. Reimbursements are made in parallel with the Programme. 

Open book can be used to establish a Target Cost, a Compensation Event value and can eventually be used to ensure the payment of actual costs to an organization. A number of forms of contract cater for this functionality of which only the NEC goes to into any great depth of methodology.  


Target Costs 

An estimate of what the Actual Nett Cost is likely to be plus the agreed Fee. Thus it includes any risks allocated to the Contractor. 

Open book methodology confirms what should be included in the Target Cost and open book reimbursement. Prime cost principles are constant across all forms of work. Open book can be used in multiple ways depending on the Client’s approach to risks, procurement, and the form and wording of the contract. 

Open book can be used either as an integrated team set Target Cost or where the Target Cost is tendered and reviewed by the Client. Thus the open book approach must be known before tendering. 

The relationship between Target Cost and open book is not mutually exclusive in as much as open book can be used without the setting of targets. This process is commonly known as cost plus. Conversely, the process of open book cost reviews can be used to establish lump sum non-target cost contracts; in these instances the target can be perceived as being the contractor’s aim to return a cost for the works less than the lump sums with a view to increasing their profit margin. 

A side effect of open book and Target Costs is that the Employers lose an element of cost certainty that is often perceived to be important. Cost certainty often comes with a cost premium, which reflects the risk transferred to the contractor. Open book cost principles can identify the source of costs behind the price, which when combined with the risk management and Target Cost processes found within the NEC can reduce risk premiums to the benefit of the Employer. 

Target Cost and open book methodology is often related to using the prime principles of cost. This is often perceived as an outmoded form of accounting; however the understanding of cost is a cornerstone to effective risk management, value engineering, process mapping and lean construction initiatives, which are at the forefront of the construction industry.  


Confidentiality 

Accountability is required for open book to work and yet the nature of information required from the Contractor (audit trails etc) is highly sensitive. As such, the level of information exchange required must be established from the offset, as well as an agreed format for the collation and storage of information. Access protocols must be implemented and the Freedom of Information Act complied with. 

Compliance with the Freedom of Information Act can often be catered for in its simplest form by seeking the approval of individuals whose names and details may be stored as part of an open book cost build up, or by the removal of personal data and the use of anonymous references / job titles. 

The Employer / individual responsible for a project’s costs should ultimately take a pragmatic and sensible approach with regard to commercially or personally sensitive data provided by the contractor. The primary goal of all open book cost management is to provide Employer comfort and security in the accuracy of commercial data; this effectively means striking a balance between undertaking full audits and blind faith.



Publications

  • Lowe, David; Leiringer, Roine Editors (2006) Commercial Management of Projects – Defining the Discipline, London: Wiley-Blackwell



Self-Assessment Task

  • Explain the methodology relating to the Open Book and Target Costs




Section 2  Different Contract Approaches




Aims and Objectives

At the end of this section you should be able to:
  • Broadly explain cost management principles within multiple construction contracts
  • Discuss the pros and cons of each system


Aside from the NEC suite of contracts, there are a number of different construction contracts that can used. Below is an overview of the cost management principles of some of the major contracts.  


Project Partnering Contracts (PPC) 

PPC is published by the Association of Consultant Architects and drafted by Trowers and Hamlin’s Dr David Mosey. 

This contract provides for a Price Framework. It leaves the parties to devise their own payment mechanism. Flexibility allows a cost reimbursable with Target Cost to be used. There is a provision for including an Agreed Maximum Price in the Form of Commencement Agreement.  

The flexibility engendered by this form of contract provides clients with the opportunity to devise their own preferred cost mechanisms. Some clients have found this openness to be a problem and have drafted cost management handbooks that closely reflect the NEC’s approach.  


Public Sector Partnering Contract (PSPC) 

Published by Stradia Consulting, formerly J R Knowles’ consultancy wing. This is similar to the NEC contract in wording and its bi-party nature as well as its use of Fee and Schedule of Cost. The cost is a reimbursable element as in PPC and JCT (below) and is less prescriptive than the NEC, thus leaving it open for individual project interpretation. It has a traditional approach to variations. As with the PPC form of contract, users are allowed an element of discretion in the process of establishing Target Costs.  


JCT Constructing Excellence 

JCT CE, formerly the BE form of contract, originally published by Constructing Excellence. This was adopted by JCT after a review of the partnering forms of contract available and subsequently integrated into the JCT suite of contracts.  

In the JCT contract, the Target Cost option includes the Actual Cost being recorded following agreement between parties. It operates on an open book basis. All details and processes, including the sharing of excesses etc, are outlined in the Contract Particulars. The Supplier’s margin is fixed unless stated otherwise.  


NEC ECC – Option C 

The first edition of the NEC was drafted by Professor Martin Barnes and was called the Engineering Contract, subsequent reviews by User Groups and drafting Panel have culminated in the NEC 3rd edition and a vastly expanded suite of complementary contracts.  

The NEC open book cost methodology differs significantly in the extent to which it is detailed. The default processes are extensively laid out with little Employer leeway without redrafting.  

The methodology includes a mechanism for disallowing costs, audit of contractor’s costs and a process for adding and removing costs at cost to avoid compounding any tendered cost advantages or disadvantages. 

The NEC’s Target Cost is derived from tender or agreement. Reimbursement is based on the Schedule of Cost Components (SCC), or Shorter Schedule (SSCC). Items not included in this schedule are deemed to be included within the ‘FEE’. Compensation Events are considered at Actual Cost / Time, as per SCC or SSCC. The fee is based on actual costs, as a percentage. The difference between the Target Cost and the Actual Cost + Fee is shared.  


NEC vs Others 

Can the flexibility of the other forms of contract be deemed a strength or a weakness? The formalized accounting principles are strongest within the NEC contract. The NEC contract does not consider fencing fees by default. Both the NEC and JCT CE consider time and cost to be linked. 

Some industry standard practices that have been recommended, such as ring-fenced fees present within the JCT CE, are not present in the NEC. Employers often redraft the NEC using Z clauses to reflect the process of ring fencing. 



Publications

  • Mosey, David (2008), PPC2000 ACA Standard Form of Contract for Project Partnering, Bromley: Association of Consultant Architects
  • Knowles, Roger; Wills, Mike (2005), Public Sector Partnering Contract, Sheffield: Stradia
  • JCT (2009), JCT 05 Constructing Excellence Contract, Revision 1 2009, London: Sweet and Maxwell



Self-Assessment Task

  • Broadly explain cost management principles within multiple construction contracts and discuss the pros and cons of each system





Section 3  The Principles of Open Book




Aims and Objectives

At the end of this section you should be able to:
  • State the 5 principles of Open Book Cost Management
  • Discuss the use of Open Book Cost Management working within the methodology of the 5 principles.


Principle 1                  Deals with cost not price 

Cost + Profit is the mechanism for cost plus. 
Price + Profit is a failure to understand cost build up and a process found in traditional forms of contract. 
Price – Cost = Profit is the process of Target Cost setting. 

The price of a job is often dependent on market conditions, interest in the work and other external factors. The actual cost of a job is less variable, ie. unless the works are changed, supply chain squeezed or corners cut, the cost to complete the Works will be the same, however the price given in a highly competitive market may reflect the price to win rather than the cost to do the Works.  

Contractors manage their costs using sophisticated cost management systems where nothing is given away. It pays to bring these skills to the table. The construction sector margins and the process of competitive tendering means that contractors have focused on precise cost management processes, these procedures and the skills to use them should be brought to bear when using open book cost management techniques.   

Principle 2                  Understand Target Cost build up 

By communicating to everyone an understanding of how costs build up, confidence is strengthened in the team and collaboration is eased. Openness surrounding costs identifies key cost drivers and provides benchmarks to measure from. It demonstrates the results of change and provides the foundations of Continuous Improvement. Different projects will have different considerations, and so understanding the relevant cost build up is important for the whole team.  

The novice surveyor or commercial manager undertaking a first open book cost management project may be faced with a plethora of costs previously unseen by the Employer. The traditional knee-jerk reaction of ‘I’m not paying for that!’ should be countered by the knowledge that the Employer probably always paid for it previously, but it was hidden within the price. 

The process of understanding cost is always tempered by a degree of uncertainty as eventual costs will only be ‘eventual’ once the project is completed. Therefore the process of establishing costs is only a process of raising the levels of cost certainty and the degree of knowledge surrounding the remaining uncertainty. 

Reaching an agreement and a mutual understanding between the parties with regard to costs and the assumptions taken to get to those costs will lead to long-term benefits through simplifying assessments of variations, settlement of final account and review of processes such as risk management of value engineering. 

Understanding costs requires a unified approach, traditional prime principles allow for elements of uncertainty between nett and gross inclusions, ie. which overhead costs are job costed specifically and which are catered for through a percentage uplift. The NEC overcomes this issue by clearly defining its prime cost components and identifies all other costs to be catered for by the Fee. This avoids traditional discussions between comparing overheads and profit of varying companies when the nett costs themselves already cater for different inclusions. 

Reviewing a typical cost build up shows a significant proportion of costs arising from subcontractor’s cost. NEC 2nd edition did not cater for subcontractors or costs were in components such as people, equipment, plant and materials etc. NEC 3 introduces the concept of subcontractors as a separate cost component. 

As a corollary to this, the NEC incorporates the Activity Schedule concept first tabled by Professor Barnes in the 1970s. This premise allows a direct correlation between programme and construction methodology, avoiding the traditional standard methods of measurement. 

A common fundamental difference between parties’ cost estimates lies in assumptions of risk waste and efficiency, understanding each others’ assumptions and processes to establish these inclusions is paramount to narrowing the gap between Employer and contractor cost estimates.  


Principle 3                  Apportion Risks 

Traditionally, much of the risk passed to the Contractor, who allows monies against certain items or allows for managing the risks. The more risk a contractor bears the greater risk premiums. In essence, given a high degree of uncertainty about costs, a contractor is more likely to err on the side of caution to avoid undue exposure. The appropriate apportionment of risks enables the parties to reduce risk premiums and manage the risks they are best suited to manage, ie. the ones that they have most control over. 

The diagram demonstrates the difference between  

a)      First column demonstrates the lowest contractor’s price with the majority of risks apportioned to the Employer. The Employer will face a lengthy process of assessing variations throughout the project with every change. The lack of incentive for the contractor to mitigate risks will ensure that the overall risk burden is higher than it would have been had the risks been more appropriately allocated. 
b)      The second column shows a significantly higher proportion of risks allocated to the contractor. This reduces the risks borne by the employer, but leaves a high level of cost uncertainty and incentivizes the contractor to mitigate the risks for their own benefit. This uncertainty leaves the Employer with a reduced likelihood of maximising their investment potential and, in the case of a shared savings contract, a significantly higher share sum paid to the contractor.
c)      The third column shows the highest level of contractor costs, but the lowest levels of combined risk as the party best suited to manage the risk has been allocated the risk. This appropriate allocation increases the certainty of out-turn costs and ensures maximum value for money and incentivisation.  





In any contract there can be seen to be a lean or optimum cost for the Works, this assumes for ideal working environments and a fair wind. However, the nature of construction means that with the best will in the world a fair wind is not always available. Therefore, in addition to the lean and optimum costs of the Works, contractors include allowances for risks, wastes and uncertainty. Many of these assumptions are taken for granted. An example of this could be seen in a unit rate for activity, such as plastering, whereas part of the original rate build up (room preparation, standing time and material preparation and sourcing) is included within a unit rate. The actual level of this inclusion becomes lost as the unit rate is taken for granted. Techniques, such as lean, look to review the inclusions and address the assumptions surrounding everyday versus optimum delivery. 

The risk allowances shown occurred from a housing scheme where to avoid extensive compensation events and additions to a lean cost for the Works; risk apportionment was calculated based on typical risks and their frequency. This mechanism was used to create a streamlined risk and reimbursement mechanism which not only incentivized the contractor to mitigate the risks, raised the awareness of causes of risks to the Employer in the first case, allowing them to incorporate some remedial measures, and finally reduce the extent of in contract cost management allowing the Employer’s team to focus on further value-adding opportunities. The open book costs were reviewed on a regular basis and at completion of the project to ensure their accuracy. The information that came from this was then fed into the next project, which delivered increasing cost certainty and led to a greater understanding of the Works. In identifying the risks in conjunction with the client, the project was able to demonstrate an excess of 20% savings on its first round of properties. 

Traditional terminology such as client contingencies, provisional sums and optimum bias would be considered to be within the project budget, but not within the Target Cost due to the incentivisation of this figure. 

In the NEC contract risks are allocated between the team and managed collaboratively. Any client contingencies, employer’s risks, designer fees and third party costs must also be considered as outside of the Target Cost.   


Principle 4                  Manage Open Book Principles   

The need to establish trust and understanding between the Employer’s and the contractor’s commercial teams is paramount to the smooth running of any open book contract. It is important to regularly review and understand the Contractor’s records and processes. It can be used to set up a robust cost management system and to ensure that no Fee elements are recovered twice. The purpose of the review is to build up a mutual understanding, level of trust and confidence in the data provided. The NEC provides Schedules of Cost Components to act as a check list in this process.   
Feedback from open book cost contracts and frameworks dictates that the earlier parties meet to review the contractor’s processes and procedures for collating costs better. In the case of frameworks, these mechanisms can be reviewed prior to the first project. Another benefit of using the early stage of project or framework to build the understanding between the parties means that on-site activities will be less and the time available to the parties will be greater leaving the review of mechanisms to a later date when costs may and the potential for contention higher.   


Open Book Management 

Open Book Management is broken down into the following stages: 
  
Stage 1 – Review Contractor’s Records and Processes 
Stage 2 – Establishing a Target Cost / Review Tender 
Stage 3 – Cost Assessments 
Stage 4 – Final Nett Costs 
Stage 5 – Share Range   


The above stages should be explored in detail by using the attached supporting information.   

Employers and their commercial teams should accept that 100% accuracy will not be guaranteed in early valuations but the nature of the open book cost process is that higher degrees of certainty and accuracy will be gathered as the valuations progress.     

Principle 5                  Use the data   

Collated cost information is essential during the project, such as for use in Compensation Events. SCC and SSCC are designed to avoid compounding losses or gains into further changes. It is important to review the data following the completion of the project – especially where works could be repeatable, but it is imperative to always remember the cost and not the price.   

Having spent an extensive amount of time building up an understanding and familiarity with the contractor’s costs, it is logical to ensure that this information is used to its best ends.  



Publications

  • Lowe, David; Leiringer, Roine Editors (2006) Commercial Management of Projects – Defining the Discipline, London: Wiley-Blackwell



Self-Assessment Task

  • Discuss the use of Open Book Cost Management working within the methodology of the 5 principles.






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