Jacob Austin 00:00:00 Hi all, it's Jacob Austin here from QS.Zone, and welcome to episode 112 of the Subcontractors Blueprint, the show where subcontractors will learn how to ensure profitability, improve cash flow and grow their business. Today, we're continuing our exploration of the JCT 2025 target cost subcontract. This episode builds on last week's Foundation, and we'll continue to discuss the JCT TCC this week, with a specific focus on risks and challenges that subcontractors might come up against in a JCT, TCC, and some pointers for pricing it right and protecting your margin so that you can come out on top. So let's dig in. So target cost contracts, as we discussed last week, come with a unique risk profile for subcontractors. You're essentially moving away from a world where you might win or lose based on a fixed price, where if you're efficient, you can pocket more profit, and if you hit trouble, you'll lose money. And you're moving towards a world where some of that risk and reward is shared. So there are seven key differences that I'm going to discuss with you between a fixed price and the open book target cost contract.
Jacob Austin 00:01:31 And I'll highlight as well some of the risks involved with them. So first let's talk shared overrun which could mean potential profit erosion under a fixed price subcontract. If your costs overrun you lose money. But if you manage to come in under budget, you keep the savings as extra profit under a target cost. Subcontract overruns are partially compensated, so you won't typically lose as much as under a typical lump sum, but you can still lose a chunk of your feet or profit if things go over. Your profit isn't guaranteed. It's at risk if the project runs into difficulties or inefficiencies. For example, if you agreed a 5050 pain share and you end up 100 grand over budget on the target with no target adjustments, they're to blame. You might only get paid 50 grand of that, and effectively 50 grand comes out of what would have been your profit, or even out of your pocket on a job with a small margin that could wipe out your margin entirely. That said, if you are on the flip side in a fixed lump sum arrangement, you could lose all of that a hundred grand, but you're only better off by comparison.
Jacob Austin 00:02:39 And this is where you need to be really tight with your pricing to make sure you set that target properly in the first place. How it ultimately pans out to you is based around the proportions of share that you're both contribute towards any overrun, and to add extra protection to yourself, you might be able to negotiate a small percentage of overspend where your contractor contributes 100% of the loss. They don't give you any more profit, but it stops money coming out of your pocket in the first instance. And then beyond that percentage, split the cost 50 over 50. The benefit of doing this is that it means you can keep the target cost reasonably tight, safe in the knowledge that if you have a small overspend then it doesn't hurt you straight away. Another alternative, albeit one that the contractor is not likely to enjoy, might be a clause where you're not required to pay in more than your profit percentage. This basically stops you from incurring any loss, but I would have thought that the contract is not likely to go for that unless they're on a cost reimbursement mechanism themselves.
Jacob Austin 00:03:39 The flip side of shared overrun is, of course, shared profit. If you knock your target out of the park, you deliver super efficiently. You buy your materials at some incredible discounts and you make mega savings. Then obviously under a 5050 split of gain share, you only get to keep half of those savings. So essentially your upside is capped in a way that it isn't under a fixed price. That isn't necessarily a bad thing because you're still benefiting from additional gain, but it means you're agreeing a smaller share of any potential windfall. So if your company's strategy is to beat your estimates and earn higher margins through efficiencies, target cost might feel like it's cramping your style. But alternatively, this kind of arrangement can encourage you to be more keen with your pricing. You don't want to feel like you're earning loads of money and giving half of it back, and so keeping the price keen helps you to win the work to guarantee the turnover with a reduced burden of risk if you do overspend. Next, I want to talk about the burden of open book.
Jacob Austin 00:04:42 Many contractors that I've spoken to think that open book requirements are quite onerous. It's time consuming. It demands twice the work for a normal valuation, and there's risk with the open book approach of disallowed cost, which is where you don't recover something that you've costed to the job because it doesn't fall within the range of chargeable items that you can genuinely include. And these are people that are working for big organisations with sets of accounting policies, and probably more resource to throw at target cost jobs than you might have as a subcontractor. And you'll have to stand the same procedures. We're talking daily diaries, detailed labour allocations, records of every purchase, every plant log, every visit from your contracts manager or QTS. All of these need to be maintained, and they all need to be codified to show that they are allowable costs. If you're not used to this, then the learning curve can be steep and you could be incurring as well higher overhead for maintaining this process, either at a site or an office level. Consider all that time pulling that cost detail together for both of your project manager and your QTS to substantiate everything.
Jacob Austin 00:05:53 That time on a lump sum job could be spent on other things, depending on the definition of the fee for the job, this might not be something that you're paid for. It might need to come out of that fee. So you need to examine how the cost components are set up. Look at what the allowable costs are. Does that include for time spent by your quantity surveyor administering the contract, or do you need to include that in your fee? And if you do, then you need to charge a typically higher fee than you might on a different job. And you can be open with the contractor about that, because they'll understand the situation as part of what needs to be done to make the mechanism work. You need to be prepared as well for audits to happen. The contract more than likely will allow for surprise inspections. It's probably a bit like a tax audit, except the taxman is the main contractors shs making sure that your costs are legitimate. Any cost that you can't back up with evidence could be disallowed, meaning you're footing the bill for it.
Jacob Austin 00:06:51 So we're back to the she's old favorite saying records Records, records. It's not glamorous, but it's got to be done to de-risk your payment and get your hands on your money. That audit leads me swiftly on to disallowed costs. The TCC sub will have a list of certain exclusions. For instance, the cost of remedying defects which aren't allowed as part of allowable costs. So if you mess something up, you have to fix it and the rework time and materials involved is on your tab. This is just as under a lump sum, you wouldn't get paid to fix your own defects. There's also costs due to negligence or default. Default is a broad term, and there's an interesting bit of case law that helps to highlight what the risk is with default. So in a case between Network Rail and ABC electrification, ABC were appointed under an Ice target cost contract. And this was a dispute that went to court to determine whether delay costs because they were an actual cost of completing the job could be disallowed by Network Rail because the contractor finished late due to a delay that wasn't the client's fault.
Jacob Austin 00:08:04 The court decided in that case that those costs weren't payable, even though it wasn't ABC electrification intention to finish late. It wasn't a deliberate delay. They still overran the contract date and therefore defaulted against their obligation to finish by a particular time. Now the GT form tries to mitigate that that quite a harsh position by clarifying that if you run past the completion date, you can still recover site overheads until actual completion. So as long as you're within the target cost, you can still recover your cost for your site management and so on. But they will be capped at the rates that applied before the overrun. So if you throw some extra resource into the mix to try and accelerate, carry out some overtime, for example, to mitigate your delay, then that mitigation cost is down to you. So the risk is if you underperform or default in any way, certain costs will get knocked out of your payable account. That might be down to quality issues inefficiency, delays. These can directly hit your bottom line in a target cost setup.
Jacob Austin 00:09:09 This is similar to a fixed price, but under target cost. There's a contractual explanation of what you can claim and what you can be paid, so there's less wriggle room for you to ask for mercy. That can make your final account process quite complex, and that's in addition to fairly complex payment calculations throughout the course of a job. At first, the process itself might be confusing. Instead of a straightforward. X and y activities are at a certain percentage complete or this milestone is finished, so your invoice for it, you're billing for actual costs. Then adjusting the fee and possibly applying a provisional pain and gain share throughout the course of a job that can make it harder for you to predict your cash flow. If the contract opts to include pain and gain in interim payments, your invoice values might swing based on how much you're tracking against your target. One month, you might get 100% of your cost. The next month. If you've gone over the target to date, you might only get 90% of your cost reimbursed, with a 10% held as your share of the early spend.
Jacob Austin 00:10:14 That could be tough on your cash flow. If pain and gain is only at final account, then cash flow during the project is likely to be easier because you'll get the full cost reimbursed as you go, but be prepared for the final account settlement. You might then end up owing money to the contractor or forgoing an amount of your final payment at the end. This is something that you just need open eyes to and to monitor throughout the contract. You don't want nasty surprises where you think you've done fine to find. At the end of the project, you owe back a six figure sum to the main contractor due to a pain calculation. Managing this, of course, requires you to forecast throughout the job. This is continually tracking expected final cost versus your target so that you know if you're heading into pain and you can try and correct errors, or at least brace yourself for the impact. Now, because target cost contracts are new in JCT and they're relatively rare at subcontract level, there's a higher chance of misunderstanding the contract or even making administrative mistakes.
Jacob Austin 00:11:19 Mispricing the target, misinterpreting what's allowable. Missing notice periods for changes. All of these things can hurt you, and it's the same on the contractors side of the coin, because if their team isn't experienced with target cost, they might fumble the ball to. In a worst case, confusion can lead to disputes. The good news is that this is a construction contract still, and that means that the Construction act still applies to that contract just like any other. So you'll have your same rights to interim payments to be informed of what you're being paid and potential withholding, and to be able to adjudicate on disputes quickly. One thing that you might need to bear in mind is that pay one pay will still be banned by law, meaning that the contractor can't make payment on your subcontract conditional on getting paid themselves by the client. So confusion on what they're able to charge the client, particularly in a pain scenario, shouldn't mean that there's confusion about how much you need to be paid, or any withholding based on a client decision.
Jacob Austin 00:12:21 If anything seems fishy to you in your subcontract, then get some advice on it. Don't sign away your Construction Act protections and that advice applies to the subcontract itself. Let's face it, as a subcontractor, you are going to have less negotiating power than a main contractor. And the target cost contract is a sophisticated document. But that won't stop some main contractors handing it to you as a fait accompli to just get on with the risk involved in doing that is accepting terms that might be unfavorable to you because you feel that you don't have a choice. And remember, even if you can't change the printed form of the JCT contract much, you can influence things like the target value itself, along with the fee and the share percentages through your discussions and your bid for the project. If you feel like there's more risk involved because of the way the contract is written, then you need to negotiate that risk into the contract in the form of those negotiated items. Now, if I sounded all doom and gloom, there are potential benefits here.
Jacob Austin 00:13:25 Shared risk means if something is genuinely unforeseeable, you're not alone in carrying the can for the cost of it. And the collaborative approach can build stronger relationships in theory and maybe lead to innovative solutions that save money. And of course, you get a slice of that saving through the contract mechanisms. Some subcontractors who are confident in their cost management actually prefer target cost because it guarantees their costs are covered and they're not stuck gambling on a fixed price. And if you can price it right and manage it right, you can do well and build trust with your client. So how do we go about pricing it right and protecting ourselves? The number one rule is get it right before sight. You want a target that is realistic and achievable, not a fantasy lowball number that's going to set you up to fail. So first of all we need to do a thorough cost estimate then add some risk allowances to it. The target cost should be a genuine pre estimate of the work you're going to carry out. You don't want to be low balling it to win the job and then pick it up later in the form of pain share.
Jacob Austin 00:14:32 So you're aiming to price as accurately as possible, including including all the known scope and likely costs. Then you need to look at risk factors, things that could go wrong, and unknowns. And these are common things like reduced productivity. Activity, working outdoors in winter, coordination and interfaces with other trades that could cause delays, things like tight access to the site, materials, distribution issues, these kind of things you can build into your price not in the form of hidden allowances, but clear, defined lump sums that you can talk to the contractor about during the negotiation stage and agree how that risk gets held. The same applies to contingency as well. You probably in a fixed price scenario, price some contingency into your work. But in this scenario I'd include you to explicitly include a risk contingency. The contractor will expect to see it, and when they carry out a review and a comparison of your breakdown, you'll be able to negotiate around it and explain why it's the amount that it is for. Risks that you genuinely need allowance for.
Jacob Austin 00:15:38 The contractor is going to understand the need for it, and you can always point out that this is a target, not a fixed price. If the risk doesn't materialize, Materialise, then you'll get a saving back in the game. Share. That pricing method enables you to keep your rates keen, which are likely to be the basis of the contractor's comparison with you and other tenders. But it also enables you to include sums that will help you set that target at a reasonable level. Next, you need to carefully consider whether you choose a fixed fee versus a percentage fee. This is a decision that can impact your incentives a percentage fee. Say you get 10% of allowable cost as overhead and profit. That means if costs increase, your fee increases to keeping your margin proportionate, though, any pain share might still bite you. But it also means if you manage to cut costs, then your fee goes down in absolute terms, because obviously 10% of a smaller cost is a smaller number. So a percentage fee protects your percentage margin with rising costs.
Jacob Austin 00:16:42 But it's not great for cost control motivation. But when you compare that to a fixed fee around £100,000 fixed margin. That means if you deliver under target, you still keep that £100,000 plus your potential gain share. So by percentage terms, your profit ends up higher. But if costs rise significantly, you only maintain that original £100,000, effectively shrinking your percentage margin and potentially not covering all of your overheads if the job drags on longer. That said, the JCT formula should adjust your profit if, say, the target jumps due to a lot of changes. So fixed fee gives a stronger incentive to reduce costs because you don't lose any by saving, but it exposes you if you start heading over budget. So in practical terms, if you're holding quite a bit of uncertainty and you could see a way that cost and duration could increase for reasons out of your control, then a percentage fee might safeguard you a bit. But if the scope is more rigid and you think you can end up in gain share territory, then a fixed fee could be good.
Jacob Austin 00:17:50 You just need to double check your calculations and make sure you're covering enough overhead and a decent profit at the outset. And to note, if you do do a fixed fee, then check the clause about fee adjustment formula. If very large deviations adjust the target cost, you might also have a go at negotiating the pain and gain share percentages. These aren't assumed to be 5050, and everything is negotiable until the deal is signed. As a subcontractor, you might argue for, say, a higher gain, share in your favour on the basis that if you save money, you keeping 70% of it is fair because you're the one doing the work efficiently. Of course, main contractors will probably push back on that and likely want to keep you at 5,050% to make sure everybody's got skin in the game. And pushing for a higher share might indicate to the contractor that you're trying to push the target value up to engineer an efficiency that isn't really there. There's also the possibility of banding the shares, for example, 5050 split on the first 5% of overrun.
Jacob Austin 00:18:57 But beyond that, the share becomes say 2,080%, so that your pain is limited on extreme cost overruns. And you can take similar approaches on savings. And I've seen this done in the past where if you wildly beat the target, let's say you come in 15% lower, then you only get to gain share on the first 5%, and the remainder goes back to the client or the contractor. This might make your client or contractor more comfortable that you aren't padding the target. One commentary noted that usually above a threshold, all overspend might fall to the contractor, which would be harsh on the contractor's side. What you want to try and avoid is the flip side of that. And saying that if overspend increases beyond X percentage, then the subcontractor bears 100%. That's basically a guarantee that you won't get paid beyond that amount, and you're effectively capping your contractor's liability and taking a big risk on it. A contractor may insist on that kind of a threshold. If that's the case, then you want to push that threshold as high as you realistically can so that it's unlikely to ever transpire.
Jacob Austin 00:20:09 And where possible, you want to be adding contingency into your target to give yourself added safety factor. My next thought is a point on clarification, particularly of the allowable costs. The definitions of what's payable are fairly standard and they might not fit all the scenarios. For example, if your work is going to involve a large amount of off site fabrication. Then at what point are those costs chargeable? Does your factory count as part of the site so that you can recover time spent? If you have design responsibility, then confirmed that design fees and even subcontracted design fees to other consultants are allowable. Look at things like head office support. These are usually costs that aren't included in the cost schedule, and you'll need to build that into your fee. You also want to look at exclusions, for example, defects during the work. Knowing what items you can't get paid for. Gives you a pointer from the contract if you can't get paid for putting mistakes right, but you can be paid for spending extra time on quality control, then you know where your company needs to invest its priorities and its time.
Jacob Austin 00:21:20 Once you've finished your review, negotiate what items needed to be added to the schedule for project specific needs. And the JCT itself even suggests that parties should be supplementing the list for specific items. The goal when you get to the end of it, is that you've got no ambiguity on what you can claim. Ambiguity today is a potential dispute tomorrow and that's what we want to avoid. Next item. Account for the cost of being in a target cost contract. As we've discussed earlier, there is extra admin involved. There might also be interim financing costs if pain share is applied on a valuation to valuation basis. If some of your money is being held back as a pain reserve, effectively you're financing the extra cost of the work until final account settlement. Or until you've caught up with the schedule and you're back into gain territory. Factoring also the cost of insurances and guarantees, if any, are needed. Some target cost contracts use a pain share retention or require bonds to secure potential payback, so check if the contract requires anything like that of you.
Jacob Austin 00:22:34 You're probably better off cashflow wise to provide a bond. Otherwise, the main contractor may be looking to deduct some money for security of pain. Share. If your costs are heading that way, that might well be looked on dimly by the courts, unless it's part of a clearly agreed mechanism. But that doesn't always stop the main contractor from doing that kind of thing. And if you've also got to suffer the length of time it takes to get through court to get your hands on the money, then it's likely the amount of withholding is going to be the least of your problems. So consider that carefully and research into bonds so that you can make the decision with your eyes open. Next we've got schedule and program. This is indirectly a pricing issue because of course time is money to a degree under target cost. If the job goes longer, even with extensions of time and place, your prelims will climb along with your actual cost. You might be able to get those costs paid if the delay isn't your fault, but if it is your fault, or even if it's no one's fault, you could be in pain territory.
Jacob Austin 00:23:42 So when planning your price and your target, you've got to be hyper realistic about that program. It's no good signing up to what the main contractor asks you for. If you know it's going to be too short because if it slips and you've got no means to get an extension of time, then you will be eating the cost of additional weeks on site without any relief to your target. So agreeing a reasonable program goes hand in hand with agreeing an adequate time related cost in the target for the likely duration. Then, if the contractor wants faster completion, he needs to instruct you to accelerate, which is a potential change that would increase your target if they ask for it. Next, plan for record keeping. Set up your cost systems that capture data accurately and with enough detail from day one. That means you might need to train your site staff to capture every delivery node, every timesheet. You might perhaps want to allocate somebody the role of cost collector to keep your ledger costs substantiated and up to date or cost engineer.
Jacob Austin 00:24:49 This isn't directly a pricing activity, but it's a protection of margin activity. If you fail to document ten grams worth of costs, that could quickly become non recoverable and come directly out of your profit at the same time, it's worth considering agreeing the audit and transparency terms with the contractor for example. What kind of notice period are they going to give you before an audit so that you're not ambushed? When you're stacked out and you're trying to get the job finished? Are there any bits of industry sensitive data that you need to hold the details back for, or have confidentiality agreements in place for? And are you subcontracting to sub subcontractors of the main contractor? That's to many contractors, isn't it? If you are, then consider whether you need them on open book basis. Two it's likely going to be yes. If there aren't significant parts of your work that make up a large part of your costs. And finally, if this is your first foray into target cost contracting, then the pricing of it is going to be more complex than a typical tender, so it might be worth seeking some further advice.
Jacob Austin 00:26:02 This could be an external QZ who's familiar with target cost contracts. Or perhaps even a lawyer to spot any nasty clauses. Either way, investing in a second pair of eyes, particularly if they catch something big, could be sound insurance to protect your bottom line. Get their input on your tender, and get some thoughts on what could go wrong so that you can plan for success. One final thought on the target cost approach is that this genuinely works best in a culture of trust and transparency with your contractor. If either party is there trying to play games, one squeezing the other to set the target unrealistically high or low, or trying to strike out genuine costs, or conversely, trying to badge costs as genuine and get them included in your account. These kind of actions will destroy your relationship, and the whole thing can quickly fall apart and lead to disputes. Because at the end of the day, what we're trying to achieve here is a reasonable target cost, with some mechanisms for you either to share the risk if you're overrunning and to share the benefits if you can make efficiency savings.
Jacob Austin 00:27:14 This is a change in mindset, but you stand to build a stronger partnership with your main contractor and potentially earn bonuses for performing well. It's a chance to show off the value that you can add as a specialist and cop for some of the incentives that are on the table as a result, at the end of the day. Target costs aren't inherently good or bad at all. They're just a contract. They're a tool. They're a means to an end. And if you're asked to end to on with what we've discussed over the last couple of episodes, you can now approach it with your eyes open and the right mindset from the start. So we'll wrap it up there for today. My mission with this podcast is to help the million SME contractors working out there in our industry. If you've taken some value away from today's episode, I'd love it if you'd share the show and pass that value on somebody else who would benefit from hearing it. And of course, subscribe yourself if you haven't already. As ever, if you want to learn more, please do find us at www.QS.Zone for more information.
Jacob Austin 00:28:15 And we're also on all your favourite socials again at @QS.Zone. Thanks all! I've been Jacob Austin and you've been awesome!
