GLD Vacancies

Term time

Martin Howe explains why term contracts mean clients can demonstrate improved efficiencies during the course of the contract which are far more significant than the savings from competitive rates and prices achieved at the outset of a contract and applied over its term.

Since the Gershon Report in July 2004, there has been a requirement for government to be able to demonstrate year on year improvements in efficiency, reporting “cashable efficiencies” (i.e. efficient practices that have actually saved money) and “non-cashable efficiencies” (i.e. efficient practices that have improved service delivery but haven’t actually saved money).

In most public sector term contracts, pricing tends to be on the basis of rates and prices for the different activities anticipated to be needed. The rates and prices will have been competitively tendered at the start of the contract and, subject to indexation to reflect the effect of inflation, are likely to remain fixed for the duration of the contract. This makes it virtually impossible to demonstrate on-going efficiencies during the course of the contract because the payment regime remains fixed, by reference to the tendered rates and prices.

The limitations of rates and prices

Obtaining lower rates and prices through competition will probably provide an initial cost saving (assuming the competitively obtained rates and prices are lower than those which previously applied). However, those rates and prices will usually continue for the duration of the contract period, subject to some form of indexation to compensate for the effect of inflation. Accordingly, whilst in Year 1 the client may be able to report substantial savings on previous years, it will not be able to report any greater savings over the life of the contract.

Some underlying realities

  • Greater efficiency comes from innovation and improvement – doing things differently. A contract therefore needs to reflect the fact that the services required, and the means of providing these services, will almost certainly change over the life of the contract. Paying rates and prices for specific activities will allow for changes in the volume of services ordered but will not reflect any changes in the way those services are delivered.
  • Initial price competition may well encourage innovation by the private sector in order to make the initially tendered rates and prices more profitable over the life of the contract. Unfortunately for the public sector client, the benefits of these efficiencies are unlikely to be shared.
  • Rates and prices disguise the true costs of carrying out services. A rate will comprise an estimate of the labour, plant and materials required to carry out a particular activity. If this activity is carried out on a small scale, over a wide geographical area, the cost of that activity is likely to be far higher than if the activity is carried out in large volumes in the same geographical area. Consider for example, the cost of carrying out small amounts of road resurfacing in six different locations within a large county, compared to the carrying out of an equivalent area of the same activity in a single area. Whether a rate offers true value for money will therefore depend in part on the volumes and geographical spread of work ordered.
  • Advance planning of services is a vital requirement for more effective and efficient delivery. At least if the contractor knows it will have to carry out resurfacing works in a number of different locations, it can carry out the works more efficiently if it is able to pre-plan them than if it is instructed, in a piecemeal fashion, to do one area after the other. Advance planning is vital regardless of the payment approach.
  • The success of a longer term contractual arrangement will in large part depend on the quality of the relationship between the parties. If the relationship doesn’t work and the parties do not trust each other, it will be very difficult to make the significant efficiencies.

Understanding costs

Every rate or price will be made up of three separate elements:

  • profit and overhead: a contractor has to make a margin to stay in business;
  • risk allowance: because a contractor cannot completely control the environment in which it works, there will always be a risk allowance, to allow, for example, for the possibility that an activity which should take four days, takes five days because of circumstances outside the control of either party (for example, inclement weather conditions); and
  • the actual cost of labour, plant and materials: the actual cost of carrying out work should be known to most contractors, at least retrospectively. However, it is usual for initial pricing to be carried out on the basis of estimates of the actual cost of work. Depending on the level of understanding of the work involved, estimates may vary significantly. Greater certainty of estimating comes from repetition and understanding of previous actual costs. Under a rates and prices regime, a client will not get to see, much less understand, the actual cost of carrying out the relevant works, despite the fact that it may be ordering many millions of pounds worth of similar work over the life of the contract. Furthermore, the rates and prices are likely to become further and further removed from the actual costs as the contract progresses as inflation affects the underlying components of any rate (plant, labour and materials) differently and contractors hopefully become more efficient in carrying out the various works.

An alternative approach

Recognising these three elements of any rate or price, the starting point is to agree an amount or percentage for profit and overheads that will be payable to the contractor. This will usually be agreed in a competitive environment so should not be out of kilter with market expectations.

Payment will then be made on the basis of the contractor’s actual cost plus his margin or fee. To ensure transparency of actual costs, it is important that the client has access to all cost data (and for audit purposes, to actual invoices or other vouchers) that the contractor has. This is usually achieved by allowing the client direct access to the contractor’s electronic accounting system so that both parties can see the same cost information.

To provide clients with greater cost certainty that actual costs will not exceed their relevant budgets, it is usual to set target costs. Our own experience is that it is better to set these as an overall annual target (recognising that there may need to be separate target costs for revenue and capital funded services, at least, for local authority accounting purposes). The target cost will be derived from the estimated cost of carrying out the services planned for a financial year including the amount of any reasonable risk allowance.

If the contractor delivers the services for less than the relevant target cost, there will usually be an arrangement for it to share in those savings. This incentivises both client and contractor to become more efficient so as to share in savings (with public sector clients, the intention will usually be to identify and spend their share of any surplus which would otherwise simply be returned to the Treasury at year end). If actual costs exceed the relevant target cost, there will usually be a small range (e.g. up to 105% of the relevant target cost) over which the contractor and client will share the cost overrun (i.e. contractor will only recover a proportion of those additional costs). Usually there is also an upper limit, above which the contractor pays all additional costs – a guaranteed maximum cost.

Linking payment and performance

In order to encourage and incentivise a contractor to achieve the wider objectives of the client, it is important to link at least some element of payment to performance against clear performance indicators. Our experience teaches us that performance indicators need to be concise, relevant to the achievement of the aims to the contract, realistic and output (not input) based. It is also probably necessary, to encourage continual improvement, for clients and contractors to review and update performance indicators periodically to ensure they are relevant and challenging (but nevertheless achievable).

Payment and performance can be linked in a number of ways including:

  • linking entitlement to payment of an element of the contractor's margin to achievement of minimum performance against KPIs;
  • allowing "performance deductions" for failure to achieve minimum performance against KPIs; and
  • making minimum performance against KPIs a condition precedent of entitlement to share in any savings below a target cost and/or to any extensions to the contract period.

Working collaboratively

For any long term arrangement to be successful, it is vital that both parties work together as a team. In our experience, this can be easier under an open book arrangement where cost transparency removes the underlying tensions of clients fearing contractors are making too much profit and contractors being keen to keep secret what they are earning, good or bad!

After a couple of years of operating on an actual cost basis, clients should have a much better understanding of where the true costs of providing its service lie and be able to discuss, in an informed way, with their contractor how some of the major cost items may be reduced and what the respective risks to achieving this objective may be.

Contrast this with an arrangement based on rates and prices: where the client will have no greater understanding of the actual costs of carrying out services at the end of the contract and, because the various components of any rate or price (the plant, labour and materials) will have been affected differently by inflation, it is likely that any rates and prices will have become more divorced from reality by the end of the contract so as to provide even less of a guide to likely underlying costs.

Martin Howe is a partner in the Commercial & Infrastructure (Construction) team at Bevan Brittan. He can be contacted on 0870 194 8975 or by email at This email address is being protected from spambots. You need JavaScript enabled to view it..