*incentives - step-by-step guide

Set out below is a step-by-step guide to the development and negotiation of the Incentive for the purposes of clause 18 of MCC-1 2003:

1.The Incentive mindset

The purpose of the Incentive is to provide a financial driver to motivate the Contractor to achieve exceptional performance in designing, constructing and commissioning the Works. Accordingly, the factors which motivate a particular contractor may differ from those which motivate other contractors. While the incorporation of a suitable incentive mechanism is a key feature of MCC-1 2003, Defence must therefore approach the development and negotiation of the incentive mechanism with an open mind and a preparedness to consider a variety of incentive structures and mechanisms.

It is unlikely that a single approach will be suitable for all contracts and contractors.

2.Relevant tender and contract provisions

Although the tender and contract documents are not prescriptive, part 4 of Tender Schedule E states the following in relation to the outline KPIs and Incentive which tenderers are required to bid:

"The Commonwealth is keen to align its interests with those of the successful Tenderer in delivering the Works under the Contract. It intends to enhance this by:

(a)providing the successful Tenderer with an opportunity to earn an incentive, contingent upon exceptional performance (measured against agreed KPIs), payable following expiry of the last Defects Liability Period; and

(b)allowing the Tenderer to nominate (within the general guidelines below) an incentive mechanism which would be most likely to facilitate the alignment of interests for the Tenderer.

As a guide, the Commonwealth considers that any incentive mechanism proposed by the Tenderer should have regard to the following principles:

(c)the extent of the incentive pool, to be made available to the successful Tenderer, will be determined prior to achieving Planning Phase Agreement, having regard to the performance of the successful Tenderer during the Planning Phase, including factors such as:

(i)the extent to which the Contractor is able to reduce the need for contingency in the Delivery Phase;

(ii)the amount spent on design development (through Reimbursable Costs) and how closely that corresponds with the outline target cost referred to in paragraph 3(a);

(iii)the Target Cost set;

(iv)the scope to be delivered within the Target Cost;

(v)the time within which the Planning Phase is completed;

(vi)how closely the Management Fee and Contractor's Work Fee (Delivery) as adjusted under clause 6.4(a)(i) of the Conditions of Contract correspond with the amounts tendered; and

(vii)the extent to which other requirements under the Contract (such as in respect of WOL) are furthered; and

(d)whether or not (and the extent to which) the successful Tenderer is ultimately entitled to any payment out of the incentive pool will depend on the Contractor:

(i)either:

(A)achieving Completion of the initially agreed scope for a total cost to the Commonwealth less than the Target Cost; or

(B)achieving Completion of the initially agreed scope, together with additional scope, for no more than the Target Cost;

(ii)achieving Completion by the Target Date; and

(iii)achieving the KPIs proposed by the successful tenderer, and agreed under clause 6.4 of the Conditions of Contract.

Apart from dealing with incentives, the Tenderer should stipulate the extent to which it is prepared to put at risk:

(e)the Contractor's Work Fee (Planning), subject to obtaining Planning Phase Approval by the Date for Planning Phase Approval; and

(f)its Management Fee, subject to achieving Completion of the initially agreed scope of the Works within the Target Cost."

Under clause 6 of the Conditions of Contract, the relevant provisions are:

  • clause 6.4(a)(iii), which requires the Contractor to undertake genuine good faith negotiations with the Contract Administrator to reach agreement on the KPIs and the Incentive (as part of the fee adjustment under clause 6.4), having regard to the factors in clause 6.4(a)(iv) - (viii);
  • clause 6.4(b), which requires the Contract Administrator to document the agreed fee structure, including KPIs and Incentives;
  • clause 6.4(c), which enables Defence to elect not to proceed to the Delivery Phase if the parties are not able to agree the KPIs and Incentive (as part of the overall fee structure). In that event, Defence is not required to make any payment to the Contractor, other than on account of amounts payable for work done;
  • clause 6.6(a)(iii)B (in tandem with clauses 6.6(c)(i) and 6.7), which sets out the position if Planning Phase Approval is not obtained and Defence does not proceed to the Delivery Phase with the Contractor.

3.Issues for consideration in establishing and implementing incentives

3.1Generally

Issues that require consideration include:

  • the benefit to be gained by Defence for paying the Incentive;
  • the principles on which Defence is prepared to agree to include KPIs and Incentive under the Delivery Phase (note that it might be open to Defence to elect to proceed to the Delivery Phase without any KPIs or Incentive, although this has not been expressly stated in clause 6);
  • the negotiation process;
  • the role (if any) of a facilitator during fee negotiations in the Planning Phase; and
  • the protocol for negotiation and the outline format for the KPI schedule and incentive mechanism.
  • Benefit to Defence

As mentioned in item 1 above, it is critical that Defence does not lose sight of the fundamental reason for establishing an incentive regime: to provide Defence with an additional, tangible benefit. That is, Defence should not place itself in the position where it is paying a premium (ie. the Incentive) where that premium is not directly relevant to the additional benefit that Defence receives.

For example, if Defence will receive no benefit from having the project completed early, then it should not structure an incentive mechanism that rewards early completion. The flip-side, however, is that if Defence will receive a tangible benefit from early completion (eg. reduction of lease costs for current premises), then it may be appropriate for Defence to pay an incentive to the Contractor.

3.3Principles

(a)KPIs must be relevant and set at right levels

The purpose of the incentive is to reward exceptional performance, not "business as usual" performance. Accordingly, Defence must ensure that the KPIs cover all relevant criteria and are set at levels that truly indicate exceptional performance. That is, simply achieving the minimum level of contractually agreed outcomes (whether relating to fundamental or secondary matters) is not sufficient.

It is also fundamentally important that the KPIs provide a true indication of performance against the key deliverables and outcomes of the project. That is, they must be able to objectively measure:

  • time (ie. Completion by or before the Target Date);
  • cost (ie. Completion within or up to the Target Cost); and
  • scope and quality (ie. ensuring that the project is completed in accordance with or exceeding the expected scope and quality requirements).

Of the three key outcomes described above, scope and quality is clearly the area that is most difficult to assess objectively. As mentioned at paragraph 3.5(b) below, the manner in which objective scope and quality benchmarks (which would ideally have general application rather than being reinvented for each project) can be established requires further Defence consideration.

It is also preferable that, for the purposes of the calculation of the Incentive, only a small number of KPIs are used.

(b)KPIs not to skew / distort

Defence must ensure that it does not focus too strongly on certain specific KPIs at the expense of other more general indicators (eg. time, cost, quality). For instance, if there is over-emphasis on a specific KPI such as safety, without corresponding emphasis on time and cost, the Contractor might devote time and resources to achieving the safety KPI at the expense of Defence achieving its time and cost objectives.

(c)Timing

The process of agreeing KPIs and incentives is not just a matter of filling in a pro forma KPI schedule and incentive mechanism. Rather, this process is likely to require significant commitment from the key personnel on each side, and robust debate in a focused workshop. This should be convened early in the Planning Phase, to ensure that these significant matters do not just become an after-thought, requiring rapid resolution in a compressed timeframe prior to the end of the Planning Phase.

(d)Documentation

The KPIs must be carefully documented, to ensure that performance can be measured and the Incentive calculated against the KPIs with certainty and minimal dispute. This requires the use of objective bases for determining whether or not each KPI has been achieved (capable of resolution by an arbitrator, if the parties are unable to agree).

Further, if there is to be a risk as well as a reward component to the Incentive (ie. the possibility of the Contractor being "penalised" for failing to achieve a KPI), then consideration will need to be given to the effect of the "prevention principle". This is a principle of law which - in the present circumstances - would prevent Defence from seeking to impose a "penalty" under MCC-1 on the Contractor for failing to achieve a KPI, where the failure to do so was caused by an act or omission of Defence.

For instance, if the failure to achieve completion on time or within budget was due to Defence delays or variations, and this resulted in the payment of a "penalty" (such as the Contractor having its Management Fee reduced by all or a portion of the cost overrun), then the prevention principle might preclude Defence from being able to enforce this. Having said that, this area of law is not entirely clear, and there may be less risk of the prevention principle applying, depending on the way in which the risk or reward mechanism is structured. Specialist advice should therefore be obtained before finally documenting the KPIs and the Incentives.

The prevention principle is the very reason why extension of time clauses exist in construction contracts. Such clauses enable the principal to extend the contractually-stipulated completion date for delays caused by its acts and omissions, thereby keeping alive its right to impose liquidated damages for late completion (albeit by the later adjusted completion date).

By analogy, if a risk and reward mechanism were to be included under MCC-1, Defence should consider whether or not an adjustment mechanism (along the lines of an extension of time clause) should be provided in the KPI schedule. The purpose of that mechanism would be to enable Defence to adjust the KPI level required to be achieved where the Contractor has been prevented from achieving that level by an act or omission of Defence.

3.4Negotiation process

Defence needs to internally consider the manner in which it carries out negotiations in relation to this form of contract. Part of this process may involve the engagement of a facilitator (as discussed below). Defence's key concern is to ensure that those Defence personnel with the requisite expertise in the relevant area carry out the negotiations on behalf of Defence.

3.5Role of facilitator

The facilitator is intended to assist Defence personnel in carrying out the negotiations, rather than actually running the negotiations on behalf of Defence.

Although the approach to KPIs and the Incentive under MCC-1 avoids prescription, it is still critical to ensure that those matters (as finalised on any given project) do not cut across the other dynamics intended under managing contractor delivery.

3.6Negotiation protocol and outline KPI schedule

Notwithstanding that Defence's overall intent is to give the parties maximum flexibility to negotiate KPIs and the Incentive with regard to the particular circumstances of each project, Defence may wish to prepare something akin to a "KPI and Incentive Negotiation Protocol". This would at least give the parties some guidance, both at the time of tender and the outset of the Planning Phase, as to what Defence's intentions and interests are.

Such a document should be discussed with the specialist facilitator and relevant Defence personnel.

The protocol could address key issues, such as:

  • structure of negotiation process, including meetings, exchange of information and draft documents;
  • stakeholders to be involved in the process;
  • timing;
  • relevant considerations, in addition to those stated in clause 6.4;
  • possible menu of KPIs; and
  • outline draft KPI schedule (particularly for the purposes of focusing the parties' negotiation and of assisting the Contract Administrator to document what has been agreed under clause 6.4(b)).

4.Steps to follow

The steps set out below are an indicative guide only as to the important steps that should be carried out in the development and negotiation of the Incentive mechanism, and an appropriate order in which they should occur:

(a)Step 1: Establish draft list of KPIs

In light of the principles listed in item 3.3 above, a draft list of KPIs should be prepared. The preparation of such a list - even if only in draft form - should be prepared as early as possible during the Planning Phase so as to focus the parties' attention as to those factors which are most important for the particular project.

If this early development approach is adopted, the list of KPIs can be refined and finalised during the negotiation process at the end of the Planning Phase.

(b)Step 2: Determine financial drivers

It is important to determine, as early as possible in the Planning Phase, the financial drivers that will ultimately form the monetary component of the Incentive.

Matters to be discussed include:

  • is the Contractor interested in a high risk (with potentially higher rewards) or low risk (with lower potential rewards) strategy?
  • in particular, is the Contractor willing to put any of its profit (ie. Management Fee) at risk?
  • how much is it worth (eg. costs, savings, improved capability etc) to Defence if the Contractor performs well against KPIs?
  • how much is it worth to Defence if the Contractor performs exceptionally well against KPIs?
  • how much money does Defence potentially have available to pay an Incentive (ie. how much is in the incentive pool)?

(c)Step 3: Finalise KPIs

Having regard to the relevance of and performance against the original draft KPIs, and the various financial considerations and drivers, the parties must - in the latter stages of the Planning Phase - finalise the KPIs which are to apply for the Delivery Phase.

The KPIs should be expressed as a list of simple, clear and objectively assessable performance measures or indicators. For example:

  • delivery of the Works against the Target Cost;
  • Completion of a certain stage by a particular date;
  • delivery of other deliverables (eg. maintenance manuals, DEMS input) by a particular date;
  • maintenance of key resources.

(d)Step 4: Allocate value to each KPI

This is one of the most critical steps. Great care must be taken to consider the total cost to Defence and the Contractor if all (or none) of the KPIs are achieved.

A dollar value (or possibly a percentage value) must be allocated against each KPI. The dollar value may then be either a flat amount or may depend on how well the Contractor performed against the KPI.

For example:

  • Completion of a certain stage by a particular date may be worth $x to Defence (by reason of savings elsewhere); however, Completion one day later may be worth nothing to Defence. Therefore, the Incentive amount should be a flat figure;
  • Completion against the Target Cost could have a number of levels/steps, allowing the Contractor to achieve differing amounts depending on the level of performance. For example, if Completion is achieved:
  • for the Target Cost - $x is payable to the Contractor;
  • for greater than the Target Cost - $x-y is payable;
  • for less than the Target Cost - $x+y is payable,

where "y" equals a percentage (or sliding scale of percentages) of the cost overrun or underrun.

(e)Step 5: Determine upper limits for each party

Following allocation of values to KPIs, a final sanity check should be carried out to ensure that the total potential amount payable (from Defence's perspective) or at risk (from the Contractor's perspective) is within acceptable limits for each party.

If the total amount potentially payable by Defence if all KPIs are achieved exceeds the amount of the incentive pool, it may be necessary to cap the Contractor's 'gain'. Conversely, it may also be necessary to cap the Contractor's 'pain' if the Contractor fails to achieve any KPIs.

(f)Step 6: Adjustment of KPIs / Incentive

It is very important to give careful consideration as to whether, and in what circumstances, the KPIs and/or amount of Incentive payable can be adjusted.

For example, if the benefit to Defence will only accrue where Completion occurs by a certain date, then there is no point in allowing an adjustment to that KPI (notwithstanding either party's conduct) as Defence will receive no benefit from Completion by the later date.

(g)Step 7: Prepare Incentive summary schedule

Following the completion of negotiations as to the details by the Contract Administrator of the Incentive mechanism, a clear, concise and accurate schedule should be prepared by the Contract Administrator setting out all KPIs and the respective amounts for achieving (or failing to achieve) the KPIs.

(h)Step 8: Incentive cannot be a penalty

The Incentive mechanism cannot be structured so that the failure to achieve the KPIs amounts to a penalty (and is therefore unenforceable). Specialist legal advice should be obtained to ensure that this does not occur.

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