The cost structure of IPD contracts is a common question for construction project owners in the early project phase when they are negotiating the value of the contract and at the end of the project.
These are some questions to answer:
- How do we calculate the final cost?
- Is there a risk or a reward?
- Does the team get all their profit or not, and is there shared savings or not?
The team develops the cost for the project as the design is evolving
At the beginning of an IPD contract, the owner engages the primary designer and builder. Through an open book process, the team develops the cost for the project as the design evolves.
The cost structure is composed of three components:
- The cost of work (including overhead)
- A negotiated contingency
- The profit of the primary designers and builders (risk/reward partners)
The builders and the designers calculate what they expect their cost to be, and then the team aggregates all of those costs into a total cost of work. Lastly, the team negotiates a contingency, which can either be set up as a percentage of the cost of work or by using a risk and opportunity log.
Let's assume it is done as a contingency. The team agrees to add a four percent contingency, for example, on top of the cost of work.
Image: Giorgio Trovato via Unsplash
Incentive compensation layer within risk and reward plans
The last piece of the cost structure of an IPD contract is the profit. In an IPD contract, the designers and builders, working within the risk and reward plan, will separate their profit from their cost of work. The profit will be aggregated into a profit band.
In some contracts, this is called the incentive compensation layer.
The reason we call it an estimated maximum price is that in an IPD contract, the owner agrees to pay the cost. So if the cost exceeds the estimated maximum price, the owner will continue to pay those excess costs. Consequently, the team will not get any profit from delivering the project.
If the project finishes below that value, then the team is going to get a percentage or all of its profit. In cases where the project does significantly better, each team member will receive their profit plus a percentage share in the savings on the project.
Whether you look at a target cost plus incentive compensation layer or you call it an estimated maximum price, the math is the same. You have a cost of work component, which includes the overhead for each of the parties.
Contingency and profit layers
How do the contingency layer and profit layer work in practice?
Once the contract values are set, and the team is delivering the project, the contingency within the cost of work will change as the project moves forward. Each month, the team builds on the project and tracks its costs, causing the cost of work to increase.
If the project cost exceeds the target costs, the profit band will shrink. If the actual cost exceeds the target cost plus the profit or exceeds the estimated maximum price, then the team will get no profit on the job, and the owner will pay for all costs including overhead for the team.
If the cost finishes below the target costs, then, as outlined in most IPD contracts, the team will get all of its profit. The profit is often fixed as a lump sum when the contract value is set, which means that the team will earn 100 percent of their profit, plus some percentage of the savings below the target costs.
In general, IPD contracts include shared savings or a loss of profit depending on the actual cost and how it compares to this target cost plan.
To build the contract value for our IPD agreements, we aggregate the cost of work for all designers and builders and add a contingency amount on top of this cost, then add the profit for all the team members. Those three values add up to the contract value for the agreement.
As the costs are built on the actual project, depending on how the team's final costs compare against the target cost or the cost of work plus contingency, the team either loses some of their profit or gets all of their profit and some amount of shared savings.
Feature image: Alexander Grey via Unsplash
James is an expert in the set-up and structure of large, complex capital projects using Lean and Integrated Project Delivery to drive highly reliable results.
He has negotiated IPD contracts and delivered over $650M in complex healthcare projects as an Owner's Representative with multiparty contracts, aligned team incentives and collaborative delivery models.