ICAEW.com works better with JavaScript enabled.

Cost-plus contracts: taking a different approach to construction

8 February 2021: Appetite for a different approach to construction projects is growing, particularly around complex contracts, says Darren Ward, managing partner at specialist firm The Orange Partnership.

"Lorem

Across the construction sector, fixed-price contracts dominate the landscape – industry estimates suggest around 60% of building projects are run this way. Clients like them because, in the absence of scope-creep, you know up-front what the project is going to cost. Once the price is agreed, the financial risk is very much carried by the contractor. On the flip side, the client never truly knows how much profit the builder is making. 

But in the 17 years since Darren Ward has been at the helm of specialist accountancy firm The Orange Partnership, the appetite for a different approach - cost reimbursable contracts - is growing. Sometimes known as cost-plus contracts, they are structured in a way that the contractor is reimbursed for the actual costs they incur, plus an additional fee to cover their overheads and profit.

“These reimbursable contracts are more suited to complex projects where clients are doing something different and there are significant risks in building that project. They tend to be £10m+ contracts,” Darren explains. In this type of arrangement, risks are more openly discussed between the client and the contractor. The fact that they are heavily preferred by the government and major PLCs means their use is gaining traction.

Darren and his business partner John Taylor met in the early noughties while working as audit managers verifying costs on the construction of Heathrow Terminal 5 – then the largest construction project in the UK. At the time it broke with convention by reimbursing on an actual cost basis. “It was £4.5bn of open book accounting records being tabled for inspection.” 

The eight years Darren worked on the Heathrow Terminal 5 project laid the foundations for his own business, he says, opening his eyes to the inefficiencies of an assurance approach that hinged on quantity surveyors painstakingly checking a set proportion of invoices. “It showed me both the right and wrong way to approach cost verification on open book cost-reimbursable projects. I saw how clients were spending a lot of money for bums-on-seats assurance work that actually provided little confidence over cost accuracy.”

Instead, Darren and John devised a risk-based approach that leaned heavily on their accountancy background. “Accountants know so much more about what makes a cost or transaction accurate in terms of the importance of it being well controlled and the level and quality of evidence required,” he explains. The Orange approach also brings cost data together with other data sets and systems to paint a picture that allows you to perform more intelligent sample testing, Darren explains. 

“We use software to make construction costs come alive. It’s about telling the story about how the costs were incurred, how they compare to budgets and how they’ve changed over time. It’s not about getting your red pen out and simply checking invoices.” Not only is their forensic accounting approach quicker and cheaper, but it’s also more effective in identifying significant overcharges, Darren says; at Terminal 5 alone, it recovered over £75m. 

The Heathrow open book project became something of a blueprint for construction contracts. The Orange Partnership has since forged an excellent reputation and an enviable client list providing cost assurance services on huge open book construction projects. The firm continues to work with Heathrow; it has been a framework consultant for the airport for the past 15 years and has a similar five-year arrangement with nuclear power station Hinkley Point C. Other clients read like a who’s who across the water, energy, defence and transport sectors. 

The framework contracts give Orange a foot in the door on these long-running projects or ongoing infrastructure contracts and while not technically a guarantee of work, they keep Darren and his team very busy. The impact of the COVID pandemic on the construction industry has been significant – presenting both challenges and opportunities to Darren and his team.

“Heathrow was spending £3-5bn every five years improving its capital infrastructure to retain its position as the main airport hub in Europe – that could be 200 to 300 projects each worth between £1m and £200m.” In the last 12 months, the financial dent to the P&L due to plummeting passenger numbers – currently at around 10-20% of normal numbers - has been severe, to say the least. “Any operational business that’s struggled to make any profit is unlikely to be making bold claims about investing in capital projects.”

The knock-on effect for the Orange Partnership has been work from Heathrow reducing massively in the last year. A bounce-back will happen but presents its own challenges, Darren predicts. “These are huge infrastructure sites – you can’t just switch the lights off and go back six months later and switch the lights on again – it will be a complex and gradual rebuilding of demand, capacity and also the appetite and confidence to invest.”

More generally, social distancing rules have increased both the complexity and cost of construction work. The Orange Partnership’s blend of accounting and commercial expertise has helped clients keep a handle on costs, amid concerns that credits from furlough schemes wouldn’t materialise in their contract accounts. “Clients want certainty and comfort around people costs, in particular where there are additional complexities that require technical accounting expertise.” 

Darren is keen to dispel the construction industry myth that builders will have the shirt off your back, not helped by programmes like Cowboy Builders. However, with tight margins in play – typically cost plus 5-7% - it is an aggressive market at the best of times, under increasing pressure since COVID hit. “We do a lot of work with contractors to help them share their costs in a clear and transparent way. This ultimately helps put the client’s minds at rest that they are receiving value.”

The experiences of the 2007/8 recession prompted some fundamental changes to avoid the rather hand-to-mouth existence for many in the construction sector. “A lot of construction companies are looking for framework contracts to give them certainty of supply because constantly working on tenders is draining.” Smaller direct labour forces complemented by specialist subcontractors also helps reduce the risk of managing businesses successfully during a downturn.

Despite the ongoing challenges, Darren is optimistic for the future, buoyed by the government’s recently published National Infrastructure Strategy, which outlines ambitious proposals backed up by hundreds of billions of pounds of public and private investment, including £27bn earmarked for economic infrastructure for 2021-22. “The construction sector will have plenty of money coming into it. We’re in a positive place and looking upwards.”

Join the ICAEW Construction & Real Estate Community for free, to access resources for finance professionals interested in real estate, property and construction.

Article series: Infrastructure and Recovery

A plethora of financial, climate, health, societal and business issues have resulted in significant challenges for economies globally. Pressure on public finances, and the need for simultaneous levelling up, will be immense – while private investment must be more enlightened. Where does infrastructure investment fit into recovery?

See the series