CONTINUING PROFESSIONAL DEVELOPMENT
Maximum Period 4 Hours
OPEN BOOK ACCOUNTING
By
Roger Knowles and Mike Gregson
Open Book Accounting
BASIC CONCEPTS
The Need for Open Book Accounting
There has in the past few years been a consistent move away from lowest
price tendering. Contracts for construction work are now regularly placed on
the basis of best value. In place of a tendered sum for carrying out the work
being the preferred method of payment, contractors are frequently reimbursed
on the basis of their recorded costs. In using this method of payment many of
the matters which lead to disputes no longer exist. Arguments relating to the
value of variations, disruption and extended preliminaries resulting from time
overruns no longer occur when the contractor is paid in accordance with the
costs incurred. To avoid inefficiency it is necessary for proper methods of cost
recording to be developed which are easily capable of being checked. This
will involve agreement being reached at the outset as to the manner in which
costs are recorded and a checking process put in place. To the recorded
costs is added a profit
Target Price
To ensure that there are incentives in place so that costs are kept to a
minimum it is usual for a target price linked to a gain/pain mechanism to be
fixed at the outset. The recorded costs are measured against the target price
and any saving shared between the contractor and employer in a pre-agreed
manner. In like manner any over expenditure compared with the target is
shared.
Basic Open Book Mechanism
The traditional method involves an agreed price for the work. Actual cost
incurred by the contractor in carrying out the work is never seen by the
employer therefore where the costs are less than the agreed price the
contractor keeps the gain. In the event of the costs exceeding the agreed
price the contractor incurs the pain. Where an open book system applies the
gain and pain are shared by the parties based upon a pre-agreed mechanism.
Open Book Accounting
KEY ELEMENTS
The key elements in the open book process comprise the following:

Terminology

Setting the target price

Defining actual cost

Cost recording

Auditing the open books

Reporting
TERMINOLOGY
Target Price
This is the agreed price against which the costs plus profit will be compared. It
should be arrived at by agreement between the employer and contractor
usually based upon information e.g. schedule of rates, overheads and profit
submitted as part of the tender bid. If the contractor is requested to submit a
target price with the tender bid it can become a lowest bidding method which
is not the intention of the process. Therefore tenders are usually assessed
based upon a price/quality matrix e.g. 30% price 70% quality. There is no
industry standard method for calculating the target price it is usually a matter
for agreement between the employer and contractor.
Adjusted Target Price
The target price is adjusted during the progress of the works to take account
of employer’s changes and the cost of other matters which under the terms of
the contract are the employer’s risk. The allocation of risk is one of the early
decisions to be taken where an open book accounting process is employed.
Guaranteed Maximum Price
This is a prefixed lump sum contract price paid to the contractor for
undertaking the construction the work. There is no provision for adjustment of
the contract price except for changes required by the employer. It is unusual
for contractors to agree to enter into contracts with no provision for adjustment
in the price where costs may increase due to changes in legislation. Where
work involves for example major alterations to services such as water, gas
and electricity contractors often seek to exclude from the contract price the
unforeseen cost of dealing with these services. Contracts none the less are
Open Book Accounting
often referred to as Guaranteed Maximum Price when in fact there are
provisions for adjustment to the price for any number of specified events in
addition to changes introduced by the employer. These are not therefore
Guaranteed Maximum Price in the true sense of the word. It is therefore
important where a contract is styled as Guaranteed Maximum Price for there
to be a definition provided in the contract as to its meaning.
Risk
The contract, by the use of a risk register, will usually indicate which of the
parties will be taking the identified risks. This represents a situation which may
or may not occur. When calculating the target cost it is necessary to include a
financial provision for the risks which under the contract the contractor is
required to bear, for example unforeseen bad ground conditions. It will not be
possible to produce a precise calculation but some allowance needs to be
made. Clarity is the key here, defining who takes what risk.
Costs
The costs incurred by the contractor in undertaking the project. There is no
industry standard by which costs are recorded it is a matter for agreement
between the employer and contractor. Some standard forms e.g. Public
Sector Partnering Contract and the ECC contain a schedule of cost
components.
Contractor’s Profit
The level of contractor’s profit is agreed at the outset and may be a
percentage added to the cost or a lump sum
Gain Share
This occurs where the total costs and contractor’s profit for the project are
less than the adjusted target price. Any saving or gain share is shared
between the employer and contractor usually on a pre-agreed percentage
basis. The contractor is usually paid the gain share when work has been
completed, the target price adjustments all carried out and the final cost for
the project available.
Pain Share
This occurs where the total costs and contractor’s profit for the project are
greater than the adjusted target price. The pain share is usually shared
between the employer and the contractor normally on a pre-agreed
percentage basis. On some schemes for example the NHS ProCure 21 the
employer takes no share of the pain which is fully carried by the contractor.
Employers are usually careful to ensure that costs in full for the project are not
paid to the contractor if there is a likelihood that a repayment of the pain share
is likely to occur.
Open Book Accounting
Disallowed Costs
The contract will usually provide for some cost which is incurred by the
contractor to be disallowed. For example it is usual for provision to be made to
disallow the cost of rectification of defective work and excessive waste.
Disallowed costs need to be defined at the outset and included in the contract.
Example
The target price for the project is £10m with no adjustment required. In the
gain share scenario the cost including profit is £9m giving a gain of £1m. The
gain share provides for equal shares for employer and contractor amounting
to £500k each. The total payment to the contractor is thus £9.50m. In the pain
share scenario the costs amount to £11m with the £1m over spend being
shared equally. The total amount paid to the contractor is therefore £10.50.
SETTING THE TARGET PRICE
There is no industry standard for arriving at a target price. However by
common practice it is usual to calculate the target price using the following
building blocks.

Unit costs

Risk allowance

Head Overheads

Profit
Unit Costs
The unit costs may be calculated using a schedule of rates for work which is
inclusive of labour, materials and plant. Measured quantities for the work are
then applied to the rates to arrive at the unit costs. Where the target is fixed at
a stage when little design work has been undertaken a more basic approach
is often used by employing the floor area of the building and applying a rate
per square metre for the labour, plant and materials. It is sometimes
convenient to calculate the areas of the various elements such as cladding
and roofs of the building and apply a separate rate per square metre for each
element in respect of the cost of labour, plant and materials to provide a total
cost for each element. These costs should always be inclusive of what are
often referred to as site preliminaries such as the cost of site accommodation.
Where a large part of the work is to be designed and constructed by
subcontractors the unit costs are often built up using quotations received from
the subcontractors who will be undertaking the work.
Risk Allowance
Open Book Accounting
The contract should be very clear as to how the risks are to be shared
between the parties. This is often achieved by using a risk register. In building
up the target price a sum should be included in respect of the risks which are
to be bourn by the contractor. For example it is usual in times of relatively low
inflation for the target price to include for inflation. On many contracts the
contractor is required to include in the target price the cost of any ground
conditions which may be encountered whether they are foreseeable or
otherwise. A financial provision should be included in the target price for these
types of risk. Where the extent of ground conditions which are anticipated to
be unfavourable is unknown before work commences it is better for a
provisional sum to be included in the target price which can be adjusted at a
later date to take account of the contractor’s actual costs. It should however
always be made clear at the outset as to which of the parties bears the risk.
Open Book Accounting
Head Office Overheads
The head office overheads are usually provided for separately in the build-up
of the target price. It needs to be made clear at the outset which costs are
included under this heading and which are site costs. For example quantity
surveyors may be site based and included in the unit costs whereas the
commercial director and chief quantity surveyor may be head office based
and form part of the head office overheads. It is usual for the head office
overhead element to be calculated by the addition of a percent to the total of
the unit costs
Profit
The profit is the reward paid to the contractor for satisfactorily completing the
work. It is usually calculated by adding a percentage to the total of the unit
costs, risk and overheads.
Adjusted Target Price
The terms of the contract should make it very clear as to the manner in which
the target price is to be adjusted. Provision should always be made for
changes introduced by the employer. There are often provisional sums
included in the build-up of the target price. Examples are the removal of rock
and running sand the presence of which is expected but the full extent
unknown. Where this occurs the target price will be adjusted to take account
of the contractor’s actual costs. The risk register will indicate the risks the
employer will be bearing and the target price may need adjusting in the light of
what has occurred during the progress of the works Whilst not inevitable,
delays are often incurred as a result of some action or failure on the part of
the employer and provision should therefore be made for adjusting the target
price where this type of event occurs. It will always be necessary to carry out
an adjustment of the target price before calculating the gain share or pain
share.
When to Set the Target Price
With tender submission
It is not uncommon for the contractor to be required to submit the target price
with the tender submission. Where the procurement route is for employer
design a pricing document is often provided by the employers QS. With a
design and construct procurement route the contractor will be expected to
produce its own pricing document. This method can be a back door route to
lowest price and not in keeping with the idea of best value.
After The Contractor Has Been Selected Prior to Signing of Contract
The selection process may require the contractor to submit with the tender
submission the prices for overheads and profit. This is often extended to
Open Book Accounting
include the prices for site preliminaries. It is more challenging if the target
price is fixed after a value engineering process has been completed where the
contract provides for a distinct process of value engineering. On many
contracts however value engineering is an ongoing process. To permit a
major value engineering process to take place after the target price has been
fixed provides little incentive to manage costs effectively.
The procedure for calculating the target price may occur at an early stage of
design when the contractor is undertaking the design process. This should
provide an incentive to ensure that the finished design produces the most cost
effective solution. Where the design is undertaken by the employer it is
normal for the design to be fairly well advanced before the target price is
fixed. It would be unreasonable for the contractor to take the risk of the target
price being too low due to it being based on an incomplete Employer’s design.
DEFINING ACTUAL COST
Contract Provision
In the early days of cost reimbursable contracts it was common for contractors
to be paid on the basis of the costs as they emerged from the computer. This
system was soon seen to be somewhat hit or miss and as a result the whole
process has become more sophisticated. Contracts such as the ECC, Public
Sector Partnering Contract and JCT Prime Cost contracts all provide a
definition of the items which are to be paid for at cost.
Cost Components
The components which are to make up the costs should be agreed and
included in the contract documents. It is not unusual for the contractor to be
reimbursed the actual cost paid in respect of the items. Care should be taken
however when paying the contractors actual paid out costs to ensure that the
contractor is not overpaying. This may be the case where the contractor is
using plant which is hired from a subsidiary company. It is not unusual for the
contractor to be requested to include the unit rates to be applied to the cost
components as part of the tender submission.
Supply Chain Costs
On most contracts a great deal of the work is undertaken by subcontractors
which in some cases totals up to 80% or 90% of the total cost for the project.
The system has not developed sufficiently to allow for many subcontractors to
operate on an open book basis. It is usual for a price to be agreed with the
subcontractors and this to be the basis for inclusion in the actual cost of the
work . Some of the major specialists are however working toward the open
book method and it will not be long before many of them are operating in the
same manner as the main contractors. The supply chain costs usually include
the supply of components such a windows and doors where the onsite fixing
is undertaken by specialist subcontractors.
Open Book Accounting
COST RECORDING
Cost Coding Structure
The better open book accounting systems are tailored and designed to sit as
a framework in conjunction with the contractor’s current cost systems thereby
minimizing business disruption and working practice changes. Each project
requires an individual cost code and for all labour, materials, subcontractors
accounts and plant employed on the project. The coding system should be
sufficiently sophisticated to enable disallowed costs to be identified.
The conditions of contract such as the ECC contract and the Public Sector
Partnering Contract provide for the contractor to be paid monthly using the
recorded costs as the basis for payment. It is important that the contractors
costing methods be understood where this method of payment applies. Most
costing systems provide for the following:

Labour costs usually included in the costing system weekly

Material and plant invoices are recorded in the costing system once
they are approved

Cost of employing subcontractors is included in the costing system
once a sum has been certified by the contractor’s quantity surveyor

Costs to be accrued where a cost obligation is recognised but either
the process of approval or certification is yet to be completed, or where
a request for payment is not fully recognised but good housekeeping
requires some provision to be made.
Discounts
The definition of cost should make it clear if the normal procedure of
discounts being credited to the employer applies. This would include trade
discounts, cash discount and discounts based upon the annual spend
Central Stores
Where materials are bulk purchased and kept in a central store a proper
signing out procedure need to be in place to ensure that all materials which
are used on the project are included in the costs.
Disallowed Costs
Most definitions of cost make provision for disallowed costs. Examples of
disallowed costs are:

Costs not justified by accounts and records

Overpayments to subcontractors
Open Book Accounting

Payments to subcontractors due to delays caused by the contractor or
other subcontractors

Cost of correcting defects

Material not used due to over ordering

Plant standing idle for lengthy periods due to poor planning
Attempts are sometimes made to disallow costs relating to inefficient working.
This can be something of a minefield as quantifying inefficiency is likely to
lead to a great deal of argument which is normally discouraged.
Typical Question
Where the contract includes a definition of costs, disagreement can occur as
to whether some costs fall within the definition and others which do not. For
example:
Is the cost of cleaning out drains adjacent to a new lighting column a
disallowed cost?
The correct answer is:
If it is builders rubble causing the blockage arising from the lamp column
foundation the answer is yes the cost should be disallowed i.e. it has arisen
from the improper execution of the works.
If it is silt or grit which has not occurred from the construction work the
answer is no and payment should be made.
Preliminaries/Site Overheads
It is common practice for preliminaries or site overheads as they are
sometime called to be included in a schedule form, priced by the contractor
and submitted with the tender. Alternatively the prices are agreed by the
contractor and the employer’s representatives after the contractor has been
selected but before the contract is entered into. Items in the schedule include
such matters as site management staff, site quantity surveyors, planners, site
welfare, site accommodation, health and safety matters, power operated
tools, site storage, protection and the like. It is important to ensure that there
is no overlap between cost items included in the schedule of site overheads
and the head office overheads.
Head Office Overheads
Most contractors have a head office which provides services to all its
construction sites. These services include estimating, overarching supervision
in the form of contracts directors and commercial directors, strategy from the
board of directors and services related to advancement in technical,
Open Book Accounting
commercial services and insurance related matters. It is usual to include a
percentage to be added to the unit costs and site overheads to provide for
head office overheads
Profit
The profit is the contractor’s reward for completing the work in compliance
with the terms of the contract. Profit is usually priced as a percentage addition
to the total of the unit costs, site overheads and head office overheads.
Sometimes it is expressed as a lump sum. Contractors are usually required to
give an indication before selection as to the level of profit required if appointed
to carry out the work.
AUDITING THE OPEN BOOKS
Skills Required
A combination of QS, commercial management and accounting skills are
required to properly carry out an audit process of contractors open book
methods which include:

Knowledge of the construction industry

Understanding the contract

Appreciation of what is actual cost

Understanding of accounting procedures including certification,
accruals and the like

A systematic approach to the work
Suggested Procedure
Definition of Cost
An adequate definition of cost may already be included in the contract. If not it
will have to be the subject of an agreement between the parties. It will be
important to differentiate between head office overheads in respect of which a
percentage addition will usually be added and actual cost to ensure that there
is no overlap. The definition of cost should enable the costs to be separately
identified by resource such as people, equipment, plant, materials and other
charges. Difficult areas are pension contributions and finance charges and
how they can be allocated to individual projects.
Understanding the Contractor’s Cost System and Procedures
Typical matters to review:
Open Book Accounting

What is the project code numbering system

How are costs recorded on site

Work through examples by resource

Become familiar with the contractor’s pro-formas

What value of work is normally subcontracted; what are the
subcontract terms; how is the work valued and paid for

Visit the site and see the costing system working in practice.
Understanding the Contractor’s Accounting Procedures
Typical matters to review:

How are discounts credited in respect of suppliers and
subcontractors

How are national agreements with suppliers and
subcontractors allocated

How are accruals dealt with

How are intercompany charges managed
Agree an Audit Strategy
An audit strategy should be agreed which deals with two main elements:

Ensuring that the stated procedures at site level are complied with

Ensuring that accounting procedures are correctly applied at head
office
Develop a table/proforma outlining what will be audited, by whom, when, what
information will be required and what questions will be asked.
Some elements of the audit process will need to remain random.
REPORTING
It should be part of the auditing procedure for an audit report to be produced
each month to coincide with the payment of the contractor. The object of the
report is to inform the parties that established procedures are in place and are
working efficiently.
Open Book Accounting
Suggested Contents

Introduction

Audit rationale

Persons involved

Key clauses in the contract

Management structures and procedures

Key personnel

Filing systems

Job costing structure

Procedure for setting budgets and financial reporting
Open book accounting procedures review

Accounting systems

Site and head office based procedures prior to systems input

Accounting procedures involved in systems input
o Labour, plant and materials
o Site overheads
o Head office overheads
Adjustment to existing procedures to comply with the contract
Actual cost audit report

Check that procedures are being complied with

Results of audit check
Recommendations
Open Book Accounting
EARNED VALUE ANALYSIS
This is powerful management tool for measuring whether open book
accounting methods are delivering best value.
It relies upon comparing two essential elements on a regular basis namely
the value and the actual cost
The value is based upon the build-up of the target price and is assessed on a
regular basis such as monthly or quarterly. This is compared with the actual
cost. The aim is for the value to be greater than the actual cost. A forecast of
both the value and actual cost is prepared at the outset and applied to a
graph. At this stage the value should be greater than the estimate of the
actual cost. If after work gets under way the value starts to lag behind the
actual cost there is time to correct the situation to ensure that by the time that
work has been completed the value is greater than the actual cost.
WAYS OF ENHANCING ACTUAL COST
The success of open book accounting methods depends upon trust. However
human nature being what it is those representing the employer need to be on
their guard against error in the accounting processes. There have also been
isolated cases of unscrupulous contractors who seek to enhance the actual
costs employing none contractual methods to help increase the profit derived
from the project. The following are examples where by accident or design
actual costs charged were greater than the contractual entitlements:
Staff included in the head office overhead percentage claimed for as site
overheads.
Inflated charges from subsidiary companies for services rendered on the
project which include:

Internal plant hire rates in excess of going market rates

Heavy maintenance and repair costs of plant and machinery

Cost of repairs to damaged plant without allowing a credit for the
money recovered from the insurers
Over order materials without allowing credit for unused materials.
Failure to declare discounts allowed by suppliers and subcontractors.
Settlement deals with subcontractors which include the settlement of
disputes on other projects.
Open Book Accounting
TEST QUESTIONS AND ANSWERS
TEST QUESTIONS
Question 1
What are the usual basic components of the target price?
Question 2
Describe what is meant by gain share and pain share
Question 3
How does open book accounting differ from a tendered lump sum and what
are its advantages?
Question 4
What is meant by Guaranteed Maximum Price?
Question 5
What are disallowed costs?
Question 6
How should a target price be calculated?
Question 7
What is an earned value analysis?
Question 8
How should the target price be adjusted?
Open Book Accounting
Question 9
What unscrupulous methods have been used for enhancing actual cost?
Open Book Accounting
MODEL ANSWERS
Question 1
1. Unit costs
2. Risk Allowance
3. Overheads
4. Profit
Question 2
Gain share/pain share is a mechanism to encourage the contractor to reduce
costs and therefore assist in achieving best value. Gain share occurs where
the total cost of the project and contractor’s profit are less than the adjusted
target price. The saving or gain is shared between the employer and
contractor usually on a pre agreed percentage basis. Pain share occurs
where the total costs and contractor’s profit are greater than the adjusted
target price. The pain share is usually shared between the employer and
contractor on a pre-agreed percentage basis.
Question 3
Open book accounting is the process by which a contractor is paid for the
work undertaken in accordance with its recorded costs. The traditional method
involves payment in accordance with and agreed price for the work. Open
book accounting usually eliminates many of the matters which lead to
disputes on contracts let along traditional lines such as variations, disruption
and extended preliminaries resulting from time overruns. To ensure that the
costs are kept to a minimum it is usual for a target price to be fixed at the
outset. The recorded costs are measured against the target price and any
saving is shared between the employer and contractor in a pre-agreed
manner. In like manner any over expenditure compared with the target is
shared.
Question 4
This is a prefixed lump sum price for undertaking construction work where
there is no provision for adjustment except for changes introduced by the
employer. It is unusual for contractors to agree to enter into contracts with no
Open Book Accounting
provision for adjustment in the price where costs may increase due to
changes in legislation. Where work may involve major alterations to services
such as gas, water and electricity contractors often seek to exclude
unforeseen costs relating to these services from the price. Contracts are none
the less often referred to as Guaranteed Maximum Price when in fact there
are provisions for adjustment in the price for events in addition to changes
introduced by the employer. These are not therefore Guaranteed Maximum
Price in the true sense of the word. It is important therefore where a contract
is styled as a Guaranteed Maximum Price that there is a definition of its
meaning.
Question 5
Where an open book accounting process is employed the contractor is paid in
accordance with the recorded costs. It is important to ensure that employers
do not have to pay for the contractor’s inefficiencies. On most contracts which
provide for payment on an open book basis it is usual therefore that provision
be made for certain costs which have been incurred due to the contractor’s
inefficiencies to be disallowed. The cost of rebuilding work which was
defective and had to be taken down falls into this category.
Question 6
There is no industry standard for arriving at a target price. It is common to
calculate the target price using building blocks which comprise:
1.
2.
3.
4.
Unit Costs
Risk Allowance
Overheads
Profit
The unit costs may be calculated using a schedule of rates which are
inclusive of labour, materials and plant. Measured quantities for the work are
then applied to the rates to arrive at the unit costs. Where there has been little
progress in the development of the design the target may be fixed by
employing the floor area of the building and applying a price per square
metre. It is sometimes convenient to calculate the areas of the various
elements of the building such as cladding and roofs and apply a separate rate
per square metre for each element. Where a large part of the building is
designed and constructed by subcontractors the unit costs are often built up
using quotations received from subcontractors who will be undertaking the
work.
The contract should be very clear as to how the risks are to be shared. This is
often achieved using a risk register. In building up the target price a sum
should be included in respect of the risks which are to be bourn by the
contractor. Some of the risk is often difficult or impossible to calculate with any
accuracy for example the presence of rock and running sand below ground. It
Open Book Accounting
is better where this occurs to include a provisional sum in the target price
which is later adjusted to take account of the contractor’s actual costs.
The Head Office overhead element is usually calculated by the addition of a
percentage to the total of the unit costs. Care should be taken to ensure that
there is no overlap between the unit costs for such matters as the onsite
preliminaries and the head office overheads.
Profit is the contractor’s reward for satisfactorily completing the work and is
usually calculated by adding a percentage to the unit costs, risk and head
office overheads.
Question 7
The terms of the contract should make it very clear as to the manner in which
the target price is to be adjusted. Provision should always be made for
changes which are introduced by the employer. The risk register will indicate
the risks which the employer will be bearing and the target price may require
adjusting in the light of what has occurred during the progress of the work. For
example the risk register may show that the employer is to take the risk of
unforeseen ground conditions in which case an adjustment to the target price
will be necessary should unforeseen ground conditions occur. A provisional
sum may have been included for this type of risk and will require to be
adjusted. Additional costs which result from employer generated delay will
also require an adjustment to the target price.
Question 8
An earned value analysis is a tool for measuring whether open book
accounting is delivering best value. It relies upon a comparison on a regular
basis of the value and actual cost. The value is based upon the build-up of the
target price and is assessed on a regular basis such as monthly or quarterly.
This is compared with the actual cost. The aim is for the value to be greater
than the actual cost. A forecast of both the value and actual cost is prepared
at the outset and applied to a graph. At this stage the value should be greater
than the estimate of the actual cost. If after work gets under way the value
starts to lag behind the actual cost there is usually time to correct the situation
to ensure that by the time work has been completed the value is greater than
the actual cost.
Question 9
The following methods have been used either by accident or design to
increase actual cost:
1. Staff included in the head office percentage claimed in addition as site
overheads
Open Book Accounting
2. Inflated charges from subsidiary companies for services rendered on
the project which include, internal plant hire rates in excess of the
going market rates; inflated maintenance and repair costs of plant and
machinery; costs of repair to damaged plant included without allowing
a credit for the money recovered from insurers.
3. Over ordering materials without allowing credit for unused materials
4. Failure to declare discounts allowed by suppliers and subcontractors
5. Settlement deals with subcontractors which include the settlement of
disputes on other projects.
Open Book Accounting