13.4.3 Costing Issues

13.4.3.1 Time and materials costs: Clearly, the costing of a variation must include the basic resource costs of implementing the change (i.e. in terms of the labour and materials expended on design, construction, facilities management, raising finance (if applicable) and/or maintenance). This can also include professional fees (e.g. where design work or construction engineering is involved), and (particularly for significant construction works) an element of contingency to deal with any performance risk being accepted by the Sub-Contractor.

13.4.3.2 Sub-Contractor margins: In addition to the basic resource costs, many Sub- Contractors charge a "margin" that provides a contribution to overheads and profits at the Sub-Contractor level. While this is fairly standard practice in the industry, the levels can vary. In the context of variations, Sub-Contractor margin levels could be set in two ways:

• the levels could be fixed in the Change Protocol with reference to the levels set in the original Sub-Contracts; and/or

• independent technical advice could provide a market benchmark for margin levels at the time of the change.

For small-value changes, the catalogue pricing should include both the time and materials cost, as well as any Sub-Contractor margins.

13.4.3.3 Contractor mark-ups: There are three potential areas in respect of which the Contractor may seek to charge a separate fee or margin over and above the elements discussed above:

• processing time and cost (e.g. paperwork, liaison, meetings, external advice etc);

• accepting performance risk on the implementation of the change (i.e. "wrapping" the performance of the Sub-Contractors carrying out the change in terms of the time, cost and quality of delivery); and

• accepting any interface risks between the implementation of the change and the provision of the existing Service.

13.4.3.4 In some cases (particularly during the construction period), the Contractor acts largely as a passive intermediary, whilst the work to process and implement changes occurs at the Sub-contractor level. In such cases, there is very little case for any additional processing charges being paid to the Contractor.

In most other cases (certainly during the operational period), the Contractor should be resourced to process changes themselves and add value in providing a change management function for the Authority. The proper resourcing of Contractors to provide an effective change management Service should be a part of the specification set at Financial Close. Since change management therefore forms a routine part of the Service provided by the Contractor, there should be no need for the Authority to pay any additional Contractor fee or margin for processing each variation. However, there may still be instances (e.g. complex changes) where the Contractor is required to put in significant additional resources of its own over and above what was envisaged as part of the standard Service. In such cases, the Change Protocol should:

• enable fair re-imbursement of any third party costs (such as consultant fees) incurred by the Contractor to supplement its own resources; and/or

• set out a standard day rate by which any additional Contractor staff time incurred on processing the change (i.e. over and above what is required as part of the Service).

The Contractor should make the case for such additional processing costs on a case-by-case basis and a suitable budget should be established with the Authority before work is commenced.

13.4.3.5 The Authority should consider carefully how performance risk is priced by the Contractor Where the Contractor is required to raise private finance to fund the change (see Section 13.3.7 above), the "charge" for bearing the Sub-Contractor performance risk will be reflected in the rates of return charged by the funders (both equity and debt) providing the additional finance, and will be reflected in the calculation of the revised Unitary Charge. No separate Contractor mark-up (over and above the appropriately benchmarked cost of capital) should therefore be included within the costing of the change for this reason.

However, where the change is funded by lump sum capital payments by the Authority, the risk of Sub-Contractor failure should be carefully considered.. It may be the case (in limited circumstances such as high-value or complex changes) that the risk of Sub-Contractor default is material. In such cases an additional mark-up in the costing of the change reflecting the risk and impact of Sub-Contractor default may be reasonable.

13.4.3.6 Finally, the Contractor will need to manage any interface risks between the implementation of the change in Service and the existing Service. How significant these interface risks are and what value should be assigned to them will vary from case to case, and it is impossible to generalise. Indeed, in some cases, it is entirely possible that a change in Service may reduce the overall risk for the Contractor. Authorities will need to seek specialist technical advice for the impact and valuation of such interface risks. In any case these risks, where justified, should be priced separately (as higher construction, operating or lifecycle costs, reserve levels and/or rates of return) rather than being included as a standard Contractor mark-up over the basic costs of the change.

13.4.3.7 In summary, there should not generally be any separate Contractor mark-up priced into the costing of changes. The exceptions to this rule would be:

• where the Contractor is likely to be required to put more significant additional resources into the processing of a change (e.g. in procurement or project management) than contemplated as part of the standard change management service (in which case an additional fee should be calculated based on a pre-set daily rate); and

• where the Contractor is not required to raise additional private finance, but is nevertheless asked to take performance risk on the Sub-Contractors implementing the change (in which case a mark-up reflecting the probability and impact of Sub-Contractor failure will usually be reasonable).

13.4.3.8 Transaction Costs: Finally, there are the costs of conducting financial, technical, legal and insurance due diligence on variations. All such costs, where reasonably incurred by the Contractor, ought to be re-imbursed or compensated by the Authority provided that budgets are agreed in advance. However, the Change Protocol should require the Contractor to minimise such costs as described in Section 13.3.8 above.