Contracts are all about risk management. The more knowledge you have, the easier it is to manage risk. But , in business, you can’t wait to gather all of the information before moving forward. One of the biggest risks is going over budget.
One side may try and hedge their risk by using a lump-sum contract or a reimbursable contract. But, because these types of agreements shift the full burden of cost overruns to the other party, most businesses are reluctant to sign onto them.
Target cost contracts provide a middle ground that gives both parties confidence that fluctuating costs will not ruin a deal or lead to significant losses on a given project.
How Target Cost Contracts Work
The two parties negotiate a target cost for the project. This will be the amount the two organizations estimate it will cost the vendor in materials, labor, and other expenses to complete the project.
If the final costs of the project are below the target cost, both sides will split the savings. In target cost contracts, the savings are typically called the gainshare.
If the final costs exceed the target costs, both sides split the extra expenses. This is called the painshare.
The exact percentages of the split of the gain share and the pain share are negotiated between the two parties.
A target cost contract allows both sides to share in the risk of increased costs. This makes vendors more willing to undertake complex projects that may require several scope increases and changes to the plan because they will not have to bear the full risk of cost overruns.
It also gives the client more confidence that a project will be delivered within their budget and that they will not be stuck with a half-completed project due to disputes over costs.
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Preparing a Target Cost Contract
When a contract administrator is negotiating a target cost contract, they must consider three primary elements:
- Base Fees
- Contractor/Vendor Fees
The base fees are the costs of labor, materials, and other resources the vendor requires to complete the project.
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Contractor fees, also known as vendor fees, are the other costs that go into the vendor’s overhead, insurance costs, and profit margin.
The risk element addresses the specific risks unique to one side or the other. These risks could include volatile material prices, changes in project requirements, or one party’s withdrawal from the project.
Target cost contracts often take longer to negotiate and draft than other commercial contracts, but they are also less likely to lead to an expensive contract dispute.
Flexibility in Risk Management
The greatest benefit of using a target cost contract is flexibility. It allows both sides to manage their risk without jeopardizing the completion of the project.
Target cost contracts are often used in construction projects. But, they are useful for any project where the costs and project parameters are uncertain. This may include software development and the creation of new physical products.