March 11, 2024
Traditional contracts are often under pinned by risk profiles that have been extensively negotiated by the parties. However, in these negotiations the risk profile is often viewed as a zero-sum game, where one party inevitably ends up bearing the risk and the other doesn’t.
Target Cost Contracts are collaborative contracts which seek to depart from such a static risk allocation and incentivise parties to work together to achieve project objectives.
Target Cost Contracts
Target Cost Contracts are designed to facilitate cooperation and focus parties on successfully delivering the project.
At a high level, Target Cost Contract provide:
- a target cost (comprises the sum for the cost of the works, as well as allowances for potential risks, profit, and overhead);
- the contractor will be paid on a cost reimbursable basis for all pre-agreed heads of costs; and
- when the project reaches practical completion, a formula or mechanism operates to apportion a painshare or gainshare, based on if the total actual costs are more or less than the target cost.
Incentivised Performance
The painshare/gainshare mechanism provides:
- if the project is delivered for less than the target cost, the contractor will be entitled to a share of the savings; and
- if the project is delivered for more than the target cost, the contractor will be required to contribute to the cost exceedance.
On one hand, this incentivises the contractor to undertake cost saving initiatives and increase project efficiency. By realising a tangible benefit, contractors can benefit from the success of a project.
However, parties must remember that despite the potential for gainshare to occur, there is also a risk that where issues with the project are realised, it could result in the painshare mechanism operating.
Principals especially should be mindful that the painshare/gainshare mechanism is traditionally developed and proposed by a principal and put forward to the contractor for their agreement. This represents little effort to collaborate. Where parties can work together to develop a mutually agreeable painshare/gainshare mechanism, it can facilitate early-stage collaboration which sets the tone for the balance of the project. Further, where the contractor is actively involved in the development of the incentive mechanism, it is more likely to function as the parties intend. This serves to increase project performance and efficiency while reducing overall costs.
Why Use a Target Cost Contract
Target Cost Contracts increasingly sees use because it appeals to both contractors and principals. It offers a tailored approach to risk allocation while incentivising both parties to work collaboratively. In doing so, both parties stand to benefit from a streamlined approach that favours collaboration, rather than disputes, and a fair risk apportionment.
To maximise the potential benefits offered, parties must develop an environment, at both a project and management level, which:
- is non-adversarial;
- allows for the proactive management of issues as they arise, including any interfaces with other parties;
- encourages ownership and resolution of issues (instead of partaking in an exercise of apportioning blame); and
- facilitates prompt, fair, and reasonable resolutions to disputes.
Where the parties take consistent steps at both a project and management level to foster such an environment, the parties primary focus can remain on the successful delivery of the project.
Key Considerations
Parties will often turn to Target Cost Contracts because they offer a number of key benefits, including:
- clear risk allocation at project commencement;
- joint and collaborative management of the works;
- incentive measures for both parties;
- reduced propensity for claims and disputes to impact project delivery given a contractual focus on collaboration;
- both parties can have increased confidence in the adopted works methods and how risks are mitigated given the collaborative approach to developing such systems and processes; and
- greater confidence can be had in the final value of the project from commencement.
However, the adoption of a Target Cost Contract significantly increases the administrative and management burdens placed on both parties. Not only do collaborative processes need to be adopted, but both parties’ management need to be prepared to work to develop an ongoing relationship. There may also be the need to engage further third parties to assist with the contractual admin, including an independent verifier or audit to assess Reimbursable Costs.
Hence, parties should carefully weight the costs and benefits offered by Target Cost Contracts, to ensure they are right for the project.
Collaborative Contracting
If you think collaborative contracting might be right for your next project, the team at LPC Lawyers have the experience and expertise necessary to assist. With experience across a variety of collaborative contracting models, LPC Lawyers can assist you with your next project.
If you would like to discuss any matters raised in this article as it relates to your specific circumstances, please contact LPC Lawyers.
The content of this article is for information purposes only and does not discuss every important topic or matter of law, and it is not to be relied upon as legal advice. Specialist advice should be sought regarding your specific circumstances.
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