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What Are Target Cost Contracts?

When you sign a contract, there's a certain level of risk that you assume. It's always a possibility that either party will fail to hold up its side of the bargain, resulting in dissatisfaction, delays and inefficiencies.

Going over budget is one of the most frequent reasons for broken contracts. Lump-sum contracts and reimbursable contracts are often both unappealing for one of the two parties because they place all of the cost burden on either the contractor or the client, respectively.

In an effort to resolve this standoff, target cost contracts have emerged as a happy medium between these two extremes. So what exactly is a target cost contract, and when is it most useful for contract management?

What Is a Target Cost Contract?

Target cost contracts base their pricing on a figure that's aptly known as the target cost. This number is negotiated by both the contractor and the client before signing the contract, and represents the expected cost to the contractor of providing the agreed goods or services.

If the final cost of the project is below the target cost, both the contractor and the client split the savings (the "gainshare"). Similarly, if the final cost exceeds the target cost, both parties are responsible for paying this extra money (the "painshare").

There are three main elements that are part of estimating a project's target cost:

  • Base fees: The bare-bones cost of the labor, materials and other resources that are necessary for the successful completion of the project.

  • Contractor fees: The contractor's general overhead, insurance costs and desired profit margin.

  • Risk: Accommodations for risk faced by both the contractor and the client, such as one party's withdrawal from the contract or changes in the project requirements.

What Are the Benefits of Target Cost Contracts?

The most obvious benefit of target cost contracts is that they're able to align the interests of the contractor and the client. Because both parties win or lose at the end of the project, they both have a common interest in making sure that the project's actual costs remain below the initial estimate.

Because target cost contracts are a powerful motivation for the contractor to stay under budget, they tend to also have other positive repercussions on the project. By having a stake in the project's final budget, contractors are more likely to keep costs low, complete deliverables faster and produce an end product of higher quality.

Of course, target cost contracts still need careful input and oversight in order to be implemented correctly. Both parties should describe in detail their desires and requirements, and provide all necessary information to the other party, to settle on a target cost that's agreeable and stands the best chance of success.

Target Cost Contracts and Agile Contract Management

The agile methodology emphasizes the value of being flexible and responsive to changes and completing units of work in short sprints. This means that target cost contracts align nicely with agile contract management.

Agile contracts are signed with the understanding that the terms of the contract will likely change during the course of the project, and that both parties will work collaboratively to adjust them as necessary. Just as both parties share in the costs or savings of target cost contracts, agile contract management means that both parties are responsible for the project's ultimate success or failure, making collaboration in the best interests of both sides.

Check how ContractWorks CLM software supports agile contract management. 

The Master Checklist for Contract Review & Management

Tips and best practices for a successful contract management process.

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