Target Cost Contracts

Posted on August 3, 2015

All contracts carry some degree of risk that may affect the final cost of a service. If a contractor goes over budget, he or she would likely want to be paid for additional costs. A customer, however, tends to prefer keeping costs as low as possible.

A target cost contract is one way to address this discrepancy. In this type of contract, both the contractor and customer negotiate a target cost for the service in question ahead of time. If the contractor is able to deliver under the initial budget, both parties share the savings. On the other hand, if the contractor goes over budget, the additional expenses are shared. In this way, target cost contracts aim to divide both the rewards and risks inherent in project implementation.

Target cost contracts tend to encourage an atmosphere of collaboration. Target cost arrangements unify both the goals and concerns of the contract parties, with each party wanting to keep costs as low as possible. By incentivizing low costs, target cost contracts help create a dialogue between contractor and customer on how to economize. In other contract types, a customer may not be very involved, but in Agile contract management, they form a crucial part of the team, allowing greater input in, and ultimately satisfaction with, the final product.

Defining and Setting Costs

While target costs can be very useful in writing contracts, it should be said that they can be a bit difficult to define and standardize. In essence, a target cost is an attempt at estimating an accurate cost prediction for the contractor. That said, there are common elements of target costs that can help facilitate initial price estimates. The three core features of target cost estimation are base costs, contractor fees and an assessment of risk.

Base Costs, Contractor Fees and Risk

The first, and arguably most important, figure to estimate is the base cost of the project. That is, what would the project cost if stripped only to its essential requirements? The base cost includes the cost of materials and labor over an estimated timeframe. Note that calculating the base cost is not intended to include desired profit and risk compensation calculations. If a contractor wishes to include risk in the base cost assessment, it is important to ensure that risk is not additionally charged in a separate part of the contract, so as to avoid counting risk twice.

Contractor fees are the second set of figures. It is here that a contractor specifies relevant overhead, insurance costs and desired profit. While overhead and insurance costs are often set in stone, profit margins are often a bit more flexible and open to negotiation.

Adequate compensation for risk undertaken by the contractor and customer is the final figure to calculate. Here, both parties agree on terms whereby the contractor may be protected from early customer withdrawal or changes in project requirements. Similarly, the customer may also be protected from excessive cost increases that take the project well beyond initial projections. It is here that the details of the shared risks, shared rewards system are outlined.

Target Cost Contracts in Agile Contract Management

Almost all contracts include some estimate of costs, profit and risks. With a target cost contract for Agile Contract Management, however, the distinguishing factor is what happens when changes are experienced. Rather than establishing terms intended to punish either the customer or contractor, Agile target cost contracts attempt to put both parties in the boat together. In this way, contract negotiation is collaborative rather than combative. With Agile CM target cost contracts, it is possible for both sides to benefit.