Target cost contracts: An analysis of the interplay between fee, target, share and price

Target cost contracts are growing in popularity but concerns remain about the interplay between fee, target, sharing ratios and the final price. This paper offers a fundamental analysis of the principles under-pinning target contracts. It shows that there is scope for manipulation of tenders and that suboptimal methods of tender evaluation are in use. The paper analyses both fixed fee and percentage fee contracts. Methods of tender evaluation are proposed that will both reduce the scope for manipulation by tenderers and increase the likelihood of the contract being awarded to the tenderer whose final price will be the lowest. The analysis reveals a strong case for setting the contractor's share of cost overrun or underrun at a value that is not less than 50%. Finally, the paper proposes two simplifications that would reduce the number of variables in target cost contracts of the future. One is for the employer to set the fee and the other requires only that a target be tendered but with the fee built into it.