Contract Solutions | E-newsletter Issue 4
The use of target cost and cost
reimbursable contracts has grown
dramatically over the last 10 years
supported by the introduction of new
contract forms such as the NEC
Engineering and Construction Contract
(ECC) which contains two target cost
Conversely if the actual cost is higher than the target cost,
there is an overspend and this overspend is then shared
between the parties on pre-agreed percentage split. This
share of the overspend is referred to as pain share.
Target Cost Mechanism
Employers Risk
Contractors Risk
In a series of articles to be published in the Contract
Solutions Newsletter we will introduce the theory and
practice of target costs and cost reimbursable contracts as
well as share the lessons we have learnt and issues that need
to be considered in their use.
This first article will cover the creation and maintenance of
a Target Cost.
Final actual cost
compared to final
targetcost to
determine gain
share/pain share
Certificate 4
Certificate 3
Base Cost
Certificate 2
Certificate 1
Target Cost
Actual Cost
Why use Target Cost Arrangements?
How do Target Cost Contracts work
The basic principle is that a target cost is agreed and then
the contractor is paid for the work undertaken on a cost
reimbursable (actual cost) basis.
The payments to the contractor are made on the basis of
the contractor’s accounts and records, which are provided to
the employer for inspection on an ‘open book’ basis.
The principle benefit of target cost arrangements is their
ability to align the objectives of the parties, which helps
to create a partnering environment. The contractor and
employer are both encouraged to work together to control
costs by the sharing of the risk of over / under spend
through the pain share / gain share mechanism.
At the end of the project the final target cost, which is the
original target cost plus any agreed changes, is compared to
the actual cost expended by the contractor.
Target cost contracts were originally developed in the
infrastructure sector to deal with complex projects that had a
high degree of risk around items such as ground conditions,
due to their ability to share risk through the pain share / gain
share mechanism.
If the actual cost is lower than the target cost, a saving has
been made which is then shared between the parties on
a pre-agreed percentage basis. This share of the saving is
referred to as gain share.
As the contractor is remunerated on a cost reimbursable
basis they have to give the employer access to their accounts
and records on an ‘open book’ basis. This open book
approach helps to build trust between the parties through
Contract Solutions | E-newsletter Issue 4
the sharing of information by the contractor and visibility
from the employer of the true cost of the project to the
A target cost contract can accommodate change easier and
through the shared risk aspect there is greater flexibility for
the employer to develop the project post award. Similarly
a target cost can be agreed at an earlier stage than a
traditional fixed price lump sum contract and can allow an
earlier start on site.
These factors also lead to a reduction in the potential for
claims as the contractor will ultimately have to substantiate
any cost claimed and will get no benefit from over inflated
What is a Target Cost
There is no set definition of a target cost and it is often not
even defined in the contracts which use them.
A working definition that I have developed is:
A target cost is a genuine pre-estimate of the most likely outturn
cost for the project as defined in the contract documentation.
Setting a Target Cost
The setting of a target cost can occur in just the same way
as a fixed price or remeasurable contract.
It can be set via a competitive tender process or negotiation.
In order for a target cost to be set, the project must have an
adequate level of design complete. This does not mean that
the project has to be fully designed and often target costs are
set on performance specifications or outline design.
Elements of a Target Cost
A target cost should represent the cost that the contractor
will incur in delivering the project. It will comprise:
The base cost
Overheads and profit
The risk the contactor carries under the contract.
In essence it should be built up in the same way and contain
all the same items as a contractor would include in a
traditional tender.
Base Cost
The base cost comprises the physical works required
in order to deliver the project as defined in the contract
The base cost will include:
■ The measured work, i.e. the works to be undertaken directly by the contractor and often priced using historical unit rates or via a resource loaded programme. The contractor may also choose to show this in its component parts i.e. labour, plant and materials
■ The cost of all temporary works to be provided by the contractor
■ Any elements of works to be undertaken by subcontractors
■ Preliminary costs, both fixed and time related.
The base cost should be priced net of risk or if risk has been
allowed then this should be clearly identified. The reason
for this is to ensure that when subsequent allowances for
contractors risk are calculated, there is no double counting
and therefore, risk on risk in the target cost.
Contractor’s Fee
Under target cost forms there is normally some form of
allowance for the contractor’s overheads and profit, often
referred to as the Fee.
The type of costs that normally form part of the Fee are:
Head and regional office overheads
Head and regional office staff
These are costs which cannot be easily or accurately
allocated to a project on an actual cost basis.
In all tenders produced by a contractor there will have to be
an allowance made for the risks they will carry under the
The contractors risks will be defined by the contract and
the contractor will have to bear the time and cost effects of
these risks, should they occur.
Employer’s risks are those items under the contract which
will entitle the contractor to an extension of time and / or
additional monies; variations for example.
Maintenance of the Target Cost
A target cost is subject to change, both positively and
negatively, as with a fixed price contract.
Contract Solutions | E-newsletter Issue 4
The time and cost effect of change is evaluated in
accordance with the contract, which is normally a repeat of
the same process originally used to set the target cost. In
effect a change is assessed as a ‘mini target cost’ built up of
base cost, fee and contractors risk.
It is essential that the target cost is ‘maintained’, by which we
mean that changes are agreed as soon as they occur if not in
advance. This enables the target cost to remain reflective of
the current scope of works and allows the pain share / gain
share calculation to remain valid.
Michael Spencer
Partner, Contract Solutions
t +44 (0)20 7812 2045
e [email protected]