This article is written by Lianne D’Souza, pursuing a Certificate Course in Introduction to Legal Drafting: Contracts, Petitions, Opinions & Articles from LawSikho.com.

Introduction

When a contract is made between two parties, certain legal obligations have to be fulfilled by the parties. These obligations are usually also accompanied by risks. Many times, due to these risks either party is unable to fulfill their obligations leading to a breach of contract. Oftentimes, the contractor prefers not to go beyond the decided cost for a project as doing so would cause a burden on either themselves or the client. Therefore, lump-sum contracts and reimbursable contracts are not favoured.  This is where target cost contracts have arisen as the preferred type of contract to stay within budget. In the United Kingdom, the National Economic Development Office – Civil Engineering (1982) defined TCC as: “Target cost contracts specify a best estimate of the cost of the work to be carried out. During the course of the work, the initial target cost will be adjusted by agreement between the client or his nominated representative and the contractor is to allow for any changes to the original specification. Any savings or overruns between target cost and actual cost at completion are shared between the parties to the contract with a pre-determined share ratio set out in the contract.” In this article, we will briefly discuss what are target cost contracts, how it works, important clauses that should be part of target cost contracts and its advantages and disadvantages.

What is a target cost contract?

“Target cost contracts specify the best estimate of the cost of the work to be carried out. During the course of the work, the initial target cost will be adjusted by agreement between the client or his nominated representative and the contractor is to allow for any changes to the original specification. Any savings or overruns between target cost and actual cost at completion are shared between the parties to the contract with a pre-determined share ratio set out in the contract.”

A target cost contract is an agreement between the contractor and a client wherein they negotiate a target cost based before signing the contract on an estimate of the expenses which will be incurred for the project. If the final expenses are below the target cost, both the contractor and the client divide the savings among themselves. If the final expenses are above the target cost, both the contractor and the client equally pay the extra expenses incurred.

Target cost for a project depends on the following factors

1. Base fees: Base cost of the physical work that is essential for the successful completion of the work including labour, materials, and other resources.
2. Contractor fees: It includes overheads, insurance costs, and profit margin. It is also known as vendor’s fees.
3. Risk: Contingency for contractor’s and client’s risks under the contract such as one party’s withdrawal from the contract or changes in the requirements of the project.

Once the project is completed, the involved parties apply a formula to calculate whether the total cost incurred for the project was above or below the target cost. This helps them determine if they will have to share the savings made which is known as ‘gain share’ or if they have to contribute towards the amount overspend which is known as ‘pain share’. The gain share is the difference between the target cost and the amount saved after the project is completed which is usually split between the contractor and the client. The pain share is when the cost incurred is more than the target cost which is also shared liability between the contractor and the client. Hence, the parties involved in a target cost contract share the risk involved in undertaking a new project.

• Examples- construction contracts, engineering contracts, construction and engineering contracts.

Significance of target cost contracts

Target cost contracts keep the benefits of the contractor and the client in check as it makes sure that only one party will not make a profit or suffer loss rather both parties will have a joint share be it profit or loss. The risk is not placed just on the contractor or client which makes such contracts preferable over lump-sum or reimbursable contracts wherein the full burden is placed on either party.

Target cost contracts are suitable for projects which are well defined rather than loosely defined ones where changes in the project would affect the target cost. Also, the project plan including the drawings and specifications must be developed before the commencement of the project for better accuracy of target cost.

Thus, such contracts are usually suitable in construction projects as the costs are unreliable and depend on other factors which are contingent. They can also be used in software development and when creating new physical products. 

Important clauses in a target cost contract

Like other contracts, target cost contracts need to fulfill the essentials required to be a valid contract. These are the inalienable clauses that are required for the contract to be valid such as the offer and acceptance, the parties involved, and intention to create legal relations. Along with these the below mentioned are clauses which are important for a good target cost contract.

Scope of work 

The contract should have a proper description of what the contractor has agreed to perform as their job and the stages of the work. 

• Sample clause-The contractor shall be solely responsible for and shall provide and furnish all materials, equipment, tools, and labour as necessary or reasonably inferable to complete the work, or any phase of the Work, in accordance with the client’s requirements and the terms of this agreement.

Time is of essence

The contract must specify the time frame within which work is expected to be done. This includes the project commencement date and the target completion date.

• Sample clause- Time is of the essence with regards to all provisions of this agreement that has a time specification for its performance. The contractor agrees that the term decided for the completion of the work is reasonable.

Escalation clause

To protect the contractor and the client from risks this clause is provided in the contract to cover up changes in the price of materials, labour, or other factors of production beyond the target decision. The contractor will have to satisfy the client with sufficient proof of such excess cost and other factors as agreed upon in the contract. 

• Sample clause- If during the performance of this agreement, there is an increase in the price of the material used through no fault of the contractor, the price shall be equitably adjusted by a reasonable amount. Any claim by the contractor for cost increase shall require written notice to be delivered to the client within 30 days stating the increased cost supported by invoices or bills of sale. 

Target cost

The cost for the project as negotiated between the parties in accordance with the market price and which shall be paid to the contractor at the beginning shall be mentioned in this clause. The cost will be subject to amendment only in accordance with the other clauses in the contract.

• Sample clause- The target cost shall mean the estimated cost of performing the work as initially negotiated and mutually agreed upon by the parties. This shall also include modifications, if any, in accordance with this agreement.

Payment clause

This clause states the various factors related to payment such as the mode of payment, time of payment, the documents required, and special conditions to payment.  

• Sample clause- The client agrees to pay the contractor the total amount of__________. Payment of this amount shall be subject to additions or deductions in accordance with any mutually agreed changes or modifications in the work.

Dispute resolution clause

This clause is an essential part of the contract as there are times when conflicts and issues may arise between parties. By incorporating this clause parties can decide at the outset itself how disputes in the future will be resolved.

• Sample clause- Any dispute in connection with or arising out of this agreement, including any question of its breach, performance, existence, validity, or termination, shall to the extent possible be settled amicably by parties. The parties will negotiate in good faith to settle any dispute through mediation conducted by a mediator to be mutually selected by the parties.

Force majeure

This clause should be included as it protects the parties from circumstances that are beyond anyone’s control. This clause becomes necessary when there’s failure to perform due to unforeseen circumstances which would not be considered a breach of contract.

• Sample clause- In the event, either party is unable to perform its obligations under the terms of this agreement because of acts of God, strikes, equipment or transmission failure or damage reasonably beyond its control, or other causes reasonably beyond its control, such party shall not be liable for damages to the other for any damages resulting from such failure to perform or otherwise from such causes.

Termination clause

This clause gives the mutually decided situations wherein the parties may terminate the contract. 

• Sample clause- This agreement shall terminate upon the completion of the work agreed upon. In addition, the client or contractor may terminate the agreement and any obligations stated hereunder with reasonable cause by providing written notice to the other party. 

Advantages and disadvantages

Advantages

1. Motivates the contractor to not overspend by finding innovative ways to complete the project quickly and economically without compromising the construction quality.
2. The client can also benefit if the contractor works efficiently within the target cost.  
3. The client and the contractor have to work together more closely compared to other agreements to manage the cost of work for mutual benefit.

Disadvantages

1. The contractor will have to share the savings made while making the project with the client. Similarly, the client may get exposed to the risk incurred and will have to bear the costs along with the contractor.
2. The contractor may try to use products that are cheaper with lesser quality to maximise his profit. 
3. Differences may occur between the contractor and the client if changes occur during the project due to which cost may increase.

Conclusion

This article aimed to make readers understand and aware of target cost contracts and also to familiarise them with the essential clauses necessary while making target cost contracts. It is important to note that the target cost contracts should be realistic and based on detailed projects. A target cost contract intends to encourage both parties in the contract to work together in order to find ways of carrying out the work as efficiently as possible and to be rewarded as a result (i.e. pain/gain share). A target contract makes the goals of both parties combined together. It encourages cooperation between the parties to achieve their mutual goals. 

References

• https://www.lexisnexis.co.uk/legal/guidance/target-cost-contracts-on-construction-projects#:~:text=A%20target%20cost%20contract%20is,the%20beginning%20of%20the%20project. 
• https://www.contractworks.com/blog/what-are-target-cost-contracts 
• Chan, Dr Daniel & Lam, Patrick & Chan, Albert & Wong, James. (2010). Achieving better performance through target cost contracts – The tale of an underground railway station modification project. Facilities. 28. 10.1108/02632771011031501.  
• https://www.lexology.com/library/detail.aspx?g=1bac0ad9-4f70-4825-b034-7fe158d08ff9 
• https://www.lawinsider.com/ 

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