Target cost with pain and gain share: worked share calculations

A target-cost contract sits between the lump sum and cost-plus. The owner reimburses the contractor’s actual cost and pays a fee, as under the cost-plus contracts of Cost-plus and open book, but the parties also agree a target for that cost. If the outturn is below the target, the saving is shared; if above, the overrun is shared. The contractor keeps some of the incentive of a fixed price, the owner keeps some of the flexibility of cost-plus, and both have a reason to find savings together.

The arithmetic is simple once it is set out, but the details matter: where the target is set, how the shares change in bands, how the target moves when the owner changes the scope, and what happens when someone forgets to move it. This chapter works each of those for the distribution centre’s works, with every number carried to the owner’s payment and the contractor’s profit.

The target, the fee and the share

This is an illustration. All amounts are in A$m excluding GST. The target-cost terms for the works are:

• Target: the estimated direct cost of the works, 13.50, the median estimate used throughout the book.
• Fee: a fixed fee for overhead and profit of 1.080, 8% of the target, adjusted by 8% of the estimated cost of any change to the scope.
• Share inside the band: the contractor bears 50% of any overrun and keeps 50% of any underrun while actual cost is within ±10% of the target, that is, between 12.150 and 14.850.
• Share outside the band: the contractor bears 80% of any overrun beyond 110% of the target, and keeps 30% of any underrun below 90%.

The owner pays the actual cost, plus the fee, plus the contractor’s share of any underrun, or minus its share of any overrun. The contractor’s profit is its fee minus its pain or plus its gain.

The NEC4 Engineering and Construction Contract offers target contracts as Option C, with an activity schedule, and Option D, with a bill of quantities. Both leave the share ranges and percentages to be stated in the contract data; the bands here are this case’s own.

Figure 1The share calculation with bands

Owner pays = actual cost + fee − contractor's pain, or + contractor's gain

Contractor's profit = fee − pain, or fee + gain

Inside ±10%

contractor's share 50% of overrun or underrun

Overrun beyond 110%

contractor's share 80%

Underrun below 90%

contractor's share 30%

1. Overrun = 15.525 − 13.50 = 2.025, of which 1.350 inside the band and 0.675 beyond it
2. Pain = 0.5 × 1.350 + 0.8 × 0.675 = 0.675 + 0.540 = 1.215
3. Owner pays 15.525 + 1.080 − 1.215 = 15.390; contractor's profit 1.080 − 1.215 = −0.135

Why the shares change in bands

A single share, say 50% of everything, is easy to administer but sends the wrong signals at the extremes.

On a large overrun, a 50% share means the owner pays half of every further dollar, and once the contractor’s fee is used up, the contractor is losing money and the owner is still paying half the loss. Raising the contractor’s share beyond 110% to 80% makes a large overrun much more expensive for the contractor, so it has a strong reason to stop the cost growing, while the owner still carries 20% and the contractor is not exposed to the whole of an overrun it may not entirely control.

On a large underrun, a 50% share pays the contractor half of a saving that is more likely to come from a generous target than from exceptional performance. Reducing the contractor’s share below 90% to 30% protects the owner from paying large gains for a soft target, while still rewarding real savings.

The band edges and percentages are a negotiation. Narrow bands make the contract behave more like a lump sum; wide bands, more like a simple share. Whatever the choice, it should be made deliberately and tested across a range of outcomes, as the table below does.

The share table

The table works the terms at eight actual costs, from 85% to 120% of the target.

Figure 2Owner's payment and contractor's profit from 85% to 120% of target

Actual direct cost	% of target	Contractor's pain (+) or gain (−)	Owner pays	Contractor's profit	Profit % of actual
11.475	85%	−0.878	13.433	1.958	17.1%
12.150	90%	−0.675	13.905	1.755	14.4%
12.825	95%	−0.338	14.243	1.418	11.1%
13.500	100%	0.000	14.580	1.080	8.0%
14.175	105%	0.338	14.918	0.742	5.2%
14.850	110%	0.675	15.255	0.405	2.7%
15.525	115%	1.215	15.390	−0.135	−0.9%
16.200	120%	1.755	15.525	−0.675	−4.2%

At the target, the owner pays 14.580: the target plus the fee. That is 0.540 less than the fair lump sum of 15.120 from Chapter 3, because the owner pays no risk premium. In exchange, the owner carries part of the risk the premium would have covered. Inside the band, the owner’s payment is 0.5 × actual + 7.83, and it reaches the lump sum price of 15.120 at an actual cost of 14.580, 108% of the target. Below that, target cost is cheaper for the owner than the lump sum; above it, dearer.

At 90% of target, actual cost 12.150, the contractor keeps half of the 1.350 saving, so the owner pays 13.905 and the contractor earns 1.755. At 110%, actual 14.850, the contractor bears half of the 1.350 overrun, and the owner pays 15.255. Beyond 110%, the contractor’s share rises to 80%, so the owner’s payment rises only 20 cents for each further dollar: from 15.255 at 110% to 15.525 at 120%.

The contractor’s break-even, where its pain equals its fee, comes in the outer band. The inner band takes 0.675 of the 1.080 fee; the remaining 0.405 at 80% needs a further 0.405 ÷ 0.8 = 0.506 of overrun, so the contractor breaks even at an actual cost of 14.850 + 0.506 = 15.356, 113.8% of the target. Beyond that, it is working at a loss, though still bearing only 80% of each extra dollar.

Figure 3Owner's payment against actual direct cost, banded and simple 50/50 shares

Banded shareSimple 50/50 share

Owner pays, A$mActual direct cost, A$m

Owner's payment against actual direct cost, banded and simple 50/50 shares data

Actual direct cost, A$m	Banded share	Simple 50/50 share
11.475	13.433	13.568
12.150	13.905	13.905
12.825	14.243	14.243
13.500	14.580	14.580
14.175	14.918	14.918
14.850	15.255	15.255
15.525	15.390	15.593
16.200	15.525	15.930

Under a simple 50/50 share with no bands, the payments are the same inside the band, but at 120% of target the owner pays 15.930 instead of 15.525, A$405,000 more, and the contractor would break even only at 13.50 + 1.080 ÷ 0.5 = 15.660. Below the band, the simple share pays the contractor more: at 85% the owner pays 13.568 instead of 13.433.

How large should the contractor’s share be

Perry and Barnes (2000) analysed how fee, target and share interact in target-cost tenders. They showed that the three can be traded against each other: a tenderer can offer a low fee with a high target, or a high fee with a tight target, and the owner comparing tenders must evaluate the combination, not the fee or the target alone. They argued that the contractor’s share of any overrun or underrun should be not less than 50 per cent, because a smaller share gives the contractor too weak a reason to control cost and too much room to recover a low fee through a generous target.

The case’s terms follow that advice inside the band and go further beyond 110%. Below 90% they deliberately reduce the contractor’s share, which Perry and Barnes’s reasoning supports only where the owner has reason to doubt the target, a judgement the owner has to make.

Fat targets

A target that is too high is called a fat target. It rewards the contractor for savings that are not savings at all.

This is an illustration. Suppose the target had been set at 14.31, 6% above the true median of 13.50, and the actual cost turned out to be exactly 13.50. The contractor would report an underrun of 0.810 and keep half of it, 0.405, though no real saving had been made. The owner would pay 13.50 + 1.080 + 0.405 = 14.985 instead of 14.580, and the contractor’s profit would be 1.485, 11.0% of actual cost instead of 8%.

The defence is an independent estimate of the target before it is agreed, open-book build-up of the target from quantities and rates, and an owner’s estimator who can challenge it line by line. Alliances face the same problem on a larger scale, and use an independent estimator to test the target outturn cost, as Alliances and collaborative contracts in Chapter 6 explains.

A target set at the median also means the overrun side is live. By definition, half the outcomes of a median estimate lie above it, and for most projects the upper tail is longer than the lower one, so the expected outturn is above the target. Reading the distribution: medians, percentiles and P-values in Reference Class Forecasting by the Numbers explains how to read a forecast distribution, and Chapter 10 of this book, Choosing the delivery model, applies that reading to the share terms across 20,000 simulated outcomes.

Moving the target when the scope changes

The target is an estimate of the cost of a defined scope. When the owner changes the scope, the target must move by the estimated cost of the change, and the fee by 8% of it. If the target does not move, the change’s cost appears as an overrun, and the contractor pays part of the cost of the owner’s decision. If it moves by too much, the contractor gains on a change it priced generously.

The change procedure therefore matters more under target cost than under cost-plus, where every cost is reimbursed anyway. Each change needs a prompt, agreed estimate of its effect on the target, made before the work is done if possible, and a log that reconciles the current target with the original one.

The error: a chilled zone left out of the target

This is an illustration. In the works’ fourth month on site, the owner decided to add a 400 m² chilled zone for sauces that need temperature control. It was the risk listed in Chapter 2’s register and the largest single change on the project. The contractor’s estimate of its direct cost, agreed by the owner’s quantity surveyor, was 0.62, and the instruction to proceed was issued. The target adjustment was not. The variation was recorded in the change log, but the target in the owner’s cost model stayed at 13.50.

By completion, the actual direct cost was 15.02. Against the unadjusted target, that is an overrun of 1.520, 111.3% of target, beyond the inner band. The owner’s model calculated the contractor’s pain as 0.5 × 1.350 + 0.8 × 0.170 = 0.811.

Against the correct target of 13.50 + 0.62 = 14.12, the overrun is 0.900, 106.4%, inside the band, and the pain is 0.5 × 0.900 = 0.450. The owner’s model had overstated the contractor’s pain by 0.361, A$361,000. The fee also should have risen by 8% of the change, 0.050, from 1.080 to 1.130. In total, the owner’s model underpaid the contractor by 0.411: it showed an owner payment of 15.289 when the correct payment was 15.700.

Figure 4The chilled-zone change, with and without the target adjustment

Item	Target left at 13.50	Target adjusted to 14.12
Target	13.50	14.12
Overrun	1.520	0.900
% of target	111.3%	106.4%
Contractor's pain	0.811	0.450
Fee	1.080	1.130
Contractor's profit	0.269	0.680
Owner pays	15.289	15.700

The error was found when the contractor’s monthly forecast of the final outturn and the owner’s diverged by more than A$0.4m. Both used the same cost to date, so the difference had to be in the target or the fee. Reconciling the two models line by line against the change log found the missing adjustment within a day. The target and fee were corrected through the contract’s change procedure, and the owner added a control: each change instruction now carries its target and fee adjustment on the same form, and the monthly report shows the original target, each adjustment and the current target, so the two forecasts are reconciled every month instead of at the end.

Had the error survived to the final account, the contractor would have disputed it, correctly, and the owner would have lost both the argument and some of the goodwill that a target-cost contract depends on.

Exercise: choosing the contractor’s share

Remove the bands and consider three simple shares of overrun and underrun for the contractor: 30%, 50% and 70%, with the target at 13.50 and the fee at 1.080. For each, work out the contractor’s pain, its profit and the owner’s payment if actual direct cost is 14.50, and the contractor’s gain and the owner’s payment if actual direct cost is 12.90. Explain what each share rewards.

Worked answer. At an actual cost of 14.50, the overrun is 1.00. At 30%, the pain is 0.300, the contractor’s profit 0.780, and the owner pays 14.50 + 1.080 − 0.300 = 15.280. At 50%, the pain is 0.500, profit 0.580, and the owner pays 15.080. At 70%, the pain is 0.700, profit 0.380, and the owner pays 14.880. At an actual cost of 12.90, the underrun is 0.60. At 30%, the gain is 0.180 and the owner pays 12.90 + 1.080 + 0.180 = 14.160; at 50%, the gain is 0.300 and the owner pays 14.280; at 70%, the gain is 0.420 and the owner pays 14.400, with contractor profits of 1.260, 1.380 and 1.500. A higher contractor share protects the owner on the overrun side and costs it more on the underrun side. A 30% share gives the contractor a weak reason to control cost: on an overrun it loses only 30 cents in the dollar, and the owner carries most of the risk, much as under cost-plus. A 70% share gives a strong cost incentive, close to a lump sum, but pays the contractor most of any saving, including savings that come from a generous target rather than good work. A 50% share, the minimum Perry and Barnes argued for, gives both parties an equal stake in every dollar. Bands, as in the main case, let the owner use a high share where it matters most, on large overruns, and a lower one where a large underrun is more likely to signal a soft target.