Target Cost Contracts

Introduction

The use of target cost contracts has increased in recent years as employers have sought means to incentivise contractors to bring in projects within cost budgets. With this aim in mind, these contracts typically provide for a pain/gain share mechanism. In this newsletter we consider the main elements of a target cost contract and look at how they are treated in a range of standard forms1.

The Target Price

Target Price Contracts are based on a cost reimbursable mechanism in which the contractor is reimbursed his costs (on an actual cost basis) subject to the application at the end of the project of a formula which allows the contractor to share any savings made and to contribute towards overspend.

In the first place, a target cost will be agreed which will be for a scope of work defined to a greater or lesser extent. The target cost will be adjustable in certain circumstances, most commonly for variations.

The target cost will be made up of three elements, of which two are "visible". These are, first, the base cost which will largely be made up of subcontractor costs as well as necessary items such as plant hire and utility bills. Secondly, the target cost will also include the contractor's overheads, profits and other head office elements which are referred to as his "Fee". The Fee may be a percentage of the actual cost or target cost or, in some cases, a fixed sum. The third element will be the contractor's price for his risk, but this will be subsumed in the Fee.

The target cost is usually arrived at through a tender process followed by negotiation. It should represent a genuine pre-estimate of the most likely outturn cost. The intention is that the contractor will be incentivised by the pain/gain mechanism (see below) to minimise his actual cost through creating efficiencies leading to savings. If properly constituted, the target cost should represent a middle way between a tender which is too low (but may win the work) and an inflated figure which may serve to discourage the contractor from seeking efficiencies.

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Soundbites

Growth Markets in International Construction

Global Construction Perspectives and Oxford Economics have recently released their Global Construction 2025 report on key international markets for long term construction growth. Among other things, the report predicts aggregate global construction growth of 4.3% per year for the next 12 years, with 66% of all global construction activity occurring in emerging markets by 2025. The report predicts the most robust growth to occur in sub-Saharan Africa (5% per year) and Asia-pacific (7%). Qatar also features heavily in the report, where it takes out the title for the fastest growing market. Growth in Qatar is predicted to surge at 10% per year.

World Cup Preparations in Qatar

Infrastructure work in preparation for the 2022 FIFA World Cup is well underway in Qatar, where Qatar Rail has recently declared the QDVC consortium to be the successful bidder of its $US2 billion design-build contract for the southern red line of the Doha Metro rail network. The project involves a 13.8 kilometre underground line between Doha airport and the Msheireb region of Doha. The announcement follows Qatar Rail’s earlier announcement of an Impregilo-led consortium as the successful bidder of the northern end of the red line. The red line is the first of 4 planned rail lines to be constructed in the Qatari capital and is expected to take 5 years to complete. Once completed, the Doha metro project will have an overall length of 300 kilometres.

Do obligations of Good Faith mean anything?

While obligations of ‘good faith’ are routinely tested in litigation between disputing contract parties, very few have had any success in imposing restrictions on a party exercising contractual powers in any manner that it wishes. That position has been reaffirmed in the recent English High Court decision of TSG v South Anglia [2013] EWHC 1151. In the case, a Contractor challenged an Employer’s termination of its contract for convenience for reasons that the Employer refused to explain. The Contractor argued that the contract provisions requiring the parties to ‘work together individually in a spirit of trust, fairness and mutual cooperation’ required the Employer to act reasonably and in good faith in exercising any rights to terminate. The High Court disagreed, holding that provisions of this kind imposed no restrictions on the Employers ability to terminate without cause.