Target-Cost Contracts: Sharing Cost Savings and Overruns
PMBOK v8 Definition
Target-cost contracts set a target cost, with provisions for sharing cost savings or overruns between the buyer and seller. These contracts are used to encourage efficiency and cost control while maintaining flexibility. Target-cost contracts are often seen in large infrastructure projects or complex manufacturing projects.
Why It Matters for the Exam
This concept appears frequently in PMI exam questions about contract types, risk allocation, and procurement management. Expect situational questions where you must identify which contract type applies based on risk-sharing needs, or questions testing your understanding of how cost overruns and savings are distributed between buyer and seller.
Key Points to Remember (for the exam)
- Primary Purpose: Encourages efficiency and cost control while maintaining flexibility
- Risk Sharing: Both buyer and seller share cost savings AND cost overruns
- Client Perspective: Encourages cost control but requires clear definition of target costs and sharing mechanisms
- Contractor Perspective: Offers incentives for efficiency but bears partial risk of cost overruns
- Common Use Case: Large infrastructure projects or complex manufacturing projects
- Hybrid Nature: Can incorporate elements of both fixed-price and cost-reimbursable models
- Key Differentiator: Unlike fixed-price (full contractor risk) or cost-reimbursable (full buyer risk), target-cost contracts split risk proportionally
Typical PMI Exam Example
A project manager is procuring a complex manufacturing system where cost uncertainty exists, but the buyer wants to incentivize the seller to control costs. The contract includes a target cost of $10M with a 70/30 sharing ratio (buyer/seller) for any savings or overruns. If actual costs are $9M, how much does the seller receive?
Analysis: The seller receives actual costs ($9M) plus 30% of the $1M savings ($300K) = $9.3M total.
PMI Exam Traps
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Trap: Confusing target-cost with fixed-price contracts Reality: Fixed-price transfers ALL cost risk to seller; target-cost SHARES cost risk between both parties
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Trap: Thinking target-cost is the same as cost-reimbursable Reality: Cost-reimbursable places ALL cost risk on buyer; target-cost gives seller incentive to control costs through shared savings/overruns
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Trap: Assuming target-cost contracts eliminate all cost risk for the buyer Reality: Buyer still bears partial risk of overruns (based on sharing ratio); requires clear definition of target costs and sharing mechanisms
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Trap: Confusing target-cost with time and materials (T&M) contracts Reality: T&M is a hybrid of cost-reimbursable and fixed-price; target-cost has a specific target with predefined sharing provisions
Important PMI Connections
| Related Concept | Relationship Type | Exam Attention Point |
|---|---|---|
| Fixed-price contract | Opposite risk allocation | Fixed-price = full contractor risk; target-cost = shared risk |
| Cost-reimbursable contract | Opposite risk allocation | Cost-reimbursable = full buyer risk; target-cost = shared risk |
| Time and materials (T&M) contract | Similar hybrid nature | Both are hybrid types but T&M lacks target cost and sharing provisions |
| Collaborative contracting | Enhanced version | Collaborative contracts use enhanced risk-sharing or reward-sharing mechanisms within fundamental contract types |
Quick Review Questions
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A target-cost contract with a 60/40 sharing ratio (buyer/seller) has a target cost of $5M. Actual costs are $5.5M. What is the total payment to the seller?
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Which contract type requires clear definition of target costs and sharing mechanisms from the client perspective?
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In what type of projects are target-cost contracts most commonly used?
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How does a target-cost contract differ from a fixed-price contract in terms of risk allocation?
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What is the primary purpose of using target-cost contracts instead of cost-reimbursable contracts?
PMBOK v8 Reference
Section 12.1 - Plan Procurement Management (Contract Types)