Mining companies are considering creative ways to save money in these tough times. While Target Cost Contracts may sound like a tempting alternative, they are anything but easy if the fundamentals are not followed. These contracts can go horribly wrong if they are not designed well and diligently monitored. I will be writing a series of posts that will cover the pros and cons of target cost contracts so let’s start with the basic concept.
A Target Cost is a genuine pre-estimate of the most likely outturn cost for the project, as defined and agreed by the contracting parties. Previous GravelBedrock posts have reflected on Independent Third Party reviews (INDEPENDENT THIRD PARTY REVIEWS and DIGGING DEEPER – 3RD PARTY ESTIMATE REVIEWS II). If your firm is considering a Target Cost contract, please consult an Independent Third Party before signing one. If not, the courts may force one on you after you find yourself in litigation.
Target Cost Contracts are intended to give an incentive to the Contractor to deliver a project below the budgeted cost and ahead of the anticipated schedule.
There are risk considerations as well and we will cover those in separate posts. The Target Cost is agreed and then the Contractor is paid by the Owner for the work undertaken on a cost reimbursable basis. The payments to the contractor are made on the basis of the contractor’s accounts and records, provided to the Owner for inspection on an open book basis.
The simplest way to describe the incentive aspect is Gain/Pain sharing. If the Contractor is able to deliver the project below the projected cost and ahead of schedule, the contracted “Gain Share” sharing mechanism is triggered where the contractor is given a percentage of the “savings”. If the costs and or schedule are exceeded, the Contractor risks “Pain Share” which can come in many forms such as pro-rated reductions in profit, actual cash payouts, etc.
The most problematic attributes when setting a Target Cost Contract:
- Target Cost (estimate)
- Gain Sharing Mechanism(s)
- Pain Share Mechanism(s)
These MUST be clearly defined and agreed to between the parties before starting the work. Agreeing on the Target Cost is the first tricky part. Projecting unknowns can be extremely risky which is why we don’t often see target cost contracts in mining. Ground conditions, productivity factors, labor rate buildup, contingency, or numbers of hours to install an item are but a few of the factors that need to be agreed upon before setting the Target Cost.
In the next few posts, we will further explore some of the risks and provide examples of what has worked well and what could have been done differently.
Written by John F. Gravel