An optimal target cost contract with a risk neutral owner

Purpose

Target cost contracts are commonly used to share the monetary outcome of work or a project. However, discussion is ongoing, as to what constitutes optimal sharing. The purpose of this paper is to examine optimal sharing and derives a result for defined risk assumptions on the owner (risk neutral) and contractor (risk-averse ranging to risk neutral).

Design/methodology/approach

The derivation is based on solving a constrained maximization problem using ideas from principal-agent theory. Practitioners were engaged in a designed exercise in order to validate the approach and propositions. The influence of the contractor's level of risk aversion, the cost uncertainty and the contractor's effort effectiveness are examined.

Findings

The paper shows that, at the optimum, the sharing ratio between contractor and owner needs to reduce and the fixed fee needs to increase when the contractor becomes more risk-averse, the level of the cost uncertainty increases, or the effectiveness of the contractor effort decreases.

Practical implications

The paper's findings provide practitioners with a useful benchmark for outcome sharing in target contracts.

Originality/value

Existing work on outcome sharing in target contracts is limited to being qualitative and anecdotal in nature. This paper extends existing knowledge by providing a quantitative treatment of optimal sharing.