Engineering, Construction and Architectural Management

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An optimal target cost contract with a risk neutral owner

S. Mahdi Hosseinian David G. Carmichael

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S. Mahdi Hosseinian David G. Carmichael , (2014),"An optimal target cost contract with a risk neutral
owner", Engineering, Construction and Architectural Management, Vol. 21 Iss 5 pp. 586 - 604
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ECAM
21,5

An optimal target cost contract

with a risk neutral owner

Downloaded by KWAME NKRUMAH UNIVERSITY OF SCIENCE AND TECHNOLOGY At 07:42 14 June 2015 (PT)

S. Mahdi Hosseinian
School of Civil and Environmental Engineering,
The University of New South Wales, Sydney,
Australia and Bu-Ali Sina University, Hamedan, Iran, and

586

David G. Carmichael
School of Civil and Environmental Engineering,
The University of New South Wales, Sydney, Australia
Abstract
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 contractors level of risk aversion,
the cost uncertainty and the contractors 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 papers 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.
Keywords Construction, Contracts
Paper type Research paper

Engineering, Construction and

Architectural Management
Vol. 21 No. 5, 2014
pp. 586-604
r Emerald Group Publishing Limited
0969-9988
DOI 10.1108/ECAM-01-2013-0003

Introduction
Target cost contracts attempt to establish cooperative behaviour between the contracting
parties by sharing any project gains/losses or reward/risk, and to motivate the parties to
work towards the same project cost goal or target (Carmichael, 2000; Lahdenpera, 2010;
Love et al., 2011). A desire for cost savings, enhanced teamwork and the elimination
of adversarial behaviour lead an owner to use a target cost contract (Chan et al., 2011a),
with a desired result of a successful project (Carmichael, 2000; Turner and Simister, 2001;
Broome and Perry, 2002).
However, concerns exist about the design of appropriate outcome sharing
arrangements (Ward and Chapman 1994; Badenfelt, 2008), which are seen as central
to achieving project goals (Rahman and Kumaraswamy, 2002; El-Sayegh, 2008;
Lahdenpera, 2010). In construction projects with large risk (Lahdenpera, 2010),
inappropriate sharing arrangements may create an atmosphere of hostility that can
reduce a contractors performance (Bresnen and Marshall, 2000), generate disputes
(Rahman and Kumaraswamy, 2005) and promote a reluctance to tender for future work
(Zaghloul and Hartman, 2003; Chan et al., 2011b). Previous research has highlighted
that a sharing arrangement should be tailored to particular project circumstances, and

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should fairly distribute risks and rewards between the parties, though how fair and
unfair are defined is not stated. (Bower et al., 2002; Love et al., 2011; Badenfelt, 2008).
A number of researchers have examined outcome sharing. However, the underlying
justification for any recommendations made is not always clear. Badenfelt (2008) notes
that outcome sharing in projects is often established in an arbitrary way and not based
on scientific evidence or mathematical modelling. Hughes et al. (2012) and Badenfelt
(2008) recommend that future studies develop appropriate sharing arrangements. Tang
et al. (2008), Broome and Perry (2002) and Uher and Toakley (1999) share a similar
perception about the lack of research in outcome sharing arrangements tailored to
the construction industry. Despite a current trend towards the use of target contracts
(Chan et al., 2011b), only a few studies have looked at optimal sharing arrangements.
This paper fills part of this gap in knowledge, by investigating the outcome sharing
problem in contracts with defined risk assumptions on the owner and contractor.
The term outcome, in this paper, refers to a projects monetary outcome expressed
relative to a target that is desired by the owner, for example, with respect to cost
underruns/overruns. The term risk neutral is used here in the sense of Clemen
and Reilly (2001) and Kraus (1996) to refer to those who do not care about risk, and
can disregard risk associated with different alternatives in decision making. The term
risk-averse is used here in the sense of Clemen and Reilly (2001) to refer to those who
avoid risk, are afraid of risk, or are sensitive to risk. The term risk is used here in
the sense of Al-Bahar and Crandall (1990) and Carmichael (2004) to mean exposure
to the chance of occurrence of events adversely or favourably affecting the project
as a consequence of uncertainty.
The derivation presented here is based on solving a constrained maximization
problem using ideas from principal-agent theory. The paper looks at the influence on
the optimal outcome sharing of the contractors level of risk aversion, cost uncertainty
and the contractors effort effectiveness.
The paper is original and will be of interest to academics and practitioners (owners,
contractors and design consultants) interested in the design of target contracts. It
proposes a solution to the problem of optimal sharing of a projects outcome between a
risk-neutral owner and a contractor (risk-averse ranging to risk neutral). As well, the
paper casts new light on establishing optimal sharing arrangements in the construction
industry and it provides those who design target contracts with recommendations on
outcome sharing. By exploring optimal sharing, both theoretically and empirically, the
paper contributes an enhanced understanding of the nature of optimal outcome sharing
within projects, over that currently existing. The paper also contributes to principalagent theory by expanding its applicability to construction contracts, and beyond its
traditional home of sales, advertising and the like (Lal and Srinivasan, 1993; Zhao, 2005).
The paper is organized as follows. First, existing approaches to outcome sharing
and the background to principal-agent theory are given. Discussion on optimal
outcome sharing arrangements is then given. Applying the results to construction
projects leads to the development of the papers propositions, which are assessed based
on a designed exercise.
Literature review
A number of publications address sharing arrangements in construction contracts. For
example, Al-Subhi Al-Harbi (1998) uses utility theory to explain how owners and
contractors determine the best sharing arrangement. Badenfelt (2008), via interviews
with construction clients and contractors, finds that any outcome sharing arrangement

An optimal
target cost
contract
587

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588

is affected by perceptions of fairness, knowledge of target cost contracts and long-term

relationships. Chan et al. (2011b) suggest, based on a survey, that risks associated
with tender documentation and project design should be borne by owners, while
construction-related risks should be borne by contractors. Hosseinian and Carmichael
(2013a, b, c, d), respectively: explore outcome sharing in alliances; suggest that a riskneutral contractor should receive/bear all project outcome underrun/overrun; explore
how outcome sharing in target contracts should be determined in projects with a
consortium of contractors; and treat projects with multiple outcomes sharing.
Broome and Perry (2002) suggest that any outcome against a target be divided in
pre-agreed and specified portions. Wong (2006) suggests similarly. Bubshait (2003),
based on a questionnaire survey, finds support for the use of outcome sharing. Tang
et al. (2008), also based on a questionnaire survey, recommend that future studies develop
incentives to match project features. Hauck et al. (2004) examine outcome sharing on
one project where it was used. Bower et al. (2002) conclude that sharing arrangements
must align the needs of the contracting parties through appropriate sharing.
Ross (2003) proposes a model for outcome sharing in alliance projects. He suggests that
any cost overrun/underrun be shared 50:50, while underrun sharing should be adjusted,
up or down, based on performance in non-cost areas (such as schedule and quality). Sakal
(2005) and Love et al. (2011) further discuss the Ross (2003) model. Perry and Barnes
(2000) suggest that the contractors share of outcome should not be less than 50 per cent.
Similarly, McGeorge and Palmer (2002) suggest that the allocation of sharing should
be 50 per cent to the owner and 50 per cent to the other parties to the project; divided in
proportion to each of the other parties contributions. Ward and Chapman (1994) argue
for contractors to nominate a sharing value as the part of their tender. Sappington (1991)
discusses of an iterative approach to establishing the sharing arrangement.
Despite an extensive body of publications on target contracts, a review of the
literature reveals that few studies have examined the influence of factors affecting
the choice of outcome sharing (Al-Subhi Al-Harbi, 1998; Broome and Perry, 2002;
Badenfelt, 2008). No literature appears to have focused on the optimal outcome sharing
in contracts with a risk-neutral owner. This paper addresses this knowledge gap using
ideas from principal-agent theory (Holmstrom and Milgrom, 1987), where the owner
is the principal and the contractor is the agent. This theory provides a useful insight
into the sharing of outcome (Eisenhardt, 1989); however, there are no studies on the
optimal sharing of outcome in target contracts with a risk-neutral owner based on
the framework of principal-agent theory. Some background to this theory follows.
Principal-agent theory
Principal-agent theory has been widely used in the literature in economics, finance,
accounting, organizational behaviour and political science (Eisenhardt, 1989).
It addresses work relationships and issues related to outcome, uncertainty and risk
( Jensen and Meckling, 1976; Holmstrom, 1979; Shavell, 1979; Eisenhardt, 1989;
Baiman, 1990). In general terms, a principal engages an agent to do work on behalf of
the principal. The agent is assumed to be a self-interested, rational actor and riskaverse (Eisenhardt, 1989; Petersen, 1993). Information asymmetry, whereby the agent
is better informed than the principal, may exist (Eisenhardt, 1989). Opportunistic
behaviour could be anticipated in such situations. The agent performs effort that
leads to an outcome. The principal is not able to perfectly monitor the agents effort.
Because effort is at cost to the agent, the agent may not give the effort that the principal
desires (Eisenhardt, 1989). The theory suggests that outcome-based contracts can be

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effective in curbing agent opportunism (Shavell, 1979; Weitzman, 1980; Holmstrom and
Milgrom, 1987). Such contracts align the agents interests with those of the principal,
but at the price of transferring risk to the agent.
Based on principal-agent theory thinking, the following section looks at a constrained
maximization problem expressed in terms of a projects outcome, the contractors fee, and
the utilities of the owner and contractor. The solution of the optimization problem leads
to the optimal outcome sharing result for target contracts.
Theoretical development
Consider an owner contemplating engaging a contractor. The owner is not able to fully
monitor the contractors effort, but the owner is able to measure the monetary outcome
of the work. The problem examined is how this outcome should be shared between the
owner and the contractor.
The works monetary outcome, x, is affected by the contractors effort, e, and events
which are outside of the contractors influence, denoted by e. e is assumed to be
normally distributed with a mean of zero and variance s2 (Holmstrom and Milgrom,
1987). For convenience, x is assumed to be a linear function of the contractors effort:
x ke e

where k is a coefficient converting units of effort to money, and represents the

effectiveness of the contractors effort. Coughlan and Sen (1989) demonstrate this
linearity assumption does not involve much loss of generality.
Consider the contractors fee, Fee, defined as the sum of a fixed component, F, and a
share of the works monetary outcome:
Fee F nx

Here n is a sharing ratio distributing the outcome between the contractor and the owner,
defined as the proportion going to the contractor, and taking values in the range 0-1.
The owner is assumed to be risk-neutral and its utility (or payoff), in monetary
units, is the difference between the works monetary outcome received and the fee paid.
Using Equations (1) and (2), the owners expected utility is given by:
EU o  Ex  Fee
1  nkeF

The contractor is assumed to be risk-averse (including risk neutral as an extreme), with

utility defined in terms of the difference between the fee received and the cost, C, of the
effort. A risk-averse decision maker (contractor) has a concave utility function, which
can be modelled, for example, by exponential, power and linear-exponential functions
(Kirkwood, 2004). The most commonly used function is the exponential form
(Holmstrom and Milgrom, 1987; Clemen and Reilly, 2001; Kirkwood, 2004), and it is
adopted in this study. Kirkwood (2004) shows that the exponential utility function is
accurate for many decision situations. For a risk-averse-contractor, this gives:
U c Fee  C 1  exprFee  C
where r is the level of contractor risk aversion.

An optimal
target cost
contract
589

ECAM
21,5

The contractor wishes, through choice of effort e, to maximize its expected utility
or its certainty equivalent. A certainty equivalent is a fee that is the same in the
contractors mind to a corresponding situation that involves uncertainty, and equals
expected fee minus the cost of its effort, C(e), minus a risk premium:

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Certainty equivalent Expected fee  Ce  Risk premium

590

Risk premium is defined as the cost compensating the contractor for the risk borne
(Clemen and Reilly, 2001) and is given by:
Risk Premium

n2 rs2
2

The expected fee to the contractor can be obtained by substituting Equation (1) into
Equation (2), while noting that E[e] 0:
EFee F nke

Following Holmstrom and Milgrom (1987, 1991), the contractors cost function C(e) is
assumed to increase with e at an increasing rate. The simplest functional form that
meets this requirement can be written as:
b
Ce e2
2

Here b is a constant coefficient reflecting the influence of contractor effort on cost; it

converts units of effort2 to monetary units.
Using Equations (6), (7) and (8) in Equation (5), the certainty equivalent corresponding
to the contractors expected utility is given by:
b
n2 rs2
CE F nke  e2 
2
2

Optimization
The owners problem is to offer a contract with a fee defined as in Equation (2), in order
to maximize its expected utility:
Max1  n keF
n;F

10

This contract needs to include a minimum fee, MinFee, required by the contractor to
motivate the contractor to agree to the contractual arrangement:
b
n2 rs2
F nke  e2 
XMinFee
2
2

11

The contractor selects the effort level that maximizes its certainty equivalent. As a
consequence, the effort level the owner favours needs to maximize the contractors
certainty equivalent:
b
n2 rs2
Max F nke  e2 
e
2
2

12

Maximizing expression (12) with respect to e yields the optimal level of effort:
k
e n
b

13

An optimal
target cost
contract

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The optimal value of F is such that expression (11) holds as an equality, that is:
b
n2 rs2
F  MinFee  nke e2
2
2

591
14

Substituting Equations (13) and (14) into (10), the owners problem can be restated as:
Max
n

k2
k2
n2 rs2
n  MinFee  n2 
b
2b
2

15

Differentiating expression (15) with respect to n and setting to zero, the optimal sharing
ratio is obtained by:
n

1
1 rs2 b=k2

16

Substituting Equations (13) and (16) into (14) provides the optimal fixed fee:
F  MinFee



1
k2
rs2 
n2
2
b

17

Optimal target cost contract

Consider the above in the context of target cost contracts. Cost plus contracts based on
a target cost may have a fee calculated according to:
Fee F nTc  Ac

18

where F is a fixed component of the fee tendered or agreed; n is a sharing ratio

distributing the outcome between the contractor and the owner, defined as the proportion
going to the contractor, and taking values in the range 0-1; Tc is a target cost estimate of
the work (excluding contractors fee); and Ac is the actual (final) cost of the work (excluding
contractors fee). Similar target formulae apply based on target durations and quality.
For the example target cost contract presented by Equation (18), when comparing
this with Equation (2), the outcome may be interpreted as cost underruns/overruns.
Hence, the optimal target cost contract determines the contractors fee according to:
Fee F  n Tc  Ac

19

where n* and F* are obtained from Equations (16) and (17), respectively. Similar
optimal target formulae can be developed based on target durations and target quality.
In practice, a risk cap may be set by some contracts so that a small return margin or
zero loss is guaranteed to the contractor; however, this can lead to extra cost to the
owner (Carmichael, 2000).

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ECAM
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The cost of the risk borne by the contractor (risk premium) is directly affected by
the contractors risk attitude, level of uncertainty and contractor effectiveness, based on
Equations (16) and (17):
.

The sharing ratio needs to increase and the fixed fee needs to reduce as a
contractor becomes less risk-averse. As the level of risk aversion continues to
increase, the risk premium becomes too large, forcing the owner to reduce
the sharing ratio and to increase the fixed fee in order to retain the contractor.

As actual cost uncertainty increases, it becomes increasingly expensive to

transfer the risk associated with cost underruns/overruns to the contractor.
According to Equation (16), the sharing ratio needs to reduce for increasing cost
uncertainty in order to manage the risk premium. For high cost uncertainty, the
owner needs to bear a high proportion of the risk. This risk is not important to
a risk-neutral owner, as assumed here. For high cost uncertainty, the fixed fee
needs to increase to motivate the contractor to accept the contract, as shown by
Equation (17); the opposite occurs when the cost uncertainty is low.

The sharing ratio needs to increase and the fixed fee needs to reduce as the
effectiveness, k, of the contractors effort towards the actual cost increases;
the opposite occurs when the contractors effort effectiveness decreases.

592

The results presented here are applicable provided the following assumptions hold:
.

The contractor is risk-averse ranging to risk neutral (Holmstrom and Milgrom,

1987; Al-Subhi Al-Harbi, 1998), and the owner is risk-neutral (e.g. a public sector
owner) (Holmstrom and Milgrom, 1987; Al-Subhi Al-Harbi, 1998).

Potential contractors have appropriate skills. Practices such as prequalification

or rigorous tender evaluation could be expected to ensure minimum good
standards amongst all potential contractors.

The works final cost is normally distributed. The central limit theorem supports
this assumption where the works final cost is comprised of the sum of many
component costs (Ang and Tang, 1975).

In practice, establishing agreement on targets may be difficult (Carmichael, 2000;

Badenfelt, 2008). Where incentives are based on targets, it is in the nature of
contractors to overstate the target, while it is in the nature of owners to understate the
target. To deal with these issues the target cost and target duration estimates can be
agreed by the parties, or established by a third independent party. Hughes et al. (2012)
stress the need for an open and transparent relationship, necessary to avoid target
costs being set too high.
Propositions
Based on the papers theoretical development, the following propositions are examined
empirically:
P1. With increasing level of contractor risk aversion: (P1a) the sharing ratio needs
to reduce, and (P1b) the fixed fee needs to increase.
P2. With increasing uncertainty in the actual cost: (P2a) the sharing ratio needs to
reduce, and (P2b) the fixed fee needs to increase.

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P3. With increasing effectiveness of the contractors effort towards the actual
cost: (P3a) the sharing ratio needs to increase, and (P3b) the fixed fee needs to
decrease.
Empirical study outline
To support the above findings an empirical outcome sharing study was carried out. This
was based on a designed interview of a sample of 60 construction contractors.
The contractors involved in the empirical study were from mid-sized companies,
typically pursuing projects in the range of $5M-$15M. The participants were instructed
to act as corporate decision makers, not as private individuals dealing with their own
funds, and to make decisions based on usual practice, workload and economic conditions
(Hosseinian and Carmichael, 2013b). This was so because the economic situation may
have affected their responses (Willenbrock, 1973). Before starting the interviews proper,
a pilot study was conducted with a number of experienced contractors, in order to fine
tune and validate the study.

An optimal
target cost
contract
593

Contractor sample
The backgrounds of the participants are shown in Table I. Approximately 43.3 per cent
of the interviewees were project managers, 26.7 per cent were contract managers,
21.7 per cent were executive directors and 8.3 per cent were construction managers.
The number of projects in which the participants have been involved is considerable as
shown in Table I; approximately 43 per cent of the contractors were engaged in more
than 26 projects, and 47 per cent of the contractors between 5 and 25 projects.
Approximately 46 per cent of the contractors had more than 21 years of experience in
the construction industry, and 33 per cent of the contractors between 11 and 20 years as
illustrated in Table I. Because the experience of the participants in the construction
industry is quite extensive, induction based on their responses could be regarded as
very persuasive.
Interview parts
The interview questions were based on this papers theoretical findings, and consisted
of three parts: first, contractor risk attitudes and levels of risk aversion; second, the
influence on the sharing ratio, n, and the fixed fee, F, of level of contractor risk
aversion; and third, the influence on the sharing ratio and the fixed fee of actual cost
uncertainty and contractor effort effectiveness towards the actual cost.
(i). Contractor risk attitudes and levels of risk aversion. The participants utility
functions and levels of risk aversion were established using the method of certainty
equivalence (Clemen and Reilly, 2001). This involved offering each contractor a series
of hypothetical, uncertain contracts (choice 1) with a 50-50 chance of either gaining
b1Tc or gaining/losing b2Tc; where Tc is the target cost estimate of the work. Given
Age (years)
o30
30-35
35-40
40-45
45-50
50-55
55-60
460
%
1.7
6.7
20.0
16.7
20.0
16.7
10.0
8.3
Experience (years)
o5
5-10
11-15
16-20
21-25
26-30
31-35
435
%
3.3
16.7
21.7
11.7
20.0
8.3
10.0
8.3
Number of projects o5
5-15
16-25
26-35
36-45
46-55
455
%
10.0
26.7
20.0
16.7
11.7
6.7
8.3
Position
Project manager Contract manager Executive director Construction manager
%
43.3
26.7
21.7
8.3

Table I.
Age, experience,
involvement in projects,
and positions of the
participants in the study

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594

Table II.
Cost variances for
different scenarios due to
events outside of the
contractors influence

b1 and b2, the participants were required to evaluate the values of their certainty
equivalents (CEs) (choice 2) such that they would be indifferent between (choice 1) and
(choice 2). The contractors utility function is then inferred from the choices made.
To frame the size of the work and complexity, contractors were asked to make their
decisions in scenarios similar to that in which they would usually operate. A target cost
of $10 M, representing the approximate mid-point value of the projects for the sample
of contractors, was used.
The level of risk aversion was obtained by asking the contractors to consider a
hypothetical contract that has equal chances of gaining aTc or losing half of that
amount. a is a constant, which varies between 0 and 1. The value of a is adjusted
during the study. The largest value of aTc is approximately equal to the decision
makers risk tolerance. The inverse of the risk tolerance equals the level of risk aversion
(Clemen and Reilly, 2001).
(ii) Effect of risk aversion on sharing ratio and fixed fee. For a fee, defined as in
Equation (18), the contractors were asked to choose the preferred value of n. To keep
the fixed fee, F, constant, the participants were asked to decide on the value of n, where
F equals 0.1Tc. The target cost, Tc, was kept the same as in part (i). The contractors
were told to consider the level of uncertainty in the actual cost of the project similar to
the uncertainty in the projects that they usually carry out.
To examine the impact of the level of risk aversion on the fixed component of the
contractors fee (for a fee defined as in Equation 1), the sample contractors were asked
to choose a minimum amount for F as their tendered fee, such they would not agree to
the contractual arrangement for any lesser amount. Keeping the sharing ratio, n,
constant at 0.5, the contractors were asked to decide on the value of tendered F. The
target cost, Tc, was kept the same. In order to limit the contractors response, the
contractors were required to select the preferred value of tendered F between 0.05Tc to
0.15Tc. This mentioned range covers the fee amount that the contractors commonly
receive from their usual projects, although fees outside this range can occur, depending
on the industry sector and the type, size and complexity of the project.
(iii) Effect of cost uncertainty on sharing ratio and fixed fee. For a fee defined as in
Equation (18), the contractors were asked to choose the value of n and the tendered
F for five different scenarios. Each scenario provided the contractors with different
levels of uncertainty in the actual cost of the work due to events outside of the
contractors influence, as shown in Table II. As an example, in Scenario 3 the
contractors were told that the optimistic, most likely and pessimistic actual cost values
equalled 0.90Tc, Tc and 1.10Tc, respectively. The contractors were asked to consider
the level of uncertainty in the projects that they regularly carry out as the usual
uncertainty mentioned in Table II. In this table the actual cost variances are calculated
using the PERT-style approximation based on optimistic (a) and pessimistic (c) values,

Scenario

Uncertainty level

1
2
3
4
5

No
Very low
Low
Usual
High

Optimistic

Project cost
Pessimistic

1.00Tc
0.95Tc
0.90Tc
0.85Tc
0.75Tc

1.00Tc
1.05Tc
1.10Tc
1.15Tc
1.25Tc

Most likely

s2/Tc2

Tc

0.0000
0.0003
0.0011
0.0025
0.0070

An optimal
target cost
contract
595

Empirical study results

Contractor risk attitudes and levels of risk aversion
According to the shape of the (contractor) utility function, three different risk attitudes
follow. A risk-averse decision maker has a concave (opening down) utility function.
A risk-neutral and a risk-seeker decision maker have, respectively, a linear and
a concave (opening down) utility function (Clemen and Reilly, 2001). Of the 60
practitioners, 48 (80 per cent) were found to be risk-averse, 12 (20 per cent) risk-neutral
and none to be risk-seekers. The following study focuses on the risk-averse contractors.
The results of the study are summarized in Table III. The associated utility
functions, using an exponential form, are shown in Figure 1.
Level of risk aversion  Tc
Low
C1-C2
5

C3-C8
6.7

C9-C16
8.3

C17-C26
10

C27-C32
12.5

C33-C36
14.3

C37-C40
16.7

C41-C44
20

C45-C46
25

Table III.
High
Ranking risk attitudes of
C47-C48 the sample of contractors;
33.3
Ci refers to contractor i

C1 and C2
C3 to C8

0.8

Utility

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namely, [(ca)/6]2 (Carmichael, 2006). Similarly to above, keeping the fixed fee, F,
constant, the contractors were asked to select the value of n, where F equals 0.1Tc.
Keeping the sharing ratio, n, constant at 0.5, the contractors were asked to decide on
the value of tendered F. The target cost, Tc, value of $10 M was kept the same.
(iv) Influence of the effectiveness of the contractors effort towards the actual cost, on
sharing ratio and fixed fee. For a fee defined as in Equation (18), the contractors
were asked to choose the value of n and the tendered fee, F, for a scenario where
the effectiveness of the contractors effort towards the actual cost increases.
The contractors chose the value of n and the tendered fee when the effectiveness
of their effort towards the actual cost was more than that of their usual projects.
The contractors were asked to make their decisions based on projects where early
involvement of the contractor is required. Here projects with early involvement of the
contractor represent projects where the contractors effort effectiveness towards
the actual cost increases. Similarly to above, keeping the fixed fee, F, constant, the
contractors were asked to select the value of n where F equals 0.1Tc. Keeping
the sharing ratio, n, constant at 0.5, the contractors were asked to decide on the value
of the tendered fee, F. The target cost, Tc, value of $10 M was kept the same.

C9 to C16
C17 to C26

0.6

C27 to C32
0.4

C33 to C36
C37 to C40

0.2

C41 to C44
C45 and C46

0
0

0.05

0.1

0.15

Fee (proportion of Tc)

0.2

0.25

C47 and C48

Figure 1.
Utility functions for
contractors

596

Effect of risk aversion on sharing ratio and fixed fee

Figure 2 (bottom data set) shows the influence of risk aversion on the sharing ratio, as
identified by the contractors. This figure indicates that a contractor with a low level of
risk aversion prefers a high sharing ratio. This supports the validity of the theoretical
result (Equation 16), and P1a.
Figure 2 (top data set) shows the influence of risk aversion on the fixed fee
component, as identified by the contractors. This figure indicates that a contractor
with a high level of risk aversion prefers a high fixed fee. This supports the validity of
the theoretical result (Equation (17)) and P1b.
In Figure 2, the sharing ratio and the fixed fee represent opposing trends as a function
of level of risk aversion. Taken as a whole, the figure shows that a high sharing ratio and
a low fixed fee need to be offered to a low risk-averse contractor. In contrast, a low
sharing ratio and a high fixed fee need to be offered to a high risk-averse contractor.

1.0

0.15

0.8

0.12

0.6

0.09

0.4

0.06

Fixed fee / Tc

Figure 2.
The relation between fixed
fee (F) and sharing ratio
(n) as a function of level of
risk aversion; data and
best-fit curves

Sharing ratio

Effect of cost uncertainty on sharing ratio and fixed fee

Figure 3 shows the relationship between actual cost uncertainty and the value
of n selected by the contractors.
According. to Figure 3, an increase in the level of actual cost uncertainty leads
to a decrease in the value of n, reflecting the contractors concern. This supports P2a.
Figure 4 plots the relationship between the fixed fee identified by the contractors
and cost uncertainty. Figure 4 shows an opposing trend to Figure 3.

0.03

0.2
Sharing ratio Fixed fee

0.00

0.0
0

10

15

20

25

30

35

Level of risk aversion Tc

r = 5.0/Tc

1.0

r = 6.7/Tc
r = 8.3/Tc

0.8
Sharing ratio

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r = 10.0/Tc
r = 12.5/Tc

0.6

r = 14.3/Tc
0.4

r = 16.7/Tc
r = 20.0/Tc

Figure 3.
Influence of uncertainty in
the actual cost of the work
on sharing ratio

0.2
0.0
0.000

r = 25.0/Tc
r = 33.3/Tc
0.002

0.004

0.006

Actual cost variance / Tc 2

0.008

Influence of the effectiveness of the contractors effort towards the actual cost, on sharing
ratio and fixed fee
Figure 5 shows the average value of the sharing ratio selected by the contractors where
the effectiveness of the contractors effort towards the actual cost increases, called
higher effectiveness in Figure 5. It compares these results with those obtained for
projects that the contractors usually carry out without any need for early involvement
of the contractor, called usual effectiveness in Figure 5.
Figure 5 supports the validity of the theoretical results in terms of the relationship
between the sharing ratio and the effectiveness of the contractors effort towards the
actual cost (Equation (2)). It shows that an increase in the value of the sharing ratio, n,
follows from an increase in the effectiveness of the contractors effort towards the
actual cost. This supports P3a.
Figure 6 shows the equivalent results for the fixed fee selected by the contractors.
It supports the validity of the theoretical results in terms of the relationship between the
tendered fixed fee, F, and the effectiveness of the contractors effort towards the actual cost
(Equation (3)). It shows that a decrease in the value of the fixed fee follows from an increase
in the effectiveness of the contractors effort towards the actual cost. This supports P3b.
0.16

r = 33.3/Tc

0.14

r = 25.0/Tc

Fixed fee / Tc

An optimal
target cost
contract
597

r = 20.0/Tc

0.12

r = 16.7/Tc

0.10

r = 14.3/Tc

0.08

r = 12.5/Tc

0.06

r = 10.0/Tc

0.04

r = 8.3/Tc

0.02

r = 6.7/Tc
r = 5.0/Tc

0.00
0.000

0.004

0.002

0.006

0.008

Actual cost variance / Tc 2

Figure 4.
Influence of actual
cost uncertainty on
the fixed fee

0.9
0.8
Higher effectiveness

0.7
Sharing ratio

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Figure 4 shows that an increase in the fixed fee follows from an increase in the level of
cost uncertainty, reflecting the contractors concern about uncertainty in the actual cost
of the work. This supports P2b.

Usual effectiveness

0.6
0.5
0.4
0.3
0.2
0.1
0.0
0

10

15

20

25

Level of risk aversion Tc

30

35

Figure 5.
Influence of the
effectiveness of the
contractors effort towards
the actual cost, on the
sharing ratio

598

Recommendations
The data derived from the participants can be used to develop a set of recommendations
for outcome sharing. In the cumulative frequency plot of the Table IV data, the level of
risk aversion of the sample contractors has been classified into three groups low,
medium and high. The results that follow are relatively insensitive to the choice of
boundaries between these classifications. By calculating the average sharing ratios
presented in Figure 3, for the risk aversion classification, recommended values of sharing
ratios can be obtained Table IV for three levels of cost uncertainty (low, usual and high)
as defined in Table II.
In Table IV the sharing ratio varies from 0.75 to 0.20. The highest sharing ratio
needs to be used in work with low cost uncertainty where a low risk-averse contractor
is engaged. By contrast, the lowest sharing ratio needs to be offered to a high riskaverse contractor in high cost uncertainty work.
Where there is little or no information about both the cost uncertainty and the
contractors level of risk aversion, the average value of the sharing ratio is recommended.
This average equals 0.45, which is obtained from data presented in Table IV.
Using the data presented in Figure 4, for a sharing ratio of 0.5, the averages of the
fixed fee selected by the sample contractors for different levels of cost uncertainty and
contractor risk attitude are summarized in Table V. The lowest fixed fee corresponds to a
low risk-averse contractor, with low cost uncertainty in the work; the highest fixed fee
corresponds to a high risk-averse contractor, with high cost uncertainty in the work.
Based on data presented in Figure 5, Table VI presents the recommend values of
sharing ratios for projects with early and usual contractor involvement. The highest
sharing ratio (n 0.8) needs to be used in work with early involvement of the
contractor where a low risk-averse contractor is engaged. By contrast, the lowest
sharing ratio (n 0.25) needs to be offered to a high risk-averse contractor in non-early
contractor involvement.
0.14
0.12
Fixed fee / Tc

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Figure 6.
Influence of the
effectiveness
of the contractors effort
towards the actual cost,
on the fixed fee

Table IV.
Recommended values of
sharing ratios for different
levels of uncertainty and
contractor risk attitude

0.10
0.08
Usual effectiveness

0.06

Higher effectiveness

0.04
0.02
0.00
0

10

20

30

40

Level of risk aversion Tc

Cost uncertainty

Low

Level of risk aversion

Medium

High

Low
Usual
High

0.75
0.55
0.40

0.60
0.45
0.35

0.40
0.25
0.20

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Based on the data presented in Figure 6, using a sharing ratio of 0.5, Table VII presents
the averages of the fixed fee selected by the sample contractors for early contractor
involvement and usual contractor involvement. According to Table VII, the lowest fixed
fee needs to be used for a low risk-averse contractor with early involvement. By contrast,
the highest fixed fee needs to be offered to a high risk-averse contractor with no early
contractor involvement.
Discussion
The above findings highlight the influence on the optimal outcome sharing of the
contractors level of risk aversion, cost uncertainty and the contractors effort effectiveness,
and how they should be acknowledged in any outcome sharing arrangement. Al-Subhi
Al-Harbi (1998) suggests that the contractor needs to be open about its risk attitude and,
in particular, its level of risk aversion. This will assist the owner and contractor in
reaching agreement on the optimal outcome sharing. In practice, it may be difficult to
assess the contractors level of risk aversion, because of commercially and politically
sensitive issues. In the situation where there is little or no information about the
contractors level of risk aversion, practitioners will find Tables IV-VII useful for selecting
an appropriate outcome sharing. Ignoring the optimal outcome sharing may translate into
an unattractive risk for contractors, resulting in a conflict of interest between the
contracting parties and perhaps putting the projects success at stake. Barnes (1983)
claims that owners in such situations have problems getting their work completed to a
satisfactory standard without substantial additional costs.
It is acknowledged that there may exist parameters affecting the selection of the
optimal sharing ratio and fixed fee other than those considered in this paper, and this
could be the subject of future research. Considering together all parameters that may
affect an optimal outcome sharing would lead to a complicated analysis, the results of

An optimal
target cost
contract
599

Cost uncertainty

Low

Risk aversion
Medium

High

Low
Usual
High

0.08
0.10
0.11

0.09
0.11
0.12

0.12
0.13
0.14

Table V.
Average values of
Fixed fee/Tc

Table VI.
Recommended values of
sharing ratios for early
and usual contractor
involvement vs different
levels of contractor risk
attitude

Contractor involvement

Low

Risk aversion
Medium

High

Early
Usual

0.80
0.55

0.65
0.45

0.40
0.25

Contractor involvement

Low

Risk aversion
Medium

Early
Usual

0.08
0.10

0.09
0.11

Table VII.
Comparison between
High
average values of Fixed
fee/Tc for work with early
and usual contractor
0.12
involvement
0.13

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600

which may be difficult for practitioners to use. Petersen (1993) argues that few
owners or contractors would contemplate taking the advice offered by very
complicated models. Although some assumptions are considered in deriving an
optimal outcome sharing, the insight gained from the results does address the problem
of the selection of the optimal sharing ratio and fixed fee. Weitzman (1980) argues
that economic models may operate in accordance with some simplification of reality,
but these models usually lead to significant insights into the nature of the problems
that they address.
This paper does not attempt to describe the way in which owners and contractors
make decisions in selecting a sharing arrangement. Rather, the paper indicates what
a rational decision maker would do. In construction projects with a high level of
uncertainty, the papers findings have a valuable role to play for decision makers
(owners, contractors) who are familiar with the concept of utility, expected utility and
optimization. Accordingly, the papers derived results give useful insight into the
outcome sharing problem. Knowing the factors that influence the optimal form
of sharing ratio and fixed fee can facilitate the process of negotiation between the
owner and the contractor to reach an agreement on the form of the optimal target
arrangement. The authors do not regard the derived results as a perfect solution to the
outcome sharing problem. Instead, it is more sensible to think of the derived results as
providing a better understanding of the sharing problem in construction.
Conclusions
This paper derives a result for the optimal outcome sharing in target cost contracts
under defined risk assumptions on the contractor (risk-averse ranging to risk neutral)
and the owner (risk neutral), and fills a knowledge gap in the literature. The paper
proposes an original solution to the problem of establishing optimal parameters in
target relationships; thereby, contributing to knowledge on target cost contracts. It is
found that the sharing ratio needs to reduce and the fixed fee needs to increase for
increasing contractor level of risk aversion. It is also found that the sharing ratio needs
to reduce and the fixed fee needs to increase for increasing actual cost uncertainty and
reducing contractor effort effectiveness towards the actual cost. The optimization
results presented in this paper may be used by contracting parties in the design of their
contracts, or as optimal benchmarks by which contracts designed differently, may be
compared. Although this paper refers primarily to construction projects, the solutions
presented here apply equally to related project types.
Limitations
The results presented in this paper are applicable provided the following assumptions,
discussed in the body of the paper, hold: the contractor is risk-averse and the owner is
risk-neutral; potential contractors have appropriate skills, and a projects final cost is
normally distributed.
The. theoretical results and the papers propositions were supported through
conducting an empirical study based on interviewing a sample of risk-averse
contractors. The study was based on a group of medium-sized contractors in the
commercial and building fields, and hence the support for the theoretical results
is limited to similar situations, until further data are assembled. Similarly, the
recommended values of the sharing ratio and the fixed fee are based on the data
collected from a group of medium-sized contractors, and hence their validity is limited
to similar situations.

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About the authors
Dr S. Mahdi Hosseinian is a Graduate of the Shiraz University (BSc) and Isfahan University of
Technology (MSc), where he achieved maximum marks among his cohorts. This paper forms
part of his PhD research at The University of New South Wales. Before joining The University of
New South Wales, he worked at the Buali Sina University.

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David G. Carmichael is a Professor of Civil Engineering at the University of New South

Wales. He is a graduate of the Universities of Sydney and Canterbury. He publishes, teaches,
and consults widely in most aspects of project management, systems, and problem solving.
He is known for his leftfield thinking on project and risk management (Project Management
Framework, A. A. Balkema, Rotterdam, 2004), and project planning (Project Planning, and
Control, Taylor and Francis, London, 2006). Professor David G. Carmichael is the corresponding
author and can be contacted at: D.Carmichael@unsw.edu.au

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