One of the advantages of the NEC suite of construction contracts is the flexibility the contracts provide to users. This is particularly so when it comes to payment arrangements where, in each of its forms of contract, the NEC provides options for the manner in which payments are to be made.
As a result of this flexibility, however, and the NEC’s desire to use consistent terminology across varying payment options, the payment regime can, on first reading, appear complicated. This article provides, in relation to the NEC3 Engineering and Construction Contract (ECC), an overview of the payment options, identifying the common principles, and the points to be considered under each option.
ECC Payment Options
The ECC provides six payment options. One must be selected for each contract:
- Option A - priced contract with activity schedule – a lump sum contract, under which the Contractor is entitled to be paid for completed activities.
- Option B - priced contract with bill of quantities – a remeasurement contract, based on a bill of quantities. The Contractor is entitled to be paid for the quantity of work completed, by reference to bill of quantities rates.
- Option C - target contract with activity schedule - a cost plus contract subject to a pain/gain share mechanism by reference to an agreed target cost (built up from an activity schedule).
- Option D - target contract with bill of quantities – again, a cost plus contract subject to a pain/gain share mechanism by reference to an agreed target cost (built up from a bill of quantities).
- Option E - cost reimbursable contract - cost plus contract.
- Option F - management contract - the Contractor is paid the cost that it pays its subcontractors plus a fee.
This article will principally focus on the most commonly used Options A-D.
Under the ECC there is no separate concept of a contract sum. The ECC uses the term Prices, which has a different meaning in each of the options:
- In Options A and C – Prices means each of the lump sum prices against each of the activities in the activity schedule. In Option A the total of the Prices is therefore, in effect, the contract sum. In Option C the Total of the Prices is the target cost for the purposes of the pain/gain share mechanism.
- In Options B and D – Prices means the lump sums and the amounts obtained by multiplying the rates by the quantities for the items in the bill of quantities. Again, in Option B the total of the Prices is in effect the contract sum. In Option D the Total of the Prices is the target cost for the purposes of the pain/gain share mechanism.
- In Option E – Prices means the Defined Cost plus the Fee. Given the cost plus nature of the option, this will not be capable of determination in advance but the Contractor is under an obligation to give regular forecasts of the Prices.
Under each of the ECC payment options the Contractor is entitled to interim payments which are certified by the Project Manager at each assessment date. The assessment dates are identified by the parties in the contract. The first assessment date is stated in the contract as are the assessment intervals for subsequent payments.
The Project Manager certifies the amount that is payable to the Contractor at each assessment date. The first certified payment is the amount due and subsequent payments are changes in the amount due from the previous certification. Certification is therefore based on a gross assessment less sums previously certified.
The amount due is the Price for Work Done to Date (the calculation of which varies between options as identified below).
In addition, the Contractor is paid other amounts due, for example VAT or any other separate entitlements that the Contractor may have, over and above the cost of the works itself. These sums are paid, less the amounts to be paid by or retained from the Contractor. This might include for instance any liquidated damages that become payable.
Each of Options A, B, C and D rely on a pricing document. Either an activity schedule or a bill of quantities.
The activity schedule is a list of activities with priced amounts against each activity. The Contractor prices a lump sum for each activity that it identifies it needs to undertake in order to complete the works in accordance with the works information. No quantities are provided by the Employer.
In principle, it is for the Contractor to identify how it intends to deliver the works and therefore to identify the activities that it considers necessary. In practise, however, the Employer is likely to want to specify at least a core set of activities to create some consistency during the tender process.
It is important that the activities are clear and distinct so that the parties know when they are completed. The Contractor is only entitled to be paid for completed activities. From the Contractor’s perspective, therefore, it will want to ensure that the works are split into as many activities as possible. In contrast, an Employer may want to ensure that activities are described such that elements of work are only paid for when related elements of work are complete. This can be achieved either by ensuring that the relevant activity includes all related elements of work, or by grouping activities.
By setting the activities appropriately, the activity schedule based options can be used to establish a stage payment contract, so that the Contractor will only be paid on completion of stages (or grouped activities).
The bill of quantities under the ECC envisages a traditional bill of quantities. The Employer will have identified the quantities of work required in order to deliver the works in accordance with the Works Information. The Contractor prices its rates against those quantities in order to establish the price at the date of the contract.
The Fee is relevant in each of the payment options. In Options C, D and E (each cost plus) the Fee is part of the calculation of the Price for Work Done to Date to be paid to the Contractor. In Options A and B, the Fee is only relevant to the assessment of the cost consequences of a compensation event.
Across each of the contracts the Fee is calculated by the application of an agreed percentage against Defined Cost. The fee percentage needs to cover all costs of the Contractor not covered by Defined Cost, and also provides the Contractor its profit and an allowance for risk.
The parties agree two separate fee percentages: one for subcontracted work; and one for other work. This reflects the possibility that the risk and profit for (and the work required in managing) direct work as against subcontracted work may well be different. Often the percentages will be agreed at the same figure, but if there is a difference, the percentage for sub-contracted work is likely to be higher.
Defined Cost and the Schedule of Cost Components
Again, Defined Cost is relevant in each of the payment options.
In Options C, D and E, Defined Cost is the principal constituent of the Contractor’s payment for work done (the “cost” in the cost plus contract). In Options A and B its relevance is limited to the assessment of compensation events.
In Options C, D and E, Defined Cost of subcontracted work is the amount of payments due to the Contractor’s sub-contractors. This highlights the need for the Employer to be aware of the terms of the subcontracts and to operate the subcontract approval processes under the ECC.
Otherwise, Defined Cost is established by reference to the Schedule of Cost Components within the ECC. Depending upon the pricing option selected, there are 2 Schedules of Cost Components, the standard Schedule and the Shorter Schedule of Cost Components.
Under Options C, D and E the standard Schedule is used for assessing the Price for Work Done to Date, although the Shorter Schedule may be used for assessing compensation events if both the Project Manager and the Contractor agree.
Under Options A and B, only the Shorter Schedule is used.
Both schedules identify categories of cost that the Contractor may incur. These include costs for people, equipment, plant and materials, charges, manufacture and fabrication, design and insurance.
The significance of the Schedules of Cost Components, and the manner in which Defined Cost is established needs to be understood. They identify a specific level of detail that needs to be established. For example, in respect of people costs the Contractor will be required to provide details of how its people costs are built up, including salaries, bonuses, any incentives, any allowances, details of absence due to sickness and holidays, subsistence and lodging, medical examinations, travel insurances, pensions and life assurances.
It is essential that the Contractor recognises the need to maintain the relevant records to justify all of its costs. It is also necessary for the Employer and Project Manager to have appropriate resources to be able to properly analyse and deal with the detail in the applications by the Contractor when received.
Further, under Options A and B, it should be noted that the Shorter Schedule applies to subcontractor costs as well as the Contractor’s own costs. The Contractor therefore needs to ensure that, in the event of compensation events, its subcontractors are obliged to provide all the relevant detail required to justify the Defined Cost in a compensation event claim.
Both parties need to establish a process and the nature of records required early in the contract to ensure that the mechanism can work. For Options C, D and E this will become apparent on day one, or at the first assessment date, when the Price for Work Done to Date is calculated. Under Options A and B, however, if not considered in advance, the issue will only arise when assessing a compensation event, by which time records may not be available.
Under Options C, D and E, the Employer is entitled to deduct Disallowed Cost from what would otherwise be Defined Cost.
Disallowed Cost is a cost which the Project Manager decides falls within the categories of Disallowed Cost in the contract. These include, for example, cost not justified by accounts and records, cost that should not have been paid in accordance with the terms of the Contractor’s subcontracts, cost incurred in preparation for and conduct of dispute proceedings and the cost of plant and materials not used to provide the works.
Assessment of Compensation Events
Under each option assessment of the financial impact of a compensation event is made by reference to the impact on Direct Cost and the resulting Fee. Changes to the Prices are assessed as the impact of the compensation event on the actual Defined Cost for work that has been done, the forecast Defined Cost of work not yet done and the resulting Fee.
Application to Options A-D
The table below summarises the application of the above principles to each of payment Options A-D.
Click here to view table.
It is important to note that in Options C and D the Defined Cost is the cost that will be incurred before the next assessment date, as forecast by the Project Manager. This keeps the Contractor in a cash neutral position because he is paid in advance what is forecast to be incurred, rather than what has actually been incurred.
Options C & D: Pain/Gain Share mechanism
As noted above, under Options C and D, the Total of the Prices operates as a target cost, as part of the pain/gain share mechanism.
The pain/ gain share is assessed by reference to the difference at completion of the works between the Total of the Prices and the Price for Work Done to Date.
The assessment is first made at completion based on a forecast of the two figures. The ECC provides for a final assessment once the final figures are known.
The ECC provides flexibility around how the share works. It is for the Employer to specify at tender stage what the share percentages under the contract are to be. At its most simple, whatever proportion of the Price for Work Done to Date exceeds the Total of the Prices is shared in agreed percentages between the parties, and likewise in respect of any savings below the Total of the Prices. The ECC allows greater sophistication by allowing for different share percentages to be agreed for different proportions of pain/gain. The key from the Employer’s perspective is to motivate performance and to encourage the Contractor to deliver a Price for Work Done to Date which is less than the target Total of the Prices.
There is no interim assessment, in advance of completion, of what the difference between the Total of the Prices and the Price for Work is going to be. That can mean that an Employer may find that at completion of the works the Price for Work Done to Date exceeds the Total of the Prices, such that the Employer needs to seek recovery of any overpayment of the Contractor’s share. This can be an issue in terms of cash flow and covenant risk.