NEC Option C: Target Contract with Activity Schedule
NEC Option C is a cost reimbursable contract set against a target contract price, more commonly known as the target cost.
The NEC defines cost through its schedule of cost components (SoCC). There is also definition as to what is allowable and disallowable. The Contractor is paid his ‘defined cost’ on a monthly basis after presenting his application for payment to the Project Manager, who accordingly assesses the amount due.
If you’re considering whether to use this form of contract, the key question to ask yourself is this: what is the likelihood of overspending on your project when delivering against the target? Or alternatively, what are the chances on an overall saving? If the Contractor overspends and exceeds the target price of the contract then the Contractor and Employer will share this overspend. This is called the ‘pain share’. Equally if the Contractor delivers the final cost within the target price then this benefit is called the ‘gain share’ or, formally known as the ‘share ranges’.
Contracting parties don’t set out to overspend, but it remains a possibility. The best tactic to avoid this is to set your target contract so that it offers a real incentive to the Contractor and Employer to collaborate in successfully delivering the project. This ‘shared’ saving creates an ideal win-win for all parties.
We recommend that you avoid competitively tendering a target cost contract as this puts the onus on Contractors to provide an unsustainable price to win the contract. When this happens, you incentivise the Contractor to chase contract variations or ‘compensation events’ and increase the target price as opposed to delivering real cost savings.
How do you avoid this scenario? Negotiate a target contract with all parties with complete transparency on the following:
- What is included within the price?
- The extent of the scope
- An agreement of rates up front
- An understanding between all parties of where responsibility lies for each risk, with appropriate allowances made
Contract Arrangement and Setting Up
The commercial risk of defined cost expenditure is shared, so now you need to set the share ranges to an appropriate level. A 50/50 share on any savings and overspends is the most equitable. However, savings are often broken down into increments. For example, on the first 10% of overspend or underspend the split may be 50/50, but then for any further increases in overspend the Employer wishes to take less of the burden so sets the split at 70/30 to the Contractor.
To offset this the Employer also defines the opportunity for any gains over 10% at the same ratio. There are many ways to balance the incentives, but you should focus on incentivising all parties to work together with a common aim to successfully deliver the project.
A charge for overhead costs incurred in the working area is calculated by applying the working area overhead to the cost of people as described in the SoCC. You should inform your decision here on how the works are likely to be delivered. For example, if the Contractor decides to self-deliver part of the works using their own labour instead of subcontracting, this could result in a large liability if a high percentage is used. For this reason, you should carefully consider the working area overhead, alongside the fee with scenarios run, as to all possible outcomes when making tender assessments.
Once in contract, pay attention to the monthly programme updates and the progress made against the baseline. Study this progress against the Contractor’s monthly forecast updates of their defined cost to completion to ensure one reflects the other.
The Employer sets the parameters of when the contract should be completed by, when the Contractor can have access to the works and the contract start date. The Contractor then provides a programme that delivers to these constraints. The Contractor must detail how the activities on the Activity Schedule relate to the operations on each programme. Here, you should provide an Activity Schedule to a suitable level of granularity such that programmes can be assessed in detail.
Once a programme is reviewed and acceptable, it becomes the baseline programme with progress performance measured against it at the stated intervals in the Contract Data. Each month the Contractor will input actual progress against this baseline, which will provide a ‘planned completion date’ against the ‘contract completion date’.
On a lump sum or re-measurable form of contract, the financial risk of finishing late almost always resides with the Contractor, but here the risk is shared. It’s important to create a detailed programme that is:
- Fully linked to logic
- Resource and cost loaded
- Complete with a clear critical path
All points above are paramount to providing real intelligence in measuring levels of manpower required versus actuals. On a project of particular complexity or sizeable duration, a detailed programme can accurately provide a likely end date and final bill.
Also, when reviewing programmes, consider the Employers obligations to keep programming and avoid these activities being manoeuvred onto the critical path, which in most cases can be used to derive entitlement to a compensation event. Such sharp practices by Contractors should be dealt with before agreeing the baseline programme.
The Contractor provides forecasts of the total defined cost for the whole of the works at intervals stated in the contract data. In nearly all cases it makes sense to match this to the same intervals as the revised programmes, every four weeks is common practice. They are also to provide an explanation of any changes between forecasts. Getting early agreement on format is important here.
If you master the programme and receive robust and accurate cost forecasts that match the rate of progress, you’ll be on the front foot in terms of being able to make decisions in good time as opposed to being reactive to issues as they arise.
The schedule of cost components dictates what can be claimed, or is allowable, in terms of defined cost and therefore what is not stated here is by default deemed to be included in the fee. Either listing a breakdown of headings for the fee or requesting one as part of a tender return is good practice as it can avoid any ambiguity or inconsistencies between the parties later down the line. It can also help in normalising any tender returns.
It’s critically important to mitigate any changes in good time, and issuing early warnings should not be something administered by the Contractor alone. The contract states that early warnings can be issued if either party becomes aware of any matter that could increase the total of the prices.
Compensation events are administered in the usual fashion i.e. they are based on actual defined cost or forecast defined cost including any affect to the planned completion date plus suitable risk allowances. Once agreed the target contract price is increased by the value of the compensation event.
When should Target Contracts be used?
Like any contract price, the target contract is only as good as the Scope, Works Information or general contract drafting that sits behind it.
What must be considered is the stage of project development at which you are procuring. If early stage development works and the Employer wishes to procure a full detailed design and build, be prepared to agree to a large amount of risk incorporated into the price and then manage that risk accordingly. Conversely, if the scheme is more developed, an Employer should expect a more palatable value of uncertainty risk. Experience tells us that when a detailed preliminary design, plus a suitably worded output specification, is used to provide an Activity Schedule, then you’ll likely set a realistic Target Contract.
Specific Contract Nuances
Be aware of the contract nuances in NEC Option C, such as Disallowed Costs, which can be invoked by the Project Manager if she decides that cost has been incurred only because the Contractor did not give a required early warning. Either party can issue early warnings, therefore to operate this clause the Employer will have to demonstrate they were not aware of the issue at the time themselves. These ‘nuances’ can also be used ‘when the Project Manager decides’ as opposed to by agreement. Maintaining ‘mutual trust and cooperation’ is vital.
The Project Manager can disallow costs for plant and materials on the basis the costs incurred were not to Provide the Works. Similarly, disallowed costs can be invoked if resources were not used to Provide the Works or not taken away from the Working Area when requested by the Project Manager. This offers some protection for the Employer when certifying payment and puts the onus on the Contractor to adequately manage their costs or face the risk of not being paid for poor cost control.
When administering payment, be aware that in assessing the Price for Work Done to Date, the Project Manager must forecast Defined Cost, which will have been paid before the next assessment date. This exerts a certain amount of trust in the Contractor that they will indeed make such payment before the next assessment date. However, the Contractor must keep proof that payments have been made and such records are to be made available to inspect at any time within working hours.
The contract also prescribes that the Project Manager makes a preliminary assessment of the Contractor’s Share at Completion, then later a final assessment based on the final Price for Work Done to Date and the final total of the Prices.
This approach could mean the Employer overpays the Contractor until Completion is achieved in the event of a likely overspend. This is not an ideal situation and bad practice can occur whereby Contractors can delay completion until they have pressed their case for more compensation events to prolong any negative certificate being issued.
To avoid this occurring, Z Clauses are often drafted to allow the Project Manager to make interim assessments of the Contractors Share if forecasts of the final Price for Work Done are predicted to be more than the final total of the Prices.
Conclusion and Summary Thoughts
If set up correctly, with suitable buy in from all operating parties, NEC Option C can be a success. It requires a full open book approach and policy on Defined Cost to be in place during the administration of the project. Any changes must be agreed with a similar level of opportunity as the original Target Contract to maintain the same level of incentivisation through the contract term.
However, what should be remembered is that if early indicators are showing signs that all is not going to plan, take immediate corrective action to mitigate the impact for the benefit of all parties.