Today we highlight the practical differences in estimating and cost management under the most commonly used options of the NEC3 contract family, namely the fixed price ‘option A : Priced contract with activity schedules’ and ‘option C : target contract with activity schedules.’
The two most often used forms of NEC contract are the Option A and the Option C forms of the Engineering Construction Contract. These two forms of contract rely on an activity schedule rather than a bill of quantities. In simple terms, an Activity Schedule breaks the works down into parts (i.e. activities) which a tendering contractor then both prices and has to show in his programme. The sum of the prices for each activity becomes the contract Prices.
One of the most cited advantages of activity schedules is, therefore, that the detail provided at tender stage can be much less than its counterpart with a bill of quantities. That is often the case from an Employer's perspective as he is able to reduce his tender cost and, in theory at least, reduce his tender risk by placing the burden not only of pricing the works but of dividing the works up into appropriate blocks to the Contractor. While this may be the approach apparently anticipated by the form of contract it can be quite difficult for an Employer to compare competitive tenders if each contractor has produced their own Activity Schedule. Therefore, it is not unusual for the Employer to produce an Activity Schedule which the tenderers then price.
Most contractors will want to prepare their tender in much more detail, or at least in a different way to the Activity Schedule prepared by the Employer, so it is common to see a Contractor's tender estimate sitting behind the Activity Schedule, never submitted or officially recognised but the real driver for pricing the works and the means by which the Contractor will record cost. It is the link between the overall tender Prices, broken down to fit the Activity Schedule and the tender estimate used to manage and control cost once the project is live that is vital to dealing with change in the Prices.
If we take as an example a 10km bypass. Within the first and last kilometre there will be a junction with a roundabout where the bypass ties in to the existing road network. At kilometre 3 there is a bridge and at kilometre 4 there is a large culvert. Kilometres 1-4 are on embankment whereas kilometres 6-10 are in a cutting, kilometre 5 being at grade. If the Activity Schedule for this project were simply broken down, for the purposes of tendering, into 10 sections, one for each kilometre of the project, it should be obvious that the Contractor will need to go into more detail. As a starting pint the Contractor is going to need to investigate, either from the Works Information or elsewhere, the nature of the necessary construction activities which will need to take place. So, from the Employer's Activity Schedule of 10 items, the Contractor may want to consider 50 different work types from embankment construction and drainage through to tarmac laying and road sign erection. Those 50 different work types are then likely to form the means of cost recording and cost management once the project is live. However, at the tender stage, many contractors will go even further, and with some justification, in producing what is in effect their own bill of quantities. That level of detail is needed by some to identify properly the risk involved in the work, how and where that should be priced into the Activity Schedule and to understand the management of the works.
As a starting point then the simplicity of the Activity Schedule approach in Options A and C is simplicity for the Employer but far from it for the Contractor.
Getting Paid once the contract is ‘live’
Once the project goes live the most important question for the Contractor will be (or should be) “how do I get paid for the work I am carrying out ?” It is at this point that Options A and C diverge quite dramatically in relation to cost management. Where the Option A form is priced against an Activity Schedule, then payment is directly against that Activity Schedule as a series of mini lump sums or milestones. In other words, under the Option A form payment is made as Activity Schedule Items are completed. That being the case great care needs to be taken in relation to how the Activity Schedule is structured as, based on the above simplistic example, the Contractor will have negligible cash flow for the vast majority of the project and will be carrying substantial payment risk as his payment entitlement crystallises on the completion of the first kilometre of the bypass. While there is some latitude for payment against partially completed tasks the milestone payment approach is prevalent.
Turning to the Option C contract, the payment mechanism is substantially different. Under Option C the Contractor will be paid his Defined Cost + Fee at each payment interval. Some cost may be disallowed, for example because it was not incurred in providing the works, but in general the assumption is that cost will be paid making this a lower risk option for the Contractor. In terms of cost management, the Option C contract can be quite demanding on the Contractor as he must maintain a very clear cost record which can, and almost certainly will, be audited regularly by the Project Manager. As payment is directly referable to Defined Cost incurred, the Contractor is incentivised to manage his cash position and maintain his records properly. Although Option C is a cost based contract is should not be confused with a Cost+ contract. There is a balancing mechanism at the end of the project where by savings or overspends against the budgeted cost, or target Prices, are shared between the parties.
Under both the Option A and Option C forms therefore cost management is an important tool in relation to payment. Under Option A, the crunch point is at the beginning and achieving an appropriate Activity Schedule breakdown whereas, under Option C, it is a month on month direct demonstration of cost to enable interim payment.
The next point to consider however is what happens when there is change in the project.
Turning back to the earlier example of a 10km bypass let us assume that the Employer, during the currency of the works being carried out, asks the Contractor to extend the bypass by another 2km. Under the NEC this would be a compensation event for which the Contractor will be entitled to amended the Prices as set out in the Activity Schedule. Crucially that adjustment is not carried out after the fact. The adjustment to the Prices is made looking forwards, prospectively, to the future. The nature of prospective pricing of compensation events, and the anticipation of both NEC Options A and C, is that the Contractor will provide a quote for the compensation event at the time it arises and that quote will be accepted shortly afterwards by the Project Manager. The quote will be produced and agreed before the work is carried out and is therefore all about estimating future work content.
The pricing of the compensation event will be based on cost already incurred in relation to the event, the estimated cost of the event in the future and a risk factor. Once the value of the compensation event is agreed (or ‘implemented’ to use the NEC terminology) it cannot be changed if a forecast is shown by later recorded information to be wrong. The value of a compensation event is therefore locked in from an early stage and whether the work required in fact costs more or less than the agreed quote is of no relevance in terms of adjusting the Prices. Therefore, once the quotation is agreed the cost management of the Contractor must be alive to the change and adjust to suit the new position.
Under Option A, the Contractor has much more incentive for dealing with compensation events promptly than it does under the Option C. This is simply because, under option A, the payment obligation arises when an Activity Schedule item is completed, so if a compensation event is not agreed then it is not added to the Activity Schedule and no interim payment is due on completion of that activity. Hence the Contractor’s cash flow suffers. Under Option C, the Contractor is paid Defined Costs + fee as the project progresses and, if the compensation event mechanism is not operated as it should be – i.e. agreements reached as the project progresses - then it is only at the end of the project when the share mechanism is applied that Contractor may have a big problem.
So the warning note under Option C is that while cost management is important to interim valuations and cash flow during the project the proper and accurate management of value, in terms of identifying, pricing and agreeing change is also vital to a successful project outcome.
Under Option C in particular, but under NEC contracts in general, the art of estimating is taken to a whole new level by requiring estimates to be produced by site teams who
- may not be used to the process and
- for those estimates to be produced within very tight timescales so as to avoid disrupting the project itself
If done well and promptly, it enables the Contractor and the Employer to properly manage both cost and value.
About the Author
Rob Horne is partner in London law firm Simmons and Simmons and is one of the most visible pro-NEC practitioner lawyers. He advises on construction, engineering & infrastructure projects all over the world, particularly the Middle East and Europe. He has over 20 years of experience on construction disputes and is recognised in Legal 500 for his work in both rail and international arbitration.Rob can be contacted on +44 20 7825 4264 and at firstname.lastname@example.org