Loopholes in the NEC’s target contract mean contractors can use their old tricks to make a profit rather than taking a share of any project savings …
Although the NEC form of contract has been recognised as being strong on project and contract management, it has always been seen, at least by quantity surveyors, as being weak on cost matters. Option C, the target contract with activity schedule, is one of the most frequently used contracts, as it shares the financial risk between the contractor and employer and fits well with the “spirit of mutual trust and co-operation” that is built into the contract.
The old NEC2 target contract was woolly in how it dealt with cost and, despite some tweaking in NEC3, these weaknesses remained. There is a lack of clarity in the definition of which costs the contractor can recover. Before going into the details, it is worth looking at why target contracts suffer from this problem.
Under this form of contract, a target contract sum is agreed; this is the total that the employer is due to pay, as long as there are no employer changes to the scope of the work. In fact, what is paid to the contractor is the actual cost it incurs in constructing the project, together with a share of any savings made – frequently 50%.
On a project where the target cost is £1m, if the actual cost incurred by the contractor is £900,000, then the contractor is paid the £900,000 plus a 50% share of the £100,000 saving – a total of £950,000.
Although target contracts are assumed to incentivise the contractor to spend less, because this will maximise its share of any saving, this may not happen when the definition of what is recoverable is vague. Any lack of clarity will mean that rather than reducing costs, it will be better for the contractor to focus on recovering more costs from the employer. Reworking the previous example will illustrate this.
If you want your NEC project to run smoothly, amend the contract to tighten up what the contractor can recover
Once again the target cost is £1m but, this time, the contractor has persuaded the project manager that £80,000 of additional costs are allowable under the contract, giving an overall cost incurred of £980,000. The 50% share of the saving comes to £10,000, so the total paid to the contractor is £990,000. The increase of £40,000 over the original example shows why it is better for the contractor to argue about entitlement rather than to do what the contract intends, which is to minimise cost. It also shows that in order to get the contract to operate as it should, it is important to define precisely what actual costs are allowable.
Some areas of imprecision in the NEC are:
- The contractor’s own recoverable costs are defined in the schedule of cost components (SCC). In addition to these costs, the contractor is paid a working areas percentage overhead charge. It is not clear whether the contractor is paid for some equipment under the SCC or whether it is deemed to be included in the contractor’s overhead charge.
- Some SCC definitions are ambiguous. An example is that the contractor is entitled to severance costs for people “related to work on this contract”. This could be interpreted to mean the redundancy cost of a long-serving member of the contractor’s staff, even though they might have been working on the project for only a short period of time.
- Some parts of the contract only make sense when read with the guidance notes. A good example is the contractor’s entitlement under the SCC to payment for “meeting the requirements of the law”. It might be sensible to conclude that the contractor is entitled to payment for employer’s liability insurance, as this is a statutory requirement. The guidance notes in fact make it clear that this is deemed to be within the contractor’s fee.
So if you want your NEC project to run smoothly, you should amend the contract to tighten up what the contractor can recover. When you do this, bear in mind that the guidance notes do not form part of the contract and that in the event of a dispute a judge will seek to interpret the terms of the contract, not the guidance notes. If you want contractual certainty, build what you need into the contract.
Andrew Hemsley is managing director of consulting at Cyril Sweett. Email email@example.com