What are the NEC payment mechanisms?

Various different NEC payment mechanisms are used across the construction industry and all standard forms of construction contract include different payment mechanism options.

The three most commonly used payment mechanisms are fixed price, target price, and cost reimbursable, and there is a myriad of variants of each of these mechanisms.

The NEC suite of contracts offers six main payment options (A to F). This article outlines:

• the NEC4 ECC Option A (Priced contract with activity schedule), Option C (Target contract with activity schedule), and Option E (Cost reimbursable contract) payment mechanisms,
• the potential benefits and the risks associated with using each of these mechanisms, and
• guidance on selecting the appropriate payment mechanism for your contract.

Option A (Priced contract with activity schedule)

In an Option A contract, subject to agreed reopeners, the Contractor is paid a fixed price (which includes all profit and overheads) based on completed activities listed in the Activity Schedule.

Examples of reopeners include compensation events (which provide a mechanism for the Contractor to claim additional cost and/or time for unexpected changes, e.g., changes to the scope, unforeseen changes in physical conditions, exceptionally adverse weather, events beyond the control of both parties, changes in the law, etc.) and adjustments for inflation.

Outside of the agreed reopeners, the Contractor carries the cost risk. If the cost of the work exceeds the agreed fixed price, the Contractor will earn a smaller profit margin or may make a loss.

Option A is appropriate where the Contractor is able to accurately price the work. Accordingly, the work must be clearly defined, with a settled and sufficiently detailed design, and significant changes to the requirements should not be foreseen.

Note: the same principles apply to an Option B (Priced contract with bill of quantities), save that the Contractor is paid based on quantities of work completed in accordance with the Bill of Quantities.

Option C (Target contract with activity schedule)

In an Option C contract, the parties agree (i) a target cost for the work based on activities listed in the Activity Schedule and (ii) a formula for sharing any underspend or overspend against the target cost. The target cost is subject to agreed reopeners such as those listed above in the context of Option A.

The Contractor is paid based on the actual costs it incurs in carrying out the work plus a pre-agreed fee percentage fee to cover its overheads and profit. Once the works are complete, the total cost paid to the Contractor is compared to the target cost and any underspend or overspend is shared between the parties in accordance with the pre-agreed formula (i.e., subject to any reopeners, the cost risk is shared between the parties). An NEC Option C contract is effectively a cost reimbursable contract, with built-in incentivisation against the target cost.

Option C is appropriate where the parties have sufficient knowledge and experience to accurately estimate the likely cost of the work and to negotiate and agree the formula for sharing any underspend or overspend. It is also important that Client (and Project Manager) is experienced in managing Option C contracts.

Note: the same principles apply to an Option D (Target contract with bill of quantities), save that the target cost is based on quantities of work completed in accordance with the Bill of Quantities.

Option E (Cost reimbursable contract)

In an Option E contract, the Contractor is paid based on the actual costs it incurs in carrying out the work plus a pre-agreed lump sum or percentage fee to cover its overheads and profit.

Option E is appropriate in the context of alliancing style arrangements and/or where the work cannot be clearly defined at the outset and the risks associated with the works are high, for example due to urgency or where projects are of such significant scale and complexity that securing a fixed price or target cost isn’t viable.

Option E is more suitable for an experienced Client and Project Manager. The Client carries the cost risk and active and skilled contract management by the Client and Project Manager is necessary throughout in order to control costs.

Selecting the appropriate payment mechanism for your contract

Whether a particular payment mechanism is appropriate for your contract will depend on a variety of factors including the certainty and nature of scope, the level of design development, the ability to price the works, and the intended allocation of risk between the parties.

Although selecting the appropriate payment mechanism for your contract is important in allocating cost risk, it is not the be-all and end-all in terms of allocation of risk.

There are other equally important strategies and risk allocation mechanisms that should also be used to manage risk.

Issues such as fee percentage, limits of liability, liability periods, incentives and pass-through risks (such as inflation and change in law) all feed into the overall risk apportionment between the parties.

In considering your approach to risk allocation, it is important to consider what your main drivers are – the matrix between time, cost, and quality – and use this information to make informed decisions on key risk allocation positions across the contract.

When in contract, irrespective of your approach to risk allocation, effective contract management (notably in respect of change control) is essential.

Our specialist construction lawyers advise councils and other public bodies on the various aspects of development contracts. If you would like to discuss your options in connection with NEC payments, please get in touch.

Sophie Drysdale is an Associate and Allan Owen is a Partner at Sharpe Pritchard LLP.

This video is for general awareness only and does not constitute legal or professional advice. The law may have changed since this page was first published. If you would like further advice and assistance in relation to any issue raised in this article, please contact us by telephone or email enquiries@sharpepritchard.co.uk