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.

Potential benefits

Potential risks

Cost certainty and simplicity: both the Client and the Contractor know exactly how much will be due and for what work. This limits cost exposure for the Client and provides the Contractor with a predictable total return.
Potentially encourages efficient delivery by the Contractor: as the Contractor carries the cost risk, it is encouraged to achieve cost-savings through efficient delivery. This means potentially higher profit margins for the Contractor as well as the possibility of an earlier completion for the Client.

·Potentially inflated price: the Contractor will likely build contingencies into its fixed price to protect itself from cost overruns which could unnecessarily increase the cost to the Client.
Potential “race to the bottom”: to win the contract the Contractor may submit unrealistically low prices and then in contract struggle to deliver the required quality, “cut corners” to maximise profit, or seek to utilise compensation events to increase the fixed price payable.
The price is only fixed for a fixed scope: cost certainty is only a benefit of a fixed price contract if the Client can clearly define the work such that the Contractor has been able to accurately price the work.

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.

Potential benefits

Potential risks

Potentially facilitates collaboration between the parties: the parties have a common interest in managing costs such that actual costs remain below the target. This is the only payment mechanism where parties share the cost risk, providing the opportunity to develop an equitable approach to unknown cost risks.
Potentially encourages efficient delivery by the Contractor: as the Contractor will benefit from any underspend and will suffer as a result of any overspend, it is encouraged to achieve cost-savings through efficient delivery.

The target price is only as good as its estimate: if costs are underestimated (i.e., if the actual cost exceeds the target cost) both the Client and the Contractor suffer as a result of any overspend. If costs are overestimated (i.e., if the actual cost is less than the target cost), then the Contractor may excessively benefit from underspend.
Potentially ineffective formula for sharing any underspend or overspend: if the formula does not incentivise delivery under target by the Contractor, costs could easily overrun as the Contractor is paid on a reimbursable basis.

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.

Potential benefits

Potential risks

Easily accommodates changes and additions to the work: as (unlike in a fixed price contract) the Client can change the scope without needing to renegotiate the price.
Potential savings for the Client: as (unlike in a fixed price contract) there is no need for the Contractor to inflate its prices to account for risk.
Potentially increased quality: as there is little incentive for the Contractor to “cut corners”.

The final cost is not certain: project costs are not capped, meaning that the Client’s exposure is unknown.
Potentially increased costs for the Client: as the Contractor is reimbursed for all of its costs, it is not motivated to reduce its total cost or work efficiently. The Contractor may be motivated to increase its total cost and work inefficiently where it will receive a percentage fee based on the overall cost (although amending standard NEC to fix the fee can mitigate this).
Burdensome contract management for both the Client and the Contractor: the Contractor is required to report all of its costs to the Client in order to be paid and the Client/Project Manager has to scrutinise applications for payment to ensure accuracy. Both sides need experience with payment based on the Schedule of Cost Components for the contract to operate effectively.
Potential widening of the scope: without a clear and detailed scope and good communication between the parties, there is a risk of the project expanding beyond its original objectives.

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.

For further insight and resources on local government legal issues from Sharpe Pritchard, please visit the SharpeEdge page by clicking on the banner below.

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

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