09/09/24
Newsletter #23:
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NEC - How to assess negative compensation events
Welcome to the Instruct newsletter. More fun than cracking an egg and getting a double yoker!
Ever wondered what to do when the effect of a compensation event will REDUCE prices!?
This week we go through the process, and explain what should be done for Options A and C in the contract, a comparison of a Priced Option and a Target Option.
Let’s kick off with a scenario:
The Scope for a project includes construction of a new car park which can accommodate 500 spaces. This has been priced by the Contractor at £500,000 and is included in the contract sum at this amount (A single activity for Option A valued at £500,000, and a sum of £500,000 making up the Activity Schedule and Target in Option C).
During construction the Client decides they don’t need 500 spaces and reduces the requirement to only 400 spaces. The Client thinks that it’s a great saving of £100,000…but is it?
How much is the Client really going to save? And how is the process administered?
Let’s discuss:
When assessing compensation events clause 63.3 says “If the effect of a compensation event is to reduce the total Defined Cost, the Prices are not reduced unless otherwise stated in these conditions of contract.”
Clause 63.4 then goes on to say “If the effect of a compensation event is to reduce the total Defined Cost and the event is:
a change to the Scope other than a change to the Scope provided by the Client, which the Contractor proposed and the Project Manager accepted or
a corrections to an assumption stated by the Project Manager for assessing an earlier compensation event
the Prices are reduced.”
In summary, if its a change to the Scope (which this is) instructed by the Project Manager because the Client wants it, then the Prices are reduced!
So how do we calculate this….and will the Client see the saving?
Options A - Priced Contract with Activity Schedule & Option C - Target Contract with Activity Schedule
The Contractor assesses the forecast Defined Cost of constructing the 100 spaces which are no longer needed (this will show how much Defined Cost is being saved). The Contractor will need to assess the programme, obtain current prices for materials, plant, labour, and calculate exactly how much it will cost to deliver those 100 spaces (in accordance with the Cost Components).
The Contractor does this assessment and demonstrates that constructing the 100 spaces has a Defined Cost of £40,000. Which means the Contractor is saying it will only cost £40,000 to build 100 spaces which the Client has agreed to pay £100,000 for!
Isn’t the Client entitled to the £100,000 back!?
How does this get administered?
Clause 63.14 states that “Assessments for changed Prices for compensation events are in the form of changes to the Activity Schedule.”
The Contractor submits a new Activity Schedule which reflects the new Scope (400 spaces) and shows a reduction from £500,000 to £460,000. I.e. A Defined Cost saving of £40,000!
The Project Manager will assess this and assuming it is acceptable (in accordance with the Cost Components), will implement the change under clause 66.1 and 66.2.
Option A - The new Activity Schedule takes precedent and the Contractor claims the lump sum for the car park work once it is completed. The full £460,000.
Option C - The Contractor is paid at each assessment date the actual and forecast Defined Cost.
Why didn’t the Client get £100,000 back?
Clause 63.1 states that the change to the Prices is assessed as the change in forecast Defined Cost. Because the Contractor was only forecasting to spend £40,000 of Defined Cost in order to construct the 100 spaces, that is the only saving which is generated by reducing the Scope, and therefore the Client will only see this reduction, not the full £100,000. The difference will remain with the Contractor as an extra saving, either by being paid the lump sum in Option A, or by giving a bigger gain share in an Option C.
What the Client’s failed to consider:
The Contractor will have priced risk such as inflation, weather, lost productivity, material availability, etc. and built that into the £100,000 price. The Contractor needs to protect their budget.
It is the Client who wants to make the change to an agreed contract, not the Contractor. As such the Contractor shouldn’t be penalised by having the full £100,000 taken from them, when the forecast shows that they were going to make a healthy profit. This profit is the Contractors incentive for doing a good job and delivering under budget, they should keep that saving with the Client only receiving the actual saving of doing the work.
Afterall it was the Clients decision to change the Scope, and they must accept the financial implications!
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