"NEC 3 and Target Cost Contracts: Defined Costs, Disallowed Costs and Defects"“pain/gain” mechanism
NEC 3 (New Engineering Contract) is a suite of standard forms of contract used for construction, engineering, and service-providing organizations. One type of NEC contract is the Target Cost Contract, which involves the client agreeing to pay the contractor a fixed sum (the target cost) for the works, subject to adjustments for actual costs incurred and forecast at completion. This type of contract is used in projects where the cost is uncertain and the risks need to be shared between the client and the contractor.
In a Target Cost Contract, there are three important elements to consider: Defined Costs, Disallowed Costs, and Defects. In this blog post, we will delve deeper into each of these elements, as well as the "pain/gain" mechanism, which is a critical aspect of NEC 3 Target Cost Contracts.
Defined Costs: In a Target Cost Contract, defined costs are all the costs that are directly attributable to the contract and which can be estimated with sufficient accuracy to allow the target cost to be calculated. These costs include direct costs (such as materials, labor, and plant) and indirect costs (such as overhead and profit). Defined costs are agreed between the client and the contractor, and the contractor is responsible for ensuring that these costs are managed within the target cost.
Disallowed Costs: Disallowed costs are costs incurred in performing the contract that are not recoverable from the client because they do not comply with the contract terms or are excessive or unreasonable.
These costs could include anything from inefficient working practices to frivolous spending. In a Target Cost Contract, the contractor is responsible for ensuring that disallowed costs are kept to a minimum, and if they occur, the contractor bears the cost of these items.
Defects: A defect is a failure of the works to comply with the contract requirements. In a Target Cost Contract, the contractor is responsible for rectifying any defects in the works and may incur additional costs as a result. The cost of rectifying defects is considered a disallowed cost, and the contractor will not be reimbursed for these additional costs. However, if the contractor has taken reasonable steps to prevent defects from occurring in the first place, the cost of rectifying these defects may be recoverable from the client.
Pain/ Gain Mechanism: The "pain/ Gain" mechanism is a critical aspect of NEC 3 Target Cost Contracts. It is a mechanism that ensures that both the client and the contractor have an incentive to manage costs effectively. If the actual costs incurred are less than the target cost, the contractor is entitled to a share of the "gain". Conversely, if the actual costs exceed the target cost, the contractor will bear the "pain".
The "pain/ Gain" mechanism is expressed as a percentage of the difference between the target cost and the actual cost. For example, if the "pain/ Gain" mechanism is set at 80/20, the contractor will be entitled to 80% of the " Gain" and the client will be entitled to 20% of the " Gain". Conversely, the contractor will bear 80% of the "pain" and the client will bear 20% of the "pain".
This mechanism ensures that both the client and the contractor have an interest in keeping costs within the target cost. If the contractor is able to complete the works for less than the target cost, they will benefit from the " Gain". Conversely, if the contractor incurs additional costs, they will bear the "pain". The "pain/ Gain" mechanism also ensures that the contractor is motivated to prevent defects and to rectify them as quickly as possible, as the cost of rectifying defects will be considered a disallowed cost.
In conclusion, NEC (New Engineering Contract) 3 is a suite of standard forms of contract for construction, engineering, and service-providing organizations. Target Cost Contracts are a type of NEC contract in which the client agrees to pay the contractor a fixed sum (the target cost) for the works, subject to adjustments for actual costs incurred and forecast at completion.