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5½ reasons to get rid of the percentage for working areas overheads

5½ reasons to get rid of the percentage for working areas overheads

A blog for the NEC3 geeks this, so I am presuming a reasonable level of knowledge about what the percentage is and how it works. I actually wrote the majority of this before the 4th edition of NEC was announced and before I was aware that they were getting rid of it as announced in their white paper [1]

I was recently challenged by a distant project sponsor to justify why I wanted to delete the percentage for Working Area overheads from his NEC3 Engineering and Construction Contracts option C and E cost based contracts for a new framework. Instead, I wanted the winning contractors to simply be reimbursed at cost for the items in the percentage.

With a few additional stories to bring it alive, this was my response.

1. Contractors play games with it at tender

At tender, contractors look at the financial assessment criteria and match it to how they think they will incur cost on a contract. Based on differences they play games e.g. if they think they will incur more People costs than in the financial model, they might well load up the percentage for Working Area overheads & unload the direct fee percentage and vice versa.

This is especially true when Employers make the mistake of only applying the percentage to the estimates of People costs for compensation events when under options C to E, in reality, the percentage is applied to all non-subcontractor People costs incurred on.

Consequently, the effect on the adjusted tendered total of the Prices can be small, but the effect – in terms of what the Employer ultimately pays should the Contractor deliver the work – large.

2. Varying base costs

Even, if the bidding contractors are not playing the game above, the percentage will vary depending on the Contractor's cost base i.e. a Contractor using a lot of their own People labour will have a lower percentage than one who subcontracts out the work as the base to which it applies will be bigger. As this might be what the Employer wants, this is my ‘half’ reason.

3. It may or may not reflect the additional true costs when change occurs.

This reason relates to the previous two reasons and may apply on a single contract even when the Contractor tendered with a straight bat. Here'a scenario : the Employer has made it clear that this is a time driven project. Consequently, the Contractor bids on the basis that compensation events will not lead to an increase in time related costs covered by the percentage. Consequently, he tenders a low percentage which does not allow for these time-related costs. But lots of compensation events outside of the Contractor's control do happen leading to large increases in time and hence these costs. The Contractor is out of pocket.

Alternatively, due to changes - which could or could not be due to compensation events - more People are brought on-Site, but the Contractor is not encountering much more cost as covered by the percentage. However, the percentage for Working Area overheads is applied to the increased People Defined Costs and the Contractor receives - meaning the Employer pays - more in Defined Costs than the Contractor is actually incurring as real or true costs.

These two scenarios assume that no games are being played. In reality, they often are with the Contractor guessing at how the contract will play out. Whatever scenario, the end result is that one party usually gains at the expense of the other for random reasons.

4. In frameworks, the percentage is a guess

If the Employer wants, at tender for a framework, a fixed percentage for Working Area overheads for all contracts over the framework’s duration, then it is tricky for bidding contractors to know where to pitch their percentage. This is because costs covered by it will vary depending on the nature of the Site and work from contract to contract. Normally, when bidding for a framework, contractors have visibility of only the first couple of contracts that will be awarded, so it effectively becomes an educated guess as to what to tender. And if that ‘guess’ is consistently wrong, whether too high or low, it will at best, be a niggle which detracts from collaboration or, at worst, a source of conflict as one Party seeks to have it altered and the other resists.

5. Extra bureacracy

Contractors have to run two 'books' for auditing and accounting purposes:

  • one book reflects their actual or true costs which includes the costs in this percentage. They need to run this for internal auditing and accounting purposes as this is how they actually incur costs; and
  • the other 'open' book for contractual Defined Costs, takes out the costs covered by the percentage for Working Area overheads and applies the percentage to People. This is normally spreadsheet based as you download the true costs, then delete and multiply columns to get Defined Costs.

As well as being bureaucratic, it increases potential for ‘manipulation’ as discussed below.

6. Niggly arguments at best

During the contract, arguments can result over what is included in the percentage and what is not. With the best will in the world, the Contractor wants all 'grey' costs to be outside the percentage and reimbursed directly, so that a greater component of the percentage becomes pure profit. The opposite is true for the Employer. Again, this can be a niggle on a team or a major issue.

To give an example, one contract I was brought into was worth approx. £50m after compensation events. The Contractor and Employer were arguing over a difference of £700k on this issue alone (before the direct fee percentage was applied): that’s pretty much the Contractor’s profit, so it matters.

Regardless, niggly arguments or major disputes, both in assessing the monthly amount due and the assessment of compensation events detract from collaboration.

 

Summary

To paraphrase Theresa May (in the loosest sense), “open book means open book” or if you are going to do 'open book', then do it properly.

One of the benefits of using ECC options C, D or E is the financial transparency which they should engender and hence trust. Or as one more cynical colleague of mine said “There is no such thing as trust, only transparency”.

Playing games at tender, guessing what percentage to put in under a framework, having to maintain two books and arguing over whether a cost is in or out of the percentage is a hassle which detracts from the efficient and effective management of a contract.

So for a long time, my advice has been to get rid of the percentage for Working Area overheads from your cost based ECC contracts and just pay these Defined Costs at cost. Some Employers - for which I can't take credit - have already deleted it from their contracts. E.g. Highways England from their 'Construction Works Framework Contracts'.

And I am pleased the drafters of NEC4 are doing so too.

[1] Garratt M (2017), NEC4 The next generation : an explanation of the changes, which can be downloaded from here.

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