This, the penultimate post in my series on variations, discusses valuation. In particular, the differences in approach construction contracts take to valuing variations and the implications of this, both during the project and in the assessment of tenders.
Construction contracts adopt two quite different approaches to the pricing of variations:
- Using rates derived from a breakdown of the contract sum.
- Using a separate schedule of rates or prices.
This distinction is often overlooked (or not fully appreciated), but it lies at the heart of a number of problem situations that arise in the valuation of variations.
Firstly, I will outline the two different methods to pricing variations before considering the implications of the distinction and the problems each gives rise to.
Valuation using figures in the contract sum build up
Of the two different methods of valuing variations this first one is the most common.
The contract’s variation clause will provide that changes are valued using pricing information that directly relates to the build up of the contract sum, for example, using the rates and prices in the bill of quantities (BOQ). A re-measurement contract will typically adopt this approach so that the rates in the priced BOQ will be used to value variations, as well as being used to price the final quantities for the original contract scope.
This methodology can be adopted for lump sum contracts as well. The lump sum may be supported by a breakdown showing how the contractor has built up the contract price. This can be in the form of a detailed BOQ or by a simpler breakdown. Provided that there is sufficient detail, the breakdown can then be used to derive rates and prices for variations.
Valuation using a separate price schedule
The second, and alternative, approach to valuing variations is to use rates and prices that have no relationship to the contract sum. For example, a contract may contain a lump sum for the original scope but stipulate that variations should be valued by reference to an entirely separate schedule of rates.
A lump sum contract can incorporate a detailed breakdown but with the proviso that this is only used for the assessment of stage payments (that is, a contract sum analysis form of document). Such a contract may require variations to be valued using a separate schedule of rates rather than the contract sum analysis.
There are two ways in which such a separate variation price schedule can operate:
- One option is for it to include prices for the additional items of work that may be required, such as the rate for excavating a cubic metre of soil or building a linear metre of fencing.
- Alternatively, it can set out rates for the resources that will be required to undertake the additional work, such as rates for defined staff, labour, materials and plant. Those rates are then used in combination to build up the valuation of the work undertaken.
This is the approach followed by the NEC3 forms of contract. For example, the Engineering and Construction Contract (ECC) Option A, which is a lump sum contract, provides that instructed variations to the scope (compensation events) are priced using rates in the Shorter Schedule of Cost Components (SSCC), which is an appendix to the contract. That appendix is designed to include, among other things, rates for staff and equipment that have no direct correlation with the lump sum contract price for the original contract. While the contract acknowledges that the parties can agree to use the figures in the contract lump sum breakdown to value compensation events, such an approach requires their agreement. The primary approach, which is followed in the absence of such an ad hoc agreement, is to value compensation events using the rates in the SSCC.
The NEC3 contracts are not alone in adopting what may be considered to be this alternative model for pricing variations. Other standard forms, such as the IChemE suite of contracts, contain separate price schedules for valuing variations.
The two approaches to valuing variations, as outlined above, create their own challenges. There are two important aspects of the distinction, the assessment of tenders and the valuation of omissions.
Tender audit of variation rates
We all recognise that variations are inevitable on construction projects and therefore the prices that are paid for variations will have a significant impact on the final cost of the works. But an employer will normally make its decision on who to award the project to without any reference to the rates for variations. The financial evaluation of the tenders will normally focus only on the contract sum.
This is a particular problem for contracts that value variations using a separate schedule of rates because the employer will normally only evaluate the bid by reference to the lump sum price. The employer ought to undertake a careful check of the rates in the schedule but pinpointing rogue rates may be very difficult. After all, high rates in a traditional BOQ lump sum build up will normally be flagged up because they impact on the overall price. In contrast, picking up high rates in a separate schedule is much more challenging. But even if the employer’s team does identify high rates in the variations schedule it may be unable to do anything about it because the tender evaluation criteria (which could be legally binding) may not allow this to be taken into account.
Even if the contract is of the type that prices variations using the contract sum build up, there are still pitfalls for the employer. This is because the contractor may strategically price the works. This involves making an informed guess at tender stage as to what variations will be instructed and therefore giving proportionately high rates for those elements of the work. In order for the contractor to win the tender it will, of course, have to include some comparatively low rates for those items of work where it does not anticipate extra work being required. As a result, the cost of variations may end up being proportionately expensive in comparison to the general cost of the works overall.
Valuation of omissions
Under the traditional method of pricing variations, using a lump sum breakdown, the process of valuing omissions is relatively straightforward. One effectively omits the part of the contract sum that relates to the deleted work. But if the parties use a form of contract that values variations using a separate schedule of rates then omissions can lead to significant problems and uncertainties.
The rate in the variations pricing schedule may bear no relationship to the money that will be saved if the work is not undertaken. Nor may it bear any relationship to the figures used by the contractor in calculating its lump sum price. Such issues are illustrated by MT Hojgaard v E.ON.
MT Højgaard A/S v E.ON Climate and Renewables UK Robin Rigg East Ltd
The contractor had been employed to install the foundations for an off shore wind farm and this involved the use of a vessel called a jack up barge. A specific barge was named in the contract but it proved to be inadequate for the job. The employer instructed a variation omitting the use of the specified barge while supplying a different one free-issue to the contractor. The employer’s instruction that the original barge should no longer be used was therefore an omission but the parties did not agree on how it should be valued.
The works were for a lump sum price and variations (including omissions) were to be valued using a schedule of rates appended to the contract. This variations pricing schedule included a daily rate for the original barge of £150,000 per day. The employer argued that the omission should be priced by multiplying this rate by the period of time the original barge would have taken to undertake the work (had it not been omitted), which was likely to be at least 160 days. The upshot was that, on the employer’s case, the omission would be valued at a sum that was out of all proportion to the value of the works.
The difficulty, of course, is that variation pricing schedules are quite crude. When a contractor is pricing such a schedule it will normally have the cost of additional work in mind and not the saving to be made if work is omitted. Therefore, in Hojgaard’s case it presumably contemplated that the marginal daily cost of hiring the barge for a few extra days was £150,000 per day. But this would not be appropriate as a means of calculating the saving if the barge was omitted completely.
If parties want to use a separate variations pricing schedule they should consider whether the valuation clause and the schedule itself should provide for greater flexibility. This could allow adjustments to be made depending on the quantities varied as well as allowing for differential pricing for additions and omissions.
In Hojgaard, the court was clearly deeply uneasy about valuing an omission strictly in accordance with the rates in the variation schedule. Using a schedule of rates for omissions can result in what appears to be a very abstract assessment. In valuing an addition, even when using a rates schedule, one will always know the extra cost involved. But when looking at an omission, a tribunal will naturally want to consider the saving that has been achieved but this can only be assessed by looking at the build up of the contract sum. The court construed the particular provision in a way that allowed it to value the omission by reference to the contract sum build up, albeit this was not obviously in accordance with the wording of the variations clause.
A contractor that undertakes a variation will be entitled to two forms of compensation. The first, money, has been the subject of this post. The second, time, will be the subject of the next, and final, post in this series on variations.