Disallowed Costs v Defined Costs in NEC contracts

Robert Gerrard, NEC Users’ Group secretary, on an issue that’s confusing many professionals brought up in a JCT world.

It goes without saying that throughout the lifecycle of any professional project contract, cost issues are invariably scrutinised by all parties. At the completion of contractual obligations, that scrutiny often intensifies even more, especially when the prickly issues of final costings and reimbursement are being considered.

The NEC suite of contracts is designed to stimulate efficient and fair project management by all parties. But recently, a significant number of questions have been put to the NEC Users’ Group helpline on the question of Disallowed Cost in NEC contracts, and as many as 600 professionals attended a webinar on the subject in March.

We would therefore like to address widespread misconceptions on what a “cost-based” contract, and therefore the concept of Disallowed Cost, entails.

Cost reimbursable, or “cost-based”, contracts are a relatively new approach for many people; most are far more familiar with price-based closed book contracts.  However, I believe it’s fair to say that the recent economic downturn, as well as natural bias towards protecting one’s own costs, has contributed to the increased interest in Disallowed Cost and compensation events in recent times.

Disallowed Cost is part of the NEC3 Engineering and Construction Contract (ECC), and can be found under Options C, D, E and F. It provides a filter for certain costs and specifically states those that project managers may disallow. As such, it should be an extremely minor aspect of managing a contract.

The nuance of the cost-based contract is to use contractors’ real cost to determine payment rather than a pre-determined rate or price. This is a new area to many and some users are clearly uncertain, nervous or surprised by this.

In some cases, there is a desire to strike out certain contractor costs that have arisen due to inefficiencies. The last chance to remove such costs during a project sits in the Disallowed Cost pot, but you do not simply disallow costs because you think they should be disallowed; they are disallowed because the contract says so.

When using a target cost approach under ECC option C or D, the basic principle is that a target cost is agreed, and the contractor is reimbursed for costs spent undertaking the work throughout the course of the project. Payments to the contractor are based on their accounts and records, which the project manager may inspect at any time.

Upon completion, the final target cost is compared to the final actual cost (called Defined Cost) expended by the contractor to which a fee is added. If the actual cost plus fee is lower than the target cost, a saving has been made, which is shared between the parties on a pre-agreed percentage basis, referred to as “gain share”. 

Conversely, if the actual cost plus fee is higher than the target cost, this overspend must be shared between the parties on a pre-agreed percentage split, commonly known as “pain share”.

Disallowed Costs are those which the contractor has incurred, but for which the employer does not have to pay. These therefore fall entirely to the contractor to pay.

Some Disallowed Costs are relatively simple to define and put into practice, such as resources not used to provide the works, incurred, for example, when a piece of equipment that is no longer required, but not removed from site, is still being charged to the project.

Another more straightforward application of Disallowed Cost is the cost of materials not used to provide the works, ie materials ordered in excess of the amount required to complete the project, after allowing for reasonable wastage.

We are, however, aware that a number of our members have reported confusion on a particular issue of “correcting defects”.

This could include costs which cannot be justified, those which should never have been paid to a subcontractor or supplier, or those incurred because the contractor did not follow certain stated procedures.

Other examples include correcting defects after completion, or the cost of resources not used to provide the works, after allowing for reasonable availability and wastage.

The cost of correcting defects before completion is an accepted cost in most circumstances. However, making correcting defects after completion is a recognised Disallowed Cost that the employer is not liable for.

Understandably, employers will often object to paying their contractors to correct defects when the project is still live. In fact, however, this provision often indirectly benefits the employer if using ECC option C or D. When the contractor is paid for correcting a defect, the contractor’s Defined Cost increases. As a result, any pre-agreed “gain shares” payable to the supplier are likely to be reduced.

If the target cost is exceeded in these circumstances, the contractor may still be liable to pay money back to the employer.

It is, of course, in the contractor’s interest to minimise defects, keeping the Defined Cost down and ensuring a smooth project handover, but a further advantage is that this can also result in a bigger gain share for contractors.

The purpose of the NEC suite of contracts is to maximise clarity and fairness of contract terms, and we entirely appreciate the frustrations which take hold on both sides of a partnership when the issue of correcting defects arises.

We receive calls for clarification over Disallowed Costs from across the full spectrum of built environment sector suppliers, contractors and clients. At a time when this industry is regaining its feet following the economic downturn, the desire to protect your company from undue cost is imperative.

Significant benefits of a successful project outcome can only be realised as a result of effective and long-term collaboration, which can helpfully be achieved by the implementation of a commercial management plan at the outset.

A commercial management plan, like any other management tool, is an agreed way forward designed to establish which project partner deals with each commercial matter, when and how.

There are a large number of commercial aspects of contracts to consider, such as payment, audit, and change control. Therefore, it is essential that an appropriate number of competent people carry out the tasks the contract demands.

To alleviate confusion and any misconceptions we believe it is imperative that all partners understand when and why to use a cost-based contract as opposed to a price-based contract; what contractors’ costs are actually reimbursable; and what costs are not actually reimbursable.