Robert Gerrard, secretary of the NEC Users’ Group, seeks to dispel confusion over cost reimbursable contracts and disallowed cost.

It goes without saying that throughout the lifecycle of any professional project contract, issues of cost are invariably among the aspects scrutinised by all involved 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. Following a significant number of questions put to the NEC Users’ Group helpline and during our training courses, we would like to address widespread misconceptions on what a ‘cost-based’ contract and therefore 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. There are a few other standard forms of contract that offer cost reimbursable payment, but these seem to have been rarely used, particularly in the building industry.

 The foundations of efficient and effective project management lie in knowledge and competency on processes like programming and early warning. 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 certainly contributed to the increased interest in Disallowed Cost and compensation events recently.

 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 contractor’s 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 user 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, however you do not simply disallow costs because you think they should be disallowed; they are disallowed because the contract says so.

If more contracts are to be cost-based then all users have to be more comfortable with the implications of this and what the contracts actually entail, not what users, from any discipline, think they should say.

When using a target cost approach under ECC option C or D, the basic principle that underlies the contract is that a target cost is agreed, and the contractor is reimbursed for costs he spends undertaking the work throughout the course of the project.  Payments to the contractor are based on his accounts and records, which the project manage 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.

This could include those 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.

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, i.e. 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’.

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.

In order 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.

There is simply no substitute for training.

The NEC Users’ Group recently hosted a webinar in order to provide further clarity on the use of Disallowed Cost. A full recording can be viewed at: www.neccontract.com/disallowedcostwebinar

For more information on the NEC and Disallowed Cost, visit www.neccontract.com.