NEC4 Disallowed Cost Explained

00:00 - Introduction and welcome

Good afternoon, everyone, and a very warm welcome to our next webinar with CECA and Gather. This is episode nine. We're just chatting how time is flying and done a year of these webinars with a few more to go. All the time people give us feedback that they're enjoying the webinars, so we'll keep producing them for you. A warm welcome from myself, Glenn Hide of GMH Planning, and joined today by Ben Walker from Gather and David Allen from CECA. You'll hear from them very shortly.

Today's episode is all about disallowed costs. When we're working on cost-reimbursable contracts, this is obviously a very big, important element. We thought we'd dive into some detail on the definition of disallowed costs and when and how they should be applied. David, over to you, just to hear a little bit about CECA.

Thanks, Glenn. Hi, I'm David Allen, the Executive Director for CECA Southern, and I'm looking forward to hearing more around the topic of disallowed costs under the NEC4. A process that in reality should help assure commercial outcomes if it is managed and delivered in a consistent and adequately informed manner. Ben and Glenn will provide more detail on the topic shortly, and there will be an opportunity to discuss any issues you may have at the end of the webinar.

Just a quick reminder about CECA. Using our full title, the Civil Engineering Contractors Association, we are a not-for-profit body who represent many of those contractors that deliver and maintain a significant part of our mainland UK infrastructure. CECA Southern is just one part of this member-led national trade association, which is now in its thirtieth year, with a UK coverage that includes England and the devolved nations of Scotland and Wales, and with our policy office in Westminster.

We engage with governments and those bodies that impact on our industry at both the national and regional levels, and you can find out more about our activities on the CECA website. As I've noted, this is a series of NEC webinars that support our CECA upskilling and training core pillar ambitions, providing an additional layer of awareness to the suite of seminars and bulletins that we already deliver around the NEC4. We're looking to increase both CECA member and the wider NEC4 user awareness, promoting the appropriate and equitable use of it that will hopefully deliver more assured outcomes for all. I now hand you over to Ben at Gather.

02:30 - What is a disallowed cost?

Thank you, David. Thank you, Glenn. Good afternoon all. Disallowed cost explained. In this episode, we're going to have a look at what a disallowed cost is. We're going to explore why we need disallowed costs, at least in parts of the NEC contract. Then we're going to look at disallowed cost in the context of payment assessments, which is the main place where we're looking at it and thinking about it, and how that fits in. Then we're going to take a deep dive into each of the six bullets that set out what a disallowed cost is.

This is a published, unamended form of NEC, and disallowed cost is one of those areas that does attract a bit of Z clause attention, so care should be taken there. This webinar series is not legal advice, but hopefully will be a good prompt to start conversation. Use the slides as a prompt to go and look it up in your contract because we can only show abridged versions here of the clauses. We'll sum up with some final thoughts and David will help us with that bit, then we'll jump into a questions and answers session where we should have plenty of time at the end. Please do keep your questions coming in as we go.

Let's have a think about what a disallowed cost is. There are two definitions for this. There's a definition for main options C, D and E, and a separate definition for F, which Glenn will take you through in a moment. For options C, D and E, it's defined term eleven point two twenty six. Disallowed cost is cost which is not justified by the contractor's accounts and records. Should not have been paid to a subcontractor or supplier. Was only incurred because the contractor did not fulfil certain procedural obligations relating to procurement, early warning or dispute. Cost of correcting defects after completion, which infers that correcting defects before completion is indeed allowable. Or due to not complying with constraints in the scope. Plant materials not used after reasonable wastage and resources not used after allowing for reasonable utilisation. And finally, that preparation and conduct of a dispute between the parties.

05:30 - Definition under option F

Glenn, what's the definition for option F? It's similar, and we've included this just for completeness. In truth, F is very rarely used, but it is there as an option, so we thought we would cover it anyway. Option F is more of a management contract where traditionally a contractor will be managing a series of subcontract packages on behalf of a client. The third bullet is a payment to a subcontractor or supplier for work or management that the contractor was required to do itself. With option F there is the potential for some elements for the contractor to do themselves, so that could then lead to a disallowed cost.

For the purposes of this workshop we're going to focus on C, D and E because they're the ones that are much more commonly used. As you say, Glenn, largely the work here is subcontracted. If those subcontracts are NEC, then of course you're likely to find those couple of bullet points that aren't in option F around wastage or underutilisation appearing in those subcontracts anyway, and it's a question of the payments being vetted for those sorts of things.

08:00 - Why we need disallowed costs (and why not in A and B)

Why do we need disallowed costs? Firstly, we don't use it in options A and B. Disallowed cost is not a thing in options A and B. It's a thing in main options C, D, E and F. Why is that? In A and B, we've got priced contracts. Option A is a priced contract with activity schedule. Option B is a priced contract with a bill of quantities. The price for work done to date, the bit we pay, is founded in the prices that we've tendered. We're literally looking things up and finding that price and paying it. We do still have to find cost, we still tender a fee percentage, but they're only used for compensation assessment. Compensation events are mutually exclusive, fully assessed, complete assessments of something. There's already quite a lot of mechanisms around establishing the right assessment.

If we turn our attention to option C, D, E and F, these are cost-based contracts. We're paying forecast defined cost to the next assessment date and the price for work done to date there being rooted in that forecast defined cost and fee. Defined cost is used for two things. It's used for the assessment of the amount due, the day-to-day payment for the works, and for the assessment of compensation events. We do have disallowed costs in the cost options. These are costs that the contractor has included in their application for payment and may on the face of it appear as defined costs but are then subsequently disallowed for specific reasons stated in the contract.

Carrying on with why we need them. Disallowed costs will be part of the definition of defined costs for our cost-reimbursable type contracts. For C, D and E, the defined cost is the cost of the components in the schedule of cost components, less any disallowed cost. The disallowed cost element is just to make sure that whilst the contractor's being paid on a cost-reimbursable basis, there is some control that the client's got. Yes, we're paying you for your actual cost, but hang on, that cost you didn't need to spend. So we need something just to make sure that the contractor is kept in check.

With options C and D, with the target cost mechanism, the contractor is arguably more incentivised not to waste money. With option E, arguably less incentive not to waste money because all they're going to do is earn fee on turnover. So arguably the more they spend with E, the better. Disallowed costs were brought in to keep things in check, that yes, while a contractor is going to be paid on actual cost basis or actual forecast cost basis, that there is some control here.

13:30 - Payment assessment process and where disallowed cost fits

We've heard about what disallowed costs are and where they're used. Let's bring those few things together so that we understand the context of a payment assessment and how they fit together. The first thing is a contractor submits an application for payment before each assessment date. That's clause fifty point three. In NEC4, that's really important. It used to be the case that it was kind of optional. Now it's a prerequisite to being paid, effectively.

The next step is the project manager assesses the amount due. It's still the project manager who assesses the amount due at each assessment date, and that's clause fifty point one. In fifty one point one, we talk about the PM certifying the amount and the project manager certificate includes details of how the amount due has been assessed. This is where you would typically start to see disallowed costs creeping in.

How the amount due has been assessed will likely include firstly a statement as to which parts of the contractor's application a project manager assesses to be correct. Hopefully that's all you get. Of course, you're much more likely to get to that point if you follow a practice that we've talked about many times around collaborating together and treating the submission and acceptance as more of a formality. A lot of the most successful teams will have worked together on the application for payment.

The second bit will be costs the project manager assesses are to be added due to the contractor omitting to apply for them. There may be cases where the contractor has forgotten to put something in, an incentive schedule payment under X20 or a price adjustment for inflation. Project managers, your job is to get the right answer under the contract. If it's missing your job is to assess the amount due and put it in. Otherwise it'll only be found later on and then there'll be interest due on it.

The third element is changes that the project manager assesses are necessary due to the contractor under or over applying. The bits that they disagree with on the first bullet point. It could be a remeasure or perhaps given that we are forecasting to the next assessment, maybe they've had a look at the programme and said, your assessment's predicated on an assumption you're going to do x meters a day and the best you've ever done is ten percent less than that. The fourth bit is the costs the project manager assesses are to be disallowed.

This is the project manager's job to do because I doubt many contractors are going to put in that application and cross out some items and say that would be a disallowed cost. It's on the project manager to be finding and unpicking and deciding what they consider would be disallowed. Obviously in collaboration, contractors shouldn't be asking for things they're not entitled to, but they want cash flow in.

In assessing what the project manager might consider needs to be disallowed, they probably need to know what context the contractor's submitted those costs in that application. It might be that's an indication that the picture is not complete, so maybe there needs to be some discussion and engagement at that point. Some project managers would actually give the contractor a very quick second bite of the cherry to say, I've assessed this. Let's have a quick meeting because I think I'm right. I'll give you twenty four hours to challenge any bits.

Three other things. The first is preparation. Clause fifty point two, the final sentence says the contractor's application for payment includes details of how the amount has been assessed and is in the form stated in the scope. If we have a particular sensitivity to an area of the contract that we want to drill down on, we might take our amended schedule of cost components and really build out the way in which we want things presented. Consult your auditors, consult your finance people, and think about how you want that application for payment to be presented. It's never too late to change the scope, but better if you've already done it before you start.

The second thing is in option C, D and E, there is a requirement under clause twenty point four to prepare forecasts of the total defined cost for the whole of the works in consultation with the project manager. That alongside updating your programme on a regular basis are two further management opportunities for aligning information so that your application is nothing other than a formality.

22:00 - Bullet 1: Cost not justified by records and accounts

The very first one is cost not justified by contractor's records and accounts. The first thing this leads us to is that option C onwards is fully open book and you've got to prove the cost that you have incurred as a contractor because unless you can prove it, then you won't be paid it. There's more onus on the contractor to prove that it has been incurred. This is a massive thing that needs to be agreed early on in terms of what records and accounts do we need to see in order to verify the cost that's incurred.

One small tip for a contractor would be not to say to the client, what would you like to see? Because their answer will be: well, everything please. Really as a contractor think what you can easily provide. This is not about hiding stuff. It's about what is a nice easy way within your records and accounts that you can demonstrate the cost you've incurred. Your own accounting system, which bits are easy to abstract and show.

For people, we've got salaries and wages for time worked. Do we need access to payroll? We've also got little things like GDPR rules in terms of what information can we give. So timesheets, allocation sheets, those are the kind of records that might be needed. For payments and expenses, were they incurred necessarily to provide the works? We need evidence of the travel, the subsistence, PPE, pension contributions.

For equipment, we've got the hire or rental of equipment multiplied by the time for which it is required. Importantly, it's how long we actually need it for. We need to justify we've got the right time for that equipment, that we've not wasted equipment. So timesheets, narratives on the requirements, or if it was stood down, why was it stood down. Head that off as a contractor.

For plant and materials, what payments are made, looking at accounts and records with suppliers. Subcontractors, this was a new element added in to NEC4. Previously we had to build up subcontractor costs in line with all the other elements; now they can be included as a lump sum element. The last one within the schedule of cost components is insurances, which tells you what you can't claim for. Any insurance premiums should be included within the fee percentage.

Defined cost, just point out clause fifty two point one is relevant here. All the contractor's costs which are not included in defined cost are treated as included in the fee. Defined cost is sometimes an absolute real cost pass-through and sometimes it's a proxy. Equipment is not passed through as real cost. It's typically the equivalent hire rental rate. What I'm getting to is that you need to map your cost capture against the rule book. In this case, it's the schedule of cost components.

32:00 - Bullet 2: Should not have been paid to subcontractor or supplier

The second bullet is the subcontractor bit. It should not have been paid to the subcontractor. When you are proposing a subcontractor for acceptance, remember to check the definition of subcontractor to make sure you're treating subcontractors and suppliers appropriately. Suppliers you engage them, but subcontractors you have to get the project manager's acceptance before you appoint them. It's actually one of the reasons for termination if you allow them to do a substantive amount of work before appointing them.

This is one of the reasons under clause twenty six point four in main options C, D and E that you have to submit further information, including pricing information about subcontracts so that the project manager can decide that actually you shouldn't have paid that to your subcontractor. It doesn't have to be an NEC subcontractor. The project manager would be able to look at the conditions of that contract you've signed with your subcontractor and determine whether you've overpaid them. If you've overpaid them, then that over element would be subject to being a disallowed cost.

It's important as a contractor that you've got robust enough records with your subcontractor that speaks to the subcontract you've signed between you. Otherwise you can have a situation where you pay a subcontractor's application and then have an element of that cost disallowed in the head contract.

A little bit of trivia: I did have a count and there's about thirty to thirty-two places in the conditions of contract that reference the scope. When we think about scope, we think about drawings, specifications and constraints, but it's also more than two dozen places in the conditions of contract that rely on some form of statement in the scope. The definition of completion is a really important one. It's an opportunity pre contract; you can do it post contract because it's scope, but better to do it before. If you're clear from the outset, that helps the contractor meet those requirements and we have a smoother management experience.

For example, contractors paying a subcontractor a bonus for some reason, and that wasn't part of their contract, that is then instantly disallowed. Although there might have been a benefit for the project, it then becomes a disallowed cost to the contractor. So it's about sharing that with the client as to why we're planning on doing this and getting the client's buy-in to do it rather than just doing it because otherwise it could be disallowed.

40:00 - Bullet 3: Procedural failures (procurement, early warning, dispute)

Cost is incurred only because the contractor did not following acceptance of procurement procedure stated in the scope. That one's relatively black and white. There would have to be a procedure in the scope that clearly hasn't been followed. There might be a certain procurement procedure. For example, the client might say we need to see you've gone to three separate subcontractors for a quote and we want to see each of those quotes before you make your decision.

Given an early warning which the contract required. That one is likely to be a bit more subjective. The cost that the project manager is going to disallow would definitely be subjective because we're now talking about hypothetically what they could have done. I remember experiencing this myself where I didn't give an early warning as a contractor and the project manager pointed that out. I said, you are right, but there's not anything you really could have done had we given the early warning. They said, if you'd have given us the early warning, we would have done X. I remember actually laughing out loud in the meeting, which was very unprofessional. I said, I've worked with you for five years. You've never once done that X in five years. And their response was, yeah, but we could have done this time. It cost us a lot of money because in theory, they could have done X and we didn't get the opportunity to do it. We couldn't argue that it was a disallowed cost. So if in doubt, share the early warning.

Notify the project manager of preparation for and conduct of an adjudication or tribunal with a subcontractor or supplier. If you don't warn the project manager about that, then the cost of all of that going around or you choosing to go into dispute with your subcontractors, that is a disallowed cost. The client's view is that's a matter for you, not for us, so that would also be disallowed.

The most common one, procurement, well actually acceptance, comes up quite often. The early warning one I always do in training as a hypothetical is not being made aware of the potential for a redundant utility apparatus through a field. If you're doing a drainage run and you hit some utility that wasn't on the plans and it looks redundant, you've got to stop work. Then you find out that actually a couple of weeks ago, the contractor's people were talking about the possibility of this, having discussed it with someone who'd worked the site previously. It's those kinds of things where suddenly it's not so difficult to demonstrate that you absolutely could have given an early warning and you didn't. If that's an unforeseen physical condition, yes that will play out as a compensation event, but in option C, D and E, there's also this other element to it, which is NF, where the costs are disallowed as well. The premium element of the call out because it's an emergency call out, and any prolongation type costs that we're in.

48:00 - Bullet 4: Defects after completion

Cost of correcting defects after completion. That does infer that correcting defects before completion is not a disallowed cost, and that is the case. However, check your Z clauses. For options A and B, your core requirement under clause twenty point one is to provide the works in accordance with the scope, so you just keep doing it until you get it right and there's no way of recovering that money.

In options C and D, I see them as partnering main options, which for me means sharing the risk and reward. If we have a bit of bad luck and we have to correct some defects, then you get paid the defined cost for them, but the target doesn't move. There's an incentive not to keep doing it. We are sharing the financial costs of doing it again. For option E, because there's no target, each time we get something wrong we do get reimbursed the costs for it, plus our fee on top. Some clients look at the Z clause, but on balance I would leave it as it is, because this incentivises a defect-free handover at completion.

What you don't want to do is be caught out by a completion certificate because you haven't fully understood the definition of completion. Then you find you're doing all your defect corrections the wrong side of completion and therefore they are disallowed. Keeping one eye on when we're going to complete is incredibly important. Completion is when the contractor has done all the works which the scope states are to be done by the completion date. That's the definition that we need to go and check.

Glenn, you're going to give us an example of not complying with a constraint. The one I sometimes see shoehorned in is the project manager saying the scope says you've got to set things out right. You didn't follow your quality procedure. You set it out wrong. Therefore you failed a constraint. I can disallow it. It's just shoehorning that in. The one I remember is if you're laying a slurry seal on a cycleway and it says don't lay this below ten degrees, that feels like a constraint in the scope. If you go and lay it in minus two and it peels, then I think that's probably a candidate for a disallowed cost to have to go and fix it. It comes down to the records, but it also comes down to the engagement within the team with the project manager.

54:00 - Bullets 5 and 6: Wastage, underutilisation and dispute costs

Another very important one is wastage and underutilisation. Plant materials not used after allowing for reasonable wastage. And resources not used after allowing for reasonable availability and utilisation. This really comes down to records, particularly the resources one. For plant and materials, what is reasonable wastage? It will be subjective and different materials have different kinds of wastage. Some material, forty percent wastage might not be ridiculous. Other materials, you should be able to order very close and there should be minimal wastage, five percent if that.

It's about a contractor not thinking, oh well, we get paid anyway, just buy a new sheet, don't reuse the old one for temporary works. I remember being on a job down at Brighton in my very first job where we were getting through so many sheets of ply, every day, and I was a bit shocked by that one. We get a new sheet, we get paid anyway. It's about making sure we're fully utilising these materials and not wasting them. There will be an element of subjectivity, but we should be ready for what is sensible wastage for that particular material and what isn't. If you've ordered eight pallet loads of bricks and you only needed one pallet load, well, there's seven wasted. They're not going to end up in the permanent works.

Resources not used after allowing for reasonable availability and utilisation, or taken away when the project manager requested. Engage the project manager in the reasons why you're keeping people on site. If you were to release certain skilled resources you don't know when you're going to get them back, so allow the project manager into the decision process. We're planning on keeping them because if we let them go we might not get them back, and when we do get to do these works, it's programme critical. We've got a hundred ton crane coming, if we don't have those resources we'll lose the utilisation of that crane and we won't get the crane for another three months as well. Explain why you've got people there.

If you've got an excavator sat there for a day, the cost of demobilising it and bringing it back is probably infinitely more than it would be to actually keep it on site for a day or even a few days. Be ready to justify why that is the case. Allow the project manager into the decision: we should be able to use that in a week. Should we off-hire it or are we planning on keeping it? You don't know when you're going to give us access. If it is within a week or two, then it's probably cheaper to keep it. If they then progressively delay you, you can justify that. With hindsight, you delayed this for eight weeks, we could have off-hired it, but you didn't tell us it was going to be eight weeks. The efficient use of plant, materials and resources is what the contract is steering us towards.

This is where context comes in. It's a mathematical situation, but actually it's supported by the risk and the consideration around why you are going to do something or not do something. If you're having that conversation with the project manager, you can get to better informed decisions. That reasoning needs to be retained so that in any retrospective view, you can see why we've done what we've done. Another opportunity would be an early warning to draw that context out. We also have the programme. We're supposed to show for each operation a statement of how we plan to do the work identifying the principal equipment and other resources. That's another opportunity to have that commentary and make sure your records tie back to it.

62:00 - Q&A: adjudication costs, HGCRA pay-less notice, in order to provide the works

One question: adjudication and legal fees paid for an adjudication between the contractor and the subcontractor are not disallowed costs in option C. But under which component can these be paid? They are paid if you've got the contractor's people working on that, then they are working on work under this contract. It's captured really by the broader definition of doing the ancillary things necessary under the definition of provide the works. They are expending money and resources under the people component, the first component of the schedule of cost components, subject to notifying the PM of the occurrence of this in the appropriate way. The second element would be any payments that are eventually made to the subcontractor in accordance with their contract, which presumably would include the elements of adjudication or ultimately tribunal that had to be paid by the contractor to the subcontractor.

Another question from Gert: for contracts where the HGCRA, the Housing Grants Construction Regeneration Act, applies, does the statutory payment regime effectively require the employers to pay disallowed costs under NEC4 ECC, where a pay less notice has not been served in time? My understanding is this would apply after an amount has been certified. We're talking about the assessment of the amount due, which on option C, D and E is a forecast of defined cost. Defined cost is defined as the components in the schedule of cost components, less disallowed cost. It's part of the assessment of the amount. The Act would apply after that. Once the payment's been certified, if the project manager or client is going to pay less than that, that's when the Pay Less Notice applies. Disallowed cost is part of the ingredients of the assessment before we get to that point.

A question from Owen: a schedule of cost components states an amount is included only if it's incurred in order to provide the works. If not incurred in order to provide the works, do you consider disallowed cost is not justified by accounts and records? It never becomes a defined cost so you don't get as far as disallowed because it just doesn't fall within the schedule. It is worth checking that definition of provide the works because it is quite broad. It's a defined term in the core clauses. It's only a defined cost if it's in order to provide the works in the first place.

And a similar question from Rhys: you mentioned earlier about costs not included in defined costs are treated as included in the fee. Can we explore that in more detail? If you're going to clean the site, clean the site huts, there'll be a service for that. That may well be a defined cost; you're doing something in the site hut, and the site hut's necessary in order to provide the works. If you're watering the plants in the contractor's head office, there's no way that would ever meet one of the tests in the schedule of cost components and therefore it must be in the fee. The working area is a very important concept to read up on when you think about the context of the schedule of cost components. If it doesn't fit within the schedule of cost components, then it must be included within the fee. Bank charges are not recoverable anywhere. Insurance premiums are not recoverable anywhere. Those kinds of things by default would be picked up within the fee.

72:00 - Final thoughts and close

The disallowed cost is not intended to be a penalty but rather as a commercial control mechanism. The reality is, from a contractor perspective, the most common reason for costs being disallowed is the submission of insufficient or adequately detailed records to properly demonstrate the defined cost expenditure. Capturing and relaying the right level of detail will help mitigate against this issue.

It's the simple actions that make a real difference from a contract management perspective. Start with all parties having a clear pre-contract understanding, with briefings that identify what may constitute a disallowed cost. Provide timely early warnings and compensation event notifications to avoid the risk of time bar. Keep contemporaneous records that support defined cost expenditure and align with the payment applications, giving due consideration for the context and narrative at that time.

Working in collaboration, even by building the application together with the project manager, you might address some of the challenges around the more complicated issues. The whole process needs to be cascaded in a consistent way to subcontractors and suppliers so that everybody's singing off the same hymn sheet. Maintain a single shared truth. Plug the records into the programmes, into the payment applications and compensation event assessments. When these basics are in place, payment assessments are significantly smoother. That helps to develop greater trust and assurance around the outcomes which ultimately creates a focus on actually delivering the works rather than just on the commercial challenges that sometimes arise.

Set the rules from the outset, share the decisions being made along the way, justify things, and collaborate. That summarises it nicely.

Briefly an introduction to the next one, episode ten on the eighth of June at four thirty p.m. on Monday. We're going to look at contractors' value engineering and the proposals from the contractor, both in terms of how we bring value engineering into the contract, but also how we might reduce the overall cost of the asset over its lifespan. We'll unlock the ways in which that value is shared with the contractors as well. So put it in your diaries.

Thank you for attending. Thanks for all the questions. Thank you to Glenn. Thank you to David. Until next time.