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Mitigate costly risks in construction contracts

By Chris Little and Tony Allman

How can construction projects so frequently exceed the estimated cost? The contract states a guaranteed maximum price, so shouldn’t it stay on budget?

While many issues are outside the owner’s control, the use of construction contract auditing can help mitigate the risks by implementing a prevention and detection program.

Owners typically realize from 0.50 percent to 3 percent cost recovery by enforcing well-designed construction contracts. Organizations with well-developed audit programs typically see little to no cost recoveries, but tend to prevent events that lead to scope creep and construction cost price inflation. Their service providers know exactly what is expected from them and when all parties understand what is expected of their performance, fewer misunderstandings occur.

Good project controls demand a good contract that spells out possible charges, billing methods, use of money and change orders. There are many factors, so here is a list to consider:

  • Document how the contractor or architect will be compensated (fixed fee or percentage of construction costs?), then determine which scenarios will cause the fee to increase or decrease.
  • Establish the owner’s right to audit the prime contractor’s and subcontractor’s project accounting records, expense reports and overhead allocation methods.
  • Define use of contingency, change order approval, estimating and pricing procedures. Time and material change orders give maximum control for your budget.
  • Decompose and benchmark all rate schedules. Understand whether rates represent true contractor’s cost or cost plus embedded markup.
  • Engage a financial controls adviser to work in collaboration with legal counsel. Contract pricing, billing documentation, rate analysis and benchmarking might not be within legal counsel’s experience, and an ability to use a construction financial professional might enable the negotiating team to maximize owner benefits and protections.

Contacting an experienced construction attorney to assist with establishing owner’s rights and protections also is advised.

One of the most effective financial controls tools available to an owner is the construction contract audit. A well-designed audit program goes beyond the compliance testing of controls and analyzes the costs to reveal whether there have been overcharging. It also determines the value of the overcharge and provides evidentiary documentation leading to owner credits.

Doing the math

The first is an elementary arithmetic verification of the application for payment or contractor’s invoice. More than 70 percent of the applications for payment submitted to owners have arithmetic errors. Errors typically come from incorrectly rolling forward previous month’s costs, supporting document transposition errors, failure to withhold “retainage,” and basic totaling and cross footing of the document.

Second, an area that often yields findings is in the pricing of change orders. Before accepting change orders an owner should verify that the labor rate complies with contracted rates, quantities are appropriate, and the markup agrees with contract terms. It is common to find change orders with an embedded profit margin of more than 10 percent in addition to the agreed upon markup.

Third is a thorough analysis of reimbursable costs. Costs that the contractor has been compensated for within their overhead reimbursement, such as labor burden or general conditions, are sometimes passed through to the owner. These double billings might result in credits back to the owner.

Fourth, labor and equipment burdens should be decomposed to expose any embedded profit margin. Burdens are the additional costs paid by the contractor above the raw wage or equipment cost. Examples of acceptable labor burdens are Federal Unemployment Tax Act, State Unemployment Tax Act, union benefits, and workers’ compensation. However, watch out for how these burdens are applied. Not all benefits are applied equally across the hourly wage.

There are dozens more opportunities to prevent overcharges and capture the maximum credits, such as supplier credits from excess construction materials, idle equipment rental charges, and small or consumable tools charge.

The best time to create a construction contract audit program is at the beginning of the project, which enables the owner to maintain the greatest amount of control. The project accounting and audit team has time to request missing source documents and interview key personnel while minimizing memory loss and opportunity to discover source documents. Of course, a program can be implemented any time, including as part of the project closeout process.

Ultimately, an audit program minimizes the financial risk of a construction project and can improve the overall delivery of the project management team.

Chris Little is an audit manager in the Minneapolis office of Baker Tilly Virchow Krause and Tony Allman is a director in the Madison, Wis., office of the accounting firm.

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