scorekeeping that wins
by Evandro F. Braz
SAFEGUARDING THE FINANCIAL STAMINA of construction projects hasn't changed that much lately. It's still business as usual except for one thing: many of today's owners watch pennies where they once watched nickels. Even though the economy always gets a lot of blame for this tighter outlook, there are two other factors in the current business atmosphere that influence owners of real estate and hospitality construction projects to carefully squeeze the most from every penny.
Basically, these two factors come from changes in the marketplace: first, new complexities due to new contracting structures; and second, an increasing specialization of today's multilayered professional staff. To deal with these complexities, experience offers one possible solution that can lower certain risks, and therefore increase the likelihood that a construction project will not overwhelm the prudent owner with risks beyond control. The solution? A construction audit.
A construction audit can provide a project with the extra edge needed to strengthen its financing relationships or bolster its access to lenders, investors or the capital markets. It can also give owners some extra peace of mind.
A Clear View of the Playing Field. When paying contractors’ invoices, sometimes project owners feel like a home team coach in a ball game where only the visiting team gets to see the scoreboard.
On the face of most billing documents, everything looks okay. But this view is only of the overall billing, not the particulars. When the savvy owner asks for a backup, he or she is presented with a confusing array of detail that can require extensive and time-consuming verification.
From an owner manager's point of view, a careful review of invoice backup documentation, which can be a pile of paperwork as thick as two or three inches per month, can mean many long hours of painstaking verification. This is beyond the means or stamina of most owners, who have more pressing concerns to deal with. Therefore, many owners decide to hire a team of construction auditing professionals to help them establish the true value of services provided in a credible and impartial manner.
Contracting's New Game Plan. Until recently, most contracts were of the lump-sum type. The terms were simple, and the risk of profit or loss weighed on the general contractor. The owner had only one number to work with, which kept budgeting and forecasting very simple. On the other hand, lump-sum contracts excluded the owner from participating in, or even knowing for that matter, the percentage of profit being realized in the contingency portion of the total contract.
In today's marketplace, various cost-plus contracting approaches eliminate the contingency fee that lump-sum contracts contain, but they don't automatically include an incentive for a contractor to finish the project in a timely manner. So contracts such as design-build, cost-plus, guaranteed maximum price, unit price, cost-plus fixed fee, or cost-plus variable fee often include incentives for sharing profits or for finishing the job early or on time.
The terms of these contracts put owners in the position of reimbursing all costs that relate to the job plus a fee. Monitoring the avalanche of details generated by these contracts can be overwhelming.
When paying contractors’ invoices, sometimes owners feel like a home team coach in a game where only the visiting team gets to see the scoreboard. A construction audit allows the owner to manage a team of professionals while ensuring that billing errors will be detected, and that the project will avoid running into major financial problems. It's like having the viewpoint of a referee from the perspective of the clubhouse.
A Crowd of Professionals. In addition to the growing complexity of the contracts, the rate at which new personnel are being added to a construction's professional staffing is also a problem for owners. This expansion further burdens owners. While in the past, a project would have involved an owner, an architect and a general contractor, today's project owner faces a multitude of professionals. Today's projects often include a concept designer, a managing architect/engineer, a preconstruction consultant, a program manager, a construction manager, trade contractors, and even a procurement specialist. Some owners have tried to simplify things by hiring a construction manager who serves as a liaison between the project owner and other contractors. However, a construction manager is yet another entity to relate to, and also requires some level of monitoring and control.
Lending institutions and investors are well aware of these drawbacks. Consequently, construction project owners are also dealing with a complicated new financing atmosphere. Getting financing can be greatly influenced by a number of factors. New instruments and financing arrangements can make a big difference in ensuring that the project continues to be a viable one.
One step owners can take to decrease any financing difficulties is to engage a construction audit throughout the term of contract payout. A construction audit is a special scope audit, not a complete diagnostic of a project's management. It can, however, become a significant element by adding an extra positive point in an owner's presentations to prospective lenders, investors and capital markets.
The Advantage of a Construction Audit. A construction audit is a systematic field-test audit of all incoming invoices, including both direct and indirect costs, no matter where these costs were incurred. Construction audits are designed to give owners confidence that invoices received for each project are proper and correct, given the commercial terms of the contract and other relevant constraints.
Of course, construction budgets can be overrun for other reasons, but a construction audit can safeguard against inappropriate payments to third parties and provide a level of comfort about some of the hundreds of aspects that have to be actively monitored. Construction audits also review and execute applications and certificates for payment; initial, progress and final payment requests; release of retention submissions; material and equipment purchase orders; indirect cost multipliers, and time sheet and expense vouchers.
The final audit report will include recommendations that evaluate the adequacy of controls over expenditures by verifying that payments comply with contractual provisions. It will identify and quantify overcharges and clear any outstanding contractual obligations before final payment is made as well as provide commentary on the reasonableness of billed costs and possible cost adjustments.
From the lender or investor's point of view, one of the most important things that affects financial cash-flow estimates is how quickly capital is spent. There is always the risk that a project's budget could increase, no matter what kind of contract you have in place, and this risk increases the longer the project lasts.
There is one other benefit of a construction audit: A successful owner will be less likely to be put in the position of funding third-party operations while an audit is in process. The audit discourages decision-makers from paying in advance, especially for equipment. For instance, an invoice of $2 million paid three months before the air-conditioning chillers are delivered is $2 million dollars unnecessarily out of an owner's control for two or three months. This situation also creates the risk of having forwarded money out of pocket to a contractor that could perhaps go into default; not a prudent practice, to say the least.
A Construction Audit's Bench Strength. Construction audits, while they cannot completely eliminate problems, can lessen their impact when they occur. Three criteria can help ensure that the construction audit is a sound, cost-saving exercise: perspective, effectiveness, and experience.
Perspective. Just as in a lending review, the most important factor is that functional personnel are independent from those subject to review. Due diligence is not the same without this independence.
Effectiveness. Unlike the focus of most audits, which are exclusively retrospective, a construction audit is prospective and ongoing, active day by day. It minimizes risks by identifying savings before the dollars leave your account.
Experience. Construction auditors must have more than a statistical model to work from: they need the depth of background and experience required to make informed responses to the specifics of your project. Strict, by-the-book recalculations of documentation or “ticking and tying” may not identify a problem.
The auditors’ professional experience lends a special thoroughness to these kinds of billing reviews. An experienced professional will know how to judge which contractors, service and material suppliers should be reviewed in more detail. This kind of professional background lends itself to an extra measure of service.
And the Scoreboard Reads ... Once a construction audit is in place, the owner should expect the auditors to track all expenditures to budget, monitor construction costs, enhance internal controls already in place, and identify costs incorrectly charged to the project. An effective construction audit will:
Reinforce proper closeout of contracts.
Provide stronger control over expenditures.
Improve confidence that payments are justified and reasonable.
Furnish documentation to support findings.
Enable an owner to be a more active and informed participant in the entire project or construction loan portfolio.
Provide remedies for small billing problems before they become big ones.
Support owner's cash-flow estimations and more accurately reflect current cost conditions.
See that payments are made in accordance with the terms of written agreements.
Communicate confidence to lenders and investors through a reputable third-party review of billing and percentage of completion.
AN EFFECTIVE CONSTRUCTION AUDIT can provide an important measure of control over a complex process that can easily slide out of control. In today's business environment, the decision to hire a professional auditing team can be a sound management practice that allows the owner to concentrate on managing his team of professionals while ensuring that billing errors will be detected, and that the project will avoid running into major financial problems. It can also be a significant element in ensuring that a project is completed on time and within budget. And it can give the owner the viewpoint of a referee from the perspective of the clubhouse. ■
Did You Know?
The No. 1 invoice miscalculation is in direct labor costs—either from higher rates than those agreed to in the contract or charges billed out at improper job classifications.
The second most common error is from incorrect indirect labor burden rates or allocations.
Insurance premiums have been known to be estimated incorrectly or even allowed to lapse during a multiyear project.
Sales/use tax charges and other miscellaneous nonreimbursables often find their way into indirect allocations.
Percentage of completion claims are often consistently wrong.
A Construction Audit …
Reviews and monitors the contract terms when invoices are received.
Evaluates proposed and incurred direct labor, overhead or direct material costs to compare these costs to the parameters of what is allowable or reasonable.
Checks methods and calculations of fees.
Compiles relevant data needed to confirm or dispute charges.
Looks into methodology applied to allocations.
Analyzes capital construction costs.
Reviews change order requests.
Summarizes costs incurred to date and the amount of funds remaining.
Comments on the appropriateness of billed costs, invoice conformance with contract terms and potential cost adjustments to invoices.
Determines the effects of modifying existing drawdown payment schedules in the event of approved new contract amendments.
Comments on adequacy of costs incurred to date and the magnitude of pending costs, prior to closeout of contracts.
Formulates an impartial and accurate assessment of the construction's percentage of completion.
Evandro F. Braz is a partner in the engineering and construction practice of Coopers & Lybrand Consulting. He is a registered professional engineer in Brazil, and also a commercial arbitrator and a certified management consultant in New York.
PM Network • November 1997