Know your construction contract: Recognizing and managing risk based on contract type
August 12, 2013
By Matt Gardner, CCA, CICA
Partner, Construction Audit Practice Leader
When business owners plan a construction project, they seek a fair contract that reduces their risk while remaining mutually beneficial to their own and the general contractor’s interests. Nevertheless, no contract eliminates all risks associated with a construction project. In fact, all contract types contain different inherent risks to the owner. Auditors who understand the risks associated with the contract type can help the owner better manage them. This article examines some of the most common contract types and their vulnerabilities.
Price-based contracts and underachievement
Simpler projects that don’t require much flexibility often use a lump sum contract. An advantage of lump sum contracts for owners is straightforward planning — the price is known right from the start. However, the fixed price also presents a risk. General contractors (GCs) may interpret the fixed price as money in their pockets and include additional fees for unforeseen contingencies throughout construction. They maximize their profits by expediting the project timeline and reducing cost through substitution of scope and materials, thereby taking a larger share of the savings. Auditors must scrutinize change orders diligently to verify there were no scope changes or substitutions that were not included in the original scope and lump sum pricing. If the auditor can help prevent contractors from cutting corners, lump sum contracts become a tool for efficient project completion.
A similar risk affects guaranteed maximum price (GMP) contracts: GCs often misconstrue GMP contracts, assuming the GMP amount is their entire budget. The max price should represent the cost ceiling, so expenses must continually be monitored to remain at or under the established max price. While reviewing change orders is again important when auditing these projects, auditors should also be on the lookout for reimbursements for unallowable costs. These costs are often general conditions or scope of work costs, such as charging for a journeyman when an apprentice completed the work.
Unlike lump sum, all costs are visible in a GMP contract, which greatly expands the audit scope. Auditor involvement should start early to negotiate a detailed contract that ensures the project management team, labor rates, labor burden, material costs and equipment rental costs are fair and agreed upon prior to contract execution. This will further eliminate disputes during the construction process.
Cost-based contracts and overcharges
While price-based contracts risk scope elimination and quality loss, cost-based contracts present a different risk. Rather than decreasing cost to share in potential savings, GCs have incentive to overcharge, increasing cost to increase profit.
Unit price contracts are based on estimated quantity of work and cost per unit, usually in linear measurement (feet or yards). This type of contract is useful when quantities of work cannot be determined before construction, such as with airport runways or highways. Actual costs are unknown until the project is complete, giving the contractor a lot of flexibility. An auditor should help ensure accurate estimates when the contract is developed and stay involved throughout the project to ensure costs are reasonable and consistent with industry and region standards.
The highest risk for owners and the securest option for GCs is a time and material contract. Time and material contracts are often used when a formal timeline cannot be established while allowing construction to begin. These contracts are often necessary for complex designs or incomplete owner construction plans, and though the risk is higher, auditors can take measures to prepare and effectively limit the risk. Before work commences, labor rates should be agreed upon and discounted in each contract to allow for ease and efficiency of audit. Owners and auditors should establish general timelines and anticipated costs to further ensure owner funds are used in a reasonable manner and to act as benchmark against actual costs charged by the GC.
Cost plus contracts reimburse the GC for specified allowable costs plus a fixed fee or some variation, such as an incentive or award fee. Owners use cost plus contracts, as with time and material contracts, when cost of work cannot be determined, design documents are incomplete, or quality takes precedence over cost, leaving the GC with an open pocket book to perform the work.
An auditor must keep several things in mind when working with cost plus contracts:
- The final cost may be unclear at the beginning and still unclear as the construction process is well underway.
- Additional administration and owner/auditor oversight is required to monitor costs deemed allowable and part of the scope of work as reimbursed costs.
- The GC may not be inclined to finish the project in a timely and efficient manner.
- Should I continue to even offer coverage in the future?
- If I am a small employer, what are the benefits and downfalls for me?
- How do I determine who is eligible for coverage under the new law, and how long must I offer them coverage?
Auditors should focus their approaches to ensure the utmost efficiency when auditing cost plus contracts by agreeing to allowable and unallowable hard and soft costs prior to contract execution. These costs include overhead, home office expenses, labor, materials and equipment. They must understand contracts with thousands if not millions of dollars in claimed costs are rife with GC dishonesty and fraud. Dedicating proper time up front can ease the burden of reviewing cost records as the construction process moves forward.
Knowing what to look for is half the battle. No matter how they are structured, construction contracts present risks to the owner. Whether it means taking a closer look at change orders and unallowable costs or helping owners negotiate favorable contract estimates, auditors who understand the unique risks posed by individual contract types are better equipped to conduct an efficient audit that protects the owner’s interests.