Auditing Construction Costs

• Selecting the project and scope of the audit
• Requesting and evaluating support documentation
• Direct labor costs
• Contractor-owned equipment
• Insurance
• Information technology (IT)
• Change orders
• Other costs

Selecting the Project and Scope of the Audit

Construction is delivered under multiple approaches, often called “delivery methods.” The construction contract is tailored to the delivery method being employed on the project in question. Common delivery methods include Design-Bid-Build, Multi-Prime, Design-Build, Construction Manager-at-Risk, and Integrated Project Delivery.
 
The most common construction delivery methods in higher education today are Design-Bid-Build and Construction Manager-at-Risk. Design-Bid-Build contracts are commonly referred to as “hard bid” or “lump sum”. These projects are completed for a fixed price and are often used on smaller projects where drawings are complete and the scope has been finalized. Given the reduced risk from a financial perspective, the scope of an audit would be primarily focused on any change orders.
 
Larger projects are often built utilizing a Construction Manager-at-Risk delivery method. This method engages the construction manager prior to final drawings in order to leverage their expertise with constructability reviews at various stages of design. This approach utilizes a Guaranteed Maximum Price (GMP) contract. This contract segments the recovery of project costs into the following components:

• General Conditions, the cost of managing the project

• Cost of Work, subcontracted work, self-performed work

• Insurance/Bonds

• Fee, a percentage of the project cost or a stipulated amount

The GMP contract establishes a cap for the amount paid for the construction, but allows the project owner to retain any variance should the GMP exceed the total realized project costs. As a result, GMP contracts generally have more areas of potential audit exposure from a financial perspective. With resources often being limited, audits of construction in higher education naturally gravitate to GMP contracts given their compensation terms and greater project values.

Requesting and Evaluating Support Documentation

(For the purpose of this and the remaining steps, it is assumed a GMP contract is being reviewed)
 
Once the project(s) to audit has been selected, the Auditor will need to develop an initial documentation request to obtain the following items:

• The executed construction contract with all amendments, exhibits, workbooks, etc.

• Fully supported Owner Payment Applications from Owner or Contractor including:

  • Schedule of Values

  • Subcontract Payment Applications

• A project cost report, for the period being audited, from the Contractor, inclusive of all reimbursable costs.

 
Requests sent to the Contractor should be directed to the Project Executive and/or Project Manager. The construction contract should then be reviewed, specifically sections addressing the “costs to be reimbursed” and the “costs not to be reimbursed.” The compensation terms should detail the usage of pre-determined rates and actual costs. Additionally, the contract should specify the overhead items covered by the Contractor’s fee.
 
A source documentation request should then be sent by the Auditor to the Contractor’s Project Executive and/or Project Manager for multiple items:

• Direct labor and equipment costs

• Subcontractor costs (if not provided above as noted in the initial documentation request)

• Insurance costs

• Information Technology (IT) costs

• Change orders

• Other miscellaneous costs

The lowest source document should be determined for the request. For example, the original timesheet should be requested to validate the hours worked by an employee. These lowest source documents are utilized to create the monthly project billings and provide valuable insight often lost if reports are created specifically to satisfy audit requirements. These documents often contain commentary and details about transactions later adjusted and/or ‘corrected’. In some cases, the source document can further demonstrate how a transaction has been ‘cleaned’ to avoid scrutiny during the payment approval process.

Direct Labor Costs

The contract should specify whether labor is to be billed at pre-determined bill rates or actual cost plus burden. To effectively review labor costs utilizing bill rates, timekeeping records should be requested. To the extent the contract does not explicitly specify the bill rate components, the Contractor should be requested to provide them. Bill rates routinely include paid time off, benefits, base wages, payroll taxes and unemployment insurance.
 
Labor billed at actual cost plus burden will require payroll records, including employee deductions and timekeeping records. To the extent the contract does not explicitly specify the burden components, the Contractor should be requested to provide them. Burden rates are applied to base wages and routinely include paid time off, benefits, payroll taxes and unemployment insurance.
 
If the contract does not specify the use of pre-determined bill or labor burden rates, the labor is normally reimbursed at actual cost plus actual burden. The audit will need to independently estimate the cost of the labor burden. Documents needed to complete this estimate include:

• State Unemployment Rate for your state.

• Workers’ Compensation including Experience Modification from the insurance carrier.

• Medical Insurance at the employee level from payroll records and at the firm level from the insurance carrier.

• Retirement from payroll records.

• Accidental Death/Long Term Disability from the insurance carrier.

Contractor-Owned Equipment

Contractors may lease their owned equipment to the project. The contract language often specifies these rental rates are to be indexed to a third-party source, such as the AED Green Book or EquipmentWatch Blue Book. The contract language may specify the lease rates are to be indexed at less than 100% to the index in question. Additionally, the language may specify when lease payments are to cease. If not, the fair market value or replacement value is the
implied point when payments should cease. The Contractor should be requested to provide a leased equipment summary, inclusive of the following items:

• Equipment tracked down to the serial number.

• Fair market value when first utilized on the project.

• Rental rate and index rate (if applicable).

• Cumulative rental charges to date for each item.

Insurance

The construction contract should specify the various insurance coverages required by the contract. The most common coverages, and their means of compensation, are as follows:

• General Liability Insurance, which may or may not be defined as a percentage rate in the contract.

• Contractor Controlled Insurance Program or ‘CCIP,’ often specified as a percentage rate in the contract or contract amendment.

• Builder’s Risk Insurance, purchased specifically for the project.

• Subcontractor Default Insurance, which is almost always specified as a percentage rate of the enrolled subcontracts.

• Performance and Payment Bond, purchased specifically for the project.

 
General Liability Insurance will often be charged at a rate that may or may not be defined in the contract. If the rate is not specified in the contract, request a breakdown of the rate charged to the project. The rate breakdown provided should be analyzed to determine if it includes coverage not required and/or if overhead has been included. The project requirements for policy coverage and limits should be located in the Contract agreement. The Auditor should verify the coverage and appropriate limits have been obtained by requesting a Certificate of Insurance from the Contractor which lists the project owner as the named insured for the project in question.
 
Builder’s Risk Insurance and Performance and Payment Bonds are usually purchased specifically for the project. An invoice should be requested to document the purchase. The vendor providing the invoice should be confirmed to be an independent third party, as captive insurers are often used, reducing the transparency of the actual cost incurred.
 
Subcontractor Default Insurance is routinely charged at a rate specified in the contract. This rate is applied to the combined subcontract values enrolled in the program. To confirm the amount charged, a list of enrolled subcontracts should be requested. The Schedule of Values in each subcontractor payment application should then be separately scrutinized for the inclusion of bond costs. If identified, this is most likely a duplicate charge to the Subcontractor Default Insurance.

IT

IT expenditures are often allocated and charged to project costs by Contractors. Contracts may allow for “project-specific” IT expenditures such as laptop computers, internet connectivity, and on-site support. Correspondingly, contracts normally disallow corporate overhead IT expenditures (accounting systems, home office servers, and home office support). The contract language related to IT, however, is usually nebulous. As a “rule of thumb,” if the IT item is utilized on-site, it’s likely permissible, but if utilized in a home office, it is likely overhead and should not be billed. Invoices should be provided for all IT charges without contract language specifying an IT rate. This approach is the most transparent from an audit perspective. As with the insurance, the Auditor should be wary of any IT invoices from a related party. Any computers and other hardware charged to the project should revert to Owner control at the project’s end. To the extent an IT rate is specified in the contract, the project cost report should be scrutinized to ensure IT charges covered by the rate have not been direct billed to the project. If the IT rate’s components are not defined, the Contractor should be requested to provide them.

Change Orders

A retrospective review of project change orders will require copies of fully supported Owner Change Orders, which are the summation of multiple change requests made to the project owner for approval. The support should include a cover sheet with an itemized list of the change order items. The subcontractor support for each individual change order should then follow, and this support should then be reconciled to the cover sheet. The Contractor’s markups for insurance, overhead, and profit should be present on the cover sheet and should be confirmed against Contract stipulations. The markups applied on Change Orders should be validated for the following:

• Will markup, overhead and profit (OH&P), insurance, bonds, etc., be applied to both additive and deductive Change Orders?

• Is an OH&P cap defined separately for each tier (i.e., Contractor, Subcontractor, Sub-subcontractor)?

• Can the Contractor get separate markups for its role on self-performed work?

• Is the aggregate markup capped?

 
In addition to markups, the Change Order review focuses on these items:

• Validation of costs (material, labor, etc.).

• Identification of duplicate scope in selected instances such as rework, back charges, and items intended to be covered by the fee for overhead

• Review of the approval process.

Other Costs

The project cost report provided in the initial document request should be sorted to segment transactions not falling into labor, equipment, subcontracts, insurance, and information technology categories. Most of these charges will be for vendors paid via purchase orders. The transactions should be further segmented into a list where the reimbursable basis cannot be readily determined – these invoices should then be requested from the Contractor. The invoice review should focus on the following items:

• Is the charge reimbursable per the contract, or was it intended to be covered by a rate and not billed directly?

• Was the charge incurred on the project in question?

• Do the date and invoice number trace to the project cost report transaction?

Journal entries may comprise the remaining transactions, and backup should be requested for any that are questionable.

Conclusion

Auditing construction costs may seem like an impossible task without specific expertise and limited resources. However, focusing your audit program on projects with contracting terms with more material financial exposure is the first step in developing an effective review of these capital expenditures. Following project selection with targeted documentation requests will allow the development of an effective and efficient process for reviewing construction project costs.

About the Author

Curt Plyler

Mr. Plyler is a Principal with Fort Hill Associates, LLC. A Certified Construction Auditor (CCA) and CFA charterholder, Mr. Plyler co-founded the firm in 2006 to specialize in construction auditing. His practice focuses on providing construction...
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Curt Plyler

Mr. Plyler is a Principal with Fort Hill Associates, LLC. A Certified Construction Auditor (CCA) and CFA charterholder, Mr. Plyler co-founded the firm in 2006 to specialize in construction auditing. His practice focuses on providing construction auditing services to owners of large, complex higher education and healthcare projects.

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Auditing Construction Costs