Change orders outsize construction contracts
A picture is worth a thousand words
ECLUB NEWS |
Despite the pervasiveness of the Great Recession, leading private clubs, resorts, and hotels are aware of the need to continue to invest in their physical property in order to keep amenities and facilities fresh and encourage repeat usage and enjoyment by members and guests. While operating budgets and costs, service contracts and individual purchase orders and invoices are frequently subject to robust scrutiny, the same is often less true for payments relating to substantial cash outlays for construction projects. In fact, original construction contracts are all too often left to look like a rubber dingy next to a mammoth boat of change orders, and clubs and hotels are left with little assurance that what was paid for is what has been received.
Consider the following myths about construction costs so that the next capital investment project does not leave the property capsized—and management searching for a life vest.
Myth #1 – No need; we have our financial statements audited every year.
A common misconception is that owners need not worry as they are covered by the annual financial statement audit. In reality, financial statement audits have nothing to do with obtaining assurance relative to the costs charged for a project that a construction manager or contractor includes in their monthly billings or payment applications. What is typically considered from a financial statement audit perspective is:
- The monthly contractor payment applications are properly approved as evidenced by the signatures of the contractually appropriate parties.
- The amount billed agrees with the amount recorded in the financial records.
- Any incurred liability (construction costs incurred, but not paid) must be accurately reflected as a liability in the financial records
The financial statement auditor relies on the amounts billed in the Contractor's Payment Application since it is a third-party vendor document. This is normal and appropriate for the financial statement assurance audit in accordance with what auditing standards stipulate.
However, when it comes to determining if the contractor's billing is appropriate, management needs to look beyond the contractor's payment application and review third party documentation that supports the detail of costs included in the payment application's scheduled values. This ensures that the amounts charged on the payment application are within the agreed scope of the original contract and enables management to verify that the work has actually been physically performed at the time the payment application is submitted.
This is especially true where a Construction Manager (“CM”) at Risk model is used and the basis of payment is the cost of the work, plus a fee, with a Guaranteed Maximum Price (“GMP”). These contracts are typically structured so that a CM is hired to manage the project, on behalf of the owner, from Pre-Construction to Construction and through to Closeout. The CM may only perform a minor amount of actual labor (i.e. clean-up, etc.). The primary role of the CM is to manage the project, which could include up to 40 subcontractors depending on its size and complexity, with subcontractor costs representing the vast majority of the total construction cost. The CM then bills the owner in the monthly pay application process for its costs and agreed upon fees. These costs, or general conditions, include such items as insurance, bonds, and the CM's direct costs to manage the project such as project staff labor and labor burden, telephone, equipment rental, tools, computer equipment, dump charges, and trailer rental to name but a few. In addition to the CM costs the payment application will also capture the costs incurred in respect of the subcontractors.
Without a careful review of the documentation supporting the payment application the management is left to operate under the assumption that what the CM bills on behalf of the subcontractors and what it bills for its own general conditions is accurate and within the scope of the contract. Otherwise, there is no actual assurance that what the CM is billing that month accurately reflects what the subcontractors billed the CM, or what the CM incurred on general conditions.
Myth #2 – Our contract has a guaranteed maximum price.
Another misconception is that a guaranteed maximum price in a construction contract negates the need for thorough review of payment application documentation. After all, if the CM needs to bill in excess of the GMP, then an approved change order will be necessary.
This, however, is only half the story about what these types of contracts say regarding the basis of payment. The basis of payment is the cost of the work plus a fee with a guaranteed maximum price. Furthermore, such contracts indicate that the final overall cost of the project to the owner is:
- The cost of work plus the agreed upon CM fee (profit and overhead) or the guaranteed maximum price, whichever is less.
If at the end of the project, the CM fully bills the GMP amount, consider whether the owner has any level of comfort that the cost incurred plus the CM fee was not less than GMP—potentially substantially less. Conversely, if the total billings are less than the GMP, consider whether there is any way to know that the actual incurred costs plus the CM fees were not even less and significantly so. As the expression states, "You don't know what you don't know." Club and hotel management can only know that it received what it paid for through a review of third-party support each month for the amounts billed by the CM.
It is worth pointing out that the standard AIA contract includes a provision that requires the CM to provide such third-party support and any other support related to the project that the owner might require with each monthly pay application submittal. The support should be reviewed against the Schedule of Values for each pay application to ensure they are appropriately billed. The costs should also be reviewed for allowability and appropriateness in accordance with the contract. The owner should not approve a pay application for payment unless all supporting documentation has been properly reviewed and any errors in the pay application have been corrected. This would significantly mitigate the risk of overcharges.
Examples of appropriate supporting documentation for major categories of costs include:
- General conditions – Third-party invoices (vendor invoices, receipts)
- CM-performed labor and project management wages – Certified payroll or equivalent
- Subcontractor costs – Subcontractor invoices or pay applications with schedules of values
- Insurance and bonds – Third party invoices and/or allocation calculations, as applicable
- Change orders – Evidence of proper review and approvals by owner designees; vendor invoices, subcontractor cost estimates, as applicable
- CM fees – CM fees should be recalculated to ensure the current billing is in accordance to the amount specified in the contract and GMP and in accordance with the project's percentage completion
Myth #3 – The architect does all this before signing off on the payment application.
General managers and CFOs often ask whether such detailed review is really necessary. A common belief is that the architect must already do all this as part of their own review in order to certify payment on the cover page of the monthly pay application. Consideration of the following clause, typical in most construction contracts, is relevant:
§ 7.1.10 In taking action on the Construction Manager's Applications for Payment, the Architect shall be entitled to rely on the accuracy and completeness of the information furnished by the Construction Manager and shall not be deemed to represent that the Architect has made a detailed examination, audit or arithmetic verification of the documentation submitted in accordance with Section 7.1.4 [the type of documentation listed above] or other supporting data; that the Architect has made exhaustive or continuous on-site inspections; or that the Architect has made examinations to ascertain how or for what purposes the Construction Manager has used amounts previously paid on account of the Contract. Such examinations, audits and verifications if required by the Owner will be performed by the Owner's auditors acting in the sole interest of the Owner.
Without instituting a pay application review process that includes the underlying third-party support as described above, an owner would never know it paid for a boat but only received a dingy.
Myth #4 – Our existing payables processes are sufficiently robust.
Many clubs and hotels believe they have a sufficiently robust pay application review process and that they already review the support each month and that there is no reason to have a complete audit of each project performed. However, in addition to the monthly pay application review process, owners are recommended to exercise the right to audit clause as referenced in the contract provision quoted above.
Exercising the right to audit clause enables the owner to make a more detailed, comprehensive examination of the construction costs and fees charged and confirm their allowability and supportability pursuant to the terms and conditions of the contract and assumptions and exclusions stipulated in the GMP. In an audit, they are afforded access to any of the CM's accounting records and files that pertain to the construction project. Furthermore, the cost recoveries from contractors that arise from the audit process regularly exceed the direct costs associated with the audit.
The combined benefits of the monthly pay application review process and exercising the right to audit provide a high level of assurance and confidence to ensure the completed project actually represents the vessel for which the club paid.