RSM Resources

Because the recent economic climate has spurred tighter capital budgets, owner review of project construction costs for potential recovery of overcharges is critical.

Determining whether the contractor or construction manager has complied with the provisions of the contract is a key issue facing owners and their representatives of major building projects. In fact, many owners mandate a review of project costs in excess of a threshold amount, such as $5,000.

The owner’s right to review or audit the construction costs depends on the provisions of the contract.Sophisticated owners generally insert very specific auditing provisions, often limiting reimbursement for certain costs.

The type of review for each primary contract category includes:

• Fixed price (stipulated sum)contracts – For this type of contract, the contractor agrees to perform the work for a stated lump sum amount. Since the primary construction costs are fixed, often only a review of change orders costs is necessary.
• Cost reimbursable contracts– In cost reimbursable contracts, the contractor is reimbursed for all allowable costs incurred plus a fee. Because virtually every cost is subject to review and potential adjustment, perform cost reviews for these contracts.
• Unit price contracts – A unit price contract is used when the contractor performs the work at a fixed price per unit of output. Examples include the construction of highways or large quantities of work where the exact quantities are unknown until the work is completed. Review whether the number of units (quantities) performed by the contractor has been correctly calculated.
• Potential for cost recovery.In certain situations, there is a high potential for cost recovery by the owner, particularly when the contract is a cost reimbursable contract.
• Labor rates. The components of employee labor rates include employees’ base salaries with the associated labor burden. The labor burden, or overhead, includes benefits associated with base salary, such as vacation and holidays, sick and personal leave, payroll taxes, unemployment taxes and retirement benefits. Determine whether the benefit is mandatory and generally allowable in the labor burden, or discretionary and either excluded or subject to the owner’s approval.  

Since an employee’s base salary can be quickly confirmed, focus the review on: 

• Payroll taxes – Federal and state laws impose caps on the amount of certain payroll taxes that an employer must pay on behalf of its employees. The amount of the tax assessment rate is based upon past claims made by employees against the employer subject to both a minimum and maximum statutory rate. In many instances, the contractor and subcontractors err and include more than the assessed rate of the employee’s total salary in the labor burden, ignoring the statutory limitation.
• Workers compensation insurance – Most contractors purchase a policy from an insurance carrier that sets the rates for each employee classification. The issue here is that the contractor may have few claims resulting in a reduction of his or her insurance costs (experience modification factor), but he or she doesn’t pass on the savings to the owner. Contractors who are self-insured generally establish a reserve and obtain an excess coverage policy to cover catastrophic claims. The reserve liability is the contractor’s estimate of current and future liability at that time. This estimate must be analyzed by obtaining the cost of administering the insurance program and the amount of the claims paid to injured employees for the prior few years to determine a trend and reasonable cost generally using a weighted average method.
• Employer pension and profit sharing contributions – In the labor burden, the contractor often includes the maximum contribution percentage amount required by the applicable retirement plan although it may be determined that either the employee isn’t enrolled in the plan or has elected a lesser amount of contribution than the maximum percentage allowed by the plan provisions.
• Overhead disguised as labor burden – A detailed analysis of the labor burden reveals whether non-reimbursable costs are included in the labor burden, such as computer costs, maintenance and repair expenses and accounting costs.
• Change orders. A change order is an amendment to the construction contract, agreed to by the owner,contractor and architect. It usually relates to an increase or decrease in the scope of the work, adjustment of the contract sum and the timeline for performing the work. Accordingly, the threshold issue is whether the work included in the change order is already included in the base contract and therefore, no change order is warranted. 
• Fees (markups, profit and overhead). The GMP contract should establish the amount of the contractor’s fees for the project and the contractor and subcontractors’ markups for profit and overhead on change order work. Analyze the calculation of the fee and markup to determine compliance with the provisions of the contract.

Carefully weigh the benefits of conducting reviews of the construction costs against the risk of not doing so. A review aids the owner in determining whether assets and funds have been expended in accordance with the contract and often results in the recovery of overcharges in excess of the review cost.

Paul D. Donovan, CPA, CIA,JD, is a director with RSM McGladrey. For more information, contact him at paul.donovan@rsmi.com.