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Auditing construction costs helps bottom line

By Kevin Kenyon

With a close eye on the bottom line, a growing number of developers are looking to benefit from auditing their construction costs, though most still don't see the light.

With pressure mounting to trim costs at every turn, especially for public companies looking to create value for shareholders, no area is immune to scrutiny today.

Construction costs are no exception to this rule.

Considering the millions of dollars being spent each year on renovations, expansions, and ground-up development, experts say the decision of whether to audit construction costs can have a significant impact on a developer's balance sheet.

"The importance and value of construction auditing has increased significantly in recent years," said Ray Bocci, audit director for General Growth Properties, Chicago. "More and more developers are seeing the cost benefit of auditing construction projects, mainly because it's a good way to add value to the company."

Gone are the days when developers would simply rely on accounting clerks to perform spot checks to keep contractors honest, he said. Many firms are now either using their own audit staffs or are bringing in outside specialists on a contingency fee basis.

By Bocci's estimate, General Growth has easily saved millions over the years by auditing all of its major projects, and by periodically auditing some of its smaller developments.

The size and breadth of projects being undertaken today leave plenty of room for errors, and thus, potential overcharging.

"With the complexity of construction contracts these days, there's some real risk and exposures to potential contractor overcharges," he explained. "It's all a matter of interpretation."

As for possible areas of risk, Bocci noted that payroll, benefits, equipment rentals, subcontractor payments and overhead costs are usually the main areas of contention.

An audit would help determine, for example, if a contractor was incorrectly passing on his home office overhead costs to a developer, or if a contractor was accurately passing on savings from rebates or discounts received, he added.

Equipment rentals are another problem area. It is not uncommon for contractors to expense rental equipment, but an audit can make sure developers aren't charged more in rental rates than it would cost to buy a particular item.

Timing of the audit also is important to achieve maximum savings. While the word audit usually relates to something that is done after the fact, Bocci said it's best to set the parameters with the contractor at the very beginning of the process.

"Ideally it should be started in the development stage, before the contract is even finalized," he explained. "You should review the contract language for each and every cost, and then there should be a continuous auditing of the contract for the duration of the project."

Although more companies are beginning to realize the value of construction auditing, the majority of developers, for whatever reason, do not employ the practice, according to John Turney, audit supervisor for The Rouse Co., Columbia, Md.

"It's definitely increased drastically, but I would say the majority of companies still don't audit their construction costs," he explained.

At various ICSC meetings and construction seminars over the past few years, Turney said he's conducted several informal polls on the subject. He discovered that almost 90% of developers don't audit their construction costs.

According to Turney, those companies may be missing out on an opportunity to save thousands of dollars.

"I'd be very surprised if someone couldn't find some sort of savings by auditing their construction costs," he said.

The size of the developer should not be a factor in deciding whether to audit. Although larger companies like Rouse and General Growth can afford the luxury of having their own audit staffs, Turney said smaller developers can still benefit by using third-party specialists that split any savings they find.

Companies that don't audit, Turney added, are most vulnerable to contractor overcharges, and the situation may only get worse in the near future.

"The fees being paid to general contractors, for the most part, have come down, so what they've done is tried to find other ways to get the fees back up," Turney said.

However, much depends, he added, on the contractor/developer relationship.

"When we find problems it's usually auditing somebody for the first time who might have been involved in a lot of government work and have never really been scrutinized," he said.

"Most of the time they get in line the second and third time around because they're more familiar with the process."

The degree of risk often depends on what type of contract is used, Turney said, noting that the three most common contract types are GMP, cost-plus, and lump-sum.

GMP, or guaranteed maximum price, places a cap on a project's total cost, and often allows for shared savings if a project ends up under budget, he said.

"GMP is the most commonly used contract, because it protects you and provides a little incentive for the contractor to keep costs down," Turney said.

A lump-sum contract, on the other hand, usually involves one fixed price, but can be adjusted to incorporate change orders. Any savings go strictly to the contractor, he noted.

The third type of contract -- cost-plus -- is by far the riskiest contract out there. Turney said that besides not placing caps on expenses, cost-plus contracts provide little incentive for contractors to keep costs down, and actually encourage them to pass through as many expenses as possible.

"Although cost-plus is the least favorable of the three, there are certain instances, such as a situation where you're not sure of your budget and the entire scope of the work, where it is used -- but you have to be real careful."

Whatever contract is used, it's important for developers to make sure they include an audit clause, even if there is never any intention to perform one, Turney said.

According to Jeffrey M. Brown, president of Jeffrey M. Brown Associates, a New York-based construction firm, audits give developers a sense of comfort that their money is being properly spent.

For his part, Brown noted that his company was doing an increasing number of projects that use audits, as developers continue to look for ways to cut costs -- and ensure that the ones they do incur are legitimate.

"Nobody in this business likes surprises, so it's important to communicate along each step of the process," he said, adding that an honest builder should have no problem opening his books.

"It only becomes a problem when you're dealing with a dishonest builder; then it's a real dilemma."