Utilizing a Pre-Construction Contract Review to Minimize the Potential for Construction Billing Disputes

In Division 1, many of us tend to focus on how to resolve disputes after they have come to light.  This article, written by Curt Plyler, CFA, CCA of Fort Hill Associates, identifies a method for our clients to avoid disputes later in the game by doing the key legwork before construction even begins.  

Curt and I met at the meeting in Nassau, and he was kind enough to forward this article to me for our use in the Dispute Resolver.  Thank you, Curt!

Here's the article:

As a project moves from an idea towards construction inception, the Owner, Contractor, and their attorneys work together to create a construction contract designed to meet their mutual interests. Much effort and expense goes into this process, which is necessary given the potential risk exposures. However, once the Contract is set for execution, an essential step to minimizing future disputes is often omitted. A Pre-Construction Contract Review assists in identifying and mitigating many issues often arising from the Contractor’s billing practices.

Why Conduct a Pre-Construction Contract Review?

A Pre-Construction Contract Review enhances the efforts of the Owner’s representatives, attorneys, architects, and project managers in ensuring the underlying financial intent of the Contract is met. The additional intelligence provided by this review maximizes cost transparency, and as a result, the Owner’s fiscal responsibility. Most importantly, a Pre-Construction Contract Review establishes the proper expectations at project inception. A Contractor will seek to be compensated appropriately to complete a project not fully defined under a fixed price contract. 

As a result, Guaranteed Maximum Price (GMP) contracts are often utilized by Owners to get a better price on this type of construction project. The Contractor is normally paid the Cost of the Work plus a fee. Defining ‘cost’ is paramount. Assuming no language to the contrary, if the Contractor charges the Owner anything other than the cost incurred for labor, leased equipment, insurance, information technology, and etc., the underlying intent of the Contract has been changed. The Contractor can still utilize predefined rates to bill certain elements of project cost. However, the Pre-Construction Contract Review will validate the rates to be utilized to charge the project are representative of the actual cost incurred.

Step 1: Auditor Review of Contract Language

Ideally, a Pre-Construction Contract Review is done prior to Contract execution. The Contract is designed to eliminate ambiguities, but the complexities of a large construction project often leave the various parties with different understandings and assumptions related to project billings. The Auditor’s work complements the work done by both group’s attorneys. The attorneys are focused on a Contract to minimize their respective party’s risk, and the Owner’s Auditor (external or internal) seeks to minimize the potential for future billing disputes. These disputes often involve billing methodologies that alter or differ from the intent of the Contract. In most instances, the first step normally entails the Auditor reviewing the draft Contract language and identifying areas of concern.

Step 2: Review Labor Billing Methodology

Labor is the largest component of General Conditions and can be easily manipulated in the Contractor’s favor. The Contractor is entitled to recover the cost of payroll taxes, insurance, and customary benefits. These costs are often recovered through a labor burden billing based on the base wages. Since these costs will vary depending on who is assigned to the job, an estimated labor burden is often billed to the project. The Contractor’s estimate tends to be conservative, and each of the labor burden components is normally slightly overstated as a result. 

A Pre-Construction Contract Review proactively examines the proposed job roster and reviews employee payroll records. This review ensures the base wages billed are the actual wages paid to the employees. Additionally, the labor burden is reviewed to ensure it is representative of actual cost for both regular and overtime hours worked (many labor burden components are not applicable to overtime hours) for the Contractor’s hourly and salaried workforce. 

Other Contractors utilize labor billing rates, inclusive of base wages and labor burden, to charge the project. These billing rates may or may not be representative of actual Contractor cost. The Contractor’s payroll records should be reviewed during the Pre-Construction Contract Review to ensure these rates are representative of actual cost incurred.

Step 3: Review Contractor-Owned Equipment Rates

Many Contractors lease various pieces of their own equipment to the project. During the Pre-Construction Contract Review, the following items should be determined and/or validated:

• Fair market value of each item of equipment upon arrival on the project site
• A derivation of the components of the rate to be charged for each item of equipment
• The aggregate amount allowed to be charged for each item of equipment
• Any other charges to be billed separately and directly for equipment

It is recommended these rates be indexed to a respected industry source (for example, the AED Green Book). Additionally, the aggregate rental payments should not exceed a Predefined percentage of each item’s fair market value.

Step 4: Review Defined Rates for Other Items

Contractors will often insert Contract language allowing insurance to be charged at a stated rate, or they will bill the coverage at a rate despite Contract language stating only the premiums directly related to the project are allowed. As with the leased equipment and labor billing rates, it is very important to understand and validate the items comprising the insurance rate. It is not uncommon to find excess coverage and ‘home office’ insurance costs included in the rate.

Similar to insurance, many Contractors attempt to insert Contract language specifying a rate (a predefined percentage or an amount per labor hour of work) for information technology (IT), or they will charge a rate despite Contract language specifying actual cost incurred for direct project-related expenses. Any IT billing method utilizing a rate needs to be reviewed to ensure the components comprising this rate are reimbursable
pursuant to the underlying Contract. These IT components should not be billed directly if included in a predefined rate. Additionally, any rate based on a charge per work hour should be restricted to regular time wages only. 

Other items, including document reproduction and document retention, are often charged to the project with pre-defined rates. The Auditor should request the Contractor provide a list of all rates to be utilized in lieu of actual cost during the Pre-Construction Contract Review. All of these rates should be reviewed to ensure they are representative of actual cost incurred.

Step 5: Define a Budget for Daily/Interim Cleaning

Daily or interim cleaning charges can create issues of contention as a project progresses. In most Subcontracts, the Subcontractor is responsible for maintaining a clean job site. Thus, if the Contractor is not self-performing work on the project, the Owner may perceive a duplicate billing when daily/interim cleaning charges are billed to the project (if the Contractor is self-performing work, keeping that portion of the job site clean should be within their scope). The responsible Subcontractor should be back charged for any further cleaning required as a result of their work. 

In reality, though, it is nearly impossible to determine the responsible party for cleaning in all instances, especially given the common areas used by multiple Subcontractors. During the Pre-Construction Contract Review, it is recommended the daily/interim cleaning budget be reviewed and agreed-upon. This budget should be capped to prevent abuse.

Step 6: Defining the Required Documentation

The Pre-Construction Contract Review is the ideal time to specify the documentation required to approve Owner Change Orders, payment applications, and allowance/contingency usage.

• Change Orders should be fully supported, including templates specifying allowable markups for labor, equipment, and materials.
• Allowance and contingency expenditures should be reviewed with the Owner prior to the incurrence of these costs. Utilizing a ‘no cost’ Change Order to track usage provides the proper transparency to the Owner.
• Each payment application should be fully supported with Subcontractor payment applications, invoices for all expenditures above a predefined threshold, and a job cost report inclusive of a reconciliation for that month’s billing. 
• Monthly labor and leased equipment reports are also recommended to ensure visibility is provided for individuals and equipment moving to and from the project. 

Interim/Closeout Construction Reviews

The Pre-Construction Contract Review validates the basis for a Contractor’s billings to the Owner at project inception. On larger projects, periodic audit reviews are recommended every six to nine months of activity after project inception and the Pre-Construction Contract Review. These reviews are done for two reasons. First, it should be determined whether the Contractor has billed in a manner compliant with any understandings reached during the Pre-Construction Contract Review. Second, staff turnover -- both with the Contractor’s and the Owner’s project management teams -- often leads to misunderstandings regarding the agreed-upon billing methodologies. The findings in an interim or closeout audit should be minimal in the absence of large clerical errors. 

Conclusion

From the Owner’s perspective, eliminating billing issues upfront eliminates negotiating for a partial credit later on in the project for a ‘difference of interpretation’. From the Contractor’s perspective, the upfront review eliminates the bad feelings that can arise if the Owner calls in to question the Contractor’s billing methodologies later in the project. Thus, the ‘rules’ by which the game will be played are clarified. The Pre-Construction Contract Review is fair for both parties, and successful financial oversight of the project will be significantly enhanced when these reviews are employed. 

Curt Plyler is a Principal with Fort Hill Associates, LLC. Fort Hill is a consultancy specializing in construction contract audits and pre-construction reviews with offices in Raleigh, NC and Greenville, SC.