Construction Fraud/Waste/Abuse Case Study: Causes of Construction Budget Disasters - Part 1
A construction auditor is constantly benchmarking performance. We benchmark performance against the contract, Owner policies and procedures, industry norms, and budgets. As a result, our experience has given us the opportunity to observe what occurs, and what is missing, on successful and unsuccessful construction projects.
Sometimes an unsuccessful project can overrun its budget in epic fashion. This blog and several blogs to follow will discuss the causes for the worst construction budget disasters we have encountered in our years of construction auditing. Following is our list of the top causes of construction budget disasters:
- Selection of the wrong project delivery system
- Incomplete design or design voids
- Unforeseen circumstances (conditions and/or events)
- Poorly written contract financial controls
- Weak and/or ineffective owner financial oversight
- Billing abuse and fraud
- Owner change orders and schedule interference
- Personnel turnover or turnover among third party support entities
- Schedule delay
- Technical failure
- Scarce resources
- Poor control over the bidding process
This blog will discuss the first three of the budget busting causes listed above. Later blogs will discuss the remaining budget busters.
Selection of the wrong project delivery system:
A famous quote from a 1973 movie is, "A man's GOT to know his limitations." This message applies to construction Owners as well. A construction project Owner has got to know its limitations.
When a construction project Owner organization (the "Owner") selects a project delivery system that does not match its internal capabilities, there is a strong likelihood that things will go wrong. For example, an Owner with no construction oversight experience should not embark on a time-and-material construction project without extensive support from an Owner's representative or program manager. This applies to all Owners, whether they are a large hospital system or an individual person contracting to build a house. Another example of Owner limitations, is an Owner that routinely builds cookie cutter projects (e.g., box stores, service stations, etc.) that assumes it can manage a fast tract project involving new technology without altering its in-house and/or third party support team.
The Owner must do an honest self-assessment and map its skills into the skills needed to successfully participate in a project using a specific project delivery system. If the Owner does not have the internal skills required of its role under the project delivery system, then the Owner must either find a different approach or hire third party providers that can fulfill the skills gap.
Project delivery systems that are the most demanding of Owner expertise are:
- Time and Material ("T&M") contracts
- Fast Track projects
- Integrated Project Delivery ("IPD") projects
- Engineer Procure Construct ("EPC") projects
Incomplete design or design voids:
Incomplete design frequently creates a syndrome among project managers that we refer to as "delusional optimism." Delusional optimism occurs when the Owner is convinced, either by itself or its third parties advisors, that shortcomings and/or voids in the project's design can be overcome by:
- Rigorous negotiation of change orders
- Fast track techniques
- Value engineering
- Self-performed work
We have rarely encountered a construction project that was completed below budget after suffering a material delay in its design deliverables, or after discovering material voids in its design documents. Contractors and subcontractors that are asked to include ambiguous or undefined scope in their price proposals will inevitably load their prices with contingency dollars to mitigate financial risks.
Sometimes the Owner will omit a trade's undefined scope from the initial request for proposal. The scope of work bid will therefore be less than 100% of the expected final scope, for example 80% of the trade's expected scope of work. In these situations, the Owner's hope is to put the 20% scope of work into a follow-on change order once the design is finalized. Unfortunately, this approach typically results in a follow-on change order that far exceeds 20% of the original budget estimate for that trade.
In our experience, the best approach to filling a design void, assuming the void is not too extensive, is through the use of allowances. This approach however, requires rigorous oversight on the part of the Owner. The Owner must ensure that any change order used to set the final price of the allowance is effectively negotiated and that any unused allowance dollars are not syphoned off to be used elsewhere on the project.
Another way to mitigate the damage caused by delayed design and/or incomplete design is to adjust the completion date of the project and thereby allow more time for the design process to occur. However, one of the most frequent reasons Owners continue with projects knowing that the design is incomplete, is because of the Owner's desire to meet a deadline that it consider
s important. Therefore, the first thing the Owner should do when faced with the prospect of moving forward with an incomplete design is to revisit the deadline question. Many times the cost of mitigating losses created by a delayed delivery date are far outweighed by the extra cost suffered when the project is started with an incomplete design and/or design voids.
Under all circumstances, the Owner's senior management must implement controls to ensure that it is made aware of delayed or incomplete design. We have frequently seen situations where project managers have hidden the fact that the design is incomplete from senior management. These project managers do this because they may suffer from delusional optimism. They may have convinced themselves that they can avoid the extra costs that result from incomplete design documents by the actions they take during the remaining phases of the project such as rigorous change order negotiation, value engineering, or some other action.
Unanticipated circumstances are unplanned conditions or events such as the following:
- Owner changes
- Underground conditions:
- Rock removal
- Concealed obstructions
- Protected antiquities
- Unforeseen conditions in rehabilitation / restoration projects:
- Structural deficiencies
- Construction site accidents
- Crane collapse
- Worker injury or death
- Foundation settlement
- Design defect affecting constructability or performance
- Contractor and/or subcontractor default
- Extreme weather or fires resulting in damage to construction in process
- Environmental challenges
- Protected wildlife
- Soils contamination
- Toxic spills or ground water contamination
- Labor turmoil
Unanticipated site conditions and events can have a devastating impact on the anticipated cost of a project. Owners will mitigate the cost of unanticipated situations by either:
- Contracting away responsibility to a third party.
- Purchasing insurance to avoid the risk.
- Manage the risk by setting up the control procedures to minimize the probability of the event occurring and the cost of overcoming the event if it does occur.
To select the preferred course of action for a particular risk or triggering event, the Owner may prepare a risk matrix similar to the example below. The Risk Matrix allows the Owner to evaluate the various options it has with regard to the risk in question so that it can select the course of action that is optimum under the circumstances.
Contractually Allocate the Risk to a 3rd Party
Purchase Insurance to Avoid the Risk
Manage the Risk
Design Defect affecting constructability or performance
- Avoid waivers in A/E agreement that bar loss of use damages and pass-through of contractor's claims
- Use a delivery method that transfers design risk to contractor
- Contractual waiver of contractor's consequential damages, such as lost profits and bonding capacity
- Contractual waiver of impact claims upon contractor's acceptance of change order
- Contractually limit contractor's delay and impact damages to contractually defined cost of work items, verified with right to audit
- Contractually require cost and time impact estimates with notice of claim
- Verify practice professional liability policies for negligent acts, errors or omissions of project design, consulting, and engineering professionals
- Purchase project-specific professional liability policy covering negligent acts, errors and omissions of all project design, consulting and engineering professionals.
- Purchase Contractors Protective Professional Indemnity and Liability insurance to cover vicarious liability of design builder and provide first-party coverage excess practice professional policies
- Put plans and spec through a constructability review releasing them for bid
- Avoid CCDs for directed schedule acceleration; rather, use lump sum change orders or cost of work or GMP change orders if costs cannot be ascertained
- Include a full waiver of all impact claims in all change orders
- Place design professional on notice of claim and your damages
- Engage a certified expert to review or monitor the project
- Define goals and get agreement in writing
- Define milestones
Using the structure demonstrated in the example above, an Owner can set up a process for identifying and evaluating the risks it faces from unanticipated conditions or events during the course of the construction project.
About ResX – Construction Audit Practice:
Our construction industry services are founded on the following:
- A deep understanding of construction contracts
- Extensive experience with, and knowledge of, normal construction industry practices
- The ability to quickly acquire data from the field and identify anomalies through benchmarking the field activities against your contract and industry norm's
Clients benefit because our construction audit projects typically identify cost savings that significantly exceed the cost for our services, and because we always provide a comprehensive list of control improvements and best practices.
Experience is what makes ResX Construction Auditing unique. For more information and to learn about working with ResX, please visit our website: www.resxpc.com.