Cost Assurance in Practice
Once a construction contract is underway businesses and individuals alike tend to struggle with effectively monitoring and managing risks and cost. Picture a scenario where a family has employed a builder to build an extension in their back garden. Then in what the family believed will be the last month, the builder confirms to the owners that “due to unforeseen risks and change, the final completion cost will double from £25,000 to £50,000. On most infrastructure projects, it is the exact same picture, but this risk is magnified is millions rather than in thousands. This scenario is usually devastating for both client and contractors project teams. It is these crystallised risks, additional works and largely the underestimation of the cost of making a change or variation to the original scope that leads to cost overruns.
Cost Assurance the Definition
Cost assurance consists of a programme of independent assurance and audits activities to validate the accuracy between the intended contract costs, agreed contract changes signed by the parties and actual costs claimed and reimbursed over the project lifecycle. In this process, ensuring that robust commercial and financial controls are in place and effective is vital for governance and safeguarding value for money. Cost assurance is a critical component that provides a robust independent approach to identifying risks early on throughout the lifecycle of the project. There is a need to interrogate the cost systems, commercial and financial controls in the client and contractor environment and to verify adherence to the contract conditions. On collaborative cost-based or alliance contracts requiring open-book accounting, this process is a must and should be driven by all parties.
Cost Assurance & Audit Roles & Responsibilities
From the contract onset, the formation of a cost assurance strategy based is vital for both client and contractor. Cost assurance involves an examination of the commercial and financial controls and systems that govern projects to minimise risks and improve cost-efficiency. The independent auditor appointed by a client, sponsor or funder will provide valuable insight and an independent view on the project and contractor costs. This allows the parties to gain increased confidence that they have control over the project’s cost and progress minimising risks at the final accounts phase. An independent cost assurance team or project audit team (PAT) will require expertise and professional judgement to develop, agree and execute an effective risk-based approach. This could begin with the evaluation of compliance with the contract terms and conditions and an initial risk assessment. They may conduct an assessment to validate the effectiveness of commercial, finance, project or contract controls. This may include an audit of cost systems, staff rates and overhead costs.
Related: How to minimise disallowed costs on construction projects and contracts
Cost Assurance on Staff Costs
Assessing and agreeing to the actual cost e.g. pension costs related to people on a project is the single largest challenge for large infrastructure projects. Another area of contention is whether non-site-based staff should be classified as overheads or reimbursed project. A consistent definition of the site working area and pre-agreeing the core project team costs and how changes will be addressed will provide a clearer view of the likely cost, of who owns potential risks and prevent disputes. Another common issue that may arise is agreeing on the actual staff costs components of the staff rate build i.e which elements to include in the total cost, that is paid for in the fee and should be disallowed in the staff rate. Early ownership of direct and indirect employment costs such as training, bonuses, pay rises, holidays, mobile phone, company cars are cost components that should be agreed on at the inception of the contract. Pre-agreeing a set of protocols, mechanism and records needed to substantiate or evidence actual costs is strongly recommended in advance.
Cost Assurance on Plant & Equipment
Pre-agreeing conditions and timescales of cost to be incurred on site relating to the buying, hiring or operating of plant and equipment is vital on projects. This could be difficult to assess as projects usually have to adjust to risks that may occur during the delivery of works on a project. The parties should agree on a schedule of rates and percentage fee for processing plant and equipment supplied as part of inter company trade to avoid fee-on-fee disputes. This is where the same contractor organisation delivers the equipment used on site. They will need to demonstrate value for money and competition rules. There are many decisions, e.g. purchase versus hire, financing or investing, and long term value to verify if it is more cost-effective to buy or hire new equipment. Pre-agreeing a mechanism for clearly evidencing that purchase or hire decisions, duration and subcontract awarded within the same group of companies represented the best value for the client is key to minimise risks.
Disallowed Cost
A key component of cost contracts is addressing the issue of disallowed cost that often result in counter claims and disputes. It is not uncommon that one project manager decides that certain costs are not justified, while another on the same team believes that they are based on each person’s interpretation of the contract. The disagreement may also relate to the contractor’s accounts, level of detail and records for substantiating these. Furthermore, the parties may disagree based on their view with regards to delay in providing project information, approval, design, or authorisation. The parties need a mutual agreement of contractual information and level of detail early on to justify the costs and prevent risks of disallowed or non-compliant costs. That is critical for the viability of many projects and managing client cost risks and contractor’s revenue risks.
Fees
On cost-based contracts e.g. the NEC contract, the contractor’s fee may consist of profit alone or include items such as overheads and risk. The fee component often results in disputes between the parties on what is included or excluded from the fee and on what has already been paid for as part of the total cost. Many contracts do not clarify these and often there is no one clause or supporting schedule to explicitly state or define what is included or excluded in the fee. Often in the later stages of the project or at final accounts, disputes regarding cost included in the total cost or costs in the fee emerge as significant cost risks. This final account surprise represents a significant cost risk to the client and revenue risk for the contractor.
Emerging Risks and Costs
There is a need for collaborative contracts to drive efficiency and transparency on infrastructure investments that drive the economy. Cost assurance audits are crucial for independent governance and accountability over a project’s lifecycle. Cost assurance involves cost reviews to verify that costs are contractually accurate. Cost audits are independent audits to verify that costs reported, claimed, and reimbursed are contractually accurate. Cost audits are forward-looking and different from statutory external audits to verify the truth and fairness of financial statements. Cost audits use evidence to inform future cost decisions. In 2021 and beyond, clients, governments, funders and leaders will need to rethink project cost-benefit and estimates e.g. Brexit related cost risks, the effect in aviation of changes in consumer behaviour to reduce carbon emissions and their impact on the environment. These will be crucial post COVID19, as governments and businesses globally react to the transformational change and financial impact of the pandemic. Budget limits and other essential investment in health, education or technology will result in projects being postponed, cancelled and alternative funding models. With these emerging risks, the need for cost assurance and audits on collaborative contracts to improve cost decisions and drive transparency has never been more important.
“The need for cost assurance and audits on collaborative contracts to improve cost decisions and drive transparency has never been more important.”
Our Top Tips for Cost Assurance in 2022
1. Safeguard Cost Assurance
Organisations must safeguard assurance and adherence to standards, framework, contract terms, and contract commercial and financial cost controls.
2. Risks and Early Warnings
Maintain an up to date register for risk early warnings and emergency change e.g., Covid19 costs across all cost components prior to approved contract changes.
3. Communicate Change Carefully
Drive timely, clear supply chain communications and adherence to gov.UK, client and supplier communications.
4. Programme of Cost Audits
Pre-plan an indicative programme of cost audits, systems audits, and cost assurance reviews aligned with project milestones.
5. Independent Audits
Engage an independent audit firm to undertake independent cost, systems, and cost assurance audits on behalf of the client, sponsor, or funder.
6. Clarify Roles
Understand the importance of independence in clarifying roles and differences between key terms – cost assurance audits, cost verification and cost management.
7. Be Proactive with Findings and Decision Making
Be proactive with audit findings, decision making and using improvements from lessons learnt to influence future cost decisions.
8. Collaborative Contracts are here to stay
The need for efficiency, transparency and sustainability is driving the use of open-book collaborative cost-based contracts. Be prepared for Brexit, Covid19 and carbon costs.
9. Rethink Cost-benefit and Estimates
In 2021 and beyond, governments, funders and leaders will need project teams to rethink project cost-benefit and estimates in response to changing consumer behaviour
10. Begin Cost Assurance at the Investment Appraisal Phase
A cost assurance strategy should be developed at the investment business case phase and implementation linked to milestones should continue throughout the project lifecycle.