In a challenging economic climate, contractors feel the pinch. Projects are cancelled, backlogs dry up and prices decline. To compensate for reduced projects and decreased revenues, contractors must scramble to win or save work while maintaining positive cash flow; this approach reduces the working capital needed to pay employees, suppliers and subcontractors. Such circumstances demand that hospitals, looking to construct or finish a capital project in a short timeframe, pay close attention to the contractor’s progress and billings. Many contractors today are billing hospitals as fast as possible even though physical progress may be less than costs incurred, while delaying payments to suppliers and subcontractors in order to conserve cash.
For example, consider a cost reimbursable contract with a Guaranteed Maximum Price (“GMP”). While there may be some costs incurred by the General Contractor (“GC”) for general conditions and self performed work, a majority of the costs come from fixed price or lump sum subcontracts. The billing from subcontractors is typically based on percentage of completion estimates, which bases the percent on progress (physical, costs, hours, etc). In order for the GC to maintain positive cash flow, they want to ensure the percentage of completion is as high as possible even though the physical progress may not be in line with costs or billings (e.g., physical progress may be at 40 percent with costs at 50 percent and billings at 60 percent). At the same time, while the GC is collecting payments from the owner for potentially inflated progress, the GC may be delaying payments to the suppliers and subcontractors in order to maintain positive cash flow.
Challenges and Opportunities
These issues create several risks for hospitals, including contractors with billings in excess of actual costs incurred. Contractors typically refer to this as BIE within their financials. From a progress perspective, such billings may be greater than physical progress. Therefore, the contractor could walk off the project and not suffer even though retainage may be taken by the hospital. Another risk for hospitals is delayed payments made to suppliers and subcontractors. When suppliers and subcontractors are not paid in a timely manner, liens may be issued against the project, which the hospital may have to settle. They also may not deliver critical equipment on time or at all, and may even walk off the project, leaving the hospital to hire another contractor or even subcontractors to finish the project. These risks further complicate projects that may already be at risk of being completed on time and on budget.
A Point of View
We recommend several preventive and detective processes to employ in any project. From a preventive standpoint, hospitals should review processes and controls that will help manage and monitor these risks such as contract management and invoice review processes. Hospitals can then address gaps in processes and controls to ensure risks are appropriately mitigated and add resources to help manage and monitor these risks throughout the project lifecycle. From a detective standpoint, hospitals should review current progress and billings to ensure these risks have not occurred. If these risks have occurred, hospitals can improve processes and controls to ensure they are mitigated as the project continues toward completion. The goal is to recover costs (detective) and reduce future cost overruns (preventive).
A Prime Example
A premier healthcare institution hired a general contractor to construct a research building and outpatient facility. Cost increases and schedule delays prompted management to take a closer look at the construction contracts.
The client engaged Protiviti to audit a sample of payment applications associated with the construction contracts between the hospital and the contractors for a $25 million Cost Plus GMP research building addition and a $100 million Cost Plus GMP outpatient facility. The client was sold on Protiviti’s proven tools, methodologies, experience and knowledge in construction contract auditing within the healthcare industry. Protiviti’s audit identified more than $4 million in contract exceptions and provided detailed recommendations on how to reduce future cost overruns through improved controls and processes.