Think you know how to R.E.V.I.E.W. defined costs?

This paper focuses on reimbursable options, where Defined Cost is based on the Schedule of Cost Components (SoCC).

Allowable items relate to the purchase of goods and the associated delivery and removal charges. Under Clause 11.2 (26) plant and materials not used to provide the works (after allowing for reasonable wastage) are a disallowed cost. There is an element of subjectivity here, and the onus is on the contractor to demonstrate that waste is minimised.

There may also be additional requirements identified in Z-clauses and it is essential to read the contract properly. We reviewed a contract recently where tendered rates used to build up the Total of the Prices were then used to assess the Defined Cost, instead of the SoCC. However, it is rare to find these changes to the core NEC clauses.

Defined Cost needs to be justified by accounts and records. These will typically include accounting records (such as purchase orders, delivery notes, invoices and proof of payment) and site records (material allocation sheets, photos, as-built drawings). Payment information is often overlooked. It is particularly important as it may reveal early payment discounts, contras or missed credit notes. It will also enable the project manager to establish that Defined Cost will be paid before the next assessment date.

Often clients include additional document requirements in the Scope, listing further records the contractor is required to provide to support its claims for Defined Cost. These may include specific site records, for example, CCTV, vehicle logs, weighbridge records, security information, barcodes and production tracking. On major earthwork projects, survey and LIDAR data may even be specified.

For all reimbursable options, the contractor needs to demonstrate that the plant and materials claimed have been used to provide the works.

The project manager or inspector/auditor should not rely solely on an invoice as sufficient evidence!

Lastly, under clause 52.1, Defined Cost is at open market rates or competitively tendered prices, with deductions for all discounts, rebates and taxes that can be recovered by the contractor. Generally, volume rebates offered by plant and material suppliers are not credited direct to contracts.

Expect a struggle when asking for copies of group level supply chain agreements to identify potential rebates. If the contractor does not provide access to accounts and records relating to rebates, it is reasonable for the project manager to make an assessment.

It is worth noting that these rules apply in the same way for key reimbursable subcontract packages.

The NEC is based on parties acting in a spirit of mutual trust and cooperation. However, there is an onus on clients to check contractors and subcontractors operate a robust risk framework, setting out good governance through effective internal control, enterprise risk management, and fraud deterrence.

Ideally, clients should review contractors’ internal controls, financial systems and application for payment processes, prior to starting works on site. Prevention is better than cure! In our experience, this does not happen very often, based on an expectation that the supply chain already operate robust systems.

Assurance providers typically dive straight in with sample testing, without first understanding core financial processes and key controls. This is very important as the effectiveness of internal controls can also shape test plans and sample sizes e.g. you would typically expect more errors on plant and material costings supported by a manual spreadsheet than a report downloaded direct from an accounting system. The higher the expected misstatement, the larger the sample size.

So, a great first step in any review is to understand and assess the effectiveness of internal financial control.

• What core processes for plant and materials are operated by the contractor?
• How are their third party suppliers identified, tendered and contracted?
• How does the contractor go about demonstrating value for money?
• How is spend budgeted and controlled?
• What delegated authorities exist over say PO approval or invoice sign off?
• What checks and balances are in the accounting system to match invoices, reverse accruals, prevent error?
• How are key financial records stored and accessed?

Understand what additional reports are available from the contractor’s accounting system to supplement your review e.g. order analysis and material delivery reports.

• Does the contractor’s cost ledger report provide evidence of invoices and payments, or does the cost report supporting the application for payment merely show goods received?
• What process does the contractor operate for clearing old system accruals?
• Are costs claimed likely to be paid before the next assessment date?

Get a good feel for the core processes and then walk through them to embed your understanding.

• As a minimum, firstly expect to see that any plant and materials claimed should tie back to the underlying accounting system of the contractor – these systems have a number of built in checks and balances to help drive accurate project costing.
• Do this check “real time” with the contractor so you know the data is fresh out of the accounting system (and not exported/manipulated/then shared).
• It is also really important to walk through the accruals process. Most contractor accounting systems use accrual-based accounting. This means plant and materials are initially costed to the project by processing a delivery ticket, which is matched to a purchase order. The invoice is then matched at a later date to the delivery note (completing the 3-way matching and usually generating an automatic payment release). At this stage, expect the transaction in your contract cost ledger data set to pick up a specific reference to a supplier invoice number. This is normally an indicator of a match. Conversely, a lack of referenced invoice numbers may show a large volume of aged accruals! This would certainly be worth following up.
• As per other papers in our REVIEW series, it is essential to step away from the pure accounting side of transactions and understand the importance of how plant and material costs are prepared, controlled and reported at Site, as this heavily influences the risk of mischarging.
• Obtain a good background to the project and the contractor you are auditing. A tour of the Site, discussions with stores managers and site logistics will be useful to understand what plant and material items are used on Site, where and how they are received and inspected on arrival. This could be direct to Site, or at local depots, where marking up may be relevant (clause 71) if the contract identifies them for payment.

Good analysis is only possible with a decent data set (via both accounting and site records). Often, cost reports only include basic data fields such as value, supplier name, cost code and date. Better description fields and data sets may be available from purchase order reports that are not included in the application for payment.

• Start with a simple breakdown of supplier spend and establish the types of plant and materials being delivered or used on site.
• An overview by cost head or description and date will provide a high level of analysis but won’t necessarily identify higher risk transactions.
• Look for invoices that are not matched to goods received notes or purchase orders.
• Complete a review of potentially non-recoverable items using key word searches, such as stock loss, damage, wastage, obsolescence, theft.

Advanced analytics on the data can be really helpful but may require specialist statistical or data visualisation software – you may find your analysis limited if all you have is Excel or Power BI.

We often carry out more complex analysis on plant and materials datasets, including duplicate testing, regression analysis and Benford’s Law. We also undertake various analytical review procedures at this stage looking at trend/variance analysis, as well as comparing actuals to project budgets (simple, yet often over-looked).

Remember, at this stage, we have not selected any samples!

A simple graph shows what analysis is possible.

A thorough understanding of the environment, plus good data analysis should help shape where costs may be mischarged against the identified rules. This will help drive specific tests and the riskier transactions you will definitely want to inspect.

Beyond this, assurance providers need to decide how best to test and sample the remaining population to draw reasonable conclusions about the accuracy of plant and material costs.  Test types may vary from basic direct verification checks back to source documents, computational checks, confirmation checks (direct evidence from plant and material suppliers regarding rebate existence as an example), proof in total etc.

Proof in total tests can be really useful when testing plant and material costs, as the actual costs claimed can be compared against contemporaneous site records, design drawings etc.

The volume of samples to be selected for each test need to be carefully considered. Sampling strategies are varied and may include approaches such as attribute, haphazard, and monetary unit, to name but a few. Remember most importantly however, the samples chosen must ultimately be representative of the wider population. This may mean you need to divide plant and material transactions down into sub-groups (or sub-populations) with similar characteristics, and test and sample from there.

Determining an appropriate sample size is often seen as both a science and an art!

The NEC contract is relatively vague about what constitutes appropriate ‘accounts and records’. Disallowed Cost is cost which is not justified by contractor’s accounts and records.

Too often we see poor assessments on plant and material costs (whether initially challenged as Disallowed Cost or With-held) merely because one or two records are missing relating to a particular transaction i.e. we have seen the invoice and payment but are awaiting proof of delivery! Be pragmatic here. If it relates to a series of steel columns and beams going up dead opposite your site office, then perhaps use your eyes?

Extrapolation is another important issue of concern we see. If you find 15% of Plant and Material costs in your sample are not supported by delivery notes, is it reasonable to extrapolate? The answer is: it depends! But a more robust approach may be to stratify samples and complete root cause analysis to determine the reason why sub-populations of costs are not supported. Consider if you are able to design alternative audit tests to isolate the error. The misstatement you have found could just be an anomaly. In all cases, present the initial findings to the contractor to see if there is an obvious explanation.

Often issues identified have a common feature, for example, type of transaction, supplier, or period of time. In such circumstances, identify all items in the population that possess the common feature and extend audit procedures to those items.

Record your work, write it up and report. You never know who may need to access it after.

If you need a hand, please give us a call.