Strategies to Control Your Health Care Organization’s Construction Budget

Construction projects represent a large portion of a health care organization’s budget, with costs running from thousands-to-millions of dollars. Projected budgets can increase due to common program pitfalls, including cost overruns resulting from ineffective procurement practices, schedule delays that impact operations, or penalties for noncompliance with state or federal regulations

As the COVID-19 pandemic continues to impact the health care construction industry, controlling budgets and properly managing projects has become exponentially more difficult for both owners and contractors. Projects are subject to constantly evolving work situations, which can translate into costly change orders and schedule increases. 

Additionally, expertise in construction programs and the related controls aren’t typically core competencies for hospitals and health care organizations, which can lead to costly errors and oversights.  

One way to keep projects in check is for organizations to engage with an experienced construction audit and health care team and develop a capital program assessment plan. Developing capital-program-assessment strategies during the planning phase of construction can promote cost containment and improve risk management throughout the capital project’s lifecycle, while saving time and energy spent on potential ambiguities during later phases of a project.

Here, we outline details of the process and key benefits for your health care organization.

Contract Types

Contract-type selection can be as critical to managing budgets as competitive bidding procedures. Understanding the different contract types available to your organization, and potential risk areas for each, can help increase transparency and accountability between parties. The most common contract types include the following.

Lump Sum Contract

Under this contract, a lump sum price for all work is agreed upon before a project begins. These types of contracts can be a good fit for smaller and less complex projects because the contract terms offer organizations less liability and exposure for cost overruns.

However, lump sum contracts, if not properly procured, may include higher markups, increased change orders, and inadequate material quality.

Time and Materials Contract

Under a time and materials contract, the organization pays a contractor for time spent performing at unit rates that have been predetermined by both parties in advance. The main advantage is transparency because contractors need to give a breakdown of every cost billed for as well as a labor summary. This type of contract is used when it’s difficult to get an accurate estimate of the total project cost, when the schedule cannot be defined, or when changes are likely to occur during construction.

Like lump sum contracts, these contracts are often a good fit for smaller projects that have adequate owner supervision. However, if not properly managed by an owner, projects under these contract types may encounter low productivity, resulting in schedule delays and increased construction spending.

Cost-Plus Contract

Under these contracts, organizations agree to pay a contractor for defined allowed expenses, which can include subcontractor work, labor, materials, and equipment—plus additional fees to allow for a profit. This type of contractual arrangement contains aspects of both cost-reimbursable and fixed-price contracts. Like time and materials contracts, the value of the contract isn’t defined when the contract is awarded, and the project cost will depend on time and costs incurred to complete the project. These contracts don’t have to wait for an exact estimate, so the project can generally commence quicker than guaranteed maximum price (GMP) contracts.

The benefit of a cost-plus contract is that the project will result in what was intended, even if costs run high. Also, if actual costs are lower than estimated, organizations get to keep the savings. However, like time and material contract types, cost-plus contracts can also be subject to reduced productivity and schedule delays, so they require additional oversight by the owner. 

Cost-Plus: Guaranteed Maximum Price Contract

Guaranteed maximum price (GMP) contracts state that contractor compensation is based on a fixed fee, or agreed-upon fee and overhead percentage, and that the total cost won’t exceed an agreed-upon limit. These contract types are most common for larger and more complex projects, such as hospital expansion renovations and new, large-scale initiatives.

GMP contracts may suffer from poor cost-of-work definitions that result in a lack of controls surrounding budget and cost, but these risks can be mitigated with an experienced project team and controls. When GMP contract types are effectively procured, they can increase transparency, promote accountability, and help management control project costs and manage timelines.

Choosing the Right Contract Type

Especially with the added challenges of COVID-19, each contract type needs to be evaluated thoroughly. Common assessment factors include project size, scope complexity, and duration.

Keep in mind that large, complex projects typically have a higher risk profile, and GMP contracts, when coupled with competitive bid procedures and strong cost of work definitions, can help owners manage project budgets and control costs.

Bidding Procedures and Delivery Methodologies

Obtaining comparative bids on contractor work can help your organization secure competitive pricing for a complete project. Best practice is to obtain three bids. This is enough to provide an effective comparison between contractors and subcontractors and drive cost competitiveness without being overly burdensome for the contractor, owner, or developer.

For complex projects, implementing design-build construction delivery methodologies can help key project team members better collaborate, likely resulting in reduced change-order risk during the project.

Cost-of-Work Definitions

Owners and builders are still navigating compliance and safety requirements as the COVID-19 pandemic continues. Construction costs are likely to increase—in particular material costs are expected to rise, labor costs are projected to increase in response to productivity decreases, and costly schedule delays are anticipated due to supply chain disruptions and additional safety implement requirements.

That’s why clearly defined contracts are essential for all parties involved. For contracts that don’t have fixed costs, it’s especially important to have agreed-upon terms and definitions. Clearly defined terms can also provide guidelines and starting points for project participants who find themselves in disputes—whether midstream or post-completion.

Here are five ways to mitigate the risk through careful use of contract language.

1. Include Competitive Subcontractor Bid Procedures

If you’re an owner or developer, it’s important to articulate the importance of obtaining comparative bids on all subcontracted work to help ensure competitive pricing. This is especially important if a contractor self-performs work. Without this clause, there’s no way to know how competitive the pricing is.

For contractors, this clause is an effective way to validate subcontractor cost competitiveness in the event of an audit—which will likely be required by most contracts.

2. Clarify Allowable and Unallowable Labor

One of the most effective ways to manage project cost is to clearly define allowable and unallowable labor rates along with the associated burden. This generally includes determining if labor charges are based on actual wages or predetermined rates as well as defining on-site versus off-site requirements. These procedures can help all parties understand which costs are directly associated with, and billed to, the project and what rates are compliant with the contract.

Adding an owner or developer approval requirement for non-approved labor types further protects each party from unanticipated costs or audit exposures. Without this clarification, it’s easy to get into gray areas that can quickly turn into cost disputes or overruns.

3. Set Rates and Caps on Contractor-Owned Equipment

If equipment costs aren’t controlled by the contract from the outset of a project, rates can easily become excessive. By establishing set equipment rates, allowable equipment charges, and charge caps, developers and owners can be more protected from unexpected overruns.

This may include defining whether rates are charged hourly, daily, weekly, or monthly, and it typically involves adding an owner or developer approval requirement for non-approved equipment types. 

This clause also shields contractors from potentially being exposed during a contract audit, especially if minimum reporting standards are written into the contract. This is because all necessary documentation is understood from the outset of the project.

4. Define Change-Order Reporting Requirements

Change orders aren’t uncommon, so they should be anticipated and managed accordingly in the project contract. This can be achieved by defining a mutually approved price, agreed-upon unit pricing, or an itemized backup requirement for change orders with actual cost.

If change orders aren’t billed based on actual costs incurred, the quotes or estimates provided by the contractor could be more than the actual cost of the scope change. Requiring validation to back up the change order helps verify the cost of those changes aren’t artificially inflated and, just like the previous step, it also protects contractors from potential exposure during a contract audit.

5. Add a Right-to-Audit and Accounting Records Section

Incorporating a clause stating that project costs are auditable can help establish the expectation that all costs sent to the owner or developer can be reviewed, audited, and validated for contract compliance.

Without this wording, contractors may not be contractually obligated to provide developers or owners this information, even if it’s requested. Additionally, if contractors aren’t aware that this level of documentation is expected from the outset of a project, they may not have it available.

We’re Here to Help

If you’d like more information around navigating construction contracts, contact your Moss Adams professional.

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