How to successfully mitigate financial risk during a healthcare construction project

Project planning can be an overwhelming task, especially for a business with core competencies that don’t include construction management.

Whether you’re considering a new addition to a hospital or redesigning and updating existing inpatient facilities, construction projects are costly investments for healthcare organizations and can introduce considerable risk, including cost overruns, environmental risks, and project schedule delays. In addition, organizations also should consider adherence to new healthcare laws and insurance coverage requirements.

As part of the construction program planning process, organizations must evaluate a list of requirements and details, including available funding, end-user and patient needs, and staffing requirements. At the foundation of any construction project, cost management is one of the most important factors in overseeing and implementing a successful project. Prior to breaking ground on a healthcare construction project, it’s important to consider two key questions:

• What are some of the most common construction project risks our organization will face?
• How can we minimize our risk exposure?

A project scope that’s well defined is fundamental to cost management and project success. An effective project schedule will contribute to cost efficiency and timely delivery of needed results. Every aspect of the project both impacts and is impacted by project cost and related financial exposures.

Financial risk exposure

Construction projects most commonly experience financial risk exposure in three main areas: excessive labor, equipment, and change order costs.

Labor

Labor typically accounts for much of a contractor’s billings. Labor overcharges pose a significant risk because these costs can be overbilled in a variety of ways.

The most common issues are labor charges that exceed actual take-home pay and the billing of unallowable labor burden components. For example, an audit of a new $34 million healthcare facility revealed the project experienced $122,000 of unallowable labor charges for duplicated paid time off. The contract specified that the agreed-upon labor rates included customary benefits such as vacation, holiday, and sick pay; however, the contractor charged hours to the project while utilizing paid time off, resulting in duplicate charges.

Similarly, another $26 million project incurred $28,000 of labor overcharges because rates charged to the project significantly exceeded the actual take-home pay verified with payroll documentation. Also, it isn’t unusual to find allowance costs, such as vehicle or per diem allowances, included as part of the labor cost. During review of a hospital patient tower project, $26,000 of allowance costs were billed as part of the contractor’s labor, although it wasn’t approved by the owner.

Equipment

Construction equipment is another high-risk area that healthcare systems and organizations should be aware of. Charges for equipment can be for contractor-owned items or third-party rentals. The healthcare facility project mentioned above included overbillings of $242,500 for equipment rental costs that exceeded the purchase price.

As a project owner, it’s important to understand the importance of obtaining appropriate and verifiable cost support for all project costs. Further, focus on the big picture. For example, buying versus renting can save thousands of dollars over the life of the project.

Change orders

Change orders, which modify the project scope or cost, can be one of the most problematic construction cost areas. Contractors and subcontractors often bill for costs without providing supporting documentation, or they bill for costs in excess of what’s allowable according to their contracts. For example, a $26 million replacement hospital project included $922,000 of unallowable contractor and subcontractor supervision, overhead and profit, fee, and insurance costs as a result of a lack of knowledge of contract terms and controls surrounding change order review.

Protect your project

It’s natural to ask, what’s the best way to mitigate these risks? A three-pronged approach including a well-defined contract, a strong control structure, and an internal audit plan that includes construction audits is fundamental.

A construction contract should always define allowable costs and controls as mandated by the owner for the review and approval of all project costs. Other items to include:

• Right-to-audit clause. This should be sufficiently clear to enable efficient and complete auditing of project charges.
• Final project accounting. This should be a requirement that allows you to reconcile billings to actual cost incurred.
• Strong controls. Include, at a minimum, project reporting requirements, communication and approval authority expectations, and documentation required for payment applications and change orders. Implementation of strong controls over contractor and architect activities and internal organization-wide policies and procedures can greatly reduce project risk.

Outside cost auditor

An external construction auditor can provide an independent assessment of a construction project’s financial risks. Construction cost auditors are beneficial for healthcare organizations that:

• Have a significant capital program or project
• Have multiple key stakeholders or various funding sources
• Don’t have the in-house expertise or can’t make the time commitment to review project costs
• Don’t have established policies and procedures for construction controls

Each construction audit is different; however, the average cost savings ratio is 15:1. The potential cost savings and recovery greatly outweighs the cost of a construction audit and allows for peace of mind.

The risks identified above are common for healthcare construction projects, and they span all contract types and their components, such as a stipulated sum and guaranteed maximum price. Conducting construction audits on a periodic basis — at the beginning of a project, the midpoint, and at the close-out phase — can help you with early cost prevention and cost recovery as well as provide an assessment of controls that can be strengthened, so your project has every opportunity to succeed.