OPEN BOOK ACCOUNTING - The QSi



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OPEN BOOK ACCOUNTING

By

Roger Knowles and Mike Gregson

BASIC CONCEPTS

The Need for Open Book Accounting

There has in the past few years been a consistent move away from lowest price tendering. Contracts for construction work are now regularly placed on the basis of best value. In place of a tendered sum for carrying out the work being the preferred method of payment, contractors are frequently reimbursed on the basis of their recorded costs. In using this method of payment many of the matters which lead to disputes no longer exist. Arguments relating to the value of variations, disruption and extended preliminaries resulting from time overruns no longer occur when the contractor is paid in accordance with the costs incurred. To avoid inefficiency it is necessary for proper methods of cost recording to be developed which are easily capable of being checked. This will involve agreement being reached at the outset as to the manner in which costs are recorded and a checking process put in place. To the recorded costs is added a profit

Target Price

To ensure that there are incentives in place so that costs are kept to a minimum it is usual for a target price linked to a gain/pain mechanism to be fixed at the outset. The recorded costs are measured against the target price and any saving shared between the contractor and employer in a pre-agreed manner. In like manner any over expenditure compared with the target is shared.

Basic Open Book Mechanism

The traditional method involves an agreed price for the work. Actual cost incurred by the contractor in carrying out the work is never seen by the employer therefore where the costs are less than the agreed price the contractor keeps the gain. In the event of the costs exceeding the agreed price the contractor incurs the pain. Where an open book system applies the gain and pain are shared by the parties based upon a pre-agreed mechanism.

KEY ELEMENTS

The key elements in the open book process comprise the following:

• Terminology

• Setting the target price

• Defining actual cost

• Cost recording

• Auditing the open books

• Reporting

TERMINOLOGY

Target Price

This is the agreed price against which the costs plus profit will be compared. It should be arrived at by agreement between the employer and contractor usually based upon information e.g. schedule of rates, overheads and profit submitted as part of the tender bid. If the contractor is requested to submit a target price with the tender bid it can become a lowest bidding method which is not the intention of the process. Therefore tenders are usually assessed based upon a price/quality matrix e.g. 30% price 70% quality. There is no industry standard method for calculating the target price it is usually a matter for agreement between the employer and contractor.

Adjusted Target Price

The target price is adjusted during the progress of the works to take account of employer’s changes and the cost of other matters which under the terms of the contract are the employer’s risk. The allocation of risk is one of the early decisions to be taken where an open book accounting process is employed.

Guaranteed Maximum Price

This is a prefixed lump sum contract price paid to the contractor for undertaking the construction the work. There is no provision for adjustment of the contract price except for changes required by the employer. It is unusual for contractors to agree to enter into contracts with no provision for adjustment in the price where costs may increase due to changes in legislation. Where work involves for example major alterations to services such as water, gas and electricity contractors often seek to exclude from the contract price the unforeseen cost of dealing with these services. Contracts none the less are often referred to as Guaranteed Maximum Price when in fact there are provisions for adjustment to the price for any number of specified events in addition to changes introduced by the employer. These are not therefore Guaranteed Maximum Price in the true sense of the word. It is therefore important where a contract is styled as Guaranteed Maximum Price for there to be a definition provided in the contract as to its meaning.

Risk

The contract, by the use of a risk register, will usually indicate which of the parties will be taking the identified risks. This represents a situation which may or may not occur. When calculating the target cost it is necessary to include a financial provision for the risks which under the contract the contractor is required to bear, for example unforeseen bad ground conditions. It will not be possible to produce a precise calculation but some allowance needs to be made. Clarity is the key here, defining who takes what risk.

Costs

The costs incurred by the contractor in undertaking the project. There is no industry standard by which costs are recorded it is a matter for agreement between the employer and contractor. Some standard forms e.g. Public Sector Partnering Contract and the ECC contain a schedule of cost components.

Contractor’s Profit

The level of contractor’s profit is agreed at the outset and may be a percentage added to the cost or a lump sum

Gain Share

This occurs where the total costs and contractor’s profit for the project are less than the adjusted target price. Any saving or gain share is shared between the employer and contractor usually on a pre-agreed percentage basis. The contractor is usually paid the gain share when work has been completed, the target price adjustments all carried out and the final cost for the project available.

Pain Share

This occurs where the total costs and contractor’s profit for the project are greater than the adjusted target price. The pain share is usually shared between the employer and the contractor normally on a pre-agreed percentage basis. On some schemes for example the NHS ProCure 21 the employer takes no share of the pain which is fully carried by the contractor. Employers are usually careful to ensure that costs in full for the project are not paid to the contractor if there is a likelihood that a repayment of the pain share is likely to occur.

Disallowed Costs

The contract will usually provide for some cost which is incurred by the contractor to be disallowed. For example it is usual for provision to be made to disallow the cost of rectification of defective work and excessive waste. Disallowed costs need to be defined at the outset and included in the contract.

Example

The target price for the project is £10m with no adjustment required. In the gain share scenario the cost including profit is £9m giving a gain of £1m. The gain share provides for equal shares for employer and contractor amounting to £500k each. The total payment to the contractor is thus £9.50m. In the pain share scenario the costs amount to £11m with the £1m over spend being shared equally. The total amount paid to the contractor is therefore £10.50.

SETTING THE TARGET PRICE

There is no industry standard for arriving at a target price. However by common practice it is usual to calculate the target price using the following building blocks.

• Unit costs

• Risk allowance

• Head Overheads

• Profit

Unit Costs

The unit costs may be calculated using a schedule of rates for work which is inclusive of labour, materials and plant. Measured quantities for the work are then applied to the rates to arrive at the unit costs. Where the target is fixed at a stage when little design work has been undertaken a more basic approach is often used by employing the floor area of the building and applying a rate per square metre for the labour, plant and materials. It is sometimes convenient to calculate the areas of the various elements such as cladding and roofs of the building and apply a separate rate per square metre for each element in respect of the cost of labour, plant and materials to provide a total cost for each element. These costs should always be inclusive of what are often referred to as site preliminaries such as the cost of site accommodation.

Where a large part of the work is to be designed and constructed by subcontractors the unit costs are often built up using quotations received from the subcontractors who will be undertaking the work.

Risk Allowance

The contract should be very clear as to how the risks are to be shared between the parties. This is often achieved by using a risk register. In building up the target price a sum should be included in respect of the risks which are to be bourn by the contractor. For example it is usual in times of relatively low inflation for the target price to include for inflation. On many contracts the contractor is required to include in the target price the cost of any ground conditions which may be encountered whether they are foreseeable or otherwise. A financial provision should be included in the target price for these types of risk. Where the extent of ground conditions which are anticipated to be unfavourable is unknown before work commences it is better for a provisional sum to be included in the target price which can be adjusted at a later date to take account of the contractor’s actual costs. It should however always be made clear at the outset as to which of the parties bears the risk.

Head Office Overheads

The head office overheads are usually provided for separately in the build-up of the target price. It needs to be made clear at the outset which costs are included under this heading and which are site costs. For example quantity surveyors may be site based and included in the unit costs whereas the commercial director and chief quantity surveyor may be head office based and form part of the head office overheads. It is usual for the head office overhead element to be calculated by the addition of a percent to the total of the unit costs

Profit

The profit is the reward paid to the contractor for satisfactorily completing the work. It is usually calculated by adding a percentage to the total of the unit costs, risk and overheads.

Adjusted Target Price

The terms of the contract should make it very clear as to the manner in which the target price is to be adjusted. Provision should always be made for changes introduced by the employer. There are often provisional sums included in the build-up of the target price. Examples are the removal of rock and running sand the presence of which is expected but the full extent unknown. Where this occurs the target price will be adjusted to take account of the contractor’s actual costs. The risk register will indicate the risks the employer will be bearing and the target price may need adjusting in the light of what has occurred during the progress of the works Whilst not inevitable, delays are often incurred as a result of some action or failure on the part of the employer and provision should therefore be made for adjusting the target price where this type of event occurs. It will always be necessary to carry out an adjustment of the target price before calculating the gain share or pain share.

When to Set the Target Price

With tender submission

It is not uncommon for the contractor to be required to submit the target price with the tender submission. Where the procurement route is for employer design a pricing document is often provided by the employers QS. With a design and construct procurement route the contractor will be expected to produce its own pricing document. This method can be a back door route to lowest price and not in keeping with the idea of best value.

After The Contractor Has Been Selected Prior to Signing of Contract

The selection process may require the contractor to submit with the tender submission the prices for overheads and profit. This is often extended to include the prices for site preliminaries. It is more challenging if the target price is fixed after a value engineering process has been completed where the contract provides for a distinct process of value engineering. On many contracts however value engineering is an ongoing process. To permit a major value engineering process to take place after the target price has been fixed provides little incentive to manage costs effectively.

The procedure for calculating the target price may occur at an early stage of design when the contractor is undertaking the design process. This should provide an incentive to ensure that the finished design produces the most cost effective solution. Where the design is undertaken by the employer it is normal for the design to be fairly well advanced before the target price is fixed. It would be unreasonable for the contractor to take the risk of the target price being too low due to it being based on an incomplete Employer’s design.

DEFINING ACTUAL COST

Contract Provision

In the early days of cost reimbursable contracts it was common for contractors to be paid on the basis of the costs as they emerged from the computer. This system was soon seen to be somewhat hit or miss and as a result the whole process has become more sophisticated. Contracts such as the ECC, Public Sector Partnering Contract and JCT Prime Cost contracts all provide a definition of the items which are to be paid for at cost.

Cost Components

The components which are to make up the costs should be agreed and included in the contract documents. It is not unusual for the contractor to be reimbursed the actual cost paid in respect of the items. Care should be taken however when paying the contractors actual paid out costs to ensure that the contractor is not overpaying. This may be the case where the contractor is using plant which is hired from a subsidiary company. It is not unusual for the contractor to be requested to include the unit rates to be applied to the cost components as part of the tender submission.

Supply Chain Costs

On most contracts a great deal of the work is undertaken by subcontractors which in some cases totals up to 80% or 90% of the total cost for the project. The system has not developed sufficiently to allow for many subcontractors to operate on an open book basis. It is usual for a price to be agreed with the subcontractors and this to be the basis for inclusion in the actual cost of the work . Some of the major specialists are however working toward the open book method and it will not be long before many of them are operating in the same manner as the main contractors. The supply chain costs usually include the supply of components such a windows and doors where the onsite fixing is undertaken by specialist subcontractors.

COST RECORDING

Cost Coding Structure

The better open book accounting systems are tailored and designed to sit as a framework in conjunction with the contractor’s current cost systems thereby minimizing business disruption and working practice changes. Each project requires an individual cost code and for all labour, materials, subcontractors accounts and plant employed on the project. The coding system should be sufficiently sophisticated to enable disallowed costs to be identified.

The conditions of contract such as the ECC contract and the Public Sector Partnering Contract provide for the contractor to be paid monthly using the recorded costs as the basis for payment. It is important that the contractors costing methods be understood where this method of payment applies. Most costing systems provide for the following:

• Labour costs usually included in the costing system weekly

• Material and plant invoices are recorded in the costing system once they are approved

• Cost of employing subcontractors is included in the costing system once a sum has been certified by the contractor’s quantity surveyor

• Costs to be accrued where a cost obligation is recognised but either the process of approval or certification is yet to be completed, or where a request for payment is not fully recognised but good housekeeping requires some provision to be made.

Discounts

The definition of cost should make it clear if the normal procedure of discounts being credited to the employer applies. This would include trade discounts, cash discount and discounts based upon the annual spend

Central Stores

Where materials are bulk purchased and kept in a central store a proper signing out procedure need to be in place to ensure that all materials which are used on the project are included in the costs.

Disallowed Costs

Most definitions of cost make provision for disallowed costs. Examples of disallowed costs are:

• Costs not justified by accounts and records

• Overpayments to subcontractors

• Payments to subcontractors due to delays caused by the contractor or other subcontractors

• Cost of correcting defects

• Material not used due to over ordering

• Plant standing idle for lengthy periods due to poor planning

Attempts are sometimes made to disallow costs relating to inefficient working. This can be something of a minefield as quantifying inefficiency is likely to lead to a great deal of argument which is normally discouraged.

Typical Question

Where the contract includes a definition of costs, disagreement can occur as to whether some costs fall within the definition and others which do not. For example:

Is the cost of cleaning out drains adjacent to a new lighting column a disallowed cost?

The correct answer is:

If it is builders rubble causing the blockage arising from the lamp column foundation the answer is yes the cost should be disallowed i.e. it has arisen from the improper execution of the works.

If it is silt or grit which has not occurred from the construction work the answer is no and payment should be made.

Preliminaries/Site Overheads

It is common practice for preliminaries or site overheads as they are sometime called to be included in a schedule form, priced by the contractor and submitted with the tender. Alternatively the prices are agreed by the contractor and the employer’s representatives after the contractor has been selected but before the contract is entered into. Items in the schedule include such matters as site management staff, site quantity surveyors, planners, site welfare, site accommodation, health and safety matters, power operated tools, site storage, protection and the like. It is important to ensure that there is no overlap between cost items included in the schedule of site overheads and the head office overheads.

Head Office Overheads

Most contractors have a head office which provides services to all its construction sites. These services include estimating, overarching supervision in the form of contracts directors and commercial directors, strategy from the board of directors and services related to advancement in technical, commercial services and insurance related matters. It is usual to include a percentage to be added to the unit costs and site overheads to provide for head office overheads

Profit

The profit is the contractor’s reward for completing the work in compliance with the terms of the contract. Profit is usually priced as a percentage addition to the total of the unit costs, site overheads and head office overheads. Sometimes it is expressed as a lump sum. Contractors are usually required to give an indication before selection as to the level of profit required if appointed to carry out the work.

AUDITING THE OPEN BOOKS

Skills Required

A combination of QS, commercial management and accounting skills are required to properly carry out an audit process of contractors open book methods which include:

• Knowledge of the construction industry

• Understanding the contract

• Appreciation of what is actual cost

• Understanding of accounting procedures including certification, accruals and the like

• A systematic approach to the work

Suggested Procedure

Definition of Cost

An adequate definition of cost may already be included in the contract. If not it will have to be the subject of an agreement between the parties. It will be important to differentiate between head office overheads in respect of which a percentage addition will usually be added and actual cost to ensure that there is no overlap. The definition of cost should enable the costs to be separately identified by resource such as people, equipment, plant, materials and other charges. Difficult areas are pension contributions and finance charges and how they can be allocated to individual projects.

Understanding the Contractor’s Cost System and Procedures

Typical matters to review:

• What is the project code numbering system

• How are costs recorded on site

• Work through examples by resource

• Become familiar with the contractor’s pro-formas

• What value of work is normally subcontracted; what are the subcontract terms; how is the work valued and paid for

• Visit the site and see the costing system working in practice.

Understanding the Contractor’s Accounting Procedures

Typical matters to review:

▪ How are discounts credited in respect of suppliers and subcontractors

▪ How are national agreements with suppliers and subcontractors allocated

▪ How are accruals dealt with

▪ How are intercompany charges managed

Agree an Audit Strategy

An audit strategy should be agreed which deals with two main elements:

• Ensuring that the stated procedures at site level are complied with

• Ensuring that accounting procedures are correctly applied at head office

Develop a table/proforma outlining what will be audited, by whom, when, what information will be required and what questions will be asked.

Some elements of the audit process will need to remain random.

REPORTING

It should be part of the auditing procedure for an audit report to be produced each month to coincide with the payment of the contractor. The object of the report is to inform the parties that established procedures are in place and are working efficiently.

Suggested Contents

• Introduction

• Audit rationale

• Persons involved

• Key clauses in the contract

• Management structures and procedures

• Key personnel

• Filing systems

• Job costing structure

• Procedure for setting budgets and financial reporting

Open book accounting procedures review

• Accounting systems

• Site and head office based procedures prior to systems input

• Accounting procedures involved in systems input

o Labour, plant and materials

o Site overheads

o Head office overheads

Adjustment to existing procedures to comply with the contract

Actual cost audit report

• Check that procedures are being complied with

• Results of audit check

Recommendations

EARNED VALUE ANALYSIS

This is powerful management tool for measuring whether open book accounting methods are delivering best value.

It relies upon comparing two essential elements on a regular basis namely the value and the actual cost

The value is based upon the build-up of the target price and is assessed on a regular basis such as monthly or quarterly. This is compared with the actual cost. The aim is for the value to be greater than the actual cost. A forecast of both the value and actual cost is prepared at the outset and applied to a graph. At this stage the value should be greater than the estimate of the actual cost. If after work gets under way the value starts to lag behind the actual cost there is time to correct the situation to ensure that by the time that work has been completed the value is greater than the actual cost.

WAYS OF ENHANCING ACTUAL COST

The success of open book accounting methods depends upon trust. However human nature being what it is those representing the employer need to be on their guard against error in the accounting processes. There have also been isolated cases of unscrupulous contractors who seek to enhance the actual costs employing none contractual methods to help increase the profit derived from the project. The following are examples where by accident or design actual costs charged were greater than the contractual entitlements:

Staff included in the head office overhead percentage claimed for as site overheads.

Inflated charges from subsidiary companies for services rendered on the project which include:

• Internal plant hire rates in excess of going market rates

• Heavy maintenance and repair costs of plant and machinery

• Cost of repairs to damaged plant without allowing a credit for the money recovered from the insurers

Over order materials without allowing credit for unused materials.

Failure to declare discounts allowed by suppliers and subcontractors.

Settlement deals with subcontractors which include the settlement of disputes on other projects.

TEST QUESTIONS AND ANSWERS

TEST QUESTIONS

Question 1

What are the usual basic components of the target price?

Question 2

Describe what is meant by gain share and pain share

Question 3

How does open book accounting differ from a tendered lump sum and what are its advantages?

Question 4

What is meant by Guaranteed Maximum Price?

Question 5

What are disallowed costs?

Question 6

How should a target price be calculated?

Question 7

What is an earned value analysis?

Question 8

How should the target price be adjusted?

Question 9

What unscrupulous methods have been used for enhancing actual cost?

MODEL ANSWERS

Question 1

1. Unit costs

2. Risk Allowance

3. Overheads

4. Profit

Question 2

Gain share/pain share is a mechanism to encourage the contractor to reduce costs and therefore assist in achieving best value. Gain share occurs where the total cost of the project and contractor’s profit are less than the adjusted target price. The saving or gain is shared between the employer and contractor usually on a pre agreed percentage basis. Pain share occurs where the total costs and contractor’s profit are greater than the adjusted target price. The pain share is usually shared between the employer and contractor on a pre-agreed percentage basis.

Question 3

Open book accounting is the process by which a contractor is paid for the work undertaken in accordance with its recorded costs. The traditional method involves payment in accordance with and agreed price for the work. Open book accounting usually eliminates many of the matters which lead to disputes on contracts let along traditional lines such as variations, disruption and extended preliminaries resulting from time overruns. To ensure that the costs are kept to a minimum it is usual for a target price to be fixed at the outset. The recorded costs are measured against the target price and any saving is shared between the employer and contractor in a pre-agreed manner. In like manner any over expenditure compared with the target is shared.

Question 4

This is a prefixed lump sum price for undertaking construction work where there is no provision for adjustment except for changes introduced by the employer. It is unusual for contractors to agree to enter into contracts with no provision for adjustment in the price where costs may increase due to changes in legislation. Where work may involve major alterations to services such as gas, water and electricity contractors often seek to exclude unforeseen costs relating to these services from the price. Contracts are none the less often referred to as Guaranteed Maximum Price when in fact there are provisions for adjustment in the price for events in addition to changes introduced by the employer. These are not therefore Guaranteed Maximum Price in the true sense of the word. It is important therefore where a contract is styled as a Guaranteed Maximum Price that there is a definition of its meaning.

Question 5

Where an open book accounting process is employed the contractor is paid in accordance with the recorded costs. It is important to ensure that employers do not have to pay for the contractor’s inefficiencies. On most contracts which provide for payment on an open book basis it is usual therefore that provision be made for certain costs which have been incurred due to the contractor’s inefficiencies to be disallowed. The cost of rebuilding work which was defective and had to be taken down falls into this category.

Question 6

There is no industry standard for arriving at a target price. It is common to calculate the target price using building blocks which comprise:

1. Unit Costs

2. Risk Allowance

3. Overheads

4. Profit

The unit costs may be calculated using a schedule of rates which are inclusive of labour, materials and plant. Measured quantities for the work are then applied to the rates to arrive at the unit costs. Where there has been little progress in the development of the design the target may be fixed by employing the floor area of the building and applying a price per square metre. It is sometimes convenient to calculate the areas of the various elements of the building such as cladding and roofs and apply a separate rate per square metre for each element. Where a large part of the building is designed and constructed by subcontractors the unit costs are often built up using quotations received from subcontractors who will be undertaking the work.

The contract should be very clear as to how the risks are to be shared. This is often achieved using a risk register. In building up the target price a sum should be included in respect of the risks which are to be bourn by the contractor. Some of the risk is often difficult or impossible to calculate with any accuracy for example the presence of rock and running sand below ground. It is better where this occurs to include a provisional sum in the target price which is later adjusted to take account of the contractor’s actual costs.

The Head Office overhead element is usually calculated by the addition of a percentage to the total of the unit costs. Care should be taken to ensure that there is no overlap between the unit costs for such matters as the onsite preliminaries and the head office overheads.

Profit is the contractor’s reward for satisfactorily completing the work and is usually calculated by adding a percentage to the unit costs, risk and head office overheads.

Question 7

The terms of the contract should make it very clear as to the manner in which the target price is to be adjusted. Provision should always be made for changes which are introduced by the employer. The risk register will indicate the risks which the employer will be bearing and the target price may require adjusting in the light of what has occurred during the progress of the work. For example the risk register may show that the employer is to take the risk of unforeseen ground conditions in which case an adjustment to the target price will be necessary should unforeseen ground conditions occur. A provisional sum may have been included for this type of risk and will require to be adjusted. Additional costs which result from employer generated delay will also require an adjustment to the target price.

Question 8

An earned value analysis is a tool for measuring whether open book accounting is delivering best value. It relies upon a comparison on a regular basis of the value and actual cost. The value is based upon the build-up of the target price and is assessed on a regular basis such as monthly or quarterly. This is compared with the actual cost. The aim is for the value to be greater than the actual cost. A forecast of both the value and actual cost is prepared at the outset and applied to a graph. At this stage the value should be greater than the estimate of the actual cost. If after work gets under way the value starts to lag behind the actual cost there is usually time to correct the situation to ensure that by the time work has been completed the value is greater than the actual cost.

Question 9

The following methods have been used either by accident or design to increase actual cost:

1. Staff included in the head office percentage claimed in addition as site overheads

2. Inflated charges from subsidiary companies for services rendered on the project which include, internal plant hire rates in excess of the going market rates; inflated maintenance and repair costs of plant and machinery; costs of repair to damaged plant included without allowing a credit for the money recovered from insurers.

3. Over ordering materials without allowing credit for unused materials

4. Failure to declare discounts allowed by suppliers and subcontractors

5. Settlement deals with subcontractors which include the settlement of disputes on other projects.

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