Contractor Management Controls
There’s a great story about a town with a clock tower that rang every day at exactly noon. The man in charge of the tower called City Hall each morning to confirm the exact time before adjusting the clock. Everyone in the town knew for certain when the tower clock rang; it was straight-up 12:00 noon. One day, after many years on the job, the bell tower man happened to ask the city hall clerk how he always knew the exact time. That’s easy, the city hall clerk replied, I rely on the clock tower.
This circular logic is how many large, otherwise sophisticated manufacturing plants manage financial accountability over their industrial contractors. They create a PO and send it to the contractor. The contractor performs the work, keeps track of hours, equipment and materials used, then prepares and submits an invoice. The contractor is both the bell tower and City Hall. Contractor invoices are often in error (it’s not really 12:00 noon). The hours are inaccurate and the rates or math are wrong. It’s not unusual for the error to equal 10% of the average invoice. The planning and scheduling, and execution of the work are first rate, but the financial control needs upgrading.
This business problem has been in existence for over thirty years, with little improvement. If anything, the problem looms larger because of a renewed emphasis on financial responsibility as a result of Sarbanes Oxley. The huge increase in outsourcing hourly labor work has also magnified the problem: the error rate has stayed the same while the volume of contractor spend has risen ten-fold. The result is hundreds of millions of dollars in overcharges across any single industry.
The following results from an actual audit of the top five contractors for a single refinery site shows a 14% overcharge rate in dollars, and 10% in hours.
How can this problem be so widespread, particularly in the manufacturing plant industry where great strides have been made toward 99.999% reliability? The answer is simple but the solution is not. Except for the occasional historical audit, there is no easy way to know that error exists, nor is it easy to measure its impact on the bottom line. It takes a great deal of effort to inspect contractor timesheets and complete accuracy is difficult to attain. For example, who can remember if the person who clocked out four hours early six months ago was really sent on an errand or just left early? Audits also do not provide value for managing plant contractor expenses in real-time. It usually takes 30-45 days at best to even receive a contractor invoice and longer to validate it.
The fact is that a contractor may be great at executing mechanical work, providing IT support, or performing administrative duties but he or she is not the world’s best time keeper or cost accountant. Yet, the owner is completely dependent on the timesheets and invoices offered by the contractor. ERP systems can automate much of the payment process; however they can not and do not evaluate the quality or accuracy of the hours reported by the many contractor firms demanding payment. Instead, payment authorization is granted by the owner’s field supervisor as the first (and often only) line of defense against contractor timesheet and invoice errors. Unfortunately, the supervisor truly has no way of knowing if the hours on the timesheet are right. Assumptions are made by everyone involved, and the result is a normative 10% error rate. When a plant spends $100 million in contractor costs annually, that comes to $10 million spent unnecessarily.
Why does this problem persist? In order to achieve financial accuracy, all the pieces of the puzzle must be in place and connected. All too often the pieces reside in separate silos and under disparate authorities. For example, the timesheets are the responsibility of the contractor foremen and timekeepers; gate logs are kept by security and facilities; individual schedules are managed by the contractor; contract terms and conditions are in a file drawer in procurement; and work orders and purchase orders are locked inside of a project management system. Although the latter two are captured in ERP systems, they have no basis for validation of costs in real-time.
Of course, it is possible to manually spot-check gate logs and compare them to timesheets, or write a program to do so. Various time and attendance programs often perform some combination of these activities. Unfortunately this presents a false sense of security and accuracy. Neither gate logs nor timesheets reliably account for the contractor who shows up early for coffee or spends extra time getting to the actual work site from the front gate. A scant fifteen minutes is actually 3% of the workday. Multiply that by $50 million dollars and you have $1.5 million in overpayments due to what could be called fuzzy time.
What about the individual who badges in and works even though he wasn’t assigned (required, given the work orders scheduled for the day)? The only way to catch these errors is to perform a multi-way comparison between:
- the perimeter security system badge time in and out,
- the contractor’s dispatch log (shift assignment) for each craftsmen,
- the contract Terms & Conditions (business rules) concerning show up early/late; leave early/late
- cumulative time-on-site for the work week to automatically calculate Straight and Premium time
- And a half dozen other variables.
Ironically, it is the contractors timesheets currently the foundation of determining pay that’s the least reliable.
Determining accurate hours spent on work is only half the solution, however. It’s impossible for your first line folks (foreman, supervisors, and contract administrators) to know the terms and conditions of the hundreds of contracts. Yet it is critical to have a clear understanding of the subtle complexities of every contract in order to determine, for example, when overtime is to be paid. For example, a contract states overtime is paid after 40 hours of work a week, regardless of where those hours were worked. So, if the worker put in 39 hours at Client 1 during the first four days of the week, and 8 on Friday at a Client 2, the second client pays 1 straight and 7 overtime hours! While this would be nearly impossible to validate by any measure, it serves as a convincing example of how important contract terms and conditions are to the accuracy of expenditures. Even though contracts are generally complex, replete with vague legalese, incomprehensible commercial terms and conditions, and incomplete rate structures that lead inexorably to undetected time reporting and invoicing errors, they can’t be ignored.
So, the foundation for achieving financial accuracy on contractor invoices is:
1. Knowing when someone is scheduled to be on-site,
2. Verifying that information against when they were actually on-site, and
3. Validating the net result against the terms and conditions of contracts.
This can be done manually or with software, but it can’t be done sufficiently unless all parts are included.
The confident reader is probably thinking that unit pricing that darling of European processing industry avoids all of these problems. However the blush of utopia fades in practice. Unit pricing merely replaces the challenges of managing thousands of contractors with the even greater challenge of managing tens of thousands of unit conditions. Case in point: one plant had 120,000 conditions in a single contract, exceeding the capacity of their ERP system. The compromise, a mix of Unit Pricing and Time & Materials, with a little Lump Sum thrown in for good measure, inevitably leads to change orders and a call for the same rigorous attention to cross-checking and validation that pure time & material contracts demand.
That leaves us with the question of how to definitively eliminate inaccuracy in contractor invoices. Financial accountability demands we can no longer accept not knowing about the problem. The common method of auditing selected contractors provides a historical snapshot, but is subject to the ability of supervisors to remember the details of exceptions. It is also limited in scope.
The alternative to an historical audit is to create a process that prevents errors in the first place. Most homegrown processes only address part of the problem, at best, and simply automate faster pay of inaccurate invoices at worst. For example, linking the gate access system to the time and attendance system is a step in the right direction, but time on-site is not the same as billable time and speaks not at all to straight time/premium time split. Thus, these types of processes are usually more focused on automation than accuracy. As a result, they capture only half of the errors in labor, and none of the errors for equipment and material.
Only a process that compares time sheets against gate access data, but also verifies them against contractor schedules, and then validates the net time against the contract terms and conditions can achieve the desirable 99.999% accuracy.
Once a process is in place that accurately tracks who is on-site, who is supposed to be on-site, and how much time they are allowed to bill for, it is easy to include data about safety certifications and expirations for those individuals, thereby meeting OSHA 1910 requirements as well. Add work order allocations and delay codes, and the system becomes the foundation for measuring and improving productivity and wrenchtime. While not required, the ability to link to a plant’s ERP system is beneficial, eliminating duplicate entry and allowing for quick entry of calculated costs into accounts payable.
In an ideal situation, real-time costs are completely accurate so that contractors and owners can agree on the costs on a daily basis. This eliminates the need to wait for an invoice and many companies have been able to negotiate quick pay terms of 2%. From the contractor’s point of view, they are relieved to know that the amount paid was exactly the amount earned and that there is no danger of receiving a letter demanding credit some months in the future.
Using this type of process, one contractor was able to reduce a $16 million accounts receivable balance to > $10,000. A major refiner, at one of its larger refineries, was able to reduce contractor timekeeper headcount from 13 to 3 after implementing a more reliable and automated process. The juice is worth the squeeze is how one way of saying that the effort of putting a reliable tracking system in place is well worth the financial rewards. It is absolutely possible to achieve complete, real-time accuracy, pay the right amount on a timely basis and at the same time use the associated data to improve operations, maintenance and construction in your business.
Bob Harrell is a process industry financial executive with over thirty years experience in internal auditing and consulting. He has also been on the other side of the table as CFO and COO of a large contract services company. Bob founded Management Controls, Inc. in 1989, and began working with some of the largest refining and petrochemical companies in the world in 1990 to design an automated real-time contractor management system, Track Software, now in its fifth major release. Every day, Track Software manages over 15,000 contractor companies, 25,000 contracts, 120,000 contract personnel and over $1 billion in contractor spend. Mr. Harrell is a frequent speaker at audit associations, contractor management events, and industry trade shows. He can be reached by calling 281-590-5881 x111.