Why, How, and When to Audit Contractor Performance
The need to audit contractor performance and compliance is something I’ve encountered often. In fact, two client questions have come up on every contractor audit and consulting project I’ve led since 1992:
- “How can we do a better job of monitoring and managing our contractor relationships?”
- “How should we take advantage of our audit team partners in the process?”
Almost every business organization uses contractors to perform tasks they don’t want to do (e.g., major facilities construction) or simply don’t know how to do (e.g., manufacturing robotics and automation). Of course, the need for contractors depends on the organization’s internal capabilities, but I’m confident you get the picture.
The cost-benefit calculation for retaining contractors usually rests on the answer to this question: “Why create it in-house with our limited staff and expertise if it already exists and can be retained as needed from outside?”
It’s clear there’s value in utilizing third parties, but with it comes the need for contractor compliance evaluation.
Why You Should Audit Contractor Performance
The challenge is that any third party, including contractors and suppliers, has their own key result objectives. And at times, their objectives may not parallel those of the owner. Occasionally, their objectives flat-out conflict with ours.
Here are a few examples of contract relationship risks:
- Implicit in any contractor relationship is billing and payment. Whenever a procure-to-pay cycle transaction occurs, there’s a risk that the wrong amount for the wrong work at the wrong time might happen. Contracts often represent major disbursement obligations.
- The owner (that’s us!) never has the contractor’s full story simply because the contractor has at least half of the relationship and related transaction records.
- Management objectivity is often impaired. It’s not intentional; it’s just human nature. A manager who sets the deliverables, selects the contractor, approves the contract, is responsible for monitoring contractor performance, and then reviews and approves the payments has a lot of skin in the game. If a problem surfaces, their signatures are all over the transaction documents going back weeks, months, and sometimes years. Just how objective can any manager be when they are a crucial party to building and overseeing the relationship?
- The contract and other “deal documents” may be flawed, outdated, or just plain inaccurate. This can happen because conditions change, costs move with market forces, field conditions are not adequately checked before contract approval, critical labor is no longer available—and a long list of other causes.
- Contract relationships have a long and storied history of shadow dealing. Large gifts, high-value entertainment, and outright fraud are not uncommon. They are not the norm, nor are they nonexistent. And internal controls have a limited impact on preventing and detecting nontransparent handshake arrangements.
Compounding these risks is the fact that an objective audit of contractor compliance remains the exception rather than the norm.
Compliance audits of significant contract commitments are just a good idea. A contractor audit determines whether agreed-upon contract terms are being honored, that contractor invoicing is proper, and that management’s faith and trust in the contractor remains valid. Ultimately, you should audit contractor performance to ensure a successful contractor-owner relationship.
How to Do a Contractor Audit
Before officially bringing on a third party, telling the contractor how to do business with the organization is essential. And that means including right-to-audit language in all documents. Once that’s agreed upon, the auditor can move forward.
Contractor audits for performance and compliance are conducted at several levels.
Periodic desk reviews of contract documents, including bids/tenders, proof of deliverables, invoices, and related support can be conducted quickly, in real time, and across the full spectrum of contract commitments.
Field audits can be conducted both on-site at contractor locations and increasingly in a hybrid format. On-site audits, where virtually all audit work is performed at the contractor’s site, provide the potential for the most comprehensive results. Easy access to transaction support, visual first-person verification of contractor activities, and one-on-one in-person interviews and meetings provide the auditor with the access needed to test and draw conclusions with minimal risk of missing something important. But with that full-scope on-site work to audit contractor performance comes additional costs, including travel for out-of-town and foreign locations.
Hybrid audits are usually conducted in three phases:
- The first steps include gathering and analyzing data prior to going on-site at the contractor. This includes contractor electronic uploads of data files that auditors anticipate they will need in their work. Of course, requests for data and slow contractor response can be a time-consuming, inefficient, and frustrating process. So, clearly defining what’s needed and communicating requests as early as possible is critical.
- Once the response is received, auditors need time to analyze this data, submit additional requests, select samples, and organize preliminary findings prior to step two—going on-site at the contractor.
- Step three involves all work remaining to close out the project. This work phase is typically performed back at the auditor’s home office location.
Advantages of a hybrid audit approach include minimizing the time and cost of travel to contractor sites and the scheduling flexibility to manage several contract audits simultaneously. Disadvantages include limited time with contractor personnel to build rapport, conduct in-person interviews, and pursue follow-up work while on site.
When to Audit Contractor Performance
There are several risk points in the contractor procure-to-pay cycle where auditors can provide measurable value-added service. Examples include analysis of internal budgets prior to soliciting bids, participation in the bid or tender review, at interim points during project performance, and certainly just prior to contact final billing and close-out. Management input regarding risk tolerance should be considered, as well as the following:
- Contract type
Balance is the key to determining when and how to bring a contractor audit into the picture.
Step Up Your Contractor Audit Initiatives
The suggestions in this article are implicitly high level. A much deeper dive into why, how, and when to potentially audit contractor performance and compliance is appropriate based on management input, audit risk analysis, and a dozen other factors. But the goal here was to provide a starting point for discussion and perhaps a soft nudge in the direction of stepped-up contractor audit initiatives in the coming year and beyond.
As always, contact Hall Consulting and let us know if we can help. We’ve performed audits of contractor performance for over 30 years.