Common Construction Fraud Schemes and How to Combat Them
A report by the Association of Certified Fraud Examines stated that the average fraud loss among construction firms is about $240,000, twofold that of other industries. Construction companies and contractors seem to be most prone to fraud schemes. The lack of financial expertise on both owners and contractors is the main reason for fraud.
Also, it occurs mainly because of the nature of the work since the average construction project is the midpoint of controlled chaos. In fact, all financial activities are usually overseen by a controller, bookkeeper, or CFO. Unfortunately, there’s no owner oversight and internal controls are lacking, making it easier for financial staff to commit a range of fraud schemes.
Read on and take a closer look at some common construction fraud and discover ways how to combat them effectively.
Understanding the Most Common Construction Fraud Schemes
Fraud seems to occur more frequently in the construction industry compared to other industries, and it’s easy to determine why. A construction project has a good number of various project members with tons of moving parts. The current system for payment and construction financing is both in chaos. What’s even more surprising is that the transparency and communication on many construction job sites are practically non-existent. On top of everything, there’s an unlimited number of ways construction fraud schemes can happen at any point during the development of a project.
Without knowing and understanding all common types of fraud, it’s hard to detect fraud quickly or even to develop effective means of preventing it. Below are some of the most common forms of fraud schemes that you need to know.
1. Bid-Rigging (Collusion)
It usually occurs during the bidding process. It often involves collusion or price-fixing amongst the prospective contractors and subs. This type of construction fraud typically occurs when contracts will be granted by soliciting competitive bids. When the bidding is somewhat tainted, it dents the entire process, which is considered illegal!
If you are keeping up with the current events, you will know that it’s common for bid-rigging schemes to include or involve public authorities.
Here are the four main bid-rigging tactics that could be employed:
· Bid Suppression
Bid suppression is self-explanatory. It is when bidders are bribed, threatened, or otherwise convinced not to continue bidding a particular job. It can be a mutual agreement, lucrative payouts, or even by threat of violence.
· Complementary Bidding
It’s similar to bid suppression. However, with this type of bidding, competitors prearrange who will win the bid. The other bidders may submit high bids or bids having unacceptable added terms to improve the illusion that there’s genuine competitive bidding. In all honesty, this fraud can be seen as a creative form of bid suppression.
· Bid Rotation
Every participating competitor will take a turn to be the lowest/winning bid on the project. They arrange everything, letting each other know the individual pricing to guarantee the desired outcome.
· Promising Subcontracts in Exchange for Bids
Another possible way bids may be fraudulently rigged is for a particular party to convince some other bidders to lose their bids intentionally. They can be asked to withdraw in exchange for huge subcontractors on the job. Whoever wins that contract must promise the contemporaries subcontracts under that agreement.
2. Falsifying Invoices and Payment Applications
The falsification of both invoices and payment applications is one of the most common types of fraud schemes in the industry. It mainly accounts for over half of all fraud in the construction industry, occurring at the payment chain.
Here are the four common methods that payment applications and invoices are manipulated:
· Inflating Labor or the Material Costs
This fraud may happen anywhere along the payment chain at any level. Those placed at the bottom of the chain might inflate costs or perhaps the percentage of work being completed. Doing so will boost their profit margin, and the party might try to exaggerate or hide what’s being paid to the suppliers and subs.
In a worst-case scenario, the material costs or labor may fluctuate multiple times, and by that time, the payment application price can reach the top level.
· Improper Wage Rates
In most cases, the subs try to charge a journeyman rate for the job that the apprentice has performed. Also, they may charge you rental fees for the equipment they had already owned.
· Payment Applications that are excluded in the Scope of Work
The top chain parties can receive any payment applications, no matter the project size. The parties are processing each application as they come in. However, parties may manipulate payment apps by entirely making them up or putting additional work into the original scope, possibly changing the project timeline. It’s a practical move to deploy software that helps you track down all details, from the least important ones to the most critical data.
· Billing for Unperformed Work
This fraud is self-explanatory and a lot easier to keep in check if you execute a proper oversight. The contractors and subs may overstate the labor, equipment, or production units used on the project.
3. Manipulating Change Orders or even the Schedule of Values
Compare to the contract and initial bidding process, change orders are typically given less scrutiny. Hence, it makes change orders quite unsafe and susceptible to fraud, especially if not properly monitored. For the record, change orders can be issued for the contract’s work scope or the other way around. However, a change order includes improper price reductions and excess charges for any substituted materials and work. So the moment change orders stack up fast, fraud breeds quickly in the chaos.
Another aspect of a particular project that can fully be manipulated is the schedule of values. Failing to update your Schedule of Values frequently may lead to various issues down the line. Whenever buyouts or changes are made, it increases the likelihood of fraud and cover-up. Hence, using subcontractor scheduling software is becoming vital since this application allows you to track and then update details about the schedule of values, effectively protecting you from any form of fraud.
4. Diverting Lump-Sum Costs to Time and Material Costs
It may happen whenever the project’s budget includes items in the lump sum calculation. However, a particular item is already billed later on by the contractor or sub on a time and material basis. Since the work has been accounted for within the budget and then billed later on, it directly results in double-dipping.
5. Substitution or Removal of Equipment and Materials
Another form of the construction fraud scheme is through removal, substitution, or a basic exaggeration of materials used on the project. For instance, a contractor or sub may promise to utilize a specific brand of material or particular equipment. However, the modus is to substitute it with a much cheaper one, thus, pocketing the difference.
Anytime equipment or any material is going to be delivered on-site. Firstly, you must request receipts from the sub and confirm the brand and exact quantity directly from the suppliers. You can trust, but you need to verify first. That’s the rule.
Also, keep track of all equipment and materials needed for the projects using scheduling project software. Whether it be equipment or tools already owned, leased, or purchased — keep a detailed and running inventory of everything.
How Can You Combat Any Construction Fraud and Protect Your Project From It?
The best way to prevent fraud in any construction project is careful oversight both by the management team and the owner. Take a closer look below at some ways how to protect your team from any potential fraud schemes.
1. Due Diligence
When hiring a crew for a project, make sure to do due diligence. Try to employ local and well-established contractors to minimize the possibility of fraud. Ensure to perform background checks and get references on everyone. Try to do a quick Google search because you can search anyone and anything on that site.
2. Designating a Chief Compliance Officer
It’s a long task to perform due diligence on everyone involved in your team. Today, most construction companies elect a crew member and designating him as the Chief Compliance Officer. This officer acts as a bridge point between the owner/management team and the contractors on the project. Your very own compliance officer will both conduct initial investigations as well as to conduct frequent reviews.
3. An Inventory management system will help you
Despite the emergence of software that aims to help different industry functions like workforce management, lien management, and field operations, many construction companies are still lagging behind and still combatting construction fraud. Managing tools and equipment has been one of the challenging tasks to do in the industry. If any of it isn’t properly managed, it will directly affect the two largest factors — labor and materials. That is why it makes sense to exert effort in supervising and maintaining it to prevent loss and theft.
Construction site theft has always been a common issue and is considered fraud is usually done by some crew members. Project managers often faced this every time since most job sites don’t deploy an effective security system or even use any software that tracks down all equipment and tools.
Only an inventory management software like Pro Crew Schedule can help you solve those pain points. This inventory management solution will show you who checks out a specific tool for use, the tool’s location, how the tool is being used, and which tools are yet to be returned.
You can use all data to determine where each piece of equipment is located, helping you manage your inventory efficiently. And most importantly, the collected data gives you enough information to identify which of your employees are exploiting and stealing tools and equipment.
Pro Crew Schedule offers a LIVE demo experience, and it’s FREE! Check it out and start exploring its features!
Key Takeaways
How you supervise yourself and your company’s financial affairs will be directly reflected by the people who work for you. If your employees notice you taking kickbacks, overbilling, or cutting corners, they will do the same thing. Instead, run your construction business fully above-board. Build internal controls and always be fair to your employees, vendors, subs, and your clients. Doing so will let you build a good reputation in the industry, protecting your company against fraud schemes.
