Open book accounting
Open-book accounting is a method of procuring work under which contractors are reimbursed on the basis of transparent records of the costs they have incurred. It is generally associated with incentivised target-cost contracts, management contracts and framework contracts, but can also be applied to the first stage of a two-stage, fixed-price contract. Transparency can apply to the main contractor (whose direct costs may only amount to 20% of the total construction cost) who procures tendered, fixed-priced sub-contracts that are not open book and/or down the whole supply chain for every party involved in a project.
There is no industry standard as to how incurred costs are recorded. Some public sector framework agreements and civil engineering contracts carry standard formats but in the majority of cases it is a matter for the client to be given access to the contractor's records and accounting systems and then agreeing how costs can be monitored and audited using data output from such systems.
Collaboration and trust are paramount to success under such arrangements. Clearly the client must be satisfied that codes are being used that separately allocate accounts, hours worked and invoices paid project by project. Where costs are shared, such as head office staff and overhead costs, these need to be analysed on an annual basis and then pro-rata'd to the client's project. This should be agreed prior to the start of construction. Normally overheads are expressed in the form of a percentage against the total specific project expenditure running through the contractor's books. The agreed profit needs to be determined at the outset on the basis of the amount of risk being taken by the contractor and market forces. Profit can be paid as a fixed, lump sum or as a percentage on the same basis as overheads. It is best to agree that profit covers pension contributions and finance charges, whether corporate or a project cost.
- All trade discounts and other credits such as insurance claim receipts should benefit the client. They may well be recorded separately from the expenditure systems. Some discounts may be paid annually and apply to purchases across all projects such as brick orders, so they need to be tracked and proportioned.
- Care should be taken that the contractor is achieving value for money in obtaining prices. This means random market testing. Relationships with subsidiary companies can give rise to a conflict of interests.
- Any cost associated with rectification of defective work is normally disallowed.
- Having defined what is a head-office overhead, it should not then be duplicated in the reimbursable element. Examples might be; a visiting safety inspector, or transport costs between the head office and site.
- Unauthorised or overpayments to sub-contractors should not be reimbursed.
- Costs incurred through contractor negligence should be challenged, though items such as poor planning, over ordering and wastage might be fiercely contested.
Auditing is within the skill set of either a professional quantity surveyor or an accountant. Both will require experience and knowledge of construction contracting. Detailed understanding of the contractor's cost systems and project procedures is essential. This will include:
- Code numbering systems.
- Site records.
- Allocation sheets for labour and plant.
- Bonus and non-productive overtime payments.
- Valuation and payment to sub-contractors including claims and variations.
- Inter-company charging.
- National agreements with unions, suppliers and sub-contractors.
- Discount credits.
- Insurance claims.
- Policy on accruals.
- Random market testing to ensure pricing has obtained fair value.
- Changes in legislation affecting cost.
- An understanding of the contract conditions.
This requires routine site and head office inspection of documentation.
Some public sector authorities look to tender schedules of unit prices with or without inflation criteria. In particular this can apply to framework contracts, or where work is of an unknown quantity but its general scope can be identified. In such cases a document requesting unit prices against various specifications and quantities is sent out to selected contractors for tendering, together with percentages to be applied for overheads, risk and profit. As the project reaches the point of starting construction, the contractor commences work on the basis of measurement of quantity applied to the appropriate unit rate. This saves a lot of auditing since the majority of payment to the contractor is based on quoted pricing and not actual cost. Open books will be required to demonstrate quantities involved and the unit rate applied. However there will be the question of items for which there is no appropriate rate. Generally this is settled by transparency of accounts and open books to establish actual costs.
Although open-book accounting is about actual costs, very often a target price is set on the basis of a shared risk formula. In effect the client and contractor share any gain by notional savings of actual costs against the target, or any pain through notional losses. The formula is normally set as a stick or carrot against fees or profit. There are usually cut off levels, so for example, a sliding formula set at a 3% base fee for the target price might be capped at 4.5% as a maximum and 1.5% as a minimum. The target price will include allowances for contingency and inflation. It will be subject to adjustment if the client introduces variations to the base scheme against which the target price was agreed, providing the variation is deemed to have a significant effect on actual cost. The advantage of a target-cost arrangement is that it incentivises the contractor to build within the budget and achieve savings whenever possible. Some fee is guaranteed and the reimbursement of cost removes the element of contractor risk that so often leads to adversarial relationships.
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